infrastructure prospects and opportunities, quantum report

Infrastructure

Structural BoomInfrastructure, once one of the dullest financial sectors, is now among the best-performing asset classes and is set to offer huge opportunities for financiers and investors as the demand for transport, energy and other facilities grows worldwide.Nick Mathiason reports.

Infrastructure

that the Standard & Poor’s 500-stock index has returned about 10 per cent a year, counting dividends, since 1926. Bonds have returned about 5 per cent. Firms say infrastructure funds can beat both, and without having to endure market plunges along the way – a significant selling point.

The emerging market in infrastructure can be traced to the wave of privatisations of state-run gas, electricity, telecommunications

and airports businesses introduced by British Prime Minister Margaret Thatcher in the 1980s. Since then over $1 trillion of assets has been privatised in OECD countries, two thirds of which have been utilities, transport, telecommunications and oil facilities.

This policy sea-change evolved into the private finance initiative – essentially a hire purchase scheme – to build hospitals and schools. In the US, the privately financed infrastructure sector took longer to develop because of the municipal bond market,

which runs to hundreds of billions of dollars. This had been an efficient source of capital for governments over the years.

But banks and private equity funds have in recent years sniffed out fresh opportunities. In infrastructure, they found one. Realising that roads, bridges, ports, airports, railways and even hospitals offer stable, long-term cashflow, they have – armed with cheap finance – spent hundreds of billions of dollars hoovering up key

Over the next 22 years, it will cost $70 trillion to ensure that the world’s economy and its rising global population has reliable access to water, food, energy, transportation, health provision and education.

This sobering figure – more than 4 per cent of global GDP – was contained in a report last year from the Organisation for Economic Cooperation and Development (OECD), which also revealed that government spending on capital projects fell from 9.5 per cent of overall spending in 1990 to 7 per cent in 2005.

As public sector spending on infrastructure slows, transport systems and power generators fail to cope with continued economic and population growth. Blackouts, road congestion and capacity problems in airports and on railways are now commonplace in both the US and Europe – and they will continue unless alternative ways of financing these projects are found.

With government budgets under pressure and changing demographics shrinking the tax base in developed nations, the scale of finance needed to keep the world’s economies ticking means consumers must pay more for their services through access fees or tolls. But user charges are just one part of the solution. The public sector now has little choice but to encourage private companies to finance, build, run and maintain everything from roads and airports through to power generators, waste

treatment centres, hospitals and schools.

Though a controversial and often difficult area, this call has been heeded. Today, infrastructure has become a separate asset class in its own right. When the world’s biggest banks raise infrastructure funds, they are over-subscribed. Last year Goldman Sachs was inundated with $6.5 billion for its new infrastructure fund, more than twice the $3 billion it was seeking. It

is in the midst of tapping investors for another fund which will close later this summer. The Carlyle Group last November closed a $1.15bn fund.

“US public infrastructure requires $1 trillion in funding over the next five years,” said Robert Dove, a former high-ranking Bechtel executive who jointly heads the fund. “The private sector has a role to play, as seen in Europe, and can be a proven means of helping to satisfy such dramatic funding needs.” Analysts point out

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12 Quantum - Finance In Perspective - Issue 4

facilities. And despite the global credit crunch, financing packages for major infrastructure projects are going ahead, albeit more slowly, and new investor funds are being established.

In Mumbai, for instance, there are plans to build an extension of the city to house 15 million people – nearly double the size of London’s population. One UK infrastructure banker involved in the building of this project, said: “I left London depressed at the state of the markets. Going there is so refreshing in the sense that there are people making huge sums of money.”

For years one of the dullest sectors in the financial firmament, today infrastructure is among the best-performing asset classes. Pension funds are increasingly keen to invest. With real estate prices falling though still expensive, infrastructure is becoming a more attractive alternative. The two California public sector pension funds two years ago unveiled plans to invest $15 billion in state infrastructure, while two major Canadian funds took stakes in UK water firm AWG, several Fairmont luxury hotels and Canada’s largest laboratory operator. But the challenge is to see more pension funds pour into a wide range of funds.

Funds like Australia’s Macquarie Group, which last year raised $10bn, have risen on the back of an acquisition spree of airports and roads. Likewise, Spain’s Ferrovial is a huge player in the sector. Sovereign wealth funds have now joined the fray. Last year

Temasek Holdings, the Singapore state-owned investment company, launched an infrastructure fund which it backed with $513 million of its own money. In March, Troika Dialog, Russia’s number two investment bank, said it planned to raise a $1 billion infrastructure fund.

