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AD B

DEVELOPING BEST PRACTICES

FOR PROMOTING PRIVATE SECTOR

INVESTMENT IN INFRASTRUCTURE

PORTS

Asian D evelopment Bank

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The views, conclusions, and recommendations presented here arethose of the study consultants, and should not be considered torepresent the official views of the Asian Development Bank or itsmember governments.

Asian Development Bank 2000

ISBN No. 971-561-281-4Stock No. 010400

Published by the Asian Development BankP.O. Box 789, 0980 Manila, Philippines

For more information on ADB, visit http:\\www.adb.org

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FOREWORD

This report is one of a series of five commissioned by the Asian Development Bank(ADB) to identify and recommend best practices to be followed and specific steps to be taken,by ADBs developing member countries in order to encourage both private sector investment

and competition in infrastructure development. The study was financed through a $600,000regional technical assistance grant - RETA 5753: Developing Best Practices for PromotingPrivate Sector Investment in Infrastructure. This report focuses on the port sector; the otherreports cover the power, water supply, airport and air traffic control, and road sectors.

Transport is central to achieving prosperity and the quality of life to which most countriesaspire. This report examines the various arrangements used throughout the world to transferpublic port activities and assets to the private sector. The rising volume of these transactionsover the last decade has shifted attention from port reform to terminal concessions and hashastened the transition from operating ports to landlord ports. The review of current practicesresulted in a menu of better practices which are consistent with the objectives and environmentof the public port. In addition, the study also examines the specific steps that ADB can take in

facilitating both private sector investment and competition. It is hoped that the report will helpADBs developing member countries attract well managed and cost-effective private sectorinvestment in the port sector.

The five reports have benefited from the support of and valuable contributions frommany individuals, both inside and outside ADB. The reports were prepared by a team ofindividual consultants: Water Supply - Michael Porter of Tasman Asia Pacific; Power - ElliotRoseman of PricewaterhouseCoopers; Ports - John Arnold, an independent ports specialist;Airports and Air Traffic Control - Ian Jones of National Economic Research Associates; andRoads - Roger Allport of Halcrow Fox. In ADB, Sean OSullivan, Senior Public/Private SectorSpecialist managed the technical assistance implementation with the help of Marcelo Minc,Project Economist. ADB staff in the Energy; Transport and Communications; and Water Supply,Urban Development and Housing Divisions as well as the Private Sector Group helped inguiding the direction of the study and in reviewing the outputs. In December 1998, a workshop,hosted by ADB as an integral component of the study, provided a forum for the exchange ofideas and experiences. Participation and contributions of delegates from many developingmember countries and representatives from the private sector in the workshop were very muchappreciated by ADB.

The publication of the five reports is especially timely as it coincides with the introductionof a new strategy for private sector development by ADB.

Vladimir BohunDirectorInfrastructure, Energy and FinancialSectors Department (East)

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ABBREVIATIONS

ADB - Asian Development Bank

BOOT - build-own-operate-transfer

BOT - build-operate-transfer

EDI - Electronic Document Interchange

EU - European Union

HIT - Hong Kong International Terminals

HPH - Hutchinson Port Holdings

ICTSI - International Container Terminal Services Inc.

IFC - International Finance Corporation

JNPT - Jawaharlal Nehru Port Trust

KCTA - Korean Container Terminal Authority

MDB - multilateral development bank

MPTA - Major Port Trusts ActPAT - Port Authority of Thailand

PDB - Port Development Board

PRC - Peoples Republic of China

PSA - Singapore Port Authority (now Corporation)

PSP - private sector participation

SLPA - Sri Lanka Port Authority

SOE - state-owned enterprise

TA - technical assistance

TEU - twenty-foot equivalent units

UK - United Kingdom

US - United States

ii

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GLOSSARY

Capital (asset) lease - The lease of existing facilities, equipment and infrastructurealong with the right to provide services using these assets and to charge for theseservices. The lessee generally commits to maintaining these assets and returning them

in reasonable condition at the end of the lease. The lease generally includes an operatingagreement which stipulates the conditions under which the lessee must operate. Thetypical period for a capital lease is 5-15 years.

Concession or wholesale concession The combination of a capital lease along withthe right to provide services using these assets and a commitment to make specificinvestments to improve the quality and capacity of these services. The typical period fora capital lease is 20-40 years.

Debentures - Debt instruments issued by a corporation and secured by assets orrevenues.

Management contract - An agreement to provide personnel to manage an activity, serviceor facility in return for a fixed fee or cost-plus payment.

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PART TWO: PORTS SECTOR REPORT

I. BACKGROUND ................................................................................................................ .18A. In the Public Interest ..................................................................................................... 18B. The Cycle of Privatization .............................................................................................19C. The Failures of Public Ports ......................................................................................... 19

D. Standard Organizational Structures ............................................................................. 20

II. FUTURE TRENDS ............................................................................................................. 22

Ill. INSTITUTIONAL REFORM IN PUBLIC PORT MANAGEMENT..........................................25A. Decentralization............................................................................................................25B. Commercialization .......................................................................................................27C. Corporatization .............................................................................................................28

IV. STRATEGIES AND OBJECTIVES .....................................................................................29A. Unique Characteristics of Ports ...................................................................................29B. Strategies ..................................................................................................................... 30

C. Port Objectives .............................................................................................................33D. Private Sector Objectives .............................................................................................39

V. COMPETITION AND CONTESTABLE MARKETS ............................................................. 41A. Potential for Monopoly Behavior ...................................................................................41B. Sources of Competition ................................................................................................43C. Avoiding Monopoly Behavior .........................................................................................44

VI. FINANCIAL COMPONENTS OF A CONTRACTUAL AGREEMENT .................................. 45A. Pricing of Services ....................................................................................................... 47B. Payments to the Port .................................................................................................... 47C. Investments .................................................................................................................. 48

D. Sources of Financing ...................................................................................................49

VII. RISK AND MITIGATION ...................................................................................................... 51A. Protection from Competition ......................................................................................... 55B. Period and Penalties .................................................................................................... 55C. Pricing Regulation ........................................................................................................57D. Currency Risk............................................................................................................... 57E. Lenders and Investors Concerns ................................................................................ 57

VIII. LABOR REFORM .............................................................................................................. 58

IX. THE CONTINUING ROLE OF THE PUBLIC SECTOR...................................................... 59

X. BEST PRACTICES ............................................................................................................61A. What Defines Port Privatization?..................................................................................62B. Private Ownership ........................................................................................................ 63C. Private Management .....................................................................................................65D. Private Investment ........................................................................................................66E. Institutional Reform.......................................................................................................68F. Top-Down Reform Versus Bottom-Up Restructuring ...................................................68G. Privatization of Individual Port Activities ........................................................................69

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XI. THE PRIVATIZATION PROCESS AND THE ROLE OF ADVISORS..................................72A. Strategic Review ..........................................................................................................74B. Legal Review ................................................................................................................ 75C. Financial Review ..........................................................................................................76D. Investment Review .......................................................................................................77

XII. THE ROLE OF THE ASIAN DEVELOPMENT BANK ......................................................... 78A. Technical Assistance.................................................................................................... 79B. Network Planning..........................................................................................................80C. Lending ......................................................................................................................... 81

APPENDIXES1. Major Container Terminal Operators and Concessions2. Current Role of Private Sector3. Port Privatization in India and Thailand4. Experiences in Other Countries5. Leases and Concession Agreements

