Flashcards in infrastructure Deck (16):
The financing of long-term infrastructure, industrial and public services projects is based upon
a non-recourse (or limited recourse) financial structure where project debt and equity used to finance the project is paid back from the cash flow generated by the project.
Infrastructure tends to be separated into two broad subsets
Economic infrastructure includes:
water and sewerage facilities
Social infrastructure encompasses:
The financing for either subset
may come from government, local councils, private companies or a mixture.
In 2005, the UCH hospital, part of University college London, was built using £422 million of private infrastructure finance.
Infrastructure assets are generally characterised by
high development costs (high barriers to entry) and long lives. They are generally managed and financed on a long-term basis. Historically it was seen as the role of government to fund and manage these assets for the good of the population.
Today, the role of the government as the provider of public services is increasingly being questioned both in terms of absolute cost to taxpayers and as to whether a government can deliver the assets as efficiently as a private company competing for the privilege.
From the government’s perspective there is a strong case for privatisation, where the debt raised by the private partner remains on their balance sheet, not on that of the Treasury.
Advantages claimed for privatisation include:
1. Better customer service as private organisations depend on the quality of service being provided and public satisfaction to generate profits.
2. Private business generates more revenue (and/or operate at lower cost) compared to government enterprises, so governments can indirectly increase revenues by leasing out enterprises to private organisations.
factors have resulted in a gradual migration from the public provision of infrastructure to the private sector. The private provision of these assets may take many forms from joint ventures, concessions and franchises through to straight delivery contracts. Essentially the private sector is being brought in to design, build, finance and/or maintain public sector assets in return either for long term contracted payments from the government or for access to the revenue generated from the asset.
What are the disadvantages of privatisation?
Infrastructure assets display a number of characteristics that distinguish them from more traditional equity or debt investments:
The assets themselves tend to be single purpose in nature, such as a gas pipeline, toll road or hospital.
The private investor’s participation in the asset is often for a finite period. This is generally a function of the agreement the investor has made with the government authority, or a function of the natural useful life of the asset.
Infrastructure assets are characterised by their long lives. In fact the capital invested in these projects is often referred to as ‘patient’ capital, in that the initial development involves high upfront capital costs with payback occurring over the asset’s generally lengthy life.
One of the key characteristics of infrastructure assets, and what can make them particularly attractive as investments, is that they tend to be, or exhibit the characteristics of, natural monopolies. Under a natural monopoly, economies of scale are such that the unit cost of a product will only be minimised if a single firm produces the entire industry output.
This environment has the potential to weaken market forces, particularly when there are few, if any, alternative suppliers of the infrastructure. In this case, firms operating in a natural monopoly, protected from new competitors by the high barriers to entry, may be able to earn abnormal profits by charging higher prices.
As a result of these monopolistic characteristics, infrastructure assets tend to be subject to varying degrees of government regulation, depending largely on the degree of natural monopoly. This is not necessarily to the detriment of investors in infrastructure, as it provides a level of certainty regarding the income streams that will flow from the asset.
The risks of an investment in infrastructure may be generally divided into:
those specific to the infrastructure asset and
those affecting the broader asset class.
The asset specific risks encompass risks pertaining to the design, construction and operation of the infrastructure asset. The asset class risks include:
market / economic risk
This is important when consumers can choose alternative services such as with toll roads, railways and ports. Occasionally, the Government absorbs this risk explicitly or by default. In a Mexico toll road, the Government awarded the concession guaranteeing a minimum amount of traffic. If this could not be achieved, then the concession period would be extended.
One element of market risk is demand risk – ie the overestimation of customer demand and “willingness to pay” for the proposed infrastructure. In several cases, like the toll road network in Mexico, the demand for the facility is high but inadequate willingness to pay on the part of the users raises serious questions about the viability of such projects.
regulatory risk and political risk.
A lack of clarity in Government policies and selection procedures has created
political risk a key risk in infrastructure development.
This may arise due to underestimation of operating costs. If the pricing of infrastructure services is regulated by the government, the burden of underestimation of operating costs cannot be passed on entirely to the users.
Infrastructure assets may also exposed to large-scale disasters, such as the fire in the Channel Tunnel in 2008.
The asset specific risks will largely depend on the maturity of the asset. For example, in the construction phase, there is considerable risk associated with the construction process.
In the initial high-risk planning phase only equity capital is suitable for financing. The construction phase may be financed by a combination of equity and debt with guarantees.
Importantly, a key feature of infrastructure assets is that as an asset matures its risk profile declines and valuation increases, all other things remaining equal.
Of the more generic risks affecting the infrastructure asset class,
perhaps the most pertinent is interest rate risk. The prevailing level of interest rates can have an impact on the discount rates applied to the valuation of infrastructure investments, and on the debt portion of the investment structure.
Over the medium to longer term however, any initial fall in value as interest rates rise is mitigated as revenue from the underlying asset grows. Generally, revenue increases are derived from inflation-linked pricing increases and the volume increases that occur in a growing economy.
Of specific relevance to infrastructure projects is foreign exchange risk. Given that infrastructure projects involve costs and revenues in the local currency, the foreign exchange exposure taken for such investments, especially in the nature of off-shore debt, can prove to be risky.
Although infrastructure assets vary in terms of the level of regulation they face, this regulation generally results in income streams that exhibit low growth. To compensate investors for this, infrastructure investments tend to be higher yielding than equity investments.
In terms of capital values, this stable, high yield results in infrastructure assets displaying a lower level of price volatility than equity investments over the longer term. It also acts as a support to the price of infrastructure assets in periods of poor returns in the broader equity market. As such, infrastructure is often referred to as a ‘defensive’ asset.
Forecast returns from individual infrastructure investments vary depending on the characteristics of the underlying asset, its maturity, risk and taxation treatment in the context of the prevailing macro environment. Over the longer term, as industry structures and regulatory regimes mature, the listed infrastructure sector will most likely behave like a hybrid between an equity and a bond.