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Corporate Governance Issues in Infrastructure Finance. World Economic Forum - Financing for Development Workshop Tuesday - Wednesday, March15 -16, 2005 Hong Kong. Infrastructure Finance vs Corporate Finance.

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corporate governance issues in infrastructure finance

Corporate Governance Issuesin Infrastructure Finance

World Economic Forum - Financing for Development

Workshop

Tuesday - Wednesday, March15 -16, 2005

Hong Kong

J. Robert Sheppard, Jr.

[email protected]

infrastructure finance vs corporate finance
Infrastructure Finance vs Corporate Finance
  • Typically, most corporate governance issues concern publicly-held corporations, but most infrastructure projects are financed using:
    • Special purpose, project-financed entities
    • Subsidiaries of foreign corporations
    • Joint ventures between major corporate partners
  • Corporations that finance new investments using their own balance sheet may engage in a wide variety of businesses, but infrastructure firms are typically limited to one line of business
  • Corporations that finance new investments using their own balance sheet offer products or services that vary across a wide spectrum of price and features/quality, but infrastructure firms typically offer products or services that are:
    • Regulated so as to reduce possible pricing strategies
    • Standardized with respect to features and quality

J. Robert Sheppard, Jr.

[email protected]

infrastructure finance vs corporate finance1
Infrastructure Finance vs Corporate Finance
  • Decisions regarding new investments are hidden from public view when new projects are financed using the corporation’s balance sheet:
    • Project costs may not be disclosed
    • Rates of return for individual projects are unlikely to be disclosed
  • Decisions regarding new infrastructure investments can and should be made publicly
    • Standards for service are public
    • Regulatory regime is a governmental activity
    • Competitive bidding processes can be widely used
    • Operating period inputs for infrastructure can sometimes be benchmarked to publicly-available indices
    • Conventional, broadly available technology for most infrastructure services permits meaningful comparisons of cost among different countries and time periods

J. Robert Sheppard, Jr.

[email protected]

non transparent costs of infrastructure finance
Non-Transparent Costs of Infrastructure Finance
  • Risk premium for fixed-price construction contract that includes performance guarantees
    • Typical form of contract used to arrange non-recourse financing for privately-financed infrastructure projects
    • May be necessary for projects sponsored or owned by host-country governmental units
  • Risk premium for infrastructure project financing
    • Project-financed entities command a premium compared to corporate borrowers issuing comparably-rated debt of the same tenor
    • Host-country lenders may require a larger risk premium for non-recourse financings than lenders in US or European markets
    • Country-risk premium applied for financing arranged in international markets
  • Tenor of project financing is one of the most significant factors affecting cost of service
    • Available tenors may vary significantly depending upon financing approach
    • Where financing is arranged by private supplier of infrastructure services, public knowledge of financing arrangements may be very limited
  • Revised project economics following a restructuring occasioned by financial distress
  • It is important to distinguish between increased project costs based on risks borne by third-parties and increased project costs resulting from above-market equity returns

J. Robert Sheppard, Jr.

[email protected]

regulatory regime considerations
Regulatory Regime Considerations
  • Risk allocation, objectivity of service standards, and tariff adjustment mechanisms can significantly affect:
    • Required returns of infrastructure equity investors
    • Risk premium demanded by domestic and international lenders
  • Risk allocation and specification of standards of service:
    • What risks are private investors required to bear?
      • Are these risks controlled by the private investor?
      • Can they be hedged, insured or otherwise transferred to a third-party?
    • What penalties are applied for a failure to meet required standards?
      • Are penalties financial only or do they threaten loss of a concession or franchise?
      • Do the penalties adversely affect only equity returns or do they also threaten the interests of project lenders?
  • Tariff adjustments:
    • What index or indices are used?
    • Can anticipated changes be borne by the public? Renegotiation risk?
    • Ability of tariff adjustment mechanism to reflect changes in project costs?
    • Existence of hedging, insurance or other risk-transfer mechanisms to cover mismatch risks?
    • Frequency of tariff adjustments?
    • Certainty, fairness, objectivity of adjustment process?

J. Robert Sheppard, Jr.

[email protected]

infrastructure process design considerations
Infrastructure Process Design Considerations
  • Sequencing of projects can significantly affect success of a development program
  • Sizing individual projects is important – promote modest size, not mega projects
    • Average size of international projects has always been significantly larger than for US projects – size increases project-specific risks in situations where country risk is already a concern
    • Modest-sized projects offer a number of advantages:
      • Spread risk among a larger number of equity investors
      • Provide more comparable projects for cost and operational comparisons
      • Easier to audit
      • Can more readily enable the host-country to build a track record of success
  • Use competitive bidding but understand its limitations
  • A successful track record is the most important factor in reducing the risk premium demanded by equity investors and project lenders

J. Robert Sheppard, Jr.

[email protected]

competitive bidding considerations
Competitive Bidding Considerations
  • Appropriate design of bidding process requires a legal, financial, and engineering consultants
  • Risks to be borne by contractor, including price and performance guarantees, must be an explicitly-designed component of the RFP
    • Alternative risk allocation structures may facilitate identification of additional costs incurred by transfer of certain risks to the contractor
    • Alternative risk allocation structures can also lower expected project costs
  • Ensure competitive bidding or benchmarking of all major project components
    • Avoidance of new technology is easy in most infrastructure projects and will promote a broader market of bidders and verifiable cost estimates, as well as reduce project risks
    • Benchmark standards for costs to be borne by the public, such as fuel costs
    • Eliminate cross-subsidy opportunities, e.g., contractors that are also fuel suppliers, etc.
  • Structure tariff adjustment mechanisms that facilitate long-term financing and that ensure that an appropriate portion of benefits from cheaper or longer-term financing are passed through to the public
  • Understand that negotiations with the winning bidder will unavoidable resemble sole-source procurement in many respect

J. Robert Sheppard, Jr.

[email protected]

success means
Success Means….

Aside from adequate service at an affordable price, attributes of success will include:

  • Declining returns required by equity investors and project lenders – with returns being driven down by a track record of successful projects
    • The corollary of this attribute is that later projects will make earlier projects appear to have above market costs – even though these earlier projects – at their pricing – were a necessary step in reaching the more attractive later projects
  • Equity investors who want to re-invest in the host country
  • Capital markets issues to finance infrastructure projects that maintain investment-grade ratings on a long-term basis
    • Capital markets debt issued by infrastructure project should be significantly de-linked from the host country’s sovereign rating and should not automatically be downgraded to below investment-grade in the event of an economic crisis that does not directly affect the project
  • A successful result, not necessarily a pretty process
    • The history of international infrastructure development includes:
      • Large public subsidies and many bankruptcies for US railroads in the 19th century
      • The US nuclear power industry in the 1960s and 1970s
      • Overbuilding and financial distress in US merchant power and telecommunications in the 1990s
    • Developing countries can do better but it’s important to ask: “Compared to what?”

J. Robert Sheppard, Jr.

[email protected]

recommendations for action
Recommendations for Action
  • Design a regulatory regime that can survive macroeconomic stress and that will not require renegotiation of project economics after commencement of operations
  • Require competition, but structure each competitive process to reveal the premium that the public must pay for risk assumption by third parties
  • Understand the impact of financing costs and tenors on tariffs paid by the public and attempt to reduce the required risk premium and to facilitate long-term financing
  • Build a track record of successful projects to drive down the returns required by project sponsors as well as local and international lenders

J. Robert Sheppard, Jr.

[email protected]

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