6. Objectives of Port Privatization7. Findings of Workshop on Private Sector Participation in Infrastructure

REFERENCES

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LIST OF TABLES

Table 1: Major Ports in the Region Grouped by Type of Port

Table 2: Degree of Centralization of National Port Systems in Asia

Table 3: Agreements for Increased PSP

Table 4: Port Functions

Table 5: Matrix of Objectives and the Contractual Agreements for Increased PSP

Table 6: Financial Components and Their Impact on Objectives of Privatization

Table 7: Sources of Long-term Capital

Table 8: Types of Risk

Table 9: Source of Risk and Risk Mitigation

Table 10: The Continuing Role of Public Ports

Table A1.1: Major Terminal Operators and Their Port Involvement

Table A4.1: Objectives of Program to Increase PSP in the Port Sector

Table A4.2: Approaches Used to Increase PSP

Table A6.1: Positive Objectives of Port Privatization

Table A6.2: Negative Objectives of Port Privatization

LIST OF FIGURES

Figure 1: Interactions Between Public and Private Sector and Users

Figure 2: Three Levels Where Efforts to Increase PSP Continue

Figure A2.1: Allocation of Responsibility for Port-Related Activities

LIST OF BOXES

Box 1: Past Project Finance and Future Infrastructure Demand - East Asia

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Divestiture of existing services and assets to the private sector on a temporary orpermanent basis requires a change of management. It can be accomplished through contractualarrangements including service contracts, capital leases, franchises, service contracts, andconcessions or through the sale of assets and open competition for specific port services.2Theterm privatization, when properly defined, refers to the outright sale of assets and opencompetition. In practice, it has come to refer to all these options.

Investment in new facilities and servicesoccurs as a follow-on to divestiture when theprivate sector rehabilitates and expands existing assets. It also occurs through theestablishment of private ports or through concessions for new facilities within public ports. Inboth cases, the private sector is given effective control over all assets, including land andforeshore, either in perpetuity or for a lengthy period.

The best institutional structure for promoting private sector involvement in public portoperations and investment is the landlord port. This structure provides a broad framework inwhich the private sector can replace the public sector in the provision of services to the vesseland its cargo. It allows the public sector to retain ownership of the land and infrastructure andto continue regulating their use, while sharing responsibility for capital investment. This

framework has been used throughout Western Europe and the United States for much of thiscentury. In the last decade, it has become increasingly popular in Asia and South America. Itspopularity is based on the effectiveness of this framework for increasing operational efficiency,providing flexibility in the structure of the tripartite relationship between government, labor, andprivate management and promoting client-oriented management. It allows a port to improve thequality of its service through a process of evolution, which can accommodate the changes intrade, shipping and regional political structures.

The introduction of the landlord structure requires a consensus between government, labor,and private management on the procedures for transferring control of services and assets to theprivate sector. This is followed by a gradual expansion of the private sectors role in operations andinvestment, the evolution of the contractual relationship between the parties and thedevelopment of a common set of goals for the port and its users. The process should notemphasize the shift from one institutional structure to another, but rather the continuingreallocation of responsibilities so as to improve the quality of port services. In order to beeffective, this process requires specific objectives. The experience of the last decade hasconfirmed the need for commercialization of management, timely and efficient investment,efficient allocation of risk between the public and private sector, and active competition amongservice providers. To these objectives, there is a need to promote the integration of the port intothe logistics chain connecting producers and consumers.

A strong client-orientation is needed both for improving existing services and facilitiesand for introducing new services and facilities. For the former, the management must trade-off

the quality and price of port services. For the latter, the management must determine thepotential demand and the price required to justify the related investments. Timely investmentrequires the ability to determine if existing assets are being used efficiently as well as thecapacity to procure new assets without being encumbered by lengthy procurement procedures.Effective risk allocation requires that risks be assigned according to which party has the greatercapacity to mitigate the risk. Since the objective of this process is to introduce commercial

________________________________________________________

2 The definition of these arrangements is presented in the Glossary at the beginning of the report.

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behavior, the commercial risk would be transferred entirely to the private sector. The publicsector would retain the regulatory risk since it is directly involved in the design and enforcementof these regulations.

Competition can be in the form of direct competition between service providers orindirect competition among providers of complementary network services Where competition

is not possible, a contestable situation can be created through the terms and conditions of thecontract between the public port and the private sector, or by allowing the shipping lines andcargo owners to provide services where existing providers do not meet their needs. The role ofthe public and private sector in port investment will vary from port to port, but the public sectorgenerally retains responsibility for basic port infrastructure and the private sector for mobileequipment and operations-related structures.

The port industry has undergone rapid technical and organizational change since thestart of containerization nearly a half century ago. During this period the sustained growth ofoceanborne commerce and the development of international shipping have been served througha combination of improvements in technology, tighter integration of network functions and

productivity gains for general cargo operations, which have averaged four percent per year forfacilities and eight percent for labor. In this environment, it is not possible to identify bestpractices except as a snapshot on time. It is anticipated that the practices mentioned in thisreport would be modified and replaced over the next 10-15 years as the requirements ofinternational trade and the accepted role of government change.

The value of the landlord port model is closely associated with the need for governmentto maintain control of its foreshore, especially areas suitable for port development. Publicownership of the port land is likely to continue as long as the sites for port development arescarce. In the future, this scarcity will diminish as:

The location increases in importance relative to the physical suitability of the site.

Financial resources for dredging, breakwaters etc., become more readily available forwell-located but unsuitable sites.

The technology of cargo-handling improves, e.g., the development of the Single PointMoorings for oil transfer.

More sophisticated and complex logistics chains generate a larger number of solutionsto transport needs.

The public interest dimension shifts from local to national to international.

With these changes, the limitations of public sector landlord ports will become moreapparent. These limitations as observed in the port networks of the United States and NorthEurope, include:

The continued use of public subsidies (albeit in more subtle ways).

Public investment based on local/national pride rather than commercial objectives, whichleads to over-capacity.

Public political concerns overriding commercial judgment.

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Within the next two decades, the role of common-user public ports is expected todiminish and be replaced by private terminals, thus marking a return to the structure of earliercenturies. For now, however, the improvement in port efficiency and move towards commercialmanagement will be accomplished through public landlord ports with private sector operationsand shared investments.

The Asian Development Bank and other multilateral development banks can providean important impetus to the shift from public operating ports to landlord ports. They can arrangefor technical and financial assistance for assessing the legal, political, and financial constraintsto divestiture of responsibilities and assets. They can also provide this assistance to supportthe process of negotiation between the government, labor, port users, and private management.This would include the development of an agreement with labor on the process of divestitureand with the private sector on a contractual relationship that will provide efficiency gains andincreased competition while allowing reasonable returns on investment (both capital andmanagement). The Asian Development Bank can provide financial support for the labor reformand for the public investment required to promote competition. It can also assist in designingan appropriate tendering system and the formulation of the contract terms followed by the

negotiation of a sustainable relationship between the public and private sector.

These institutions can also provide assistance with related reforms. One is thedevelopment of the long-term domestic capital markets, which are needed to provide a reliablesource of funding for the development of port infrastructure. Another is the integration of thetransport network to provide seamless intermodal transport. They can also provide assistanceto the public port organizations and the ministries of transport for developing national transportnetwork plans and port masterplans.

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PART ONE

STUDY OVERVIEW

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I. INTRODUCTION

An Asian Development Bank (ADB) regional technical assistance was approved withthe aim of developing sector specific best practices for promoting private sector participation(PSP) in key infrastructure sectors in ADBs developing member countries (DMCs). The sectorsstudied included power, water supply, roads, ports and airports and the best practices covered:

(i) sector policy issues relating to pricing and competition; (ii) conducive legal and regulatoryframeworks; (iii) the unbundling, mitigating, and management of risks; and (iv) mechanismsto reduce transaction costs. Five individual experts were engaged to undertake the study, onefor each sector. A two-day regional workshop was held at ADB on 9-10 December 1998 forthe experts to present their findings and validate them with an invited group of experiencedsenior government and private sector individuals, together with ADB staff. These volumes representthe final outputs of the study.

