An 8-point plan for closing the infrastructure gap

The global need for infrastructure is significant, particularly in emerging markets. By consensus estimates from the Organisation for Economic Co-operation and Development (OECD) to the Boston Consulting Group and the World Bank Group, the estimated annual global infrastructure investment need is about US$3.7 trillion – of which only about $2.7 trillion is currently met on an annual basis.

This much-discussed “infrastructure gap” is large and it is widening. Even if fiscal conditions in developed and emerging economies improve, the need introduced by the infrastructure financing gap is unlikely to be met from public sources alone. This generates an expectation that private capital and user charges must be mobilized to fill these gaps.

But this is an entirely predictable problem, and over many years the international community has made efforts to provide assistance in building public-private partnership (PPP) capacity in emerging markets. Finding ways to leverage private sector investment through sound, consistent and sustained public sector policies should be a focal point for governments around the world.  International financial institutions (IFIs), given their unique relationships with emerging market governments, can and do play an important role. The community of professionals in multilateral development banks (MDBs) is listening; MDBs are willing and able partners.

Of course, stating that idea is one thing; practicing it is another. Here are eight ways that together, we can move from the theoretical to the actual and reach our goals for infrastructure.

1. Because PPP projects are often politically sensitive, we need to manage political risks during the PPP lifecycle. PPPs are a form of outsourcing the financing, operation, and user charge systems for public infrastructure, and therefore political aspects of considering and allowing the private sectors to participate are crucial. We know there is a fundamental timing-mismatch between typical election cycles and the long-term nature of infrastructure PPP projects. Changes in governments following elections may often be associated with changes in attitudes towards PPPs. We have all seen this before. Therefore, strong political will and its continuity are an important factor for the success of PPP projects. We need to pay real attention to this issue when preparing and implementing PPPs, and provisioning for handling political risk/renegotiation risk is a must. Managing political risks by using robust value for money methodologies is one means of warding off pure political attacks on PPPs during and after tender award.

2. Off-budget or on-budget, PPPs still need robust and long-term public sector backing. We know that PPPs are sometimes pursued by governments to counteract fiscal constraints, by treating PPPs as “off-balance.”  Whatever the reason for implementing a PPP, the project should provide value for money over a whole-of-life basis versus the public sector procurement alternative. Regardless of which accounting convention one adopts, governments should pay close attention to the efficiency benefits derived from locking in long-term PPP projects. This we know: governments must have the ability to service such obligations, and the money to sustain a PPP must be secure, credible, and lasting.  This leads me to my third point…

3. The credibility of the underlining sources of funding of PPPs is crucial. Both user charges and direct government payments contain inherent challenges. While there are many instruments for financing the upfront investment costs of infrastructure projects – plain budget financing, long-term loans, bonds, equity – for most types of PPPs there are essentially only two sources of funding the full cost of infrastructure: either from the budget through general taxation, or directly from the users of the infrastructure asset. Unless there are adequate fiscal resources and/or end-user willingness to pay that can cover the full cost of the new service, it is not possible to develop bankable projects. Some combination of these two sources of funding is often needed. Where full cost recovery tariffs are not feasible due to affordability constraints, public budget financing is needed and it must be stable over the life of the PPP contract. According to the World Bank PPI database, in 2013, 78 percent of the new PPP projects used an availability payment mechanism; full demand risk structures accounted for only four percent. Therefore, the government’s ability to pay is a must when designing PPPs.

4. The private sector prices in risk and uncertainty, and, as a result, the private sector will factor these into its  own rates of return targets for projects. At the start of a PPP, investors compare the risk-return profile in PPP projects in one country with alternative investments in another, and in other non-PPP sectors in general. If the comparison is unfavorable for the PPP, capital will not flow. Therefore, it’s important to strike the right balance between risk and reward in a project structure. At the same time, we can all recall the reality of the last 20 years in PPPs: if a project is well-structured and has credible public sector support, money will flow to that project.

Now, I’d like to turn to structuring issues.

5. No single formula fits all requirements: different types of PPP structures are appropriate at different times and for different sectors. Private sector involvement can come at different levels and within different contractual structures. For example, in the water sector, structures can include a management contract, an operational lease, and full 30-year build-operate-transfer (BOT) arrangements. The Yerevan water utility example demonstrates the benefits of an incremental approach that the Armenian government underwent in order to ensure increasing risk transfer to the private sector. To begin with, Yerevan started with a simple management contract without investment obligations by the private party. After successful implementation (i.e., after the end of the initial five-year contractual term), the authorities have moved into a leasing arrangement supported by EBRD and EIB in 2013. It also shows the vital role of the IFIs at the early stages of private sector involvement in supporting public utilities in countries where governments usually lack institutional capacity to engage with private operators on their own.

Implied in the above example is the issue of local capacity strengthening.

6: Local private sector capacity in PPP transactions needs to be built. In the long run, the capacity of local PPP players needs to be scaled up to broaden PPP investment. EBRD has seen good progress toward such local capacity development in Central Europe and Turkey, to name just two examples. In emerging markets, IFIs can help develop viable PPP projects, both through capacity building and blending public sector and commercial financing. IFIs can play an “honest broker” role to develop reasonable risk allocations for their client countries. Knowledge transfer is more likely to happen on the ground when technical assistance is structured properly. But let’s be clear: external parties like IFIs and their external consultants cannot substitute permanently for the absence of local capacity to plan and deliver PPPs. The new Project Preparation Facilities (PPFs) created by the IFIs can all be used to create a broader a pipeline of bankable projects of the short to medium term, working closely with local national counterparties in PPP Centres and/or line ministries to build domestic capacity. Our collective challenge is to find ways to make the learning gained from working with our PPFs stick.

Beyond institutional issues, it’s important to mention product innovation.

7: The PPP industry in emerging markets needs to further develop financial products to enhance PPPs’ creditworthiness.  Many emerging market countries do not have an investment grade sovereign rating, a fact that makes most projects difficult to finance for a wide spectrum of potential institutional investors, who are logical choices under a refinancing scenario and even in some cases for greenfield projects. Under these circumstances, well-designed market-based credit enhancement mechanisms have real promise. A potential benefit of a credit enhancement mechanism is to attract long-term institutional investors into emerging markets that have a sovereign rating at or near investment grade, but where PPP projects proposed in those markets remain, for example, a notch below investment grade. This might be accomplished by applying a credit enhancement overlay such that the enhanced project is elevated, or “re-rated” in effect, to investment grade status. This is critical since nearly all international pension funds and insurers require a project to be rated at investment grade before they are allowed statutorily to invest in the project.

8: Sharing the great collective body of knowledge on PPPs gathered through hundreds of projects in all regions of the world is critical, and the new PPP Knowledge Lab, created with MDB support and allowing for true interactive peer-to-peer learning, is a one-stop-shop for anyone searching for PPP resources or exploring the points above. We can learn from one another and the PPPs that have succeeded – as well as the ones that haven’t yet achieved their goals. I‘m convinced that beyond the vast sums of investment to close the infrastructure gap, what will really sustain the much hoped-for gains in global growth will be the spreading of knowledge on infrastructure at the local level in emerging markets.

As an active member of the wider IFI community, EBRD seeks to bridge the gap – by sharing our expertise with our clients across the globe – and in so doing ensure a smoother, safer path to enhanced quality and quantity of infrastructure investment.

This article was originally published on The World Bank’s Public-Private Partnerships Blog. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Thomas Maier is the Managing Director, Infrastructure at the European Bank for Reconstruction and Development.

Image: A general view of centre Tianjin taken from Tianjin World Financial Center, April 15, 2013. REUTERS/China Daily.