Infrastructure: some universal truthsGiven the current global infrastructure deficit, governments and multilateral bodies can do more when turning to the private sector for financial support to plug the gap, writes Andrew Briggs, Hogan Lovells
Andrew Briggs is a Partner in Hogan Lovells’ Infrastructure, Energy, Resources and Projects practice, with more than 20 years’ experience advising on public-private insfrastructure. He specialises in transport, utilities, renewables, defence and social infrastructure.
On 20-21 September 2014, the meeting of the finance ministers and central bank governors of the G20 group of countries reinforced the G20’s commitment to global infrastructure investment. The G20 recognises that infrastructure investment boosts demand and lifts growth.
The economic arguments to support infrastructure growth are compelling. But, more fundamentally, infrastructure investment is at the core of political responsibility. Infrastructure investment is a social entitlement and needs to transcend short-term political pressures. Education is a core global priority, even though the return on that investment is measured in generations, not political cycles. Infrastructure investment needs to be assessed on the same basis.
The G20 clearly appreciates that there are significant challenges to accelerating infrastructure investment, particularly in emerging market and developing economies (EMDEs). The Brisbane Summit will consider how best to meet these challenges. One key theme is that of encouraging private institutional investors to play their part. They will do so, but to maximise this potential requires a shift in the way that government and multilateral institutions approach their infrastructure, energy and industrial development.
Build it, and they will come
There is no shortage of institutional investors willing and able to deploy private capital to infrastructure development; it just needs to find the right home. Understandably, the G20 places great emphasis on the potential to leverage institutional investors’ commitment to the sector, as the natural source of capital for public investments that are, by their nature, long-term opportunities. But to achieve this will require an understanding of the legitimate needs of those investors, and constructive engagement by governments and multilateral bodies. In other words, to achieve the multi-trillion-dollar investment that is needed globally will require public institutions to work more proactively in partnership with the private sector, and make use of emerging and established best practice in a more committed and coordinated way.
Two universal truths
Experience of both successful and unsuccessful infrastructure partnerships, in both developed and EMDE markets, suggests that there are two universal truths that public and private sectors should recognise in developing this ‘new’ partnership, to maximise the latent appetite of the institutional investor market for infrastructure investment.
Financing and funding infrastructure are not the same thing
Starting with the money, the infrastructure market distinguishes fundamentally between the funding of infrastructure and its financing. ‘Financing’ refers to the upfront capital needed to design, construct, commission and maintain an infrastructure asset, whether public or privately provided. ‘Funding’ is what pays for the infrastructure over its useful life.
The hard part is the funding: those providing the finance need confidence in the long-term revenue funding that will underpin their return. Ultimately, there are only three sources of funding: general taxation, sale proceeds for commodities, or asset-user charges (for example, bridge tolls or water tariffs).
- Government revenue streams: common in the classic public-private partnership model and underpinned by general or specific taxation, these provide a predictable and secure revenue model, maximise the infrastructure project’s credit (up to, or at least close to, the sovereign rating) and are perceived as low risk. But in all countries (and in EMDEs in particular), this funding source is constrained and subject to short-term political pressures.
- Offtake charges: these can work well to develop commodities infrastructure or even support general infrastructure, and can enhance a project credit rating at or above the relevant sovereign rating, dependent on project structure. But some EMDEs do not have sufficient commodities for this to provide a meaningful answer, and political instability can skew sensible long-term planning around the application of these resources.
- User charging: this works well in the energy, transport and utility sectors, but can be politically sensitive and volatile. Specifically for EMDEs, concerns over the affordability of charges (particularly around essential needs such as water), enforceability of charges and the regulatory environment to control charges bring additional challenges for the user-charge model.
If funding is limited (which it universally is), but still needs to be applied to generate infrastructure investment, there are two key priorities for public bodies:
- First, make sensible and informed procurement decisions about the most effective way to apply it. This will be both qualitatively and quantitatively driven, noting the current trend towards supporting ‘economic’ infrastructure, which more readily generates identifiable cost benefits. But there are macro-social and political policy issues to consider, too. The cost-benefit advantage of investment in education and health is less clearly demonstrable than it is in energy, water and transportation in the short term – but that is not to say that these sectors should be ignored. In fact, it is the more qualitative factors driving social infrastructure priorities that need the most careful analysis.
- Second, make sensible and informed procurement decisions about the long-term sustainability of any investment. Publicly supported infrastructure involves a long-term commitment. It follows that this works best where the infrastructure is capital-intensive and there is a clear long-term need for the relevant assets. Limited funding should not be applied to support a 30-year commitment for infrastructure that may not be required halfway through its useful life. Understanding demographic shifts is vital.
Government can never fully step back from critical infrastructure
Government is never truly remote from critical public-service infrastructure. Public-private partnerships using institutional investor capital to promote infrastructure can accelerate development, and pass economic risk and reward to the private sector in a way that lowers whole-life infrastructure costs to the general public – clearly, a good thing. Significant amounts of private capital can be exposed to, and rewarded for, the risks associated with efficient infrastructure provision. But there are limits.
The appetite of private capital controllers to deploy funds sits on a risk spectrum. Basic economics tells us that the greater the risk that capital is exposed to, the greater the return it will require: a day at the Melbourne Cup illustrates this perfectly. So the level of risk a private partner is required to take will feed directly into the value for money of that relationship.
At a macro level, certain risks (particularly in EMDEs) are set by the investment environment: for example, if you are relying on a government credit, it will be hard to exceed the relevant sovereign rating as a backstop for your risk pricing. This is where the G20 may be able to make a real and immediate difference, as we describe below. And, at a micro level, certain infrastructure delivery risks are better priced (or supported) by government, so models that seek complete risk transfer, such as the early UK private finance initiative model, may not prove to be best value. Classic examples include land acquisition, planning, price regulation and legislative interference.
