The critical building block that goes into this is assessing the `fair’ rate of return on equity capital. By and large, infrastructure projects have low betas; whether business cycle conditions are good or bad, they tend to generate stable cashflows. By this logic, the rate of return obtained by the developer should be relatively low.
India requires a trillion dollars of infrastructure investment in coming years. For this to come about properly, sound thinking on the appropriate rate of return is required. If this rate of return is set too low, then the required investments will not be forthcoming. If the rate of return is set too high, then developers will earn monopoly rents, and the economy will be hobbled with expensive infrastructure.
The regulated industry has strong incentive to lobby with the regulatory agency. Almost nobody else in the country has detailed technical knowledge about the activities within the regulated industry. This field is thus fraught with problems of governance, the capabilities of regulatory agencies, etc. High quality public discussion, and criticism of the activities of regulatory agencies, is thus critical to ensuring that the outcomes are sensible. Our puzzle in India is that of getting to an ecosystem comprised of well drafted laws that create independent regulators, high quality staff in regulators, high quality independent experts outside government, well educated journalists, freedom of press, etc.
In this setting, an important order has been released by the Airports Economic Regulatory Agency (AERA): tariff setting for the Delhi airport. This will be of great interest to people interested in the fields of infrastructure financing and corporate finance in India. In my knowledge, this is the first episode in the field of Indian infrastructure where high quality corporate finance knowledge has gone into tariff setting. The arguments and methods here will be relevant for other airports, and for other areas of infrastructure.