Infrastructure Finance: Benefits for all
Infrastructure is increasingly important in today’s global policy agenda as investments made in the previous century reach the end of its fruitful life. Investments in infrastructure, traditionally financed with public funds, are critical elements that sustain a country’s economic competitiveness, prosperity and growth sustainability. Without essential services supplied by infrastructure assets in areas such as utilities, clean water and transportation, modern society would fail. Investments in infrastructure can help billions escape poverty and raise standards of living. According to the World Bank Group, construction of paved roads in Morocco reduced travel time and costs, thus increased female students’ school attendance by 40%.
The OECD estimated a figure of 70 trillion dollars by 2030 for infrastructure investment in areas such as transport, energy generation and distribution, water, healthcare and telecommunications.. Europe alone will require between 2 and 2.5 trillion Euros in such investments. In this same period, the global middle class will grow to just shy of 5 billion people, with emerging market countries posting the highest growth. Countries will need to expand and upgrade existing infrastructure roads, railway, ports, utilities and telecommunications infrastructure to cope with the needs of this new middle class. Emerging market economies will require huge investments to bridge the existing infrastructure gap, while developed economies will need to make the shift towards efficient energy sources and accommodate changing population demographics. In light of government fiscal retrenchment and inefficient public management of infrastructure projects, investments in bridging infrastructure gaps and maintaining or modernizing nationally critical infrastructure will have to come from the private sector in the form of Public Private Partnerships (PPP).
Infrastructure as an Asset Class
Infrastructure assets have several unique characteristics that make them attractive investments. The defensive nature of infrastructure investments can act as a hedge against inflation and provide a steady stream of cash flow during a time of volatile equity and bond markets. Given the monopolistic nature of most infrastructure assets as providers of essential services, demand is often stable and inelastic. Consumer utilization does not decline regardless of the state of the economy or in the event of price hikes. Furthermore, owners are usually able to increase rates at a level pegged to inflation or the overall economy as monopoly prices tend to be regulated. Due to their low usage volatility, economic insensitivity, and inflation-protection characteristics, infrastructure assets have a low correlation to the performance to other asset classes, making it a compelling case for portfolio diversification.
Despite the potential to generate steady, long term returns throughout its investment cycle, infrastructure investment’s ability to attract private capital remains subdued. Economic uncertainty, political and regulatory risks are among a few contributing factors.
Economic Uncertainty
Infrastructure projects are notorious for being long-drawn, with each phase of the project fraught with risks. Issues faced by investors in infrastructure finance range from the long- term commitment of resources and a highly illiquid investment environment to risk ambiguity which is difficult to price.
Development projects in particular remain highly susceptible to vagaries of the economy and risk ambiguity in the credit markets, currency volatility and demand uncertainty are factors that deter investment. Due to the size of some assets, the limited number of potential buyers and regulatory approval requirements, divestments of infrastructure assets can take a significant amount of time and effort. This unholy trinity of uncertain cash flows, macroeconomic risks and illiquidity make infrastructure investments particularly susceptible to market failures.
Political ambiguity and regulatory risk
Political, regulatory and legal frameworks in regions with relatively shorter or weaker regulatory histories increase uncertainty for investors. As infrastructure investments are usually natural monopolies, in sectors such as railroads, telecommunications and utilities, governments want to have equity stakes in projects to ensure that there is no monopolistic abuse of power. In some cases, governments take this to the other extreme by nationalising infrastructure assets, with oil companies in Latin America coming to mind. Risk of political power shifts, governments reneging on PPP agreements and modification of legislation remain a concern, especially in emerging market economies.
Governments can encourage PPPs by exploiting the as-yet untapped resources of capital markets, institute more economically rational financing structures and introduce new types of financing instruments. A greater assortment of infrastructure finance instruments through better securitization of infrastructure finance sources may help to attract a broader investor base and allow greater diversification of risks.
The United States has recognized this need and the Obama Administration has proposed that a new class of municipal bonds be introduced to encourage private investment in U.S infrastructure projects. As part of the ‘Build America Investment Initiative’ launched in 2014, this new class of bonds called Qualified Public Infrastructure Bonds (QPIBs) would not have an expiry date or caps on issuance. The Obama Administration hopes that ‘QPIBs will extend the benefits of municipal bonds to public private partnerships, like partnerships that involve long-term leasing and management contracts, lowering the cost of borrowing and attracting new capital’.
Moving on from traditional forms of financing has intrinsic advantages. Closer scrutiny of funding details can bring in private investors to deliver better public infrastructure projects. Increasing accessibility to a broader range of investors will also make infrastructure investment as an asset class more attractive. Leveraging on capital markets in the form of infrastructure bonds and collateralized debt obligations for example, will allow for greater portfolio diversification, lowering risk and cost of capital.
There is no magic pill for financing the $70 Trillion infrastructure gap that the world needs. Harnessing the full potential of capital markets as the conduit for infrastructure finance is only the first step. Investors will eventually have to recognize infrastructure as an investment-worthy asset class that may help optimize the risk and return profiles of their portfolios. The Economist estimates that of the roughly $50 trillion managed by institutional investors, a mere 0.8% is allocated to infrastructure investments. This figure needs to increase rapidly. Participating in infrastructure finance not only reaps economic benefits for investors but also provides other indirect externalities, such as the accumulation of soft power. These benefits, while difficult to quantify, are hugely beneficial. If the global community’s renewed commitment to infrastructure financing is anything to go by, infrastructure development and finance may well turn out to be one of the most promising business opportunity of this century.
WRITTEN BY FELIX LIM FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT
