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Context:
- The Reserve Bank of India (RBI) has issued draft regulations for consultation to strengthen the regulatory framework for long gestation period financing for projects, including infrastructure, non-infrastructure, and commercial real estate sectors.
- Comments on the draft direction are solicited until June 15.
Proposed Regulations:
- The draft regulations aim to provide a harmonised prudential framework for financing projects, encompassing infrastructure, non-infrastructure, and commercial real estate sectors.
- It proposes revisions to the criteria for changing the date of commencement of commercial operations (DCCO) for such projects.
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What is date of commencement of commercial operations (DCCO)?
The date of commencement of commercial operations (DCCO) refers to the date on which a project or facility begins its commercial activities and generates revenue. It marks the point at which the project is considered operational and capable of producing goods or delivering services for sale in the market. DCCO is a significant milestone in project financing, as it often triggers the repayment of loans and signifies the start of revenue generation for the project stakeholders.
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Consultation Process:
- Comments on the draft direction are solicited from stakeholders until June 15.
- The consultation process allows for input from various stakeholders to ensure the regulations are comprehensive and effective in addressing the challenges of project financing.
Objectives:
- The overarching objective of the proposed regulations is to strengthen the existing regulatory framework for project financing.
- By providing a harmonised prudential framework and revising the criteria for DCCO, the regulations aim to enhance risk management and ensure the sustainability of financing for long gestation period projects.
Implementation Timeline:
- Following the consultation process, the RBI is expected to finalize the regulations based on the feedback received from stakeholders.
Purpose of the Project Financing Framework:
- Addressing Long Gestation Periods: Infrastructure projects typically have long gestation periods, increasing the likelihood of financial viability challenges.
- Diversifying Financing Avenues: Given constraints in meeting investment requirements solely from government budgetary resources, project financing from domestic financial institutions becomes essential.
- Importance of Domestic Financing: Project financing from domestic financial institutions, particularly for projects with longer payback periods, plays a crucial role in infrastructure development.
- Need for Longer Tenures: Depending on the scale and technology involved, infrastructure projects may require loans with longer tenures to align with their financial dynamics.
Challenges in Infrastructure Projects:
- Delays and Cost Overruns: Infrastructure projects often encounter delays and cost overruns, leading to significant challenges in project execution and completion.
- Magnitude of Delays: A review by the Ministry of Statistics and Programme Implementation identified delays in a substantial number of projects, with various factors contributing to these delays.
- Causes of Delay: Factors contributing to project delays include land acquisition, obtaining forest/environment clearances, changes in scope and size, delays in tendering and equipment procurement.
- Cost Overruns: Cost overruns are primarily attributed to underestimation of original costs, high environmental safeguard costs, and spiraling land acquisition expenses.
Significance of Addressing Challenges:
- Mitigating Financial Risks: Addressing delays and cost overruns is crucial for mitigating financial risks associated with infrastructure projects.
- Enhancing Project Viability: By streamlining financing mechanisms and addressing project execution challenges, the project financing framework aims to enhance the viability and sustainability of infrastructure projects in India.
- Promoting Economic Growth: Effective project financing frameworks contribute to infrastructure development, which, in turn, stimulates economic growth and facilitates overall development initiatives.
Impact on Banks and Investors:
- Factors such as delays and cost overruns in infrastructure projects affect the risk appetite of banks and investors, influencing their willingness to extend funds for such projects.
- According to the then Deputy Governor of RBI, the added uncertainty due to legal and procedural factors affects the risk appetite of investors and banks.
Key Revisions in the Proposed Framework:
- Focus on Mitigating Credit Events: RBI's focus is on mitigating credit events such as defaults or the need to extend the original date of commencement of commercial operations (DCCO), as well as diminution in the net present value (NPV) of the project.
- Revision in Provisioning: A significant revision concerns provisioning, where a portion of funds is set aside in advance to compensate for potential losses. The proposed framework recommends maintaining a general provision of 5% at the construction stage for all existing and fresh exposures, a revision from the previous 0.4%.
- Implementation in Phases: The 5% provisioning will be implemented in a phased manner, starting with 2% for FY25, increasing to 3.5% for the next financial year, and eventually reaching 5% in FY27.
- Concerns and Impact: There are concerns about the impact of this increased provisioning on the cost of debt. According to CareEdge Ratings, this could dampen the bidding appetite from infrastructure developers in the medium term.
Implications for Infrastructure Development:
- These revisions aim to enhance the resilience of banks and investors to credit events and mitigate potential losses associated with infrastructure projects.