What attracts investors to infrastructure is solid cashflows – user charges and tolls – which provide the opportunity to borrow larger sums to

Today, bankers are struggling to arrange bond financing for major projects, as it is hard to find monoline insurers to underwrite the risk of default. Delays in arranging finance are taking their toll. The $4 billion package to build the athletes’ village for the London 2012 Olympic Games should have been completed at the start of the year, but is still a long way from closure. The blame has been attributed to difficulties in the debt

markets and falling real estate prices making risk harder to value.

But big deals of various types are still being done. Market watchers took comfort that the debt for the £13bn contract to supply mid-air refuelling tankers to the UK’s Royal Air Force was completed in March during the worst financial storms that the credit crunch could summon up. The deal was originally to have been bond-financed, but difficulties with monoline insurers meant that this option evaporated. Instead the deal was financed

through bank debt.Many investors think of

infrastructure investing as similar to the private equity model, based on rich cashflows and lots of debt. But there are significant differences. Private equity deals typically have a three- to seven-year lifespan; infrastructure deals run for decades. And the risk levels are different. Infrastructure is low risk because competition is limited by a host of forces that make it difficult to build,

Infrastructure is going to be one of the hottest sectors in the financial firmament.

Financiers are looking forward to the liberalisation of European energy markets,

currently a big-ticket measure debated in the

European parliament, as a major opportunity.

Infrastructure

13Quantum - Finance In Perspective - Issue 4

““

pay for acquisition and investment costs. This is the monopolistic nature of assets – you generally get only one road going from A to B. However, there have been concerns that infrastructure funds have borrowed too aggressively against cashflow, compromising the efficient running of facilities. In the last two years, some financiers admit there has been a bubble, with a proliferation of infrastructure funds. But the credit crunch has taken the fizz out of the market.

say, a rival toll road. With captive customers, the cashflows are all but guaranteed. The only major variables are the initial prices paid, the amount of debt used for financing and the pace and magnitude of toll hikes – simple issues for financiers to model.

However, it is important not to take for granted the long-term nature of cashflow completely. The current problems faced by Ferrovial, owner in Britain of the country’s biggest airports including Heathrow, Gatwick and Stansted, are a case in point. Having beaten off Goldman Sachs to win the

airports in 2006 with a knockout bid of $20bn, Ferrovial has been faced with one public relations challenge after another which has seen its key asset, Heathrow, become an international laughing stock. As it struggles to perform satisfactorily and refinance its loan, the firm is now caught up in a hard-hitting regulatory review from the UK’s consumer watchdog which could force the break-up of its British assets.

Likewise, many investors in the water sector have failed to make a return as the scale of investment needed

Infrastructure

overwhelms firms which are unable to increase water bills to the level they would like for fear of sparking a political backlash. “Water is a really sensitive issue,” said Barrie Stevens, deputy director of the OECD’s international futures programme. “Water is life. It’s a precious commodity. Is anyone thinking that water is free? Well, sorry, guys, that’s no longer the case.”

“Public-facing” facilities are prone to being political footballs. There are few better examples than the $36 billion public private partnership refurbishment of the London underground. The PPP, signed off in 2001, has already seen the costly collapse of a private sector consortium involving some of the biggest names in construction. Such was the tension and suspicion between the government, the private sector and a populist City mayor that an amazing $800 million was racked up in fees for advisors.

A growing issue for financiers and investors in major energy projects – particularly in the oil and coal sector – is increased scrutiny from campaigning environmentalists. Groups like Platform and Bankwatch are now placing investors in these projects under greater scrutiny, becoming shareholders in banks and demanding they refuse to fund some controversial schemes. The first evidence of this phenomenon was seen three years ago when the European Bank for Reconstruction and Development (EBRD) faced an intense campaign aimed at denying cash to the then Royal Dutch Shell-led Sakhalin-2 gas and oil project off the east coast of Russia.

The campaign, which also forced Shell to reroute its pipeline as it went through a feeding ground for an endangered whale species, succeeded.

CHART 1 – AVERAGE ANNUAL INFRASTRUCTUREINVESTMENT REQUIREMENTS IN OECDCOUNTRIES TO 2025/30 (In USD Billions)

100

80

60

40

2005 2015

Electricity (T and D)

2025

20

0

200

150

100

50

Road

2000 2010 2020 20300

700

600

500

400

300

200

100

2005 2015

Water

20250

40

35

30

25

20

15

10

5

Rail

2000 2010 2020 20300

Note: Estimates for electricity are transmission and distribution (T&D) only.Source: OECD (2006a), Infrastructure to 2030: Telecom, Land Transport, Water and Electricity, OECD, Paris.


paid by travellers) are set to make up two thirds of the cost, with major landowners contributing the remainder, split between an increase in rates for major London businesses and a direct contribution.

