What keeps investors awake at night

The risk of unexpected scenarios developing during the course of an infrastructure concession has been vividly highlighted recently. Nothing perhaps encapsulated this more pertinently than the derision piled on the London underground PPP by London Mayor Boris Johnson (see below) as a forerunner to the project being taken into public hands. It was not something advisers to the original agreement could have foreseen, but one thing’s for sure – an enraged BoJo brought a whole new meaning to the term ‘political risk’.

In this spirit, we have arrived at the top five risks that might occupy the minds of infrastructure investors today. For reasons outlined below, these risks are topical. We should stress that they do not constitute our view of the top five risks per se. Some are arguably not among the more traditional or orthodox risks – had this been the focus we would likely have found room for the likes of currency risk or construction risk, for example. These are, however, risks that have become heated discussion points for a variety of reasons.       
So, here they are: the five risks du jour: 

1. A concerted political campaign. “Looting; larceny; a colossal waste of money; a perverse and Byzantine structure; a bunch of rogue builders”. If you are a private investor running an asset and you are on the receiving end of these types of insult you can be sure of one thing: you won’t be running your asset for much longer.

The above-mentioned descriptions were used by London Mayor Boris Johnson in a persistent two-year campaign to end the public-private partnership (PPP) contract to upgrade and refurbish the London underground.  Johnson was successful, and in mid-May the London authorities bought Ferrovial-owned Amey and Bechtel out of the PPP contract for £310 million (€364 million; $447 million) – just seven years into a 30-year contract signed in late 2002.

Johnson’s complaints about the cost-efficiency of the PPP were manifold (see adjacent box) and it matters little now to discuss whether they were valid. In the end, and even though it was under no legal obligation to do so, the consortium succumbed to the Mayor’s onslaught and relented control to the public authorities rather than continue in a partnership which was rapidly deteriorating.

The London underground PPP was controversial from the start and was only pushed through by the sheer will of central government. London’s previous Mayor, Ken Livingstone, actively campaigned against the project. When Johnson was elected in May 2008, he took up the mantle.

Since the private sector was dependent on the London authorities to fund planned refurbishment works, disputes were commonplace and London’s constant opposition to the PPP ended up dooming it – regardless of central government support.

The lesson then, especially when engaging in flagship projects, is to make sure that whatever you are investing in has broad political support, or you may find yourself in serious trouble not far down the line.

London underground PPP: timeline of a broken relationship

Dec 2002: Metronet and Tube Lines sign PPP contract.
Jul 2007: Metronet is placed in administration.
May 2008: Government bails out Metronet for a reported £2 billion.
Jun 2009: Disagreements about capex for 2011 to 2017 emerge.
Dec 2009: PPP arbiter Chris Bolt tells the London authorities in preliminary note that the works will cost £4.4 billion. Tube Lines wants £5.75 billion and the authorities want to pay £4 billion.
Mar 2010: Bolt sets final capex from 2011 to 2017 at £4.46 billion. London authorities threaten legal action.
May 2010: Amey and Bechtel sell their equity in Tube Lines to the authorities for £310 million.

2. Unrealistic traffic projections. In February 2009, Robert Bain, an independent infrastructure consultant based in the UK, wrote a paper entitled “Error and optimism bias in toll road traffic forecasts”. Bain was given unprecedented access to ‘commercial-in-confidence’ documentation relating to predicted and actual traffic usage for over 100 international, privately financed toll road projects. What he found was that toll road traffic forecasts were characterised by large errors and considerable optimism bias.

This will come as little surprise to those who have followed the fortunes of toll road projects such as Australia’s Lane Cove Tunnel (see below). In an article for Infrastructure Investor’s Annual Review of 2009, ING head of infrastructure Michael Dinham wrote that of the 30 toll roads the bank has lent to, ING “can only find two instances where initial sponsor forecasts were met”. As such, Dinham considered them the worst-performing sub-sector within infrastructure:
“The underperformance of the rest (actual revenue versus sponsor case) is about 40 percent on average, with the range between 10 percent and a staggering 80 percent,” which led him to conclude that, “oddly enough, though viewed as core infrastructure, they [toll roads] certainly aren’t low risk.”