A summary of the expressed views in these volumes in relation to preferred forms of PSPin infrastructure, informed by the currency crisis, is that it is best practice to have a customerfocus and a well structured regulatory environment around infrastructure projects, in part since

this can allow domestic financing. In other words, it is financially and economically sensible toutilize the essential and often monopoly status of efficient infrastructure services in creating,in effect, a customer finance model of PSP. Under this customer-focused concession orfranchise model, government provides the regulatory and legal framework that can satisfycustomer and investor alike, with the securitization of customer accounts (say via an escrowaccount) or insurance techniques underpinning financing arrangements. Investors will alwaysseek to mitigate uncertainties, but many of the privatization models to date have done so by wayof government guarantees which have undermined the process in the longer run.

Regulation by entities appointed by the government is still required in the new model,given that monopoly provision of key network assets is often the only efficient option. Forexample there is a need to regulate access charges for connection to network assets such as

pipelines, high voltage wires and port channels. But where competition can be achieved in theproduct market, as with electricity generation selling into a power pool, then this competition isgenerally the best mechanism to achieve good outcomes for customers Realistically, in muchof Asia, there is little experience with these new pro-competitive models of regulation and thusthere is an expectation, on the part of the experts, of a substantial phase-in to this regulatoryelement of best practice in the future.

The challenge as we enter 2000 with its information-rich possibilities, is to learn from the1990s infrastructure experience on investor-to-government build-operate-transfer (BOT) dealsand concession transactions so that DMCs can benefit from the adoption of best practices in thevarious infrastructure sectors.

The following presents an overview of the study, including a discussion on the growthof private sector infrastructure investment in Asia, a review of the cross-sectoral issues, asummary of the sectoral best practices for each sector and suggestions on the role of ADB insupporting private sector investment in infrastructure. Part 2 comprises the specific sectoralreport.

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II. THE GROWTH OF PRIVATE SECTOR PARTICIPATION

A. Expansion and Contraction of Private Sector Investment

The last decade, and notably the period to 1996, saw both the rapid expansion of privateinvestment in public infrastructure and a sharp increase in private management of the servicesassociated with this infrastructure. The investment was fuelled by the development of new formsof PSP including varying forms of public/private partnerships: BOT, build-own-operate, build-own-operate-transfer (BOOT), and concessions.

New financial instruments, especially project finance, and the globalization of privateinvestment funds, played a major role in the expansion of the infrastructure sectors in mostcountries. PSP in infrastructure, and in particular power generation, was supportedenthusiastically by the multilateral development banks and bilateral development agencies, aswell as by the international financial community. But fewer transactions were completed in themore complex and customer-focused areas such as water, electricity distribution and transportinfrastructure. Early successes involved financial transactions without major organizational

restructuring; later transactions focused on major infrastructure in mega-cities such as Manila,Jakarta and Shanghai. For example, water treatment plants, bulk water supply, individual powergeneration units, container terminals, passenger terminals, and airport toll roads.

In the first half of the 1 990s, investment requirements for infrastructure in Asia were seento be on a scale that dwarfed earlier projections and experience. Asian tiger economies weregrowing rapidly, and demanding massive investments in power, roads, telecommunications andother infrastructure. In most Asian economies, there was also a sense that development wasbeing hindered by bottlenecks in power (e.g., the Philippines), transport (e.g., Thailand), water(most of Asia) and telecommunications. Since government infrastructure spending, internationalaid, and official sector lending could not be on a scale sufficient to meet requirements, theprivate sector was the focus of attention.

The new infrastructure investment requirements were estimated by ADB to be of the orderof US$1,000 billion for the 1 990s for East Asia. Subsequently, they were estimated by the WorldBank to be of the order of US$1,500 billion for the decade 1995 to 2004. Such projections wereuseful as a means of highlighting the scale and structure of the huge infrastructure requirementsof a growing and increasingly prosperous and urbanized Asia. They helped make clear the needfor a major shift of focus towards PSP in infrastructure, to some extent motivated by efficiencyconsiderations, but mainly reflecting the view that public sector financing for this scale ofinfrastructure requirements was neither feasible nor desirable.

There had also been a shift in views as to the comparative advantages of governmentsand the private sector in performing the various roles related to the provision of quality

infrastructure services. Increasingly, an expanded regulatory and restructuring role was seenfor governments, with investment, construction, financing, and management viewed as bestopened to competitive PSP. Risks should, under this approach, be assigned to the parties bestable to mitigate them, and this meant a greatly expanded role for the private sector.

There was recognition that while many private sector investments of the BOT typewere being completed, the assignment of risks in many of these projects left much to be desired.Government guarantees of bulk take-or-pay contracts (between utilities and investors), often

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indexed to exchange rates, had created huge contingent financial obligations of the utilities andtheir governments.

As with many investment trends, optimism, a proliferation of Memoranda ofUnderstanding and glossy investment announcements gradually replaced careful evaluation.Some early successes, under special circumstances, led to the assumption that this BOT

approach could be universally applied. The expression BOT had become a shorthand for PSPin many countries by the mid 1990s; but by 1999 BOTs and often the associated powerpurchasing agreements had also become a shorthand for unacceptable government riskexposure, and of project isolation from customer and market pressures.

This optimism ended with the Asian financial crisis; itself brought on by a lack of soundinvestment policies, in particular, in relation to government guaranteed power purchasingagreements. The power purchasing agreements had inadvertently converted a shortage ofpower supply into an oversupply, secured by take-or-pay guarantees. The result of the crisishas been a sharp contraction in private sector investment and a significant exposure ofgovernment and private sector investors to contingent liabilities. This contraction not only

limits the capacity of governments to stimulate economic growth but also has led to the deteriorationor stagnation of many partially completed and privately financed public infrastructure projects.The rise and fall of private sector finance is clearly shown in the private finance data presentedin Box 1.

The currency crisis has caused some dramatic revisions both to economic growthforecasts and to infrastructure investment programs. However, as the analysis in Box 1 showsthat while forecasts for infrastructure are lower due to lower growth and the expected move tobest practice, the magnitude of investment is still huge and efficient PSP will be required.

B. The Challenge for Private Sector Infrastructure Investment

As this difficult period unwinds, it is important to reconsider the comparative advantagesof the public and private sectors and the critical role of improved regulation and governanceincluding transparency, enforcement of contracts, and the adoption of viable commercial tariffstructures. There is a need to review, sector by sector, the strengths and weaknesses of theprocess that has been used to implement these investments. The opportunities and risks ofnew approaches need to be addressed - e.g., the case for expanding the emphasis on customerfocused and privately managed concessions. There is a need to develop bankable versions ofthese models, ideally backed by the security of customer accounts rather than governmentguarantees or public sector assurances. This series of volumes addresses these and othersectoral best practice concerns.

There are major challenges for governments and investors alike, emerging from thisshift to a new model for infrastructure development. The new best practice model does notmean a total retreat by governments; on the contrary, moving to best or better practice involvesa shift to good governance, and requires an upgrade of regulatory, restructuring, and monitoringroles. Without greatly improved governance, the shift to increased PSP could just mean monopolypowers being shifted to the well connected in the private sector. Moreover, without improvedgovernance, PSP would eventually flounder and the demands for infrastructure will not be met, asrisks would become unacceptable.

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Project Finance Opportunity and Volatility

Figure 1 draws on a Euromoney (CapitalDATA)database and highlights the dramatic growth, andsubsequent decline of infrastructure funded throughproject finance in selected East Asian countries. The pre-crisis level of nearly US$41 billion for 1996, contrastssharply with the estimated level at the end of the 1980s,when the total market for funding projects was less thanUS$5 billion per annum, as well as with the crisis figureof US$12 billion for 1998. Clearly, in the 1990s and wellprior to the crisis, the importance of the private sector ininfrastructure development was rapidly increasing. As aresult of the crisis, the telecommunications sector hasshown the most dramatic decline, reflecting the fact thatsuch projects are typically purely privately funded, andbear demand risk in a newly open environment. Theenergy projects, on the other hand, appear more resilient,but mainly because they have had some form of

government support, in the form of guarantees in relationto bulk sales through PPAs.