There are plans by many governments around the world to capture the increased land values associated with major transport links in particular. And the UK government is now toying with the idea of levying a roof tax on new housing developments to help pay for roads, reservoirs and other key amenities, having concluded a successful pilot.

As the world’s population grows and becomes more urbanised, governments inability to keep pace with the need to ensure societies function will present huge opportunities for infrastructure financiers and investors for decades to come. Q

Infrastructure


The EBRD withdrew from the $22 billion project. This was a blow to the Shell consortium, as it was envisaged that the EBRD’s investment would act as a bridgehead for the world’s commercial banks to follow. So far, the banks have stood resolutely on the sidelines of this deal. Likewise, in April the Asian Development Bank delayed a decision over whether to fund a huge open-cast coal project in Bangladesh after a sustained campaign by local and international groups warned that it will displace 120,000 people.

However, despite these political sensitivities, infrastructure is going to be one of the hottest sectors in the financial firmament. Financiers are looking forward to the liberalisation of European energy markets, currently a big-ticket measure debated in the European parliament, as a major opportunity. The provision of care to

a growing ageing population has also been identified as a rich seam.

The carbon economy will also present opportunities. In Europe, there are plans to stipulate that all new power generators must embrace carbon capture and storage technology, which will see a new wave of investment. And the world is on the cusp of spending hundreds of billions of dollars on new nuclear power facilities.

Financiers identify transport as another huge area for growth. Demand for railway lines and roads in Eastern Europe, China and India is surging. The recent $31 billion deal to fund a train line linking Heathrow airport to the Square Mile and Canary Wharf in London and beyond has been identified as reflecting new thinking. The government and the farebox (total amount of revenue accumulated through ticket sales

CHART 2 – GENERAL GOVERNMENT GROSS FIXED CAPITAL FORMATION(GFCF), AS PERCENTAGE OF TOTAL GOVERNMENT OUTLAYS, 1990-2005(Average for all OECD Countries)

10.0

9.5

9.0

8.5

8.0

7.5

7.0

6.5

6.0

5.5

5.0

Tota

l OEC

D o

utla

ys

2005200420032002200120001999199819971996199519941993199219911990

Note: Weighted average using government total outlays converted to USD using 2000 purchasing power parties for GDP.Source: OECD (2006c), Economic Outlook No. 80 database, November, OECD, Paris.

Infrastructure

Opportunity Beckons

Privately financed infrastructure projects in the Middle East are competing for funding with the insatiable demands of the oil, gas and petrochemicals sectors as the amount of liquidity available shrinks. However, argue Afonso Reis e Sousa and Scott Flippen of the investment bank Taylor-DeJongh, lenders should view the pipeline of new projects as an enormous business opportunity.

in the past when oil prices dropped as dramatically as they had previously risen.

In addition, the sheer scale of the region’s infrastructure needs is staggering. In order to satisfy the projected 10 per cent increase in electricity demand annually (and associated desalination), Gulf Cooperation Council utilities are contemplating adding 60,000 mega watts of new independent water and power projects (IWPP) capacity by 2015 – equivalent to 80 per cent of current capacity. The requirements for water and sewage infrastructure are similarly astounding.

There are also signs that the transport sector is set to take off, with major expansions of both the

Dubai and Doha airports in the works. These projects follow the successful financing of the Queen Alia International Airport expansion in Jordan. In addition to airports, several important port and rail projects are moving forward this year, including a $6 billion deep water port in Qatar, the $10 billion Khalifa Port & Industrial Zone development in Abu Dhabi, and the Saudi Landbridge, a $2.5 billion project designed to provide a rail link between the Red Sea and the Gulf. Work is also starting on the $2 billion friendship bridge between Qatar and Bahrain.

Finally, there are even signs of a nascent social infrastructure market in the Gulf. In April 2007 the Abu

The privately financed infrastructure market in the Middle East today faces some significant challenges. The sector has to compete for finance against the region’s oil-linked industries at a time when the sub-prime crisis has sucked a substantial amount of liquidity out of the banking market, as well as cope with rising construction costs. And with government treasuries bulging with oil revenue, some argue over whether the private sector is needed at all to fund the region’s infrastructure needs.

