De-risking sustainable infrastructure
April 2019 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2019 Issue
The world needs about $3.7 trillion investment in infrastructure every year, according to the Global Infrastructure Hub. Despite all the efforts of governments, development finance institutions and the private sector, current spending on infrastructure still falls short by about $600bn annually. The funding gap is even bigger when the additional costs of reaching the UN Sustainable Development Goals are factored in.
After years of low interest rates, investors are increasingly seeking out alternative investment opportunities in their search for attractive, stable returns. Indeed, this was one of the main drivers behind the recent popularity of the infrastructure asset class. At the same time, the increased demand has underlined the need for more robust project pipelines. The shortage of bankable projects forces investors either to stay on the sidelines or accept high valuations. This is particularly an issue for sustainable infrastructure: projects with low carbon and environmental footprints. Due to the higher upfront costs and perceived technology risks of environmental-friendly solutions, they are often harder to finance than the traditional alternatives. As infrastructure is one of the main sources of global carbon emissions, any infrastructure built today has to be low carbon in order to be in line with commitments made as part of the Paris Agreement.
Multilateral development banks (MDBs) and other development finance institutions (DFIs) play an important role in bridging the infrastructure gap by providing financing when private capital is reluctant to participate on its own. However, DFI balance sheets are not large enough to cover the additional $600bn investment needed every year through lending alone. There is a pressing need for innovative solutions to de-risk projects in order to attract private capital at scale. Indeed, that is the purpose of credit enhancement solutions. By providing guarantees or subordinated capital, DFIs can leverage their limited resources to mobilise investments orders of magnitude larger than what would be the case through senior loans alone. Indeed, credit enhancement seems like the obvious solution to the global infrastructure deficit. Yet, there is surprisingly low uptake of these instruments. In order to understand the reasons for this, one needs to examine both the demand and supply-side barriers that prevent these solutions from gaining more traction in the space.
The role of MDBs in upscaling credit enhancement
There is a wide spectrum of credit enhancement providers, including MDBs and other DFIs, export credit agencies, private guarantors and insurance companies. However, due to their large balance sheets and global presence, MDBs are by far the most dominant players in the space.
Most MDBs offer some form of credit enhancement solution, ranging from partial credit and political risk guarantees to providing risk capital on concessional terms. Yet, their activity in credit enhancement pales compared to the amount of loans they underwrite each year. One of the reasons behind this is employee incentive structures: they tend to favour lending over credit enhancement products. Bankers at MDBs are evaluated at year-end based on the annual business investment (ABI) they generated. While loans are included in the ABI calculations on their scorecard, guarantees are often excluded. Considering that lending is the core business of MDBs, it is not at all that surprising that incentives are aligned accordingly. However, when looking at their overall mandate of promoting development, adjustments to how incentives are set up is justified. One solution, which some MDBs are already considering, is assessing employee performance based on the annual mobilised investment (AMI) instead. AMI-based evaluation would not only enable the inclusion of credit enhancement, but would also encourage employees to actively explore opportunities for such transactions.
Another source of hesitation among MDBs to upscale credit enhancement is the potential impact of these instruments on their credit rating. MDBs tend to treat guarantees and loans the same way when deciding how much capital they allocate for it. This conservative approach to risk management can be explained by the fact that the most valuable asset of MDBs is their AAA credit rating. It enables them to borrow cheaply and on-lend to projects at competitive rates. This is especially important for supporting high impact, development projects, which rely on a low cost of financing to be bankable. Having a large number of guarantees outstanding with low capital allocations can raise red flags with credit rating agencies and trigger downgrades.
The global development community is discussing ways to address this issue. One idea, which is getting a lot of traction, is the creation of a ‘universal guarantee facility’. This would be a new entity created through a joint collaboration across major MDBs with the sole purpose of credit enhancing infrastructure projects. It would be capitalised by developed country governments, international finance institutions and philanthropic organisations. This facility would enable MDBs to move guarantees and other de-risking instruments off their balance sheet, so they do not have to worry about the credit rating implications of these products.
Low demand for credit enhancement
The underutilisation of credit enhancement instruments for infrastructure is also a result of insufficient demand. While there are enough projects that need to be de-risked to become investable, there is a surprisingly low awareness of the range of credit enhancement solutions available across infrastructure sponsors and investors. Public infrastructure planners are often not aware of the variety of instruments offered and whether projects under preparation are eligible. In addition, institutional investors and financial advisers also have little experience with credit enhancement. While some of them have heard about these instruments, only very few of them have actually seen them being used. This is a missed opportunity.
Furthermore, some potential users perceive credit enhancement from MDBs to be expensive. They wonder if commercial markets can provide guarantees on better terms. Indeed, MDBs have acknowledged that in some cases it can be cheaper for the borrowing organisation when MDBs resort to buying a loan guarantee from a commercial provider instead of issuing guarantees themselves.
Finally, there is a question around asset recycling. Even though there have been some notable projects with bond financing, banks are still the major source of debt financing for infrastructure. At the same time, they are required to comply with stringent capital adequacy, leverage and liquidity requirements. In practice, this means that banks tend not to keep infrastructure loans on their balance sheet, but instead sell them off their books before these loans come to maturity. This process is also called asset recycling. However, if there is credit enhancement in place, for example in the form of a guarantee, this process becomes administratively much more complicated and, in some cases, practically impossible. That is the reason why some financial institutions have been slow to embrace credit enhanced deals. More standardisation in the design and implementation of these instruments could certainly make banks more comfortable with the additional steps required for asset recycling.
Moving from billions to trillions
As a next step, the development and investor community need to assess what de-risking instruments are still missing and which financial institutions are best placed to provide them. For example, investors are asking for solutions to address currency risk for non-convertible currencies in developing and frontier countries. Current providers still lack the balance sheet to take on currency risk at the scale that would be needed globally. Also, what could be done to strengthen domestic capital markets, so local financial institutions are better placed to provide large, long-term loans that infrastructure projects require?
Similarly, refinancing risk has been a major problem in many of these countries. How can you have a financially viable project for 40 years if the longest loan maturity that local banks can provide is five years? The problem with short-term financing is that benchmark interest rates in these countries can change significantly within this time period. While the well-established, liquid capital markets of developed countries offer instruments to hedge interest rate risk, these long-term de-risking instruments do not exist for the local currencies of many low and middle income countries.
In order to close the global infrastructure deficit in a sustainable way, the global development community needs to embrace solutions that can mobilise trillions instead of just billions. The good news is that there is no shortage of capital seeking investment opportunities, and through credit enhancement the limited public resources can be leveraged significantly. Nonetheless, to reach the $3.7 trillion investment needed annually, there needs to be a more systemic collaboration among stakeholders. There should be more political and institutional support, both internally and externally, for these solutions. Also, there should be more awareness raising and education about the instruments available, eligibility requirements of providers and showcasing the potential of various de-risking solutions. Only then can the challenges of upscaling credit enhancement for sustainable infrastructure be addressed globally.
David Uzsoki is a senior advisor in Sustainable Finance and Infrastructure at the International Institute for Sustainable Development (IISD). He can be contacted by email: email@example.com.
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International Institute for Sustainable Development (IISD)