Future Demand for Infrastructure Investment

New infrastructure projections for selected EastAsian countries: the Peoples Republic of China (PRC);Indonesia; Republic of Korea; Malaysia; Philippines; andThailand for the period 1996-2005, adjusted to allow forboth the phase-in of private sector market discipline/bestpractices and reduced economic growth. The revisedprojections are 23 percent below the pre-crisis (baseline)projections. They are based on establishing the value ofthe capital stock of infrastructure in each country andprojecting infrastructure investments with varying gross

domestic product (GDP) growth assumptions and varyinginfrastructure-to-output ratios. A summary is given inFigure 2. The pre-crisis projections are based on the 1996GDP growth forecasts. Case 1 is based on the currentGDP growth forecasts while Case 2 adds the impact of atransition to a lower infrastructure-to-output ratio andassumes a gradual 25 percent increase in efficiency ineach sector in each country. An important factor to note inthe projections for this region is that the PRC is assumedto maintain its relatively high GDP growth rate, whichaccounts for about two thirds of the infrastructurespending in the region. The results for Case 1 indicate afall of 14 percent from the pre-crisis projections. If thePRC is excluded, the reduction is 33 percent. Case 2,which assumes a transition to best practices, with a

resulting change in the underlying infrastructure-to-outputand efficiency parameters, indicates further reductions inthe level of needed investments. The analysis clearlyshows the relative impact of lower growth and the potentialbenefits of moving to best practice models of infrastructuredevelopment. It also highlights the magnitude ofinvestment requirements, in excess of $120 billion peryear, and the need for PSP.

Box 1: Past Project Finance and Future Infrastructure Demand East Asia

Source: Private Sector Participation and Infrastructure Investment in Asia, Asian Development Bank paper prepared for theFinance Ministers Meeting, Asia Pacific Economic Cooperation, May, 1999; prepared by M.G Porter and C. McKinlay (MacquarieBank and Tasman Asia Pacific).

Figure 2:1996-2005 Infrastructure Investment Projections

Scenario US$ trillion %

Baseline 1.78 100

Case 1 1.53 86

Case 2 1.37 77

Figure 1:Project Finance

45

40

35

30

25

20

15

10

5

0

US$billion

1995 1996 1997 1998

YEAR

Energy

Telecoms

Transport

Water

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III. CROSS-SECTORAL ISSUES FOR PRIVATE SECTOR PARTICIPATION

There are a number of cross-sectoral issues relating to promoting private sectorinvestment in infrastructure that were identified during the study. The review of best practicesin each of the five sectors highlighted the importance of competition, transparent tendering,and effective regulation. There was broad agreement that:

Government should specialize in planning, structuring, and regulation while theprivate sector should specialize in management, investment, construction, andfinancing;

The transfer of responsibility to the private sector should be accomplished throughderegulation and open competition or well-established contractual arrangementsincluding management contracts, capital leases, concessions, sale of assets andrights to operate;

Economic regulation should be applied where there is insufficient competition but it

should be transparent and predictable while still accommodating the concerns of theaffected parties;

Long-term domestic financing sources must be developed; and

Commercial risks should be assigned to the private sector but other risks should beassigned according to which party is able to mitigate the risks.

The cross-sectoral issues are discussed in more detail below.

A. The Need for Reform and Role of Government

PSP in infrastructure development still requires the government to play a key role inplanning, policy, and regulation. The reason that infrastructure industries have remained solong in the public sector is that they have components that are natural monopolies; e.g., thecosts are lower with only one provider and the services are often essential (water, power andtransport). These infrastructure monopolies also typically have a relatively high proportion of capitalcosts, have long-lived assets with low unit variable costs, and exhibit significant economies ofscale. It had been a common judgement that state ownership of such monopolies, rather thanstate regulation of privately owned assets, was likely to deliver the best outcomes.

Existing service providers in these infrastructure areas have also had a considerablecompetitive advantage over potential new entrants, because of the relatively long time requiredto construct expensive new networks and to build up the market for their services. The scarcityof land, rights-of-way and airspace suitable for development of the network also act as anadditional barrier to competition. Sites for airports and seaports, dams, power plants, andrights-of-way for roads, rail lines and transmission systems had become increasingly difficultto acquire. Another common argument for retaining these industries within the public sector wasthat they must provide common (or universal) access to their services and that subsidies arerequired.

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It turns out that public ownership and management is neither necessary, nor the bestway to ensure universal access. Subsidies can easily be a requirement of a competitive tenderor can be directly financed by government. A key advantage of having the private sector providepublic services is that it allows public administrators to concentrate on planning, policy andregulation. The private sector, in turn, is empowered to do what it does best (i) invest capital;(ii) manage the businesses; (iii) manage and create appropriate incentives for staff and

management; (iv) deal with customers; and (v) improve the efficiency and quality of service;more recently, under the spur of benchmark competition - competition by comparison.

Governments should allow the private sector to provide infrastructure services to themaximum extent possible, with governments concentrating on planning, policy and regulation,and with the private sector on efficiently investing capital and improving the efficiency andquality of such services.

B. Institutional Reform

The organization of the infrastructure sectors (i.e., ministries, regulatory agencies,and utilities) has remained largely unchanged with the introduction of PSP. With financial

transactions being the primary mechanism for transferring infrastructure services to the privatesector, insufficient attention has been given to the broader issue of institutional reforms. It hasbeen implicitly assumed that the introduction of private management into the ownership oroperation of specific assets would obviate the need for such reforms. Instead, the weaknessesof existing institutional structures have limited the effectiveness of the private sector initiatives.In most countries, the piecemeal transfer of infrastructure components has proceeded slowlyand the controlling bureaucracies that add overhead costs and often limit improvements ininfrastructure performance, have remained relatively unaffected. The currency crisis hasemphasized the importance of institutional reforms but government bureaucracies rarely reformthemselves. Governments should carefully review the structure, size and responsibilities ofstate-owned utilities and other entities in the infrastructure sectors and establish special reform

units reporting directly to top level ministers to spearhead the necessary reforms.C. Strategic Planning

Governments acceptance of private sector investment in infrastructure has been due,in part, to their failure to anticipate future bottlenecks and make timely strategic investmentsto prevent shortages in capacity. The increased role of the private sector in developinginfrastructure has caused many governments to neglect their responsibility for sector planning.Instead, governments have offered assets and public services to the private sector in an adhoc manner, often failing to ensure that individual investments were complementary. In certaincircumstances, unsolicited proposals have been used as a surrogate for planning For its part,the private sector has selected projects that had already been identified in government plans,

giving preference to those which offered the highest rate of return, the lowest risk or the greatestshort-term benefit. The private sector has had neither the interest nor the capacity to considerthe network implications of its proposals. Governments have failed to subject these proposalsto rigorous financial analysis to determine their sustainability in the absence of major increasesin user charges or government guarantees. Governments have also often overlooked theComplementary investment required from the public sector to make the private investmentssuccessful. The results have been unsolicited proposals that involved little commercial risk(government guarantees, wrap-around provisions, transfer of existing assets, granting selectrights of way) or politically generated proposals. Governments should maintain and strengthen

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their role in strategic planning of the infrastructure sectors and in the process identify where PSPshould be encouraged and the level of complementary support that should be provided.

D. Legal and Regulatory Framework

The effectiveness of PSP has suffered from the lack of adequate regulatory structures to

control both technical and economic performance. Regulation of tariffs and other economic factorsis particularly undeveloped. The basic objectives of autonomy, accountability, transparency andpredictability have been difficult to achieve. More importantly, the mechanism for consultation betweenthe public and private sector and for dispute resolution between the providers and users of thenetwork has not been fully developed. A further problem has been the failure to separate regulationfrom administration in order to avoid conflicts of interest. Most countries have been slow to establishautonomous regulatory agencies with independent funding and professional staff.