The answer lies in part with the understandable reluctance of governments to increase public spending, because they remember all too well how they have been burned

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Infrastructure

A CAPITAL TRADITION

The Middle East is no stranger to major capital projects. Oil majors and petrochemical companies have been working with the region’s national oil companies for years and have successfully mobilised private capital for hydrocarbon-related projects, par ticularly in the countries that make up the Gulf Cooperation Council. Governments have also enjoyed increasing success in attracting private power developers to finance and build independent water and power projects (IWPPs).

The majority of this activity has historically been financed through limited recourse bank debt (project

finance). According to Project Finance International, last year saw the United Arab Emirates ranked fifth globally in the volume of project finance bank loans received ($11.7 billion), ahead of both China and India – despite the fact that China’s and India’s GDP are respectively 73 times and 30 times that of the UAE.

As a whole, the Middle East region borrowed some $39.1 billion (Char t 1 and Char t 2), almost 20 per cent more than the combined bond and bank loan volumes dispersed in the US market.

CHART 1 – MIDDLE EAST PROJECT FINANCE LOAN VOLUME BY COUNTRY,2007

Source: Project Finance International League Tables.

CHART 2 – MIDDLE EAST CLOSED PROJECT FINANCE TRANSACTIONSBY SECTOR, 2005-2007

Source: Infrastructure Journal Projects Database.

Egypt $4,051 USD millions}Oman $3,317 USD millions}

Kuwait $1,400 USD millions}Bahrain $641 USD millions}

Industrial 14%}Power 19%}

Transport 4%}Other 2%}

Jordan $385 USD millions}UAE $11,718 USD millions}

Qatar $9,547 USD millions}

Saudi Arabia $8,080 USD millions}

Oil & Gas 33%}

Petrochemical 28%}


Dhabi Development company, Mubadala announced the close of a $410 million financing for UAE University. The scheme was the first education project to close in the GCC and, in true Gulf fashion, was also the world’s largest single education Public Private Partnership (PPP) project.

Overall, it appears that there is a good mix of infrastructure deals in prospect for the Middle East in 2008, but these projects will have to compete with some major petrochemical and oil & gas projects (Chart 3). However, for the first time in recent memory there are no Qatari LNG deals on the horizon, and this year will also see the end of the wave of mega petrochemical deals in Saudi Arabia. Over the next few

Infrastructure


CHART 3 – MAJOR PROJECTS PIPELINE FOR 2008

30

25

20

15

10

5

0

Source: Middle East Economic Digest.

Oil & Gas

Petrochemical

Power

Industrial

Transport

Municipal PPP/PFI

Mining

US

D B

illio

ns

Ras Ta

nura

Al-Zo

ur R

efine

ry

Khali

fa P

ort

Juba

il Refine

ry

Saud

i Kay

an

Sipc

hem O

lefins

Saud

i Lan

dbrid

ge

AD A

irpor

t Exp

Mec

-Med

Rail

Dubai

Airp

ort E

xp

Med

ical C

ity

Ras al-

Zour

IWPP

Ras La

ffan IW

PP

GCH R

io Tin

to A

lum

Maa

den Ph

osph

ate

Smar

t Ind

ustri

al Ci

ty

Rabig

h IPP

Qasco

Duqm P

ort

Dubai

Power

years infrastructure could overtake hydrocarbons as the most important sector in the project market – no mean feat indeed.

Dealing with the consequences of the sub-prime crisis is potentially more complex, not least because it comes after a period of economic growth in the Middle East which was largely funded by international banks. The banks were attracted by the region’s inherent cost competitiveness, improving country risk profiles and – in the case of IWPPs – long-term offtake guarantees from credit-worthy governments. And, as banks became increasingly comfortable with the region, competition increased and margins tightened.

It was, therefore, no surprise that the sub-prime crisis and the resulting credit crunch had a noticeable impact on project financings in the Middle East, particularly on pricing.

For example, Qatar Steel Company (Qasco) postponed its planned financing after an initial attempt in October 2007 due to deteriorating debt market conditions. Qasco purportedly withdrew from the market after lenders expressed unwillingness to guarantee pricing during the syndication period and insisted on imposing a “market flex” condition – a term that had been absent from Middle East deals since late 2001. Market flex is designed to protect mandated lead arrangers by allowing them to increase margins in the event

Infrastructure

MAJOR ADDITIONAL SOURCES OF INFRASTRUCTURE FINANCE


REgIONAL COMMERCIAL BANkSRegional banks have already stepped in to take

part in project loan syndication, albeit more often as participants than as lead arrangers, a role for which many regional banks still lack the necessary underwriting capacity. The infrastructure financing potential of these banks is somewhat constrained by their unwillingness to provide long-term loans, given that their main source of funding remains short-term deposits. Regional banks also face increased costs in securing large amounts of dollars. That said, regional banks have been able to step up to major projects, as evidenced by the $1.37 billion Sohar Refinery refinancing in Oman, which received funding from only two international banks, compared to ten local and regional banks. Before the credit crunch that ratio would have been reversed.

