A “perfect storm” of converging macroeconomic challenges is hitting Europe.
- Firstly, getting post-crisis economic growth back on track is a daunting task for most countries.
- Secondly, retirement income and care facilities for Europe’s rapidly ageing population need to be secured.
- Thirdly, the continued low-interest-rate environment sets pension funds and insurance companies hunting for new investment opportunities that enable them to deliver returns matching their liabilities.
Can we even begin addressing this complex situation?
Over the last couple of years, long-term financing of infrastructure projects has come to the fore as something of a saviour– but of course, not without its difficulties. This article takes a closer look at the characteristics of infrastructure projects and how they help drive growth, why non-banking financial institutions (NBFIs) capital is crucial to realizing them going forward and, perhaps most importantly, the risks and obstacles that need to be carefully managed.
Definitions: Long-Term Finance and Infrastructure
Long-term finance is often characterized as investment that finances productive activities while being:
- Patient – it supports longer-term objectives rather than being driven by short-term metrics
- Engaged – investors have a more direct, hands-on, interest in the investment
Infrastructure covers a range of differing assets, but is broadly broken down into:
- Transport – e.g. construction of new roads, railways, ports, bridges and tunnels
- Telecom and technology – e.g. erection of mobile phone masts, placing of fiber-optic cable or establishment of server farms
- Energy – covers conventional assets like pipelines, refineries and support infrastructure for oil/gas fields as well as alternative assets such as wind farms and hydroelectric systems
- Social infrastructure – construction and maintenance of hospitals, schools, universities and prisons
- Resources and waste management – includes water management, waste collection and recycling
Infrastructure investment is viewed as a key contributor to generating sustainable growth. Building and improving infrastructure allows any economy to function more efficiently while creating new jobs and acting as an enabler of future economic development.
Retrenching Banks Set the Stage for NBFIs
Traditionally, banks across the globe have been the foremost funders of infrastructure projects while other types of financial institutions – primarily insurers and pension funds – have faced a number of barriers to serious participation in such investments.
Banks, however, are retrenching from project finance – not only due to the 2008 credit crunch, which drove many players out of business, but also due to the ensuing Basel regulatory framework making long-tenor debt increasingly expensive to hold on the balance sheet.
The result? In the EU, the estimated funding gap between planned infrastructure spending and needed financing amounts to EUR 600 billion in the coming 5 years (to 2020).
Still, there is no shortage of money to finance infrastructure projects – insurers and pension funds (and to some extent larger family offices and sovereign wealth funds) are more than keen to participate in such investments.
Their business case – in an otherwise low-interest-rate environment – is that infrastructure projects offer good long-term yields that have proved to be fairly stable and normally provide inflation protection—an excellent match indeed for their usually long-term liabilities.
In addition, the benefit of investment diversification should be mentioned.
So how come these alternative financiers are still struggling to enter the field?
Risks and Obstacles NBFIs Need to Manage
Infrastructure projects are not without risks.
- Political risk – changes in government leading to contracts being cancelled, assets being seized or subsidies being removed/lowered is probably the most important and most notably beyond the control of private sector institutional investors.
- Construction risk – for new projects, the key risk is that they are not completed, have serious delays and/or cost overruns
- Environmental risk – disputes over environmental issues causing delays and environmental fines/restrictions leading to lower-than-expected project cash flows
- Financial risk – primarily in the shape of higher interest rates or changes in foreign exchange rates
Perceived construction risk explains why investor demand so far has been primarily for existing infrastructure assets, whereas 70% of infrastructure requirements are estimated to be greenfield projects.
In addition to apparent risk management demands, some obstacles need to be overcome:
Solvency II incentivizes insurers to take only highly rated debt while other institutional investors commonly have internal rating restrictions. Traditionally, however, the bonds issued by infrastructure project special purpose vehicle (SPVs) have not achieved the credit ratings required.
Banks involved in project finance apply frameworks of rapid and frequent decision-making to control the project process, whereas institutional investors traditionally have accepted lower levels of control in their investments.
Debt Bias Concern
Over time, debt has been favoured (deduction of debt interest cost) over equity for long-term financing by most corporate tax and legal environments in Europe. A tax bias towards debt financing has incentivized projects to take on debt rather than equity investors – often “squeezing out” institutional investors.
How is the EU Planning to Get More NBFIs to the Infrastructure Table?
From a policy point of view, the EU is determined to accelerate investment into infrastructure projects to drive economic growth. The European Commission’s investment plan of EUR 315 million (a combination of public and private capital) over the next three years is an ambitious start to bridge the funding gap. However, more than money is needed for institutional investors to successfully manage the risks and obstacles previously mentioned. The necessary measures found at the top of the wish list are:
|Review the risk-based capital requirements of Solvency II further to allow for more investment by insurance companies and pensions funds into illiquid assets – e g infrastructure||EIOPA|
|Mitigate the political risk surrounding infrastructure investments by including big infrastructure projects in an EU-wide official infrastructure plan – thereby “depoliticizing” them and making them less sensitive to changes in government in individual member countries||EC|
|Mitigate the construction risk imminent in greenfield infrastructure projects by having the European Investment Bank offering guarantees, e g in the form of its so-called Project Bonds||EIB|
|Develop innovative financial instruments to encourage more institutional investors – not only the very largest ones or those with the longest investment horizons – to invest in infrastructure projects, e g by making loan syndication and securitization easier||EC/ECB|
|Recalibrate the fiscal bias against equity||EC|