The construction of myth

Whether it’s the young child struggling to complete a Lego model that looks anything like the one in the assembly booklet, or that child’s parent muttering expletives as the latest DIY job increasingly resembles mission impossible, we’re all forced to appreciate from time to time how difficult it can be to put things together.

Perhaps it’s this bitter first-hand experience which helps to explain why construction risk has attained an almost mythical status in institutional investor circles as the risk to fear above all others when it comes to investing in infrastructure. Ever since the Crisis, with hopes pinned on pensions and insurers as the future of long-term finance, we’ve been hearing the expression “if only” time and again – as in: if only they could handle construction risk.

It was more than a year ago that the EDHEC Risk Institute challenged conventional wisdom. Picking up on a National Audit Office report that questioned the wisdom of the UK government’s guarantees scheme (offering the possibility that the public sector would step in to take construction risk off private investors’ hands), EDHEC argued that construction firms should be big enough and experienced enough to take construction risk on their shoulders.

Efficient builders only

The argument was developed further at an event organised last week by rating agency Standard & Poor’s and the International Project Finance Association. Describing how construction risk is typically dealt with these days, Dejan Makovsek, a policy analyst at the OECD’s International Transport Forum, said: “Construction risk is passed from the lenders and investors to the contractors through date-certain, fixed price contracts. The builder now has strong incentives to control costs and, if enough risk is transferred, only those builders who know they can control costs well will bid.”

Boil it down to an ability to draw up a sufficiently tight contract and construction risk surely loses some of its capacity to keep investors awake at night. And so it should: after all, there are scarier monsters out there.

The S&P/IPFA gathering suggested that bigger threats to the solvency of project finance transactions were posed by operational risk (20 to 25 years is a longer period for things to go wrong than three or four years of construction) and counterparty risk (consider UK developer Jarvis and the £120 million funding shortfall it faced on 27 PFI projects, before eventually toppling into administration in 2010).

S&P acknowledged that construction risk may have been the main cause of defaults in infrastructure projects 20 years ago but since then the market has changed to such an extent in terms of project structures, counterparties and risk transfer, that the agency had been prompted to redesign its project finance ratings criteria.

The big question is – are investors also getting the message? Participants in this month’s infrastructure debt roundtable were cautiously optimistic. Construction risk is generally better understood now and some pensions are even starting to see exposure to it as a potentially useful portfolio diversification tool.

Some investors will still need persuading though: too many physical and mental scars from their own domestic household projects, perhaps.