ISLAMIC FINANCEIslamic financiers are making significant inroads as

a source of project financing and are poised to play an even greater role in infrastructure finance. Islamic finance products are one of the fastest growing asset classes in the region, and the sub-prime crisis has had little direct affect on the industry: Shariah law prohibits the trading of debt, so the complex instruments that were used to trade sub-prime debt were absent from Islamic banks’ balance sheets. Even for banks that have announced large write-downs, the Islamic finance units have been a source of strength and reported robust returns. Sukuks (Shariah-compliant bonds) have been especially popular as corporate finance instruments for infrastructure projects such as the Dubai Airport expansion, and are expected to play an increasing role going forward. However, the market capacity is still relatively limited (no major project has been funded to date wholly from Islamic sources) and is more widely used to complement conventional sources of finance.

AgENCy LENDERSExport Credit Agencies (ECAs) are once again

becoming an important source of funding. They

too have been unaffected by the sub-prime crisis and can offer both long tenures and large tranches on competitive terms. ECAs have historically been criticised by project sponsors for being slow and bureaucratic, but have worked hard to change that image and have in many cases evolved and adapted to market needs. They and other multilateral institutions such as the International Finance Corporation (IFC) and the Islamic Development Bank (IDB), also play an important role in mitigating country risk in places such as the Levant, Yemen and North Africa. A case in point is the Queen Alia International Airport expansion, where a significant portion of that project’s limited recourse debt funding was provided by the IDB and the IFC. Multilateral capacity, however, may be limited by the development goals of the respective institution, while ECA financing capacity will be dependent on the amount of equipment and materials procurement from the respective agency’s home country.

PROJECT BOND MARkETThe sub-prime crisis has effectively shut down the

international project bond market for the near future. However, there is hope that the market will recover, as evidenced by the structure of the recently closed $7 billion Emirates Aluminum (Emal) financing, which includes a $2 billion bond tranche targeted to close at the end of 2009. Sponsors and lenders both seem reasonably comfortable with the financing risk that this structure entails, inspiring confidence that the bond market will return.

SOVEREIgN WEALTH FUNDSWith the current flood of petrodollars filling their

bank accounts, it seems only logical that the region’s sovereign wealth funds should become major sources of funding for regional infrastructure projects. There is legitimate concern among governments regarding bloated public budgets and the resulting exposure to oil prices. However, deploying funds as a lender via structured finance transactions would bring discipline to the process as well as match the funds’ long-term investment horizons.

Infrastructure

that they are unable to syndicate the debt. Qasco is expected to return to the markets later this year, but there is no certainty that it will obtain better pricing or lighter covenants than were offered in 2007.

It is easy to blame the credit crunch for the more stringent financing terms that have recently been seen in the Middle East, and it certainly has played a large role. Margins on many deals in the region have increased by 10 to 30 basis points since the beginning of the sub-prime crisis. But this may not be the complete explanation. For, while lack of liquidity has been partly responsible for this, it is also true that banks were chafing against the wafer-thin margins and have seized the opportunity to take back some ground.

Liquidity may not even be the biggest issue faced by Middle East projects. Before the US housing market took centre stage, the most publicised issue in the region was the rise in construction costs. A number of factors are leading to higher investment costs and increased risks. Higher commodity prices have made this a global phenomenon, but the Middle East, where everything – including labour – has to be imported, has been especially sensitive to the problem.

The enormous number of large projects being built within a relatively confined area has put a great deal of additional pressure on contractors, who find themselves increasingly competing with each other for scarce

material and human resources. And the problems of cost have been exacerbated by dollar depreciation: the region’s construction industry imports a significant amount of equipment from Europe and is almost wholly reliant on labour imported from South Asia.

None of the problems facing infrastructure finance is insuperable, and a critical part of the solution will come from the increased availability of additional funding sources. The international commercial banks, which had great success in this market due to their ability to provide lowest-cost funding, may have lost their competitive edge due to the credit crunch. But this has opened the door for other financiers to play a wider role in the infrastructure market. Liquidity at competitive prices now comes from regional commercial banks, Islamic finance, agency lenders and sovereign wealth funds, while borrowers can also tap the project bond market (see Major additional sources of infrastructure finance box).

