Using PPPs to Fund Critical Brownfield Infrastructure Projects

Green development will not make a bad deal a good deal; like any other project, it requires the right location, marketing, and design. But green development can make a good deal a great one by maximizing a district’s economic and environmental potential.

May 2014 | by Jack Kuhlman

Given the long life span of most infrastructure assets—from 15 to more than 100 years—a higher share of global savings will have to be allocated to infrastructure in coming years. The fast-growing savings managed by institutional investors—estimated at $75 trillion by the Organisation for Economic Co-operation and Development—must play a central role.

Funding for infrastructure projects can take a number of forms, including non-infrastructure financial products (such as government bonds, infrastructure-related corporate equity, or debt products) and dedicated pure infrastructure financial products. Dedicated infrastructure financial products include unlisted equity investment in infrastructure and infrastructure project debt. To date, these products represent a limited share of institutional investors’ asset allocation—less than 5 percent on average, but more than 10 percent for large investors, such as Canadian and Australian pension funds. 

A particularly interesting area is so-called brownfield infrastructure—projects, which are developed as public–private partnerships (PPPs). While PPPs represent a limited share of total infrastructure investments, they are gaining speed. In the United Kingdom, the new framework to fund low-carbon energy-generation projects, the so-called Contract for Difference scheme, strongly resembles a traditional PPP. Also, PPP schemes are becoming more popular in mature economies like the United States and are expected to play a major role in addressing the infrastructure challenges of fast-growing economies like Africa’s.

Why Brownfield Infrastructure is Attractive to Institutional Investors

Traditional infrastructure-market players, such as governments and utilities, are under financial pressure, and their budgets are strained. They are increasingly looking to private investment to fund infrastructure projects. PPPs can offer a number of benefits, including a whole-life costing approach that optimizes construction, operation, and maintenance costs, better risk management, and efficient project delivery. Well-structured PPPs can help ensure that brownfield projects are delivered on time and within budget and at the same time generate attractive risk-adjusted returns for investors.

Investors that enter a project in its early stages can capture a premium of several percentage points. Such a return usually takes the form of patient capital, or long-term capital. Investors must wait for the end of the construction period before they can expect a project to begin generating yield. Depending on the complexity of the project, this can take five years or longer; for instance, high-speed rail projects are known to be on the longer end of this timeline. However, investors in patient capital are willing to forgo quick returns for greater long-term returns. Typically, while investors in patient capital expect a return, they also value the economic and social benefits of a project.

To secure this premium, investors must ensure that the risks associated with a project are properly managed. Brownfield projects usually begin with a clearly defined contractual framework that allocates risks to the most natural owners. Contract frameworks bring structure and discipline to the execution of brownfield infrastructure projects. For example, the construction risk associated with brownfield projects is typically greater than greenfield projects. By transferring construction risk to experienced contractors and by establishing fixed prices and specific design and build deadlines, project managers and investors can protect against the delays and cost overruns that can plague infrastructure projects. 

For investors to secure long-term returns, contracts must address the key risks inherent to all infrastructure projects, not only brownfield projects. Examples include revenue and volume risk, which relate to the effective use of the infrastructure at expected tariff levels (for instance, road traffic), or the availability and affordability of a critical input (for example, gas supply to a gas-fired power plant). These risks can be managed through risk-sharing mechanisms like minimum traffic guarantees from public authorities.

Political risk assessment and management is also essential over the long term. An infrastructure asset is captive by essence, and its performance relies on the willingness of local counter-parties to respect the commitments made at inception. Managing this risk over the long term typically involves focusing on critical assets with proven added value (for example, a strategic urban-transportation project or a power plant essential to national energy supply), negotiating robust contractual agreements, and fully addressing the environmental, social, and governance aspects of all infrastructure projects. Project participants that do this are more likely to secure and sustain support from key government stakeholders and simultaneously protect their investment over the long term.

What Government Can Do to Encourage Investment

As investment in infrastructure is based on specific assumptions regarding the stability of legal frameworks and public policy over a projected investment period, government agencies can take several steps to encourage PPPs. One, governments are more likely to attract long-term investment if they can provide a clear pipeline of investment opportunities. Investors will only develop internal knowledge and skills in a specific sector, such as infrastructure, if concrete investment opportunities exist. Similarly, government agencies must establish clear guidelines and reasonable timelines from project announcement to award in order to convince investors to develop their internal skills. Put another way, to make development risk manageable for investors, procurement agencies must avoid any “stop and go” when launching infrastructure projects. This will be instrumental to building credible pipelines of investable opportunities and enabling institutional investors to actually engage.

Two, long-term investment requires visibility into cash flow. PPP frameworks, and in particular, contracted cash flows, provide this visibility and also ensure predictability. Predictability, in addition to the natural correlation of cash flows to inflation, contributes to the attractiveness of PPP projects for institutional investors seeking assets that match their long-term goals. Still, some industries that are of great importance to the public sector suffer from a lack of investment predictability. The power sector in Europe offers a case in point. Securing funding for critical facilities such as thermal power plants is proving more difficult when revenues are derived from European deregulated wholesale markets. In the United Kingdom, where merchant and regulated energy assets did not typically benefit from the visibility that private-finance-initiative assets could provide—specifically with regard to appropriate mitigation of a change in law or public policy, force majeure, or hardship risks—low-carbon facilities may be an inflection point.

This is also the case in the rest of Europe, where regulated power transmission and distribution networks are better suited to short- or medium-term private-equity strategies, because visibility on tariffs is typically limited to five years. In contrast, the power sector in Africa, which is dominated by PPP-like independent-power-producer projects, can be considered more predictable by long-term investors. By providing greater and enduring visibility to investors, typically under contractual arrangements akin to PPPs, European governments could attract long-term investors in the power sector.

Three, financial regulations help ensure economic and financial stability. They also affect long-term investment. Government agencies must think strategically about how regulations can encourage long-term investment in infrastructure projects and whether they reflect the risk-reward equation of these nuanced investments. For instance, it will be interesting to see how Europe’s forthcoming Solvency II framework evolves and potentially affects infrastructure investment. Regulations should also be built on hard data. 

Finally, government agencies can play a key role in addressing market failures, either directly or through public development banks. They can act as facilitators and provide credibility to infrastructure projects. By funding transactions or supporting active market players, development banks provide a powerful signal to the private sector. Their presence suggests political support and stability over the long term. In addition, dedicated financial instruments—such as guarantee instruments, long-term funding, seed investment, and early-development stage facilities—can encourage long-term investment. Channeling wealth and savings into productive investments, including brownfield infrastructure, will be essential for the global economy to grow. 

 

Executive Editor

 Ms Anna Sullivan

Ms Anna Sullivan