How to pay for infrastructure investments is a vexing issue in developed and emerging markets alike. It is also a top priority for both the public and private sectors, with widespread acknowledgement that the quality and robustness of infrastructure are key factors that affect all countries in a globalised investment landscape.
Economic growth also hangs in the balance. According to recent global analysis by BCG, an increase of $1trn in infrastructure investment worldwide would unleash approximately $1.5trn in additional economic activity each year. Furthermore, a major Africa-wide study – Africa’s Infrastructure: A Time for Transformation, by the World Bank – concluded that a doubling of infrastructure investment levels on the continent (from $45bn to $90bn per annum) would boost GDP by 2.2 percent.
Infrastructure investment not only stimulates economic activity in the short-term during construction, but also drives secondary job creation in the private sector as economic competitiveness improves. Despite being widely acknowledged by governments and the private sector, not enough infrastructure investment is occurring globally.
Regardless of the financing modality chosen – public-private partnership (PPP) or traditional public sector financing – there are three basic commonalities present in all successful infrastructure projects:
- A strong underlying business case, generating an economic return through sufficient, lasting demand for the new or refurbished infrastructure;
- A robust project structure to achieve bankability, legal enforceability, political and social buy-in and environmental compliance;
- Sustainable funding sources, either from user charges alone or in combination with predictable, stable and credible public sector support.
Based on the European Bank for Reconstruction and Development’s (EBRD) experience over the past 20 years, infrastructure projects containing these elements will attract ample financing.
Approach to financing
The EBRD has broad and varied experience involving infrastructure projects using various forms of private sector participation (PSP) approaches, encompassing both PPPs and projects funded with the public sector according to the user pays principle, typically using the public service contract (PSC)/public service obligation (PSO) model. Over the past 15 years, the EBRD has funded some 40 PPPs in the infrastructure sector, including water/wastewater systems, roads, airport terminals, urban transport, district heating, ports and national rail. To date, it has financed €2.3bn in direct private sector financing. These projects leveraged an additional €3.5bn in other private financing from commercial lenders or other co-financiers. The demand for PPPs in the EBRD region remains steady, and has persisted throughout and beyond the 2008-09 financial crisis. In fact, certain countries, such as Russia and Turkey, are planning large pipelines of infrastructure projects.
[T]he quality and robustness of infrastructure are key factors that affect all countries in a globalised investment landscape
Using the PSC/PSO model, the EBRD has financed some 375 projects across the water/wastewater, urban transport, rail, district heating and solid waste sectors, totalling approximately €6.3bn. Importantly for the municipalities and ministries of finance, these projects are typically structured as non-sovereign, off-balance sheet in respect of the municipalities/sovereign, with the municipal utilities (or national transport operator) acting as borrowers. While full-cost recovery tariffs are pursued wherever possible, when public subsidies are necessary based on policy or affordability grounds, performance-based contracting holds the management of these public utility companies accountable under the PSCs/PSOs. This PSC/PSO model has proven resilient over the past 15 years, having withstood serious crises, including the fallout from the financial crisis.
The funding challenge
Infrastructure competes with other social and economic priorities for public resources. In this context, governments in both emerging and in OECD countries find it increasingly difficult to reconcile the financial demands for infrastructure financing based on tax revenues or state borrowing with the need for fiscal sustainability and the urgent need to reign in public debt levels. The ability of governments to deliver infrastructure by means of conventional direct borrowing or funding, known as the ‘general revenue model’, is consequently diminishing rapidly.
It is often not the lack of financing for infrastructure that is the problem – testified by the numerous and very substantial multi-billion dollar private and public infrastructure funds that have been established over the past decade, and that remain, in many instances, under-utilised or even largely undisbursed. Clearly, there are other, more fundamental, issues at play; namely, the lack of properly robust funding mechanisms and the lack of adequate project preparation.