While the traffic forecasts for toll roads have not always come from third-party consultants, some market participants feel they should bear the brunt of the blame for inaccurate traffic forecasting. “The advisers don’t get exposed,” says one market source. “I’ve gone back and given some [of them] hell because their forecasts were too optimistic but there’s no point exposing them publicly – there are too many who are guilty.”
It’s not only toll road business plans that have been afflicted by poor forecasting. Rail and airport projects – some already having achieved financial close, others still planned – are also cited by market sources.

Lane Cove: road to ruin   

Controversy surrounded who bore responsibility for the traffic forecasts relating to the Lane Cove Tunnel toll road PPP in Sydney, Australia – a three year-old PPP project which ended up in receivership earlier this year after failing to service debt commitments.

Opposition politicians accused the New South Wales government of having drawn up the forecasts, while the government denied this and said that the private sector participants had based their investment on their own forecasts.

Not in dispute is the wild inaccuracy of the forecasts.  Original traffic expectations pointed to daily traffic in the region of 100,000 vehicles but Lane Cove had been averaging half that amount. A peak of over 62,000 vehicles was reached last November. But that number compares highly unfavourably with the 134,000 vehicles per day expected in 2011, according to the original estimates.     

In May 2010, Australian toll road operator Transurban agreed to acquire Lane Cove Tunnel for A$630.5 million – almost A$1 billion less than was paid by the original consortium of Leighton Holdings, Mirvac and Cheung Kong Infrastructure.  

3. Regulators moving the goalposts. Utilities – with their quasi-monopoly market position, low correlation to economic cycles and regulatory protection – are usually highlighted as the very definition of what is commonly referred to as ‘core’ infrastructure investment.

 It’s little wonder then that they have been a favourite investment of many infrastructure funds, pensions and all those seeking long-term, steady cash flows.

The caveat, though, is that the regulation underpinning these assets is subject to frequent changes. Many of these changes are little more than adjustments to the framework with limited impact on the cash flows an asset generates. Others, however, have the scope for broader and longer-lasting consequences.

That’s the case, for example, with a regulatory change unveiled in Germany in late March which gives state competition authorities the power to regulate water company charges. Up until March, water sector regulation was mostly in the hands of municipal authorities.

The change stems from the judgement made in Germany’s constitutional court on a long-running dispute with a local utility accused of overcharging customers. Under the new rules, state competition authorities can now use price comparisons with other water companies as a basis for market abuse charges, trade publication Utility Week reports.

This means that if a utility’s charges are found not to be in line with the industry average, they can be brought down by the state competition authorities. The trade publication estimated the court’s ruling could cost another company accused of overcharging some £1.4 million (€1.6 million; $2.0 million) in annual revenues.

But losses in annual revenue may not be the ruling’s only consequence. The decision also strengthened a campaign to renationalise one of Berlin’s municipal utilities, in which Veolia and RWE bought a 49.9 percent stake in 1999, reports Utility Week. To quote a local politician, the decision “puts renegotiation [of the sale] firmly on the agenda”.

‘You can never predict everything’

Niall Mills, a senior asset manager in the London office of fund manager First State Investments and member of the board at UK utility Anglian Water, says regulatory risk is among First State’s top three deal risks.

“We always look at regulation very closely and we would always seek local advice on a country’s regulatory regime and practices. If you assume things are similar across national boundaries, you could easily get into trouble,” Mills warns. However, he adds that legal challenges, like the recent one in Germany, are more commonly the result of less mature regulatory regimes:

“In the UK, the regulation is over 20 years old and is well understood, which somewhat diminishes those risks. The more significant changes here tend to be discussed over a longer period of time so even though there will be modifications, an investor can factor them in – although you can never predict everything,” he says.

