Financing India's smart cities mission: the Special Purpose Vehicle

After the first round of shortlisting of cities by the states resulting in a selection of 98 cities for the Smart Cities Mission, and the remaining two in Jammu and Kashmir and Uttar Pradesh still being contended, the second stage of evaluating the Smart City Proposals is being currently conducted with the support of the Bloomberg Foundation, the knowledge partner for the Ministry of Urban Development (MoUD) for the mission.

After the first 20 smart cities were selected at the end of January (see page 82), the next step is to set up a Special Purpose Vehicle and begin executing the proposals. Understanding the capabilities and limitations of the municipalities, such vehicles have been made the centre stage of the smart cities implementation exercise, right from planning, appraising, approving and releasing funds through to the administration of projects.

The central government has earmarked US$7.5 billion to be provided to the 100 cities over five years, with an equal contribution due from the states and the urban local bodies. Two- fifths of this amount will be provided upfront in the first year, after which yearly instalments will be disbursed in consecutive years. The latter instalments would be released to vehicles only after certain conditions have been met.

A Special Purpose Vehicle ("vehicle") can be established as a company under the Company Act 2013, with equal holdings of equity shares by the state and urban local bodies and provisions for private shareholding, provided the government shares are in the majority.

A full time CEO and a board with representation from the central, state and local governments will be in charge of the administration of the vehicle. It is the prerogative of the states and urban local bodies to ensure a dedicated and robust source of revenue to the vehicle, and investment decisions would also be made at their discretion. In order to enable operational efficiency and administrative independence of the vehicle, the guideline encourages adopting best practices of vesting project specific powers and responsibilities of the urban local bodies and state governments.

Excluding the grants from the central and state governments, the remaining funding requirements for projects envisaged under the mission are to be met through a host of tools available to urban local bodies. These include user charges, public-private partnerships, 14th Finance Commission allocations and land-based fiscal tools such as property taxes and betterment taxes, municipal bonds, loans from bilateral and multilateral organisations, the National Investment and Infrastructure Fund (NIIF), and provisions under other government programmes. The options available to urban local bodies appear to be plenty, but in terms of the scale of mobilisation of resources, most of these sources are limited. For instance, revenue from user charges for water supply or other civic amenities-even in the best performing municipality-account for only 40 percent of the total expenditure due to leakages and unmetered use.

Property tax coverage in most cities is not 100 percent, and the rates are not reflective of the value of the properties.

Municipal bonds have historically been the tool of choice for raising public finance for infrastructure projects. In recent years they have been experimented with by some of the progressive and bigger local bodies in Gujarat, Maharashtra, Karnataka, and Tamil Nadu but have been met with limited success in attracting capital from the domestic markets. However, these markets are not very active. There are problems with respect to proving the credit worthiness of the municipalities which run mostly on deficits, having to depend on grants from the upper tiers of government and loans from multilateral organisations such as the World Bank.

The vehicles need to manage these funding woes and be innovative in raising finances from market borrowings even under such adverse conditions.

Other than this, the 14th Finance Commission has earmarked over 871 billion Indian rupees (US$12.8 billion) to augment the funds of the country’s urban local bodies, a portion of which is a conditional disbursement. The National Investment and Infrastructure Fund which has a corpus of 200 billion Indian rupees sanctioned by the union government and another 200 billion to be procured from private investments has been set up to invest in commercially viable projects.

Public-private partnerships have been highlighted in this respect.

Water supply, sanitation and solid waste management projects entail long-term debt and cost recovery is very low and slow because of the population cluster these projects mostly target.

Since the smart city concept heavily relies on ICT-enabled service delivery mechanisms-even though the core objective remains that of providing better city infrastructure through integrated systems-expenditure on technology upgrades and basic infrastructure will be a costly affair for urban local bodies. This would involve not only capital investments for setting this up, but also substantial operations and maintenance costs. Thus, the additional funds are a real concern for the investment vehicles.

However, India has some successful experiences to learn from. One of these includes the Tamil Nadu Urban Development Fund (TNUDF). The fund was established as a trust under the Indian Trusts Act 1882 jointly by the Government of Tamil Nadu (71.5 percent), Indian banks ICICI and HDFC, and infrastructure and financing company,

Property tax coverage in most cities is not 100 percent, and the rates are not reflective of the value of the properties

IL&FS, with a line of credit from the World Bank. The trust is controlled by the Tamil Nadu Urban Infrastructure Trustee Company Limited which is at arm's length from the state government and prescribes policies and procedures for using the fund. It is managed by a non-government Asset Management Company, Tamil Nadu Urban Infrastructure Financial Services Limited, under a management contract.

The company, since 1986, has successfully managed the line of credit, not only because of this organisational setting and its adherence to stringent loan conditions but also due to a host of other enabling conditions such as effective use of escrow of property tax and other local body collections, advanced credit enhancement by the government, commitments from domestic and international governments to meet shortfalls if any, and a focus only on capital investments. The investment vehicles for the smart city proprosals need to learn from the best practices of institutions such as the Tamil Nadu company.

Two types of vehicles could be considered a state-level financial intermediary, and a state-level project development and fund management company.

The basic purpose of the state-level financial intermediaries is to mobilise funds from multiple sources, make preliminary scrutiny of projects and check for consistency with existing policies, channel funds to the local bodies and manage recovery of loans and repayment to investors. The intermediaries could be constituted as a trust, company, or a combination of the two wherein a company acts as the fund manager for the trust. It could also take the form of joint ventures between two or more entities. The structure of operation of the Tamil Nadu example is a mix of a trust and a company. Such a state-level financial intermediary takes charge of the overall financial functions, from raising finance in the market from governments at the national and state level, from official development assistance as well as from private investors. It decides the kind of projects which receive financial support, and ensures that local bodies are able to repay the loan amount on time along with interest payments.

Given the important role of these institutions to the success of the smart city proposals, it will be crucial to develop a detailed plan for structuring the investment vehicles under this programme. In addition to developing a structure for these smart city proposals, an appropriate regulatory process needs to be drawn up to ensure efficiencies in their operation with minimal government intervention and leakages. Adequate care needs to be taken in the planning of this stage of the Smart Cities Programme, since its success will be highly reliant on the effectiveness of such vehicles.