There is no doubt that at the very moment that the infrastructure market in the Middle East is poised for growth, the sub-prime crisis has thrown the region a curve ball. The pipeline of future projects is bulging at a time when the largest source of financing, the international banking community, is experiencing a liquidity crunch.

However, the region is fortunate in that there are a number of alternative sources of funding that can step in to fill the gap. But all of these alternative sources will need to reach their full potential in order to keep the market, and especially the much-publicised mega-projects, on track. Q

The enormous number of large projects being built within a relatively confined area has

put a great deal of additional pressure on contractors, who find themselves increasingly

competing with each other for scarce material and human

resources. And the problems of cost have been exacerbated by

dollar depreciation.

“

“


Initiative TestPublic Private Partnerships have become increasingly popular throughout the world with governments, which see them as an effective way of providing public services infrastructure through private sector funding.Jonathan Brufal, an infrastructure partner at Norton Rose, examines whether they provide the better value for money on major capital projects than other methods of finance.

Infrastructure

Infrastructure

delivery model. Critics say they offer poor value for money due to limited competition and that they still involve substantial procurement times and large upfront costs.

Concern has also been raised that the public sector lacks the skills to negotiate and implement PFIs. Projects are also felt to be expensive to terminate and inflexible due to poor change mechanisms. There is also a widely held belief that PFI projects offer disproportionate equity returns for the risks being taken. This view is not helped by the increasingly buoyant market in trading equity investments.

These question marks about the British model have not prevented the global growth of PPP (Chart 1), which is now an established means of providing public services in numerous countries including

There is a wealth of opportunity for those who wish to enter the Public Private Partnership (PPP) market. In India alone, the estimates for capital investment between now and 2012 total $200 billion, and there are active programmes in Europe as well as in the Americas, Africa, the Middle East and the Far East.

The debate has now moved on from whether the private sector should be involved in the delivery of public services to ensuring that the correct models are used by governments to upgrade infrastructure services. And, for the first time, entrants to the PPP market and those countries with little experience of it can learn from the experience of those countries whose strategies are at a more mature level.

Globally, significant strides have been made towards creating a comprehensive framework to foster PPP programmes. These typically include legislation underpinning private infrastructure projects, independent regulatory authorities (providing greater transparency), and standardised bidding processes and standard form contracts.

The UK is largely credited with being the driving force behind the first wave of PPPs internationally with the introduction of the private finance initiative (PFI). Since its launch PFI has gone from strength to strength. Before 1995 the UK government had signed only 13 PFI schemes. In that year a further 11 were signed, with the annual figures rising to 60 in 1997 and 108 in 2000. By April 2007, the UK government had signed 626 schemes.

Today more than 510 PFI projects worth an aggregate value of £45.1 billion are operational and, according to the British Treasury, the pipeline of future PFI deals in the UK is strong:

£23.3 billion worth of projects are due to be signed during the next five years.

The maturity of the British market means that it is possible to learn about the effectiveness of PPP. On the positive side, the PPP Forum, the umbrella body representing private sector participants in UK PF industry, asserts that:• 96 per cent of projects are performing

at least satisfactorily, with 66 per cent of projects performing either to a very good or good standard.

• 39 per cent of projects are achieving the contract service levels either always or almost always.

• 80 per cent of all users of PFI projects are always or almost always satisfied with the service being provided.

So much for the good news. PFIs are also facing growing criticism as a

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WHAT IS PPP?

The term PPP covers very different types of investments and

participation by the public and private sectors in the procurement

of public assets and services. It falls within a spectrum extending

from conventional procurement to outright privatisation. In some

senses PPP is not a new concept. Governments have rarely

designed and built large public assets like power stations, roads,

rail systems and buildings by themselves. They have contracted

with the relevant specialists to provide such services.

However, PPP is clearly distinct from the traditional procurement

method; it requires the public sector to assess the cost of the

required asset over its useful life, enables it to transfer risk to the

private sector (particularly where that risk can be better managed),

and assists public bodies facing short-term fiscal constraints by

allowing them access to private capital. PPP, as it is recognised

today, is used to provide services across a broad range of sectors

including accommodation, defence, education, energy, health,

justice, transport, waste and water systems/treatment.

Australia, Canada, Taiwan, Japan, South Africa and South Korea.