“But we will always look at how mature a country’s regulation is before we invest in it.”

4. Renewable technology that’s not fit for purpose. One of the emerging areas of infrastructure investment, and which is widely viewed to have enormous potential, is renewable energy. Thanks to highly attractive feed-in-tariffs designed to encourage energy producers to increase their output from renewable sources, such investments appear low-risk thanks to their government underpinning.

But, as you may conclude from this article, risk can come in surprising and unusual forms – and renewable projects have their own particular idiosyncratic version. Specifically, this is the risk that the equipment used by wind and solar energy producers may not be up to the job. “A lot of manufacturers of kit are new and the technology is new. It’s been proved in workshops but not in the real world over a 25-year period,” says Martin Bennett, senior vice president in the private equity and M&A practice at insurance giant Marsh.

There is potentially an additional complication: namely, that the business supplying the equipment (and associated warranties) may end up going to the wall in what is, after all, a highly competitive space.  Bennett says Marsh is currently developing an insurance solution to provide security behind the manufacturers’ warranties.

Providing this security is potentially a key aspect in the ‘bankability’ of renewable projects (see accompanying boxed item). After all, solar plant financial models rely on a high electricity conversion rate – typically 95 percent conversion in the early years of a project, reducing down. If this target is not met, it brings into question a project’s ability to service debt and create equity yield. 

The importance of bankability  

“Bankability” is not a beautiful word, but is much used by lenders to infrastructure projects. You may not find it in the Oxford English dictionary, but it involves the need for all parties to a project to identify and understand all risks which impact economic viability – as well as how the risk exposures should be appropriately allocated. Only when this requirement is satisfied is a project considered to be bankable.

“When these risks have not been identified in the due diligence or have been wrongly identified, then projects can go wrong,” says Martin Bennett of Marsh. “We come across projects, all the way from mature UK PPPs to emerging market PPPs, where the public bodies don’t procure their own risk advisory assistance, don’t have knowledge of the risks in projects and, therefore, ignore the risks and their possible financial consequences.”

5. Divine intervention.  Granted, mitigating against so-called Acts of God – the common legal moniker for natural disasters and other events outside of human control – is perhaps not at the forefront of investors’ minds as they approach a deal. And for good reason: usually, whatever God throws their way is covered by insurance.

However, given the recent spate of high-profile natural disasters, it is perhaps interesting to cast a look at the unintended consequences these disasters can have (and which are not covered).

Take Chile’s devastating earthquake in February. Practically all of the damage caused to concessionaires’ infrastructure is covered by insurance, and as such will be fully paid for once it is determined exactly how much damage the quake has wrought.

For Ferrovial, though, which was in the process of completing the sale of a 60 percent stake in its Chilean roads business to Colombian power group ISA, the quake has had the unintended consequence of delaying the sale. Originally targeted for an April finish, the transaction was then due to close by the end of May. But both parties agreed to delay the closing for an extra three months if necessary, to better assess the damages suffered by Ferrovial’s Chilean concessions.

One running internet joke says that the Icelandic economy’s last dying wish was to have its ashes spread all over Europe – a humorous way of framing the disruptions caused by the eruption of the Eyjafjallajokull volcano.

To date, Eyjafjallajokull has caused relatively minor damages to airport operators. BAA, owned by Ferrovial, said in a recent statement that the £30 million it lost during the disruption should be easily recoverable by cutting operating expenditure. But what if Eyjafjallajokull is not the only volcano carrying out the Icelandic economy’s final wish?

Thor Thordarson, a volcanologist at Edinburgh University, has found that Iceland’s volcanoes tend to erupt in a cyclical manner, with Eyjafjallajokull potentially signalling the end of five decades of stillness. In a worst-case scenario, Thordarson says other neighbouring volcanoes may start erupting, throwing ash into the atmosphere for months or even years to come.

This catastrophic development would be hard to factor into any business case, so what can concessionaires do when faced with prolonged periods of disruption caused by Acts of God? Probably not much, beyond offering a prayer.