infrastructure project finance

infrastructure project finance

The Role of Project Finance in Infrastructure Development

1. Introduction to Infrastructure Project Finance

The role of project finance economics in infrastructure development is attributable to the simple fact that if developed and specific assets are to come into existence, if plant, equipment, and services are to be added to or improved in the infrastructure and industrial sectors, the vast bulk of investments must be initiated and realized by legal entities that have no prior business record; that there are not and possibly cannot be lenders to these legal entities unless some set of contractual agreements is entered into. Indeed, in 1926, some four years after the first of three revolutionary court decisions specifically sanctioned such agreements in connection with the construction of the electric system of the City of Chattanooga, research by the Electric Bond and Share Company (EBSCO) indicated that 80 percent of electric facilities were owned by use of a limited recourse bond approach. This reliance upon a financial technique had facilitated the administration and utilization of risk-bearing equity, relatively long and highly leveraged debt, and maintenance and operation expenses consisting almost entirely of past knowledge. The emphasis upon the degree of prior knowledge to the owners and the sources of moneys was the rationale for distinction.

Infrastructure project finance is part of an institutional approach to reducing the risks that private developers confront when they undertake large capital investments in infrastructure. This approach involves: (a) designing projects so that they can be financed on a stand-alone basis; (b) allocating risks among the parties to a project so that the parties that are best able to bear and manage specific risks will do so; and (c) regulating the relationship between customers and private operators after the projects are completed, to protect the interests of both parties and to ensure that customers receive satisfactory service. Experience with private participation in infrastructure (PPI), when analyzed in the context of economic theory and historical evidence, suggests that this institutional approach is valid and deserves broader application.

2. Key Concepts and Principles of Project Finance

The concept of project finance is not captured by a simple literal interpretation of the word. Indeed, there is no one definition of a “project finance transaction”. The distinguishing feature of project finance is that the project’s debt, equity, interest rates and the other terms and conditions of the financing agreements should be based on the likelihood and success of the project itself, as well as on sources of payment. The project’s sources of payment for the loans must be anticipated to be available immediately upon the completion of the project, and to work very consistently over the life of the project. Several hypotheses can be emanated from the foregoing statements and they are true in general for each project financing within economic practice. Used independently, each of the above hypotheses explains one facet of several other transactions which have been structured to permit the continued operation of a wide variety of other kinds of property after an involuntary bankruptcy or financial difficulty.

What is “project finance” and what are “project finance transactions”? These are two central questions that ought to be addressed at the outset of this study if we are to properly understand the scope and reach of our investigation. What is quickly learned, however, is that project finance is a financial device of great flexibility, a structure that can be molded to the financial opportunities and obstacles the corporation may encounter in the course of building and extending its earning potential. The concept of project finance is not captured by a simple literal interpretation of the word. Indeed, there is no one definition of a “project finance transaction”. The defining characteristic of a project finance transaction, rather, is the recognition that the project is to be developed, constructed and operated by a stand-alone project company – to be known as the sponsor or borrower. The transactions are typically of a discrete, non-permanent nature. The debt is secured in whole or in part by the project’s assets.

3. Benefits and Challenges of Project Finance in Infrastructure Projects

Through project finance, all risks facing the project are allocated, transferred, and diversified to contracts handling those risks best. By giving real incentives created by risk-treaty, skill-rich contracts are created, leading to greater cost reductions and better innovation. This leads, among others, to financing benefits, making the business case more attractive. In infrastructure projects, project finance is not a unique response but will generally be used in situations where it can create value. However, when it can create value, project finance should be the response of choice. Such a statement helps demonstrate the significance of the work done during the design and management of the structures and contracts.

By looking at the various benefits and challenges of using project finance for infrastructure projects, this chapter only scratches the surface in order to illustrate the complexities and the decisions that underlie project finance in local asset infrastructure projects (LAIPs). In the case of LAIPs, and in particular of public-private partnerships (PPPs), decisions are also made regarding the ‘public’ partner. Decisions and agreements made during the planning and structuring phase are intended to balance partner goals and objectives. This is consistent with the efficiency of the project finance in reaching a sustainable financial solution, benefiting from adjustments in the collective bargaining from the willingness to contract with other parties. This is also consistent with risk management criteria and feasibility constraints.

4. Case Studies and Best Practices in Infrastructure Project Finance

The case of the Making Money project illustrates how investment from Brazilian insurance and pension funds was not welcome because construction risks were considered very high by interested funds, shouldering insurance and banks part of the risks, valuation of assets in local currency was considered too risky because it would mean high inflation, and the success of the highway would compete too much with the funds’ portfolios because they were performing very well.

The Brazilian case of the Making Money project brought interesting light about the importance of establishing deep long-term investments by insurance and pension funds in long-term infrastructure, since policies and regulations for these funds’ investments, asset and project markets, are already in use in developed economies. It is likely that in order to structure investment portfolios and projects involving long economic lifetimes as those of infrastructure, longer “investment horizons” shall be needed and shall have to be matched with long-term savings.

In the case of the Panama Canal, part of the feasibility studies involving the expansion project consisted of a project finance structuring for the construction of the works, accomplished by a consortium formed by the names already mentioned. The discussions with potential partners of the Panama Canal Authority and the strategy themes involved in the negotiations are the object of this paper.

This section provides specific cases of infrastructure project financing, discussing the importance of risk management and the participation of the public sector in these deals. It also discusses two practical examples: the case of financing the Panama Canal extension and the development of long-term insurance and pension funds in Brazil and the potential entry of these funds in infrastructure development.

5. Future Trends and Innovations in the Field of Infrastructure Project Finance

For the energy industry, project finance innovations will take the form of long-term supply contracts, power purchase agreements, fuel supply agreements, and tolling arrangements, designed primarily to create services that are creditworthy in themselves. As has been seen over the last decade, credit issues are likely to be resolved on a case-by-case basis, with little likelihood that the long-standing rules of thumb regarding debt/equity “yellow light” levels will do much to stimulate a widespread improvement in borrowers’ credit quality. Investors in emerging markets will approach project finance opportunities as special situations that are likely to offer the potential for better-than-average returns, provided careful analysis is employed to sort out the good from the bad possibilities.

Considering the study’s outcomes, activity within the sector of infrastructure project finance seems destined to move incrementally rather than through a sudden break with the past. As the need for new infrastructure mounts and government budgets come under renewed pressure, project finance is likely to see heavier reliance on new forms of private and public-private partnership such as concession agreements, demand guarantees, and contingent payment obligations. Existing government-controlled entities such as rural electrification programs may also be partially privatized to allow better access to international financial support.