There are successful programmes in Western European states including Ireland, Italy, France, Germany, Hungary, Netherlands, Greece and Portugal. And there is increasing interest in Central and Eastern Europe, particularly in Croatia and Romania, while PPP is also being developed in Singapore, Brazil, the Middle East and India.

As each country learns from its own experiences (both positive and negative) they have tried to develop the structures they use and to standardise their approach so as to reduce costs. A further solution to reducing costs, particularly expensive start-up costs, and encouraging competition would be for the public sector to remove barriers to entry so as to foster an environment in which

TABLE 1 – BARRIERS TO IMPLEMENTINg PPP

• Lack of statutory and regulatory policy framework to support

PPP.

• Lack of political will to reduce public sector control over provision

of public facilities and services; absence of well-structured,

transparent and competitive procurement process.

• Absence of clear and consistent methodology for evaluating

value for money.

• Lack of public sector PPP experience to drive the process.

• Lack of “champion” or dedicated PPP unit.

• Sensitivity to the well-publicised failures of PPP procurement

overseas.

• Political and country risk (perceived or actual).

• Lack of international investor/consortia confidence.

• Sensitivity to the well-publicised failures of PPP procurement

participants required to achieve the appropriate level of private

sector competition.

Infrastructure


CHART 1 – PPP/PFI DEBT TRANSACTIONS BY COUNTRY IN 2007

105

100

95

90

85

80

75

70

65

60

55

50

45

40

35

30

25

20

15

10

5

13,000

12,000

11,000

10,000

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

0

Num

ber

of d

eals U

S$

millions

0France Hungary Australia Ireland Spain Italy Canada Greece UK Germany UAE United

States

Source: Infrastructure Journal R&A.

Debt Value

Number of Deals

Number of Bond Transactions

Number of Loan Transactions

Infrastructure

The $675 million Queen Alia International Airport

in Jordan is the largest private project finance deal to

have been signed in Jordan and is the first Middle East

PPP-style project comprising dual tranche conventional

and Islamic facility financing. The project includes the

construction of a state of the art new terminal, the

refurbishment and upgrade of the existing airport,

its operation and management, and the collection of

revenue and toll over a 25-year concession.

The concession documentation was negotiated

and signed with the Government before the financing

structure was finalised. As the finance documentation

had not been negotiated in tandem with the project

documentation, an appropriate solution had to be

found in respect of the assets needed to satisfy the

Shariah-compliant financing requirements.

A new agreement had to be entered into between

the Government, the concessionaire and the Islamic

bank providing the Islamic facility, without transferring

any of the concessionaire’s obligations under the

concession agreement to the Islamic bank.

Although the project broadly followed a conventional

PPP approach, numerous structural deviations were

required so as to comply with the Shariah law. A

unique financing structure of four credit facilities was

provided through both conventional (development

bank and commercial bank) financing and Islamic

financing based on Istisna’a (Islamic Manufacturing)

and Ijara Mawsufah Fi Al Dhimmah (Islamic forward

lease) facilities.

The deal involved an innovative Islamic facility,

different to typical Shariah-compliant structures in the

market. The A Tranche of the conventional financing

ranked pari passu with the Islamic facility. As a result

mechanisms had to be included to allow both facilities

to have the same profits and benefit from the same

security. A mechanism was introduced to hedge the

foreign exchange risk and the interest rate risk. This

hedging was performed through a number of swaps

which covered both the conventional and the Islamic

facility.

A new approach was adopted in respect of advance

rental payments, by making them flexible enough to

accommodate any delay in the project’s construction.

A further innovative approach was taken in respect of

the Islamic bank so as to allow their interest in the

airport to automatically revert to the concessionaire

at the end of the Islamic forward lease.


QUEEN ALIA INTERNATIONAL AIRPORT, JORDAN

Infrastructure

more private sector participants have access (Table 1).

As the market matures globally, new and more flexible methods of delivery will continue to evolve. Innovative models, such as the introduction of the partnership models of Local Improvement Finance Trusts (LIFT) and Local Education Partnerships (LEP), have been introduced in the UK, generating considerable debate. A report (Building flexibility: new delivery models for public infrastructure projects, Deloitte, March 2006) suggests that an even broader range of models is needed to meet the UK’s future infrastructure objectives.

Whilst PFI enables public sector organisations to spread the cost of infrastructure investment over the lifetime of the asset, encourages

transfer of risk to the private sector and focuses on value for money, the report suggests that it can be inflexible concerning the length of contracts and in accommodating a change in the public sector requirements.

