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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


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]