Private capital for infrastructures: what are the problems and what are the solutions?
The relationship between the public and private sectors must be based on a clear identification of the infrastructure’s underlying risks. And on the principle that each party must take responsibility for the risks that it is best able to measure, manage, and eventually cover.
In 2014, I had the pleasure of working on the subject of the private financing of infrastructures with the team of researchers I coordinated as part of the “Workshop on infrastructures”, promoted by Autostrade per l’Italia at the Bocconi University of Milan. The results of our research led to the document Nine ideas for a new culture of infrastructures, which I signed along with Giovanni Castellucci, Lanfranco Senn, and Michele Polo.
There are many points of contact between our research and the document. However, three of them are at the heart of the issues we dealt with. In particular, I am referring to the following: 1. the role of private investors, who from “capital providers” become “risk takers”; 2. the transition from the need to “guarantee the investors’ returns” to that of guaranteeing “no surprises”; 3. the transition from a “gradually developing contract” to a “closed contract”.
Regarding the first point, some figures should suffice: the need for infrastructures estimated by the European Union by 2020 is equivalent to an expenditure of about 2,000 billion euros. Given the tight budgetary constraints of the member countries, the search for private capital to make up for the reduction of public investments in this type of intervention has become essential.
While it is true that infrastructures should be the elective field of investment by the public entities, which therefore should also take on the burden of financing the works, some distinctive characteristics of infrastructures make them a desirable alternative asset class compared to more traditional investments in shares or bonds: regulated sectors, high barriers to entry, market structures of a monopoly or near monopoly, and the low elasticity of demand are all factors that contribute to a reduced volatility of cash flows from investments over a medium-long time span. This profile is acceptable to long-term investors such as for pension funds or life insurance companies, which, in fact, have begun to channel more financial resources into this asset class than only half-way through the first decade of the twenty-first century, enough to lead some analysts to speak of a phenomenon of disintermediation of the traditional banking circuit based on the syndicated loans organized in the form of project financing.
The growing trend of disintermediation that is emerging at the international level shows the clear interest shown by private institutional investors in infrastructures. Nevertheless, the full use of the financing potential of the private sector can only emerge in the face of a proactive attitude by the public sector and an entrepreneurial orientation that manages to avoid considering private capital as an easy shortcut to overcome the problem of insufficient public budgets.
This attitude may be based both on the creation of a class of public officials technically prepared to enter negotiations with the private sector on the basis of risk/ return profiles acceptable to the individual parties, and on the availability of forms of financial back up that can improve the same profile in the case in which the infrastructure work itself is not found to be attractive to private investors. These two conditions are at the basis of points 2 and 3 indicated previously.
As for the problem of ensuring an adequate risk/return profile, it should be clear that the relationship between the public and private sectors must be based on a clear identification of the underlying risks with regard to the infrastructure and on the principle that each party must take responsibility for a portion of the risks: the one that the party in play can better measure, manage, and possibly cover. Thus, it follows that the private party should be responsible for risks arising from the business management of the work. Good industrial sponsors should be in the best position to ensure the construction and the effective and efficient management of the work. On the other hand, the public sector should manage the risks that cannot be controlled by the private party: the administrative risk, the regulatory risk, the risk of regulation changes, and the risk of the emergence of illegal phenomena.
In the specific case of Italy, many institutional investors complain about the absolute unpredictability of the regulatory framework, the legal and institutional framework that is not at all compatible with the long time that investments in infrastructures typically require. It is not possible to think about investing capital when the rules of the game change after that same capital has been spent. The issue of ‘legal certainty’ is an often misunderstood phenomenon that leads to seeming illogical choices in public finance policies. Just think of the various forms of credit enhancement developed by the European Commission, initially through the 2020 Project Bond Initiative and more recently through the proposal by President Juncker of the EFSI (European Fund for Strategic Investment). Such interventions are clearly heading in the direction of improving either the performance or the risk of the operation in favor of private lenders.
Guarantee mechanisms of this kind effectively distort one of the basic principles of the publicprivate partnerships: if the private parties see the investment risk reduced, they cannot be certain that the risks are being managed as effectively and efficiently as possible. As part of our research project, through a simulation of multiple agents, we demonstrated that a public administration which is inexperienced in issues of publicprivate partnerships and the use of the relevant mechanisms of credit enhancement (or, if you prefer, tools for reducing the risk of loss for private investors) has the effect of attracting the worst private entities in the construction, management, and financing of the work. Therefore, these are situations in which the absolutely legitimate desire to attract more private capital has the negative effect of the emergence of an adverse selection (prior to the award) and of moral hazard (afterwards).
Only closed contracts that are well-written and very clear about the definition of mutual commitments, accompanied by a regulatory framework that will not be changed once “the game has begun” are the best guarantee for a full deployment of the forces of private capital in the infrastructure sector and this is regardless of any guarantee of a feasible minimum return for the private entities.
(Abstract from Autostrade per l'Italia's Magazine "Agorà")