Driven by financial need, fiscal austerity and, in some cases, disenchantment with the performance of state-provided infrastructure services, many governments have turned to the private sector to build, operate, finance and own infrastructure projects in the power, water, transportation and telecommunications sectors.
With an estimated $40 trillion needed for urban infrastructure investment globally in the next 20 years, the private sector will continue to provide the main source of funding.
The vulnerability of infrastructure projects
Managed effectively, infrastructure investments promote productivity and efficiency in both the public and private sectors and foster economic growth, while managing various environmental challenges. Trillions in any currency are required at a time when capital is scarce and not all nations can tap the financial markets as easily as before the recent recession. Yet the economic life of much of this infrastructure is usually of the order of several decades and has the potential to generate a fairly stable, often inflation-linked income.
The risk to investors arises from the unpredictable behaviour of host governments. The potential for political change through democratic or violent means can reshape the investment landscape. Under these circumstances, it is not just bricks and mortar that are at risk, but the value of underlying contracts.
Infrastructure projects are particularly vulnerable to government action or inaction for two key reasons. First, the very nature of the projects requires upfront, high-cost fixed investment that is relatively difficult to withdraw. As a project is developed, the balance of power in the relationship between the investor and host government evolves and shifts in favour of the government, an evolution known as the “obsolescing bargain”.
Secondly, returns on infrastructure projects are usually derived from tariffs levied on the local population for service provision, which can be politically and economically sensitive. Investments in infrastructure projects are often made in hard currency while payments for the service provided are usually received in local currency. This creates currency inconvertibility and transfer risk in the conversion and remission of foreign currencies that governments can control.
The Argentinian financial crisis of 2001 is a case in point. In response to deteriorating economic conditions, an Argentine court issued an injunction preventing CMS Gas, a private company with a 29.42 percent share in a joint venture with the state-owned gas company, from paying tariffs in dollars with an adjustment for inflation. The case was taken to arbitration for claims of expropriation and discriminatory/arbitrary treatment. The same injunction led to a number of similar cases arising across the Argentine gas sector.
While regulatory bodies were established in many developing markets to provide effective management of infrastructure projects, regulatory risk has, ironically, come to present one of the greatest challenges to foreign investment.
Rather than depoliticising such things as tariff setting and enhancing the operating environment for project managers and private investment through transparent and predictable decision-making, many regulatory bodies are subject to political manipulation. The fact that they are not financially culpable reduces the protection afforded investors in the event of an arbitration dispute.
The regulatory risk for project lenders derives from the potential for the governing authorities to affect prices, quantities or services impacting on company returns.
This type of action was exemplified by the Spanish government which has reduced the subsidy for renewable energy projects 13 times since 2010. It then went a step further and retroactively shrunk the subsidy programme, meaning companies lost money they had already earned. This had the effect of altering the tariff agreements for renewable energy projects, leaving many projects financially unviable.
Sovereign and sub-sovereign risk
In territories where influence over infrastructure projects occurs at the federal and state level, another layer of risk arises. Often the boundaries been central government and state authority control are not clearly delineated and disputes can arise as a result.
In Russia, the Federal Public-Private Partnership (PPP) law passed in 2005 was designed to enable investment across a range of infrastructure sectors: motorways, railroads, energy, ports, and airports. However, discrepancies between federal and regional PPP law posed risks to investors as governing authorities were able to use the contradictions to declare contracts invalid.
Political risk insurance
As regulatory and political risk has become a growing challenge to investors in developed and developing markets, the Political Risk Insurance (PRI) market has seen a surge in demand as investors seek to protect their interests.
The success of infrastructure investment is dependent upon the relationship that investors (via the operating company) enjoy with the government of the host country. This can be an arm’s-length relationship within the applicable regulatory framework or, more frequently, a relationship that is underpinned by a concession agreement, off-take agreement or other form of operating licence.
The nature of this relationship with the government of the host country is central to the structure of a PRI policy and, where a specific contract is in place between the government of the host country and the operating company, a breach of this contract by the host government provides a clear trigger for cover, in addition to the other more generic PRI triggers such as confiscation, expropriation, nationalisation, political violence or restrictions imposed on the free conversion of local currency.
Historically, PRI underwriters have tended to exclude non-discriminatory actions that host governments might take in the interest of the public (a challenging issue where only an arm’s-length relationship exists between the host government and operating company).
However, where the contract underpinning the investment provides clarity on the host government’s obligations to the operating company (including the provision of compensation in the event of a breach), PRI can allow the realisation of medium- to long-term investments which otherwise might struggle in today’s challenging geopolitical environment.
The specialist PRI market has a proven track record stretching back to the 1970s with underwriters able to draw on wide-ranging sector and geographic experience. In this context, the PRI market is an increasingly important factor in the evaluation and implementation of infrastructure investments.
*Edward Nicholson and Dr Elizabeth Stephens are partners at JLT Credit, Political and Security Risks in London.