The Smart Cities Mission, presently covering 33 cities and expected to cover 100 cities over the next five years poses a unique challenge to the incumbent cities: raising money for realisation of the vision.

For the most part, the Government of India has made a significant provision – Rs. 48,000 crore over the next five years, distributed over the 100 incumbent cities, implying close to Rs 100 crore per city per annum. This is to be matched by a similar contribution from the State Government.

In addition, each of the Smart City incumbents also have access to funds under other schemes such as Atal Mission for Rejuvenation and Urban Transformation (AMRUT), Swachh Bharat Mission, Digital India, Skill development, Housing for All, etc. These funds together are meant to leverage other sources of ‘returnable capital’ such as debt and private sector investment – commonly referred to a Public Private Partnerships or PPP arrangements – which is still believed to the second largest source of funds after Government grants in the fiscal plans for smart cities.

In particular, it will be interesting to see how PPP arrangements play out in the development smart cities. While the private sector has evinced interest in smart cities, there are several concerns about the public private partnership model.

Typically, PPPs thrive on bankability of projects because private sector players try to keep the cost of capital low by relying more on debt than equity. In the case of smart cities bankability of projects is of considerable concern because of weak regulation, market risks including competition from the unorganised or semi-organised sector and a general reluctance of municipal bodies to impose additional costs on the public through enhanced user charges and/or tax burden.

Information inadequacy is another issue that plagues urban local bodies. Most municipal bodies have limited or no knowledge of actual service requirements of the private parties leading to skewed assumptions in terms of the scope of work of a private party engaged to provide services on its behalf. This problem continues during the project feasibility and structuring phase and private sector bidders often bid blindly, either overestimating or underestimating the investment required, leading to issues in actual service delivery.

The other issue with PPPs in municipal services is the lack of diversity in terms of modes of private sector participation. Our current PPP model favours large private sector commercial entities citing improved managerial efficiency as the reason. This does not always translate into appropriately scaled or scoped projects. It is a small wonder then that very few PPP contracts in cities that are initiated actually reach fruition (about five per cent only).

There is also the ongoing issue of transparency and accountability of projects taken up using private sector investment – with both civil society groups and certain political quarters demanding that public services with a natural monopoly being provided by private entities be subject to audit the same way as any public agency or authority.

However, the established view in policy (with some basis in law) is that a private company, even if providing public services should be subjected to public audit – and that any such supposedly ‘undue’ advantage that the private sector party may be getting may, in fact be a natural product of market processes, and therefore beyond the purview of scrutiny.

Established literature concerning PPP refer to what is widely referred to as a ‘public sector comparator’, a mechanism which effectively tries to determine what it would cost a competent public authority or agency to deliver the same service under the same conditions – which in turn is used to determine if any ‘undue’ advantage is being claimed by a private party providing a public service in the first place. However, there is no generally agreed method for determining this which is currently in use in India.

The problem of accountability exacerbates significantly with PPP contracts based on land based transactions – where a private party is expected to develop a parcel of land belonging to the appropriate Government and share some form of proceeds with the same. In most developed nations, this kind of transaction uses high quality, fair and independent valuation of the land and other fixed assets as a key principle of the transaction. In India, we are yet to develop a disciplinary regime where States and local authorities are compelled to use standards in valuation of fixed assets – such as IVSC (International Valuation Standards Council) or the RICS Red Book – leading to allegations of causing losses to the State exchequer. There is some improved awareness in this regard as market regulator SEBI is now insisting on such standards being followed in REITs and InvITs (Infrastructure Investment Trusts), but this is yet to permeate down to urban development and more importantly smart cities.

As far as financial sustainability of smart cities is concerned, the municipal finance system is constitutionally designed to be dependent upon a superior Government. Successive (Central) finance commissions have linked the transfer of assigned revenue (city’s share of State revenues from taxes and other levies collected by the State) to the city’s capability of augmenting its own sources of revenue. This works for large cities which have a large source of revenue base, but not so much for smaller cities – which remain largely tied and dependent on State and Central transfers.

Municipal borrowing has traditionally been a troublesome area as most municipal bodies cannot borrow without the State Government’s permission. The municipal bond market has all but dissipated since octroi – which was a keystone of revenue inflows - has now been abolished in most parts of the country.

The new GST regime does away with a number of State taxes. This could technically hamper municipal bodies more as there will now be two levels of assigned revenue settlement – one from Centre to States and the other from State to municipalities. A delay in the settlement cycle would mean liquidity crunches on municipal bodies as States also await the compensatory settlement from the Centre.

Smart Cities are expected to use two innovative approaches to overcome the above situations – one of them being the SPV (Special Purpose Vehicle) route to develop smart cities which has (i) considerably more autonomy to raise capital from markets, and (ii) SEBI promoted framework for municipal bonds and derivatives, which will hopefully re-kindle the practice of municipal bonds. This will help in ensuring financial sustainability of smart cities.

While the smart cities mission is quite ambitious in what it hopes to achieve for urban India, finding ways to fund the mission will be quite challenging.

This article first appeared in Business World Smart Cities

Sachin Sandhir is the Global Managing Director-Emerging Business, RICS