Unbundling the network into competitive and monopolistic components can significantlyreduce the need for regulation. The competitive components can be transferred to the privatesector in a way that promotes competition and allows deregulation. The monopolistic components

can then be transferred to the private sector once an effective regulatory framework has beenestablished. This regulation should create a situation where the businesses derive their profitsfrom increased efficiency and the attraction of additional demand.

Effective economic regulation covers also deterrence of anti-competitive practices. Mostof the developing countries lack laws or agencies for dealing with anti-competitive practices.Economic activity continues to be concentrated in large conglomerates. The currency crisis hasprovided new impetus for breaking up the monopolies and introducing anti-monopoly laws.

The lack of established legal and regulatory procedures applies to contract law as well. Themeans for enforcement of contracts and the resolution of disputes are not well established. Politicalinterference in the award of contracts has also been a problem.

PSP without a well-developed legal and regulatory framework increases the level of risk toinvestors. It also encourages investors to rely on special situations and political relationships ratherthan their merits as a means for securing and implementing contracts. The transfer of infrastructureservices to the private sector should not lead to privileged deals or profits secured by governmentguarantees. They should be businesses with regulated income streams which derive their profitsfrom increased efficiency and the attraction of additional demand. These income streams shouldbe capable of securing substantial private sector funding, both because their semi-regulated naturemakes them much like a government bond, and because the essential and often monopoly natureof the service lowers demand risk Such assets are also long-lived and thus attractive to pensionand similar long-term funds.

E. Unbundling and Introducing Competition

Experience in a number of countries has shown that unbundled infrastructure sectorswith individual components managed separately can perform better than centrally-controllednetworks. The additional costs of unbundled networks due to increased communications andtransactions among components have been reduced by improvements in technology. At thesame time, the unbundled management has been able to better focus on the capacity andproductivity of the individual Components and their interface with other Components.

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The unbundling of the infrastructure sectors is an important technique for reducingtheir natural monopoly and promoting competition. Many parts of the network can supportcompetition. Where it is not possible to create direct competition between suppliers of networkservices, it is often possible to create competition among providers of complementary networkservices. For example, in the power sector, many countries are separating the networks intogeneration, transmission, distribution, and in some cases, a fourth segment responsible for

retailing power to customers, with different companies responsible for each segment.

Where competition cannot be created, it is often possible to establish contestableenvironments e.g., a market for the business. One method is through effective competitivebidding for the sale or lease of assets and licensing or franchising of services. Another is toreduce the period of the contractual agreements or to provide for a periodic review ofperformance. A third is to introduce performance targets related to the quality of the service,the range of services, the prices charged for the services and overall market share. The abilityof the private sector to achieve these targets is then linked to penalties, or provisions that maylead to early termination of the agreement. A fourth method is to require comparableperformance vis-a-vis other networks. This may be in the form of requirements for increasing

market share relative to other providers of similar services, or requiring a quality of service andprice that is comparable to other networks serving similar markets.

Most infrastructure sectors are composed of profitable and unprofitable components. Onepractical, but not ideal, strategy for transferring the components to the private sector is to bundleprofitable and unprofitable components to produce a combination that has an acceptable levelof profitability. Another is to tender the profitable components through techniques ranging fromoperating agreements and franchising to sales of assets and to transfer the unprofitablecomponents using management contracts; in effect, bidding out the government support forthat component. A third strategy has been to transfer the profitable components to the privatesector and to retain the unprofitable components in the public sector, but under control of localgovernment units rather than the national government.

F. Sources of Financing

Private sector funding of infrastructure usually brings the risk of foreign currencymismatches in the financing package; income is in local currency, but the need to resort toforeign debt and equity markets means that debt service requires substantial foreign currency.The root problem is inadequate depth in capital markets in most DMCs which prevents atailoring of local currency debt to long-lived assets. The need to resort to foreign debt (andequity) creates substantial risks, which have been exposed in the recent crisis. Fewinfrastructure consortia can withstand an exchange rate depreciation of 40 to 50 percent, letalone the 80 percent decline experienced in Indonesia when their product is sold for localcurrency. Hence the priority on programs to deepen the domestic capital market.

In principle, currency matching requires that the bulk of debt funding of infrastructureservices such as transport, water supply, electricity and other urban services should be inlocal currency. In the absence of the necessary capital market reforms, it is hard to see howprivate sector provision of infrastructure can proceed on the scale required to meet futuredemand. A priority, therefore, given the recent experiences, is that international developmentagencies such as ADB expand their role both in facilitating political risk insurance and in fosteringthe development of domestic capital markets in Asia, particularly bond markets.

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Direct foreign investment will remain an important source of funds for the developmentof the infrastructure sectors. However, it will take time to restore investor confidence and, giventhe experience of Indonesia, Pakistan, Philippines, Republic of Korea and others, governmentswill naturally seek to limit their exposure to these funds in preference to local sources of capital, ifpossible. The development of domestic long-term capital markets will be critical for private sectorinvestment in infrastructure, but these markets must have much better regulation as well.

G. Risk and Risk Mitigation

In order to reach financial closure, governments have often accepted commercial risksthat should have been assigned to the private sector. This includes not only the foreign exchangerisk but also demand/traffic (volume) risk. The most obvious example has been the take-or-pay provisions in power purchase agreements. These guarantees have had three negativeimpacts. First, they have isolated the private sponsors from the influences of the market.Second, they have created a large amount of contingent liabilities for governments that nowadd to their fiscal problems. Third, they have encouraged price rigidity leading to distortions inthe market and reducing the potential of the private sector to improve efficiencies in investment

and operations. Other examples are build-lease-transfer agreements and volume guaranteesfor toll roads, airports and seaports.

Because governments have had limited contract-related knowledge or experience, the privateparties have been frequently able to convince them to assume some of the commercial risks. Also,because governments have often not been able to engage suitable legal, technical and financialexperts to assist during negotiations, they have been at a disadvantage in arguing with foreignproponents concerning international practices such as take-or-pay contracts, or withinternational lenders concerning guarantees to protect their loans. Bureaucrats who have gonethrough a long, often contentious bidding process have been willing to accept some commercialrisks during negotiations rather than to face rebidding. Alternatively, private parties frustratedwith drawn out negotiations and the continuing renegotiating of clauses have accepted risks that

should have been borne by the government.

Governments should build up capacity to negotiate and deal with the private sector.Commercial risks should be assigned to the private sector and other risks should be assigned tothe party best able to mitigate them.

IV. SUMMARY OF SECTORAL BEST PRACTICES

The challenge for governments is to encourage an appropriate form of private sectorinvestment in infrastructure. The study has identified significant differences among theinfrastructure sectors concerning the appropriate balance between private and publicparticipation in ownership of assets and provision of services. Only some of the sectors havewelt defined models for PSP. Other best practices are still evolving and the menu will continueto develop as experience grows. The decisions on which infrastructure components shouldbe transferred to the private sector are of a strategic nature. They depend not only on thecharacteristics of the sector and the market it serves but also on government objectives. Therewas consensus among the experts that the primary objective should be to benefit consumers.However there were a number of additional objectives which governments should consider: (i)reduction in national debt; (ii) stimulation of domestic capital markets; (iii) reduction in capital andoperating subsidies; (iv) investment in new infrastructure or rehabilitation of existing

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infrastructure; (v) improvements in the quality of service; (vi) increased range of services;(vii) reduced prices for services; (viii) client-oriented operations; and (ix) more effectivemarketing.