But this universal truth is even more fundamental than a basic value-for-money argument. By analogy with the large national banks during the global financial crisis, most public infrastructure is ‘too big to fail’. So, even if private capital is structurally exposed to infrastructure risk, complete private failure will simply require the public sector to step in. This de facto backstop needs to be recognised in developing public-private partnership models that get the most out of a private partner, but at best value. Upfront finance, better risk management, efficiency of delivery and whole-life costing are readily achieved. But total risk transfer is not required to achieve these benefits and, for the reasons described above, total risk transfer is illusory in any event. Government needs to be smart in determining the level of risk transfer that achieves best value for its limited available funding.
Application to EMDEs
These universal truths are relevant to any public-private infrastructure development. But they become even more acute when applied to EMDEs. This is because:
- The infrastructure need is greater, more urgent and more challenging to deliver. So, marginal gains in the efficient use (and cost) of private capital are so much more important to maximise the leverage of all available funding. The aggregation of these marginal gains can make a significant difference to social innovation at no marginal cost.
- The credit environment of many EMDEs is clearly less favourable than that of more developed markets. So, again, the most efficient application of the tools available to government institutions, to maximise leverage of available funding and minimise any ‘country risk’ adjustment to the cost of private capital, is vital.
- The institutional and legal framework of many EMDEs is less secure than that of developed markets. Smart use by governments of development finance institutions (DFIs), international finance institutions (IFIs), political risk insurance, export-credit enhancement, offshore structures and resource-backed financing can assist private partners to get increasingly comfortable with their investment environment. This is enhanced further by the use of best-practice procurement techniques.
- Perceived political, contractual and regulatory stability is key: infrastructure investment has a long time horizon. If private capital is to be tempted into EMDEs outside the current remit (of largely private IPPs and resource-backed developments), then taking seriously the need for economic stabilisation is a fundamental and necessary requirement.
Leveraging the G20 balance sheet: PPPPs – the new way forward?
Post global financial crisis, many members of the G20 have their own financial challenges – short-term fiscal policy is having a drag effect on their own infrastructure development. But the G20 initiative to promote EMDE infrastructure offers an opportunity for a symbiotic, ‘win-win’ approach: let’s call it a public-public-private partnership or PPPP.
Export investment opportunities will play a key role in developing domestic economic growth among the G20 group of countries. And G20 support will be central to developing EMDE transport, utility and energy infrastructure. G20 governmental support to key domestic export industries – manufacturing, project management, equipment supply and advisory services – in partnership with local EMDE governments could rapidly expand the export market in EMDE countries for those industries. This support could be in the form of upfront grants, domestic tax incentives, multilateral finance, export credit guarantees or political risk cover, or a combination of these techniques. Many G20 members are already active in this area. But an enhanced focus would accelerate the ability of institutional capital to invest in EMDE infrastructure.
Properly structured, EMDE country risk can be managed (or mitigated to a material extent). And enhancing the appetite of institutional capital to invest in EMDE infrastructure will have the triple effect of boosting domestic G20 economic growth, providing employment on the ground in EMDE countries and kick-starting the development of key social and economic infrastructure in those parts of the world where it is truly needed.
Many G20 countries are focused on infrastructure development that is carbon neutral, but will ‘keep the lights on’. For many parts of the EMDE community, the challenge is to turn the lights on in the first place. Intelligent leveraging of the G20 balance sheet could help to achieve this, without real or substantial cost to the G20 population.
Making the most of the G20 initiative
It is clear from the official communications that there is a real opportunity to engineer a step change in the use of private capital in developing EMDE infrastructure.
And there is no shortage of capital available. Sovereign wealth funds, pension funds, insurance providers and private capital are seeking infrastructure investment in greater volumes than ever before. The key is to use the vast array of current experience to accelerate the development of investment structures in EMDEs that will be attractive to that capital. And the G20 can make a real difference to this initiative.
In the view of Hogan Lovells, this boils down to five key principles:
- Encouragement and assistance with the continual development of the rule of law: whether contractual, legislative or treaty driven, a stable risk environment in EMDEs will drive the appetite of private capital to invest in infrastructure and reduce the cost to local consumers of doing so.
- Education – both of public bodies and private citizens: all governments can learn from experience elsewhere, and the G20 and its associate partners should continue to facilitate this education process, to promote best use of limited resources. But there is also a political debate – one that is often ignored in more developed economies. It will be important to bring the population along with the increasing use of private capital. Privately financed infrastructure can be bad, but is not inherently bad for consumers. PPP infrastructure does not ‘mortgage the next generation’, as is sometimes alleged, but rather builds now for the next generation to benefit, spreading the cost fairly across those who use it.
- Economics: infrastructure is a long-term investment, but one that also brings short-term economic benefits. Infrastructure programmes can invigorate the local industrial and supply-chain market, promoting SMEs where most needed. They can enhance and mature local capital markets. And, most immediately, they can bring jobs and economic activity where it is most needed.
- Equality: infrastructure investment is vital to minimising the gap between rich and poor countries. While the need is great in many G20 nations, the need is immediate in EMDEs. But this need not be an ‘either/or’ choice. PPPP techniques can kick-start the much-needed investment in EMDEs at a negligible cost to the more developed nations, while boosting domestic growth for those G20 members. Truly, this could be a win-win initiative.
- Execution: bad outcomes are often the result of bad execution. The G20, along with DFIs and IFIs across the EMDE geographies, can and should assist to ensure best practice in the way in which private capital is deployed to develop public infrastructure. Many lessons have already been learnt – they now need to be applied.