- However, there are concerns about the short-term impact on infrastructure development, particularly regarding the cost of debt and the bidding appetite of developers.
- Despite these challenges, the phased implementation of the revised provisioning norms reflects a balanced approach to risk management in project financing.
Provisions at Operational Phase:
- The framework allows for a reduction in provisioning to 2.5% and 1% at the operational phase, i.e., commencement of commercial operations.
- To qualify for the reduced provisioning, the project must demonstrate a positive net operating cash flow covering all repayment obligations, and total long-term debt must have declined by at least 20% from the outstanding at the time of achieving DCCO.
Impact on Projects with Stable Cash Flows:
- Projects with stable cash flows, such as road annuities, transmission, and commercial real estate, typically witness an improvement in credit profile within one year of establishing a payment track record.
- However, the mandated provisioning could delay the realization of interest rate benefits for such projects, despite an enhanced credit profile.
Sensitivity to Interest Rates:
- Infrastructure projects, being capital-intensive, are sensitive to interest rates.
- Any delay in realizing interest rate benefits may affect the financial viability and attractiveness of these projects.
Addressing Risks and Refinancing:
- Despite potential delays in realizing interest rate benefits, the move aims to address risks associated with bulky back-ended repayments and subsequent refinancing of infrastructure projects.
Introduction of Prudential Conditions:
- The framework introduces prudential conditions to ensure that all mandatory prerequisites are met before the closure of the financial year, thus before the finalization of financial statements.
- An indicative list of prerequisites includes environmental, regulatory, and legal clearances relevant to the project.
- For PPP projects, the framework proposes to accept half of the stipulated land availability for financial closure.
Clarity on Date of Commencement of Commercial Operations (DCCO):
- The DCCO must be clearly specified, and financial disbursals will be made based on the stages of project completion.
- For PPP projects, disbursals should commence only after the de facto handing over of a contract letter to the developer.
- Banks are required to deploy an independent engineer or architect responsible for certifying the project’s progress, ensuring transparency and accountability.
Emphasis on Positive Net Present Value (NPV):
- RBI proposes to mandate a positive Net Present Value (NPV) as a prerequisite to obtain project finance.
- Lenders are also required to independently re-evaluate the project NPV annually.
- This measure aims to avert the possibility of stress build-up and enables lenders to have an action plan in place to address any emerging challenges.
Scope for Revision of Repayment Norms:
- The framework allows for the revision of repayment norms, but with certain limitations. The original or revised repayment tenure, inclusive of the moratorium period, must not exceed 85% of the economic life of the project.
- Additionally, certain criteria are recommended for evaluating a change in the repayment schedule due to an increase in the project outlay. This includes an increase in scope and size of the project, which must be assessed before the commencement of commercial operations.
- Lenders must offer a satisfactory reassessment about the viability of the project, and if the risk in project cost (excluding any cost overrun) is 25% or more of the original outlay.
- Cost overruns occur when expenditures exceed the budgeted project outlay, while an increase in costs refers to the difference between the original budget and the final cost at completion.
Standby Credit Facility Guidelines:
- The framework introduces guidelines to trigger a standby credit facility at the time of financial closure to fund overruns arising due to delays.
- This facility stipulates an incremental funding of 10% of the original project cost, providing a buffer to address unforeseen challenges and ensure timely completion of projects.
Initial Observations:
- The ongoing impact assessment is evaluating potential effects on banks’ profitability, risk appetite for future project financing, and a potential increase in credit costs.
- Ratings agency ICRA noted that the higher provisioning requirement for projects under implementation could impact the profitability of non-banking financial companies and infrastructure financing companies, albeit spread over a three-year period.
- ICRA estimates that funding costs could rise by 20-40 basis points (bps) in some cases, as lenders may incorporate an additional risk premium when pricing loans.
Conclusion:
- The initial observations suggest a mixed response from stakeholders, with concerns about the potential impact on profitability and funding costs balanced by confidence in managing the proposed changes effectively.
- As the framework undergoes further evaluation and implementation, stakeholders will closely monitor its impact on the banking sector, project financing dynamics, and overall economic development.
- Adjustments in loan pricing and risk management strategies may be necessary to navigate any challenges arising from the revised framework.
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PRACTICE QUESTION
Q. Explain the measures required to strengthen the regulatory framework for long gestation period financing for projects. Assess the role of regulatory enhancements in mitigating risks, promoting investor confidence, and fostering sustainable economic growth in India.
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