Global demand for infrastructure is at unprecedented levels. From now until 2030, spending on infrastructure will need to double from the current $3 trillion-a-year levels, according to McKinsey, in order to develop the critical infrastructure needed for economic growth.
The numbers are eye-watering, particularly in a world where risks are amplified by increasing and uncertain regulation. Deleveraging banks and the impact of Basel II have contributed to a funding void that cash-strapped governments are looking to the private sector – and institutional investors in particular – to fill. Total sums held by pension funds, insurance companies and mutual funds in OECD countries alone is estimated to be in excess of $65 trillion, the OECD reports. This is somewhere between the OECD's $50 trillion and $90 trillion estimated global infrastructure funding requirement to 2030.
Participation by insurers and pension funds in infrastructure ranges from indirect investment in government bonds through to direct investment in infrastructure project equity and infrastructure project debt. At the unlisted equity end of the spectrum, institutional investors' representation remains low. On average, these products represent less than 5 percent of institutional investors' asset allocation, and around 10 percent for large investors such as Canadian and Australian pension funds, according to Using PPPs to fund critical greenfield infrastructure projects, by fund manager Meridiam.
The irony is that institutional investment into infrastructure is arguably a near-perfect match. In a low-interest environment, long-term, low-risk, inflation-proof returns make infrastructure PPPs look attractive to institutional investors seeking timely settlement of liabilities and greater diversity.
Low risk does not, however, mean no risk. The status quo persists in part due to operational-level project risk – construction risk, supply chain risk, counterparty risk and so on – and in part due to macro level factors: pipeline and procurement risk, and the financial and regulatory environment.
Lack of a pipeline of bankable projects is a significant limiting factor for infrastructure investment in the world today. To counter this and to attract long-term investment in infrastructure, governments need to provide a stable enabling environment, with assurances over the certainty of legal frameworks and public policy as well as clear procurement guidelines and timelines. National procurement bodies such as Infrastructure Australia and Infrastructure UK are among those that have recently implemented national infrastructure plans and priority project lists.
P3s: slow to take off
In the US, several decades of underinvestment has led to decaying public infrastructure and created a tremendous funding gap. Traditional government funded infrastructure investment has been dwindling. While private capital has long played a role in helping fund infrastructure in the US through the purchase of municipal bonds, pension funds and foreign investors, who cannot take advantage of the tax advantages of municipal bonds, often prefer direct investing in infrastructure through PPP delivery models.
However, procurement processes for public-private partnerships in the US have been slow. Many states have yet to use PPP models to deliver critical infrastructure, although momentum is growing. Over the last 10 years, approximately 35 states and Puerto Rico have adopted legislation enabling PPP models for transportation projects, and over 40 states have some form of PPP enabling legislation. That said, there is a large – and ever expanding – club of private financiers that are ready and willing, but currently unable, to grow their infrastructure exposure in the US faster. The challenge is that the demand to invest far exceeds the opportunities.
To improve infrastructure investment, the US federal government needs to provide leadership, further streamline planning and oversight requirements, and improve and speed-up the environmental permitting process. State and local governments need to reform antiquated procurement laws. Government at all levels needs to do a better job of explaining the public benefits that can be achieved through private investment in infrastructure and PPP models.
Eugene Zhuchenko, Executive Director of the Long Term Infrastructure Investors Association, explains how the US federal government might improve its procurement environment: “The government would need to foster the expansion of the legislative base (especially, at the state level) and enable simplification of procurement processes generally. The current system often leaves investors exposed to an unprecedented set of approvals to start a project even after winning it in a competitive setting.”
Public acknowledgment of the benefits from private infrastructure concessions also needs to be managed, says Zhuchenko. “People tend to complain about tolls on new roads, disruptions from on-going construction and 'somebody getting rich' off what is meant to be public. This is what often ends up in the American press whereas a bigger picture – greater value for money and faster implementation under private management as well as the financial return going mainly to sustain pension savings and the like – goes largely unnoticed.”
Regulatory give and take
While managing public perception is a political issue, financial regulation can provide an enabling environment that supports the development of a pipeline and encourages institutional investment in PPPs.
In Europe, amendments to the Solvency II regulatory regime have been proposed by stakeholders and industry bodies to support the recognition of infrastructure as a low-risk, long-term asset class. The European Insurance and Occupational Pensions Authority worked with the LTIIA and other stakeholders on the identification and calibration of infrastructure investment risk categories. EIOPA's advice included recommendations extending the definition of infrastructure projects to 'project-like' entities, and a 36 percent capital risk charge for equities in other infrastructure corporates.
Changes in policy and regulation can also have an unsettling effect on the project pipeline. In 2015-16 the European Commission's statistical division, Eurostat, published a ruling and several clarifications regarding the treatment of public-private partnerships in public accounts (so called ESA10 rules). Eurostat's position is that certain PPP projects now have to be recognised on government balance sheets. This change in treatment has triggered apparent concerns with some EU member states, already leading to delays with several PPP procurement processes in Belgium, Scotland and Slovakia, and raising uncertainty over many other upcoming projects. Private investors are querying how profound the consequences can be of Eurostat's ruling on Europe's future infrastructure pipeline. The LTIIA has commenced a dialogue with the European Fund for Strategic Investments and the European Commission on this, in the context of supporting the implementation of the 'Juncker Plan'.
One path to explore could be the exclusion of certain projects, confirmed by the EFSI as “European Strategic Investments”, from the Maastricht criteria of deficit/debt calculation for national governments. The approval criteria could include significant private sector participation, longevity of finance beyond 15 years, minimum capex size of € 100 million and a cost/benefit analysis approved by the EFSI Board. The total exemption could be capped in relation to the GDP of each member state (say, up to 2 percent to be paid for availability/grant payments). An approach like this could quickly deepen the pipeline of new projects.
The complex web of operating and contractual risk within a PPP project presents significant challenges for the development of project pipelines, particularly in less mature PPP markets. The appropriate application of risk allocation principles will determine whether a PPP project is bankable and able to attract institutional and other investment.
Earlier this year, the Global Infrastructure Hub (established by the G20 group of nations to foster innovative approaches to global infrastructure development) developed a tool to assist governments and stakeholders in developing economies in building a pipeline of viable PPP infrastructure projects. The online portal provides guidance that will enable governments to bring projects to market faster and more cost-effectively. It provides information on the risk allocation between public and private sectors in PPP transactions, along with related information on measures to mitigate issues and typical government support arrangements.
Developing an adequate pipeline of infrastructure investment opportunities as well as stable and supportive financial and regulatory environment is key to attracting institutional funding. A further but equally important consideration is the importance of long-term sustainability.
Sustainability is about more than climate change and reducing emissions: it is also about economic sustainability and longevity. Sustainable practices will become ever more embedded in national policy following COP21 and the adoption by 190 countries of a commitment to reduce carbon emissions. In the infrastructure PPP context, a project developed on sustainable principles will be prepared for changes to carbon legislation, and increasing taxes on energy emissions, for instance. It will be able to flex in response to digital disruption and a growing population that demands integrated city infrastructure and connected mobility solutions. The greatest risk to institutional investors in infrastructure PPP projects is in failing to understand the opportunity presented by investing with environmental and social governance being front and centre. The institutional investor needs to be 'future-ready'.