How capital recycling can ease rating pressures

Australian state governments face the significant challenge of addressing an infrastructure deficit against a backdrop of weaker finances, rising debt and a desire to protect and/or improve their credit ratings. Reflecting these pressures, public sector infrastructure asset sales look increasingly sensible.   

Public sector asset sales by state governments have, however, historically been politically tricky. The defeat of the Queensland Labor government in 2012 is the most recent example of where public asset sales played a role in the government’s election loss.

Public opinion of asset sales could potentially be lifted by a new approach, namely a transparent model of capital recycling, whereby a portion of the proceeds is allocated to “infrastructure funds”.  In practise, this may work by using sale proceeds to retire debt, therefore providing fresh balance sheet capacity to fund new projects. 

This is currently being tested, with some apparent success, in NSW. Such a self-sustaining model of infrastructure funding could be expected to lift economic growth and deliver significant community benefits. 

Australian states are capital constrained 

Australian states are rated highly relative to their global peers. Most Australian states are rated AAA, with the most poorly rated state at AA grade. Nevertheless, all ratings changes since 2009 have been downgrades or negative changes to the outlook. 

This has been due to rising debt burdens and/or a structural weakening in states’ revenue bases that have not been met with sufficient fiscal redress.  The average gross debt burden of Australian states has more than doubled since 2006 and is forecast to increase to above 85 percent of operating revenues in 2014. 

It is therefore no surprise that state governments are focused on repairing their balance sheets and preserving (or improving) their credit ratings. Indeed, in August 2012, NSW went so far as to put in place legislation specifically targeted at maintaining its triple-A rating. 

Sowing the seeds for future infrastructure spending

Against this backdrop, alternative methods of funding Australia’s perceived infrastructure shortfall must be explored. At present, many state governments appear focused on generating greater participation from the Commonwealth government and the private sector to fund infrastructure investment. These alternative funding sources however are not necessarily readily available. 

The Commonwealth government, facing its own fiscal challenges, set aside just $3.1 billion for infrastructure spending over the next five years in the 2013-14 budget. The private sector meanwhile, whilst a potentially rich source of funds, requires a new funding paradigm and regulatory regime to encourage greater participation.  

Recycling capital – that is, selling assets that could be better managed by the private sector and using the proceeds to fund other infrastructure – seems an increasingly attractive option for state governments.  Asset sales will improve state balance sheets if they assist the government to pay down some of its debt and if the benefits of doing so exceed the dividends foregone and tax benefits of holding the assets.

After retiring some debt, the proceeds of asset sales could be used to seed sovereign wealth or infrastructure funds (at state level). Infrastructure projects could be approved by state governments but managed by independent infrastructure bodies against pre-set guidelines.

The institutional structure developed in NSW – whereby Infrastructure NSW is the state’s infrastructure planning body and Restart NSW (seeded by asset sales) contributes capital towards infrastructure projects – indicates this proposition is gaining traction. The 2013-14 NSW budget confirmed that the $4.3 billion net proceeds from the leases of Port Botany and Port Kembla will be allocated to Restart NSW, and specifically the WestConnex toll road (A$1.8 billion), Pacific Highway upgrade (A$400 million) and Princes Highway (A$170 million).   

If new economic infrastructure assets are initially consolidated/financed on the states’ balance sheet to address risk-transfer issues, these assets could subsequently be considered for disposal once they become operational (post ramp-up). Indeed, this model has been adopted by the NSW government as it manages the debt implications of the WestConnex project. This would effectively create an inter-generational self-sustaining state infrastructure funding model.

Moreover, investor appetite for such privatised Australian infrastructure assets is strong.  This was highlighted when the NSW government’s 99-year leases of Port Botany and Port Kembla, raised $5.1 billion, around $1.5 billion to $2 billion more than expected, and is why the NSW government is looking to lease the Port of Newcastle.  Of course, not all assets would realise such a good outcome.

If successful, recycling capital could increase infrastructure spending, improve states’ balance sheets, lift productivity and, potentially, contribute to an improvement in state government credit ratings and/or ratings outlooks.

The value of asset sales that could lift state government credit ratings 

Infrastructure Australia has identified $220 billion of economic infrastructure assets that it considers might be suitable for sale from the public to the private sector. These assets were identified, among other factors, as having the potential to apply a user-pay framework or already having a non-government earnings stream with the potential to cover operating costs.

This full pipeline of potential asset sales identified by Infrastructure Australia however would be highly unlikely to proceed quickly. Political and community concerns as well as the required regulatory reform in some markets will remain barriers. Our analysis reveals that sales of around $50 billion could be sufficient to lift the absolute rating and/or improve the ratings outlook for Australian state governments.

A likely pipeline 

To generate enough funds to both lift credit ratings and successfully recycle capital for new investment, sales would need to rise well above $50 billion. We consider this to be achievable, and indeed have identified a pipeline of around $120 billion of infrastructure assets that could potentially come to market over the next few years. The electricity sector provides the highest value of assets, followed by water and then ports. We note however that, partly due to the perceived need of state governments to seek a political mandate to proceed, these sales are unlikely to commence until at least 2015. 

These asset sales would potentially generate an additional $70 billion on states’ balance sheets to fund infrastructure projects. This is predicated on the assumption that reducing the states’ combined debt by approximately $50 billion would deliver a sustainable capital leverage profile of a triple-A semi-sovereign borrower. Combined with private equity and debt capital, the states could help to fund infrastructure assets worth significantly more than the original $70 billion in capital proceeds.