Examples of possible alternative partnership models include bundling together smaller projects, such as schools, in order to reduce the cost of the transaction relative to the capital value of the project, or focusing on more collaborative means of working, particularly in cases where there may be unknown technological risks.

One model that is becoming increasingly popular is strategic partnering (Chart 2) where a public authority enters into a strategic partnering agreement (SPA) with a private sector partner (PSP).

The SPA will cover the strategic

development programme of the public authority in a geographical area and is a long-term partnering arrangement for the delivery of projects. Initial projects tend to be small but consolidated capital investment builds up over a period of years. The PSP will generally be given exclusivity by the public authority for a number of years, in which to develop a range of new projects. The SPA will regulate the manner in which new projects will be developed and approved and the PSP will be required to demonstrate continuous improvement based on agreed Key Performance Indicators (KPIs) in delivering the projects.

This is key as the PSP will be, in essence, a regulated monopoly provider of services, and the public authority must ensure that it has access to adequate pricing information


CHART 2 – SPA STRUCTURE

Public Sector

Strategic PartneringAgreement

Services deliveredin return for

annual charge

Unitary ChargePayment

Private SectorConstruction and Operation

ProcuringEntity

ShareholdersAgreement

Private SectorProvider

Private SectorPartner

SupplyChain

Equity InvestorsDebt Providers

Project 1 Project 2

Project 1SPV

FMContract

ConstructionContract

Building Schools for the Future (BSF) is a national

programme to rebuild or refurbish secondary

schools in England. It is the first PPP programme in

the UK to make use of SPAs and is a trailblazer for

the next generation to the Private Finance Initiative.

The £320 million project reached financial close in

July 2007 and was one of the pathfinder schemes

in the BSF programme. The aim of the project is

to provide inspirational learning environments

created through the buildings, equipment and wider

children’s services. Rather than simply deliver new

school buildings, as was the case under the PFI,

BSF is designed to provide schools the opportunity

to improve teaching and learning, and help to raise

outcomes for individuals and families.

As part of the BSF programme, a local delivery

vehicle known as the Local Education Partnership

(LEP) was set up to deliver the BSF programme.

The local authority and the LEP entered into an SPA

in order to deliver the BSF programme. The SPA

offers the LEP exclusivity to deliver the projects,

provided that it is able to satisfy agreed KPIs and

deliver the required continuous improvement.

The BSF programme in Sheffield is split into

two phases designed for completion in 2013.

Phase 1 initially included the construction of four

new schools; three were financed as a separate

project under the PFI and one is being procured

on a conventional design and build basis. Five

other schools are currently in the process of being

designed as part of Phase 1.

Phase 2 will include the construction/

refurbishment of 12 schools and for new ICT to

be delivered to a further ten schools. The LEP is

working on the initial proposals and programme of

work for the Phase 2 schools.

so that it can benchmark the PSP and establish that it is obtaining value for money. Poor performance may lead to no new projects or, ultimately, loss of exclusivity.

Another feature of SPAs is that, instead of the exclusivity being granted to the PSP, the PSP will in turn be obliged to enter into a series of supply chain agreements with third-party service providers which will provide ongoing cost savings and value for money to the public authority. The projects themselves are financed and operated independently of the SPA.

The advantage to the public sector is that projects do not have to be tendered on an individual basis. This offers real cost savings and provides the public sector with the benefit of a more standardised procurement

process, while also allowing it to prioritise long-term investment projects. The model has many applications, particularly in transport, which requires phased expansion.

Once SPAs have become established as a delivery model and exclusivity has fallen away, public authorities will be able to enter into more than one SPA in a particular geographical location with different PSPs which will further enhance competition and efficiency.

PPP does not offer a panacea for the delivery of public sector infrastructure, but the evidence to date supports the case that it has improved the delivery of public services – although critics still maintain that it does not provide value for money because of the cost of capital to the private sector.

To counter this criticism and the arguments of those who say there is something inherently wrong in privatising the delivery of public services, it is necessary to make the most appropriate use of PPP.

There is, increasingly, sufficient global experience to make it possible to identify which sectors are suitable for it to be used as a delivery model and sufficient data to determine which model of delivery works best. If governments ensure that they choose carefully the most appropriate sectors and models, address the sceptics opposed to privatisation and also ensure that the private sector receives adequate but not excessive rewards, PPP can continue to play an increasingly important role in meeting the global need for new and refurbished infrastructure. Q

Infrastructure


SHEFFIELD BSF: AN ExEMPLAR SPA

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