infrastructure and project finance

infrastructure and project finance

The Role of Infrastructure and Project Finance in Economic Development

1. Introduction to Infrastructure and Project Finance

The pace and character of securities development in cities are the result of a complex mixture of factors. This paper argues, after reviewing the principal arguments for portfolio capital liberalization, that the critical direct factors shaping the timing, size, and preeminence of the adjustment process have yet to be adequately identified. In their absence, international advisers to industrializing countries run the risk of emphasizing securities development prematurely.

The mobilization of domestic and foreign capital is critical for developing countries to achieve a self-sustained increase in economic welfare. While equity and bond markets have rapidly developed in many developed countries, they have yet to do so in many developing countries. Emulating the dramatic increase in the size and liquidity of securities markets in the 1980s should help many economies, particularly with sizable current account deficits, to lower the cost of investment and adjustments. However, the rapid deregulation of stock markets is unlikely to be the most important determinant in the timing and magnitude of countries’ adjustment to external imbalances.

2. Key Concepts and Principles in Infrastructure Finance

Infrastructure finance concerns the channeling of financial resources, primarily from domestic and international long-term investors, to the institutions and organizations responsible for developing and promoting the efficient use of infrastructure capacity, at the time and places needed, to facilitate sustained economic development. It is about financing for facilities people have difficulty seeing or touching directly: highways, bridges, ports, air and rail terminals, water and sewer facilities, electricity facilities, not to mention schools, hospitals, recreation and correctional facilities. It is about financing that is crucial to the production, processing, and distribution of goods, services, and economic opportunities, yet that too often has been ignored or treated as a second-rate piece of the financial system. Whenever financial opportunities exceed the abilities and willingness of the traditional part of the financial system to supply, infrastructure finance drives a wedge between economic fundamentals and market liquidity. The role of finance in economic development is to respond to that wedge. This function is what distinguishes this part of finance from more traditional parts of, for example, corporate finance and credit-enhancing insurance.

In this section, we develop the key concepts and principles in infrastructure finance. Our intention is to provide a balanced treatment of this topic, neither delving into the technical and legal aspects, nor treating it with a superficial touch so that the treatment would have no chance of providing a reasonable understanding of the infrastructure finance, which is a critical aspect in the understanding of the broader role of infrastructure and project finance in economic development.

3. Project Finance Models and Structures

In the basic structure of a project, an equity company is normally incorporated by the project sponsors. This company holds all shares of the construction company. The construction documents of the company are those for the construction of the project, together with the equipment supplied. It contracts with the operator to pay for the use of the facility once the construction is finished. The operator then agrees to maintain and operate the facility, with due protection of payments and step-in rights for the operating company. The operator itself maintains a limited liability company for the purposes of this contract with the construction company. The operator’s revenue pledge extends to all its revenues, including construction payments. The construction company provides limited warranties and waives recourse and applies the cross-default clauses for the Mexican operating debt. The collateral package for the terminal project includes permits and insurance, the sources of funds and bond issue, the step-in rights for the construction company and the operator, and a mortgage.

Sponsors raise limited-recourse finance for the project, which is structured in a way that limits their downside financial exposure while ensuring that they retain the ability to achieve the maximum potential gains from the project. The uses in project finance, by specific project entities, are separate from those of their sponsors. The finance may be raised in international capital markets, and the lenders to the project are typically not all the same institutions that have lent to the project sponsors. The overall structure of a project financing is a coherent combination of several facilities along with the variety of contracts needed for the specific project.

Project finance means the use of project-specific (or non-recourse) debt, equity, and export credit to finance the development, construction, and operation of a particular facility. The essential feature of project finance is that the debt is secured primarily by revenues to be generated by the project and is repaid from these revenues. Project finance also has several other important characteristics.

4. Case Studies and Best Practices in Infrastructure and Project Finance

Coming to lessons to be drawn from international best practice, some of the key factors impacting on the successful mobilization of infrastructure debt capital are: defining the right project and time for financing, whereby such financing aims at securing a particular objective in terms of permitting the private sector supply of the service; reviewing the full spectrum of financing options, be these local banks (commercial or dedicated ones, as per Deutsche Pfandbriefbank does provide some of the project cash flow with long-term facilities), local or international capital markets, or commercial project finance or government agencies direct loan finance; as much as possible, obtaining or making available a credit enhancement; where a local market does not exist, methods of achieving this include the setting up of dedicated financial intermediaries, the provision of guarantees and support by donors; protecting the cash flow and, therefore, the credit quality of the project, by ensuring that the concession agreement correctly allocates the risks (such as of demand, completion, operations, permits, fuel supplies, etc.) and its purchase price volatility (thus including hedging where possible); using financial and technical means to improve the credit quality of the project and its obligations; preventing or mitigating political or regulatory risks by providing for these within the concession contracts and through specific other financial mechanisms; finally, utilizing a combination of financial and legal engineering to get around various potential legal problems (such as of legal segregation and true sale of assets and receivables, enforceability of relevant agreements in local jurisdictions, accounting, tax, and other issues).

As the emerging markets deal with their development challenges, project and infrastructure finance have an expanded role to play in providing much of the key financing for transport, power, and other public services. Owing to current fiscal pressures and recourse to sovereign and other foreign currency obligations, finance of this kind will need to provide significant amounts of limited or non-recourse funds for these purposes. The case studies dealt with in this paper illustrate some of the key features of debt finance collateralized by the assets to be built or operated in the context of some of the key instruments, without which such finance cannot be mobilized.

5. The Future of Infrastructure Finance: Trends and Innovations

The growing recognition of the distinct nature of infrastructure risks and appropriate techniques for financing has important implications for the future development of distinct credit and reduction techniques. It has been recognized that such lending should build on the banking commercial skills and management strategies while allowing for the long-term nature of the risks. Efforts have also been made to develop specialized long-term funding sources that invest in longer-term finance and recognize the features of long-term transactions, thereby allowing early and lasting capital market development. These sources include pension funds, insurance companies, bond funds, specialized investment banks, and similar sophisticated long-term lenders.

Infrastructure finance, particularly when supported by a specialized project finance technique, can be an important engine for sustained economic development. But it is not a “magic bullet.” It is crucially important to assess the credit quality of infrastructure project finance transactions accurately and to reserve adequate equity capital to absorb the risks involved. Investors must fully understand these risks and, in the market’s terms, be fairly compensated for bearing them. And financially sound borrowers must be nurtured. Even with these requirements satisfied, an efficient infrastructure finance market may not emerge spontaneously, but companies such as IFC can play a shaping role.