Governments have at their disposal a number of means for effecting the transfer ofinfrastructure components to the private sector. The pace and sequence of such a transfer

depends on the: (i) size and complexity of the infrastructure sector; (ii) rate of growth in demandand the competitiveness of the market; (iii) options for unbundling by function or geography;(iv) legal regime regarding ownership of land and other critical assets; and (v) capacity foreconomic regulation. The established mechanisms, which range from management contractsto unregulated competition, are not new and have proven effective. The key is to have a visionof where the sector is going, and to carry through the reforms as quickly as possible so as notto allow the interim change to become the final state of affairs. The findings of the sectoral expertsfor each sector are summarized below.

A. Power

In the electricity sector, IPPs provided a quick solution (in the Philippines, for example) byoffering generation capacity needed for rapid economic growth. However, the costs were oftenhigh because the new capacity was not consistent with the least-cost expansion path and theprivate sector required high rates of return. However, these costs have been decreasing asthe IPP market has matured. The focus on production rather than efficient distribution put thepublic sector in the position of retaining that activity in which it was least effective and restrictingthe private sector from performing the customer focused activities (distribution and supply)where it had real expertise. At the same time, it isolated the private sector from the marketthrough a combination of regulated pricing and guarantees against commercial risks.

The power sector expert advocates restructuring to achieve a competitive market modelwith wholesale and retail competition. Such reform will encourage sustainable PSP and

maximize the benefits to consumers. The expert suggests five major steps in implementingthis approach, and their order of precedence. To some extent, these steps may proceed in parallel,but they should be considered sequential actions that will lead to the implementation of acompetitive power market:

1. Getting the investment framework right.

2. Deciding on the goals of restructuring and the ideal industry structure.

3. Preparing the players to participate in a competitive market.

4. Privatizing existing and new assets.

5. Ensuring that the competitive market is implemented properly.

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Best practices for power sector restructuring would include the following:

Create an enabling legal and regulatory environment to support competitive marketsin electricity.

Unbundle the power sector into separate generation, transmission, distribution, and

possibly retailing sectors to achieve the maximum benefits for customers.

Privatization should include the sale of power distribution utilities as well asgeneration, and should include existing assets as well as new projects, using atransparent process.

Open access to transmission and distribution wires, and the ability to trade powerbetween buyers and sellers in an open market, are critical to achieve a competitiveframework.

Operate the generation and retailing markets competitively, with a large number of

generators selling into a wholesale electricity market at prices which balance demandand supply throughout the day.

Operate the transmission network as a concession on the basis of competitivebidding, or privatize it within a tight regulatory framework, controlling rates of return,prices or gross revenue.

The independent regulator should mainly oversee prices and incentives fortransmission and distribution operations.

Restructuring should proceed at a pace consistent with the development of acompetitive and unbundled system.

B. Water

The water sector has moved more slowly towards private sector investment, relative toelectricity and telecommunications for example, not least because of the jurisdictional,environmental and sensitive social concerns about water supply, and its affordability. Whilemajor private sector involvement has now been achieved in distribution (Manila and Jakarta),the bulk of transactions were BOT models with take-or-pay clauses guaranteed by governments.Adding to these difficulties was the lack of knowledge about the location and condition of the(underground) networks and aquifers in many countries.

The volume on the water supply sector addresses the question of why, given thealternatives, the private sector should seek to invest in a sector with so many uncertainties,natural, governmental and financial. Water, unevenly supplied as rainfall, is often wronglydeemed a free public good, despite the costs of treatment and retail supply. Thus, there isoften an ill-informed community constraint against private sector involvement in water supply,which in most countries has prevented the sorts of best practice referred to in this report.

The water expert makes the point that when it comes to best practice in the case ofwater supply. Most of the messages are for government - to install sound and independent

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regulatory regimes, catchment management policies and enforceable laws on tariff setting andcollections. Once in place, best practices such as water supply concessions can be implemented.If not in place, then best feasible practice may simply relate to contracting out some services undergovernment guarantee, or BOOT bulk supply to public sector water supply companies. It followsfrom this that since the particular features of the water supply situation and regulatory and privatizationpolicies differ greatly across countries, so, too, will the feasible best practice.

One misunderstanding regarding the scope for bringing commercial practices to watersupply is the issue of affordability. The report notes that the poor often pay more for water than thecost from efficient commercial piped supplies. Experience has shown that low-income families willpay for quality water supply - and are not averse to PSP - if it delivers.

The key points recommended were:

The benefits of PSP in the water sector must be explained to win public acceptance.

The starting point in any reform process for water supply is to form a high-level

reform unit to drive and manage the process. It would be responsible for coordinatingand facilitating the entire reform and PSP process. The reform unit may be acrosssectoral unit.

While not essential to commence reform, the introduction of tradable water rightsleads to efficient use of water, particularly when it is scarce and has alternativeuses.

The water sector should be unbundled to the extent possible. The private sectorconcession model is most likely to achieve the greatest benefits to the communityand the economy as a whole. The government continues to own the network whilethe private operators lease the long-term right to use the assets and collect revenue

from service delivery. The benefits accrue due to strong financial incentives toreduce water losses and expand service.

If politically difficult, then the next best strategy is to use BOT, BOOT, andrehabilitate-operate-transfer arrangements to bring expertise and finance to urgentlyrequired water supply projects. The bidding procedure should be carefully managedto ensure reasonable cost and the contractual arrangements should not constrainsubsequent progression to more competitive models.

Commercialization/corporatization of water supply utilities together with tariff reformis advantageous as an interim step if the introduction of PSP is to be phased.

Tariff reform to achieve full cost recovery is essential for PSP. Cross-subsidies forthe poor can still be considered in a transparent manner.

Critical to the success of PSP in the water supply sector is for the government tocreate sound and independent regulatory regimes, catchment management policies,and enforceable laws on tariff setting and collection.

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Risks are likely to vary between countries and even between different water utilitiesin a country. They should be managed by the party best able to minimize and manageeach risk most effectively. Where no party has a clear comparative advantage tomanage the risk, it should be shared.

C. Roads

In Asias roads sector, PSP has been equated with major BOT toll roads. These have beentargeted where traffic is greatest - in and near the capital city and sometimes along majorinter-city corridors. This private investment has produced some successes but also manyfailures. After more than a decade of concerted effort, implementation experience has notmatched expectations. Indeed, surprisingly little has been implemented outside the PRC.

The road sector expert has advanced three reasons for modest progress in roads.First, governments have not defined their policy, often leaving the private sector to identifyprojects. Secondly, almost everyone involved has expected such toll roads to be profitablewithout government support, but this has only rarely proved to be the case (outside the dense

PRC market, which is deemed a special case). Thirdly, it has proved difficult to introduce promisedtariffs and tariff increases in a sector where roads have become to be regarded as free.

What is clear is that private construction and maintenance of public roads producedbetter results where there was adequate competition and effective methods for enforcingcontracts. Efforts to substitute private sector management for public sector officials in themanagement of the public network are in their early stages, even in the developed economies,but the preliminary results are encouraging.

Worldwide experience identifies a broad range of PSP modalities, in which BOT isclose to being the most difficult to implement. Other modalities include maintenancemanagement contracts, turnkey, operate, and maintain or rehabilitate-operate-transfer

concessions. Many of these modalities target improved maintenance, and rehabilitation of thenetwork (rather than solely network capacity expansion). They have potentially much greaterapplication than BOT projects. Looking ahead, the requirements are to both improve the BOTprocess, and to extend the modalities that are applied. The key points to emerge are:

Governments must prepare the PSP environment. Institutions may need to berestructured with the objectives of controlling the PSP process in the public interest,and creating a regulatory body, separate from vested interests. A sound legalframework and a predictable regulatory regime are essential.

Governments must identify priority PSP projects. This will almost always requirean independent feasibility study, which focuses on traffic and tariff policy, projectstaging, network integration issues, risk allocation, finance and implementationissues.

