How do we plug the infrastructure gap?

This week’s blog comes from Ferga Kane, Director in EY Transaction Advisory Services team, focusing upon Government & Infrastructure Advisory.

It’s a question faced the world over. Where can we find the additional funds we need, not just to maintain, but also to improve vital infrastructure?

I believe that new challenges require us to embrace more creative and flexible financing, funding and partnership opportunities. Traditional solutions need to give way to new and innovative models and potentially hybrid approaches. All of which we’ll explore in this week’s Capital Agenda Blog.

Mind the gap!

At current investment rates, Europe will spend $12.8t on infrastructure between 2016 and 2040. But, according to forecasters Oxford Economics, the region needs to spend 16% more – an extra $590b or 0.4% of GDP a year – to meet the its forecasted “investment needs”.

No-one doubts the importance of this investment. In Ireland, for example, due to a previously disjointed delivery structure and historical under investment in our water industry, we have one of the highest national leakages rates in Europe at around 47% – and at double the UK’s operating costs.

Business’ desire for increased infrastructure spending comes through clearly in EY’s latest Global Capital Confidence Barometer, where 64% of executives said that it would improve growth and 14% said it was critical to their business development.

CCB18 infrastructure

But how do governments and privatised asset investors balance the demand for increased investment against other priorities?  Where will the financing and funding come from to address new challenges and opportunities, from climate change and population growth to the growth in data analytics?

Funding vs financing

It’s important to distinguish between the two. Put simply:

Finance refers to the money required to build an asset, which often includes some form of borrowing with an associated cost. This money must be paid back, at a cost, by the funding sources.

Funding refers to the money required to develop and maintain an asset – including any interest cost and repayments. This may come from a variety of sources, e.g. government, taxpayers, customers and doesn’t have to be paid back.

The focus of infrastructure projects too often falls on finding a capital financial solution, without enough thought given to the funding required to operate and maintain the asset. Indeed, without a clear funding stream, it is difficult to find private sector finance.

Innovative financing

I believe that, as infrastructure financing needs evolve, so should financing models. For example, it may seem counterintuitive for publically-owned assets to embrace private finance solutions, given the current low-cost of government borrowing.

But, a hybrid approach allows us to build in some of the advantages of private finance, which may help to offset the potentially higher cost and bridge funding gaps. Some of these benefits are set out in the options below, but they include risk transfer, taking the pressure off government balance sheets and carrying out day-to-day asset management.

Long term leases: The private entity pays an upfront ‘right to lease’ fee and is solely responsible for the operation and maintenance of the infrastructure asset for the life of the lease. Used to finance a Sydney desalination plant, with the pipeline and site also granted on a 50 year lease to an SPV established by two institutional investors.

Vendor finance: The vendor lends money to the borrower to buy its products or property.  Typically used to finance large infrastructure development, it can be supported or replaced by export credit guarantee to make lenders more comfortable.  Used to great success globally in the renewables sector.

Corporate financing by intensive users: Selected stakeholders share the costs, risks and benefits of relevant potions of specific assets. This helps to increase resilience and meet future demand of heavy users, without significantly increasing costs for other customers. Needs a supportive regulatory environment.

Bonds:  Historically, bonds have been issued for financing of operational assets. But more institutional investors are becoming more comfortable with construction risk and are willing to invest earlier in the infrastructure asset lifecycle.

Green bonds: Fixed interest debt capital market instruments with capital used exclusively to fund environmentally friendly assets or assets.

Credit enhancement: An intermediary arrangement that helps to reduce lending risks – and lower lending costs. The Irish N25 road project was funded with senior bonds supported by the European Investment Bank’s (EIB) project bond credit enhancement initiative in 2016.

Inventive funding

I also think we can also think more inventively about funding. In particular, there are still many untapped sources of revenue and unexplored savings, which could help lessen the burden on governments, taxpayers and customers.

A number of asset owners have already explored forms of value capture, where individuals and businesses who will benefit privately from a new asset contribute towards its funding. This includes development rights above the asset – also known as air rights – and most visible in the construction of retail units above stations. But, development rights can also be established below or alongside the infrastructure asset, e.g. in the installation of fibre optic cables alongside water or power/gas infrastructure piping.

Bundling is another approach that can optimise revenue, for example where hospital construction is bundled with ancillary structures and commercial activities, thereby creating enough revenue generation to balance against building and procurement costs.

Some of the biggest innovations are yet to come and will stem from ground-breaking use of new technology. We’re starting to see the use of smart technology in utilities, for example, in water where it can conduct a regular analysis of asset status and connectivity data, to identify parts of the networks under stress and schedule preventative maintenance.

But, there is still a significant opportunity to do more and for public and private sector to work in partnership, such as the recently introduced EU ‘Innovation Partnership’ procurement approach or the Australian ‘Unsolicited Proposals’ framework. The latter allows the private sector to present innovative ideas to the Australian Government, which, if adopted, avoids a lengthy and costly tender process. This framework was used for the NorthConnex toll-road in Sydney, a multi-billion dollar project in which the private sector proposed an innovative construction and financing solution for the project.

Creative partnerships

The other crucial component – and vital in terms of attracting funding – is choosing the most appropriate and bankable structure for the project. It needs to offer the right level of risk transfer and address the project’s specific challenges and issues. There are a wide number of options out there, each offering its own specific advantages.

Public Private Partnerships can offer good value for money and timely delivery. An alliance may be useful when there is uncertainty about the nature of the infrastructure or services required to meet project objectives. A competitive partnership maybe more appropriate in a scenario where it will be possible to benchmark output and reallocate projects to a variety of partners, depending on performance. Incremental partnership allows certain elements of the work can be called off – which is useful if there is a danger that the work may be deemed unproductive.

The wide variety of options means that above all, it’s vital that each project starts with a detailed and informed analysis, using lessons from other countries and sectors. Careful, informed analysis at the outset of a project will help ensure that it is best placed to achieve its infrastructure objectives.