The best prospects for BOT projects are in middle-income countries (where thewillingness-to-pay tolls exist) along existing congested corridors, or where thereare missing links (e.g., estuarial/river crossings). A regulated income stream froma tolled public toll road is capable of securing project financing of an appropriate kind(i.e., suitable to pension funds and other long-term investor groups).

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Private sector modalities other than BOT exist, e.g., concessions, and should be appliedmore widely, as they can address many of the sector problems, and in the processcreate a new high growth industry for transport management companies.

Traffic risk is the major risk and may be shared. The core risk being taken by the privatesector, with government taking a share of the upside benefit and providing a downside

guarantee in the event of low traffic.

Transparency and competition are essential in the procurement process.

Government support should be defined upfront as a maximum so that the private sectorcan prepare realistic bids.

D. Ports

In the port sector, the transfer of cargo-handling activities to the private sector has been, inmost cases, extremely successful in replacing inefficient government bureaucracy with

commercially-oriented management. Improvements in productivity and maintenance hasincreased the quality of service. However, where there was no competition, these arrangementswere less likely to sustain these improvements. Private investment in port infrastructure hasgenerally been limited to new and existing cargo terminals. Trans-shipment terminals werethe most successful, since they were less dependent on local markets and land transport.Greenfield ports were slower to develop because they were further from their markets and thetransport access was less developed. Basic infrastructure offered few opportunities for full costrecovery.

The ports sector expert, noted that the private sector has always been actively involved inport affairs. The land and water transport services that use the port are almost entirely privatesector. Nearly all of the cargo shipped through ports is privately owned. The private sector provides

an array of complementary trade facilitation and logistics services for this cargo. Within theconfines of the public port, cargo owners, forwarders, and ship agents actively participate indecisions concerning the handling and storage of cargo. The public sectors role is to own,develop, and manage basic port infrastructure and common-user facilities.

The process of port privatization has rarely involved pure privatization, since land andinfrastructure are rarely sold. Instead, the process involves PSP in operations and investmentin equipment and facilities. The process is not a monolithic effort because of the diversity andcomplexity of ports and the services they provide. It can be divided into three components: (i)institutional reform, (ii) divestiture of existing services and assets, and (iii) investment in newfacilities and services. These can be implemented individually or in combination. For eachport component, there are many possible public-private partnerships. The main points regardingmoves to best practice were:

The bidding process should encourage unbundling not only of the network but alsofor the services within the ports. Where ports are not financially viable, they shouldnot be bundled with profitable ports, but treated as stand-alone facilities that areturned over to local government or put under management contract using acompetitive tender.

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The landlord model is the best structure for promoting PSP because it accommodatesdifferent forms of public-private partnership while recognizing that the only fixedresponsibility of the public port is the ownership of the site.

The most effective and efficient procedure for promoting PSP in the port sector is tolease existing facilities with relatively short-term agreements that allow for

reorganization and improvement in productivity. Subsequently, concessionagreements can be used to encourage private investment in additional capacity.Where this capacity is required immediately, or labor problems make it difficult tolease out existing facilities, then concessions might precede lease agreements.

Continued public investment will be required, as it is difficult to recover the costsfor basic infrastructure in a time period reasonable to the private sector. Publicinvestment may also be required to reduce the barriers to entry. This is importantwhere a new entrant would otherwise have to make a large investment beforecompeting with existing service providers.

The best form of tariff regulation is market regulation; the second best is throughthe terms of the contract that identify the non-competitive services requiringregulation, state the maximum rates, the formulae for escalating these rates overtime, and the arbitration procedures for discriminatory behavior in excess of that

justified by commercial pricing. The third best is the establishment of a regulatoryagency outside of the port which would apply a pricing formula related to cost recovery.All of these are preferable to a vague procedure for negotiating future changes in tariffs.

The private sector should assume all commercial risks. Other risks should benegotiated, based on which party has the capability to mitigate the risk.

The critical element in any effort to promote PSP is competition, or at least the

potential for competition. This can be provided through direct competition betweenprivate sector service providers, between public and private service providers orbetween bidders in the case of an activity that does not allow competition.

E. Airports

For the airport sector, PSP in terminal operations produced significant improvements infinancial performance and the quality of service. Private sector investments have increasedsubstantially over the last five years. During the previous twenty years, there was little capitalinvestment in airports, despite a five-fold increase in traffic. The airports coped with the higherlevels of traffic through a combination of larger aircraft, better air traffic control, improved runwaydesign, and the addition of second runways and additional terminal space. This period hasnow ended and most countries need to invest in new airports. These are proving to be costly,complex and often controversial investments.

The key policy questions concern how best to structure airports and groups of airports toobtain maximum customer benefits. The discussion in the volume on airports and air trafficcontrols indicates that there is little evidence of significant scale benefits flowing from multipleairport operation; equally, however, there is little evidence of significant scale diseconomies.The case for significantly reducing the concentration of airport ownership at privatization

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therefore depends on the trade-off between the up-front and visible costs of re-structuring, and thepossibly less tangible benefits of increased competition resulting from break-up. The competitionbenefits in this industry are not clear-cut, primarily because major airports mainly serve distinctregional markets.

In the United Kingdom, the authorities took the view that any potential competition gains

from breaking up the British Airport Authority prior to privatization would have been offset byrestructuring costs. In Australia, in contrast, the Government has preferred to restructure andreduce industry concentration radically, emphasizing the public policy benefits of inter-airportcompetition for long haul international traffic. The benefits of fragmented ownership also includethose that flow from yardstick competition, enabling regulatory agencies to assess individualoperator performance more effectively; and from introducing a limited element of competitionby emulation between operators. The airport expert found the benefits from the Australian model tobe greater. Key recommendations for the airport sub-sector are as follows:

Airport privatization will be encouraged by the existence of legislation in the form of aBOT law or similar, signaling the governments recognition of the need for PSP in

infrastructure provision. It is also important to ensure that the government is able todemonstrate that any projects offered to the private sector are economically viable.

Regarding the optimum approach, full privatization based on asset transfer oracquisition through long-term leases is preferable to more restricted forms of PSP(but is also more demanding in terms of legal and regulatory frameworks).

As to airport industry restructuring, there is no evidence of significant economies ofscale in airport operation other than those associated with increased traffic densityat a particular location. Hence, PSP can be based on individual airports (althoughfacilities may need to be bundled to assist financing of major new developments orextensions to capacity).

The existence of unprofitable airports does not justify the maintenance of a highlyconcentrated industry structure to facilitate cross-subsidies.

Limited sharing of traffic and revenue risk (between the private sector partner andgovernment) is justifiable in airport BOT or concession contracts.

Denomination of some, or all, airport charges in US dollars is an effective way ofhedging against currency risk and may significantly reduce the risk premium requiredby private investors;

The benefits of PSP in airports are likely to be maximized by regulatory frameworksthat incorporate good regulatory governance practice. The price-cap approach toconstraining airport charges is likely to encourage better performance outcomesthan one based on rate of return regulation.

Competition for the market, whether through sale or leases, or BOT/concessioning,will be maximized by transparent bidding/sale processes.

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V. THE ROLE OF THE ASIAN DEVELOPMENT BANK

The crisis has focused on the urgent need for institutional strengthening and governancereforms in both the financial and infrastructure sectors, areas where ADB can play a majorrole. There are a number of ways identified in the study in which ADB can assist in the reformsassociated with increased PSP in infrastructure. The most obvious is to provide technical

assistance to define policy objectives, develop network master plans, identify and evaluateprojects, define the role of new regulatory institutions, and train regulators to handle their newresponsibilities, prepare contracts and negotiate with the private sector. ADBs efforts to promotefinancial sector reform and develop long term capital markets will also be important. Thiswould include efforts to improve the bankruptcy laws, and the regulation of domestic debt andequity markets.

In order for ADB to have a significant role in promoting PSP, it should link this promotionwith on-going project lending. ADB can provide support for private sector investment directlythrough its private sector window and through its guarantee operations. More importantly,ADB should provide sovereign loans to complement but not compete with private sector

investment in the form of public-private partnerships. Public sector project lending shouldalso be used to finance basic infrastructure that cannot be packaged into financially viableinvestments for the private sector but provides significant economic benefits and improvessector efficiency. Program lending is another key modality to promote the necessary reformswhere ADB provides financing for the adjustment costs in stages, upon the satisfactory achievementor fulfillment of government actions that will promote PSP and sector restructuring. This modalityallows ADB to exercise some leverage on government decisions and actions to support reform.Country strategies should address which areas of development are to be financed by governmentusing sovereign loans, general revenues and government bonds and which are to be financed byprivate investment and should ensure a coordinated approach to all forms of ADB assistance.

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PART TWO

PORTS SECTOR REPORT

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I. BACKGROUND

A. In the Public Interest1

Ports have come to be associated with the public interest because of the concept thatthey should be accessible to all potential users and the benefits from the port should go to all

citizens. Historically, countries such as France have maintained that ports should remain inthe public sector while other countries such as England have allowed private dock companiesto establish ports. According to French law, public service refers to services that arepermanent, adapted to the needs of the user, and are to be provided equally to all users.Permanence refers to services to be provided without interruption. Equal provision argues againstdiscrimination of individuals but not of situations.

Figure 1:Interactions Between Public and Private Sector and Users

Even where ports are to be operated in the public interest, that does not mean that theymust be operated by the public sector with its civil service. Indeed, experience indicates thatthe public sector has considerable difficulty in adapting to the needs of the users and of ensuringthat the service is permanent (i.e., free of interruption). The objectives of private sectormanagement come closer to these objectives in many situations. Government retains the roleof ensuring that these services are provided and in accordance with public consensus. Thus,the move towards privatization should be undertaken in such a way as to allocate responsibilitiesbetween the public and private sector, so as to ensure that the public interest is met. Theinteraction of the public and private sector and the port users is shown in Figure 1. The privatesector is most effective in operating and maintaining ports, while government is most effectivein setting policy and regulating the port sector. The role of the government extends to planningthe port network, whereas the private sector implements individual port investments. Theresponsibility for finance should be based on which party has access to the least cost capital,taking into account not only interest rates but also competing demand for the capital.

Publicsector

Lease

PaymentsPrivateSector

Level of

ServicePublic

Interest

Level of

Charges

Port Users

________________________________________________________

1This section is derived from the Writings of J. Grosdidier de Matins.

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________________________________________________________

2 Some of the public ports were created as a result of the nationalization of these railroads.3

The multilateral development banks (MDBs) had a significant role in encouraging the formation of these authoritiesas a mechanism to coordinate Port Planning and lending to the sector.

B. The Cycle of Privatization

The efforts to privatize the port sector have been touted as a new philosophy formanaging this sector but may, in fact, be a return to an earlier philosophy. Historically, many ofthe ports of Europe and its colonies were developed in partnership with private trading andtransportation companies. Government was involved in providing basic infrastructure, e.g.,

locks, and aids to navigation, but piers were developed by both government and the privatesector. In Western Europe, municipal ports existed from early times. They were establishedto support the general commerce of a city and to provide public access to waterborne trade. Thecargo-handling services were provided by the private sector.

This century saw the introduction of ports that were both developed and operated bygovernment. This occurred in reaction to the monopoly practices of the private sector, especiallyrailroads, in port operation.2 Public operating ports provided significant advantages by openingnew gateways, lowering the costs of transport, and supporting both the growth in trade andregional economic development. Over time, the public port managements became morepoliticized and less effective in controlling labor. They behaved more and more like inefficientmonopolies unable to contain costs or provide the quality of service required by the shipping

community. The higher costs due to this inefficiency were passed on to the users. Investmentswere made only when there was serious congestion, urgent political agendas or officials whobenefited from the procurement. These problems provided the rationale for current portprivatization efforts. In retrospect, this effort addresses some of the same issues that wereaddressed through the nationalization of ports during the earlier part of this century.

A similar, albeit shorter, cycle has occurred with the rise and fall of the national portauthorities. These were established to coordinate planning, development, and funding fornational port systems and to promote legislative initiatives favorable to the port sector.3Theseauthorities were less effective in managing the maintenance and expansion of individual portsand in addressing the needs of port users. Now many countries are dismantling these nationalport authorities and unbundling the networks to allow better interaction between portmanagement and port users.

C. The Failures of Public Ports

Although some of the largest, most efficient ports in the world are public ports, relativelyfew are operated by the public sector. The enthusiasm for increasing private sector participation(PSP) in port operations derives from the failure of public port operations to meet the followingobjectives:

To provide services which are efficient and cost-effective from the port usersperspective.

To respond to changes in cargo-handling technologies.

To respond to the changing requirements of the port users. To provide choices of services and foster competition. To make timely capital investment to improve efficiency and expand capacity. To generate the funds needed to finance investments. To enforce labor discipline in the face of strong trade unions.

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These failures are attributable to a number of management problems. Bureaucraticprocedures were given precedence over the requirements of the users. Labor was able to use itspolitical power to maintain inefficient work rules and cause work stoppages. Civil service couldnot provide the marketing capacity needed to promote the use of the port. Governmentprocurement procedures encouraged under-investment in some ports and inefficientinvestments in others.4Public accounting systems did not allow for effective cost control

systems. Central government regulation of tariffs led to cost-based pricing.5Efforts to reducethe size of government and the size of its deficit have made it more difficult to finance therenewal and expansion of port facilities to meet rapidly growing traffic volumes.

Despite these failures, the public sector continues to have an important role in serving thepublic interest. This includes ensuring safe and environmentally sound port operations, providingpublic access for markets that are too small to generate a profit, encouraging competition, anddeveloping greenfield sites.

D. Standard Organizational Structures

The different approaches to organizing a public port are grouped into three organizationalstructures:

Resource (Tool) Port: The port owns the land, infrastructure and fixed equipment,provides common-user berths and rents out equipment and space to cargo-handlingcompanies and other commercial operators, on a short-term basis.

Operating (Service) Port: The port provides not only infrastructure, berths andequipment but also services to the vessels and their cargo. This may be a public port asis the case of Dubai, Singapore, and Virginia Ports Authority or a private port as is thecase of Felixstowe, Giao Tauro,6and Freeport.

Landlord Port: The port owns the land and basic infrastructure but allows the privatesector to lease out berths and backup areas either through a capital lease or concessionagreement. This is the most common structure and is found in Rotterdam, Hamburg,7

Los Angeles/Long Beach, Hong Kong, China8(Container Terminals), etc.

Many public ports involve a mix of these three as shown in Table 1. PSP is mostextensive in the landlord and resource ports. In operating ports, it is generally limited tostevedoring and some vessel services.

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4Whether by paying too much or procuring inappropriate and unnecessary assets.

5Tariffs were set according to accounting formulae rather than value of the services provided. This approach was supported byMDBs even though the results were neither equitable nor economically sound.

6The Medcenter container terminal is currently a private concession negotiated with the Ministry of Finance but the port is expectedto be converted to an Authority in the near future.

7 Although technically Hamburg is a landlord port, it also has a public sector cargo handler which accounts for 60 percent of thecargo handling in the port.

8The terminals have been built on filled land by private operators under 99-year leases.

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Table 1: Major Ports in the Region Grouped by Type of Port

Tool Service Service-Landlord Landlord Tool-Landlord

Cebu Singapore Nhava Sheva Rotterdam Manila

Davao Bangkok Bombay Laem Chabang Hong Kong

General Santos Tanjong Prio