A key issue for accelerated infrastructure development is the ability to pay for infrastructure and its operation. Only if a project has clarity and reasonable predictability of funding sources for capital expenditure and operation and maintenance can issues such as financing and delivery modality be tackled successfully. As such, the funding issue is at the heart of an accelerated infrastructure delivery. Politically, this is also the most uncomfortable issue to address. The easy option of funding through general tax revenues (clandestine funding) has been largely exhausted in most countries. Also, the failure of PPPs to make a larger contribution to worldwide infrastructure delivery can be explained to a significant degree by an inadequate funding basis. Even countries that are most active in using PPPs (such as Chile, Taiwan and the UK), only manage to fund between 10-15 percent of their entire infrastructure investments through PPPs.
Determination to deliver a piece of infrastructure must therefore be coupled with security and sustainability of funding sources. If a credible and strong mechanism to deliver payments is lacking (for example, fare box/user charges, government payments, payment enhancement/guarantee mechanisms, value capture mechanisms, or some combination of all three), the private sector will not engage as developer and financier of infrastructure projects.
It follows that there are certain necessary conditions for accelerated infrastructure delivery, namely the increased application of the ‘user pays’ principle to complement government funding; the need to find and apply realistic complementary means of financing; and the need to roll out solid contractual payment arrangements between the public sector and operators (such as PSCs/PSOs).
Case study: The Romanian water sector
Once robust funding approaches are established, successful examples of systemic uplift of investment levels in infrastructure occur. Concrete examples of the application of increased – but affordable – user charges are well documented. For example, in Romania’s municipal water sector, over the past 15 years, gradually increased user charges have led to significant capital expenditure investment in the modernisation of the country’s water and wastewater sector. The EBRD has been involved in Romania’s water and wastewater sector since the mid-1990s, and the sector-wide revenue growth has increased from approximately $400m in 1994 to approximately $1.4bn by 2011 in real terms. Hence, some $950m in additional revenues is now being collected annually by the country’s water operators compared to the pre-reform situation in 1994.
It is important to understand how this level of revenue growth – which was based on sustained tariff rate increases well above inflation rates – was achieved. First, as a matter of principle, the tariff increases were instituted in connection with the commencement of civil works to modernise the underlying infrastructure, and not once the water service actually materialised 24 to 36 months following the completion of works. Using this method, the water companies and local political leaders informed water customers that the civil works under the roads and at the water plants needed to be paid for primarily by users, and that the works would result in improved service.
When service quality did improve substantially over time, the utility companies gained the users’ trust. The rise in water tariffs has continued to the present day. Today’s average tariff of nearly $1.50 per cubic meter represents a 900 percent increase in real terms since the mid-90s, and yet tariffs remain affordable for most households. The utility companies have flourished as businesses, with many now running healthy cash surpluses. Using a conservative financial gearing ratio of 3:1, this means that the water sector’s operators are now able to make additional capex investments of $3bn versus the pre-modernisation situation of the 1990s. This level of self-financing capability, created over time by improving the underlying funding of municipal infrastructure, is the ultimate test for any multilateral development bank.
Value capture mechanisms
Another source of funding that is increasingly being used internationally is the application of value capture mechanisms, of which there are two main forms: a) a single lump sum payment by the private sector, typically property owners, developers, and/or commercial interests, made up-front (or during construction) to the public sector to offset some of the cost on the public purse of the new infrastructure; and b) an ongoing funding mechanism, which requires recurring payments by the private property owners in the form of location benefit levies, tax increment financing, betterment taxes/special assessment districts, and ‘joint development’ approaches, whereby commercial space is leased out by the infrastructure owner in the vicinity of the new infrastructure. However, value capture is no panacea in the infrastructure space: the first form requires that the public can effectively assemble and group land for development and apply an acceptably assessed increase in land value prior to the infrastructure’s implementation (Hong Kong’s metro system is the best known example, where more than 50 percent of all revenues to the metro company come from value capture at new rail stations); while the latter requires a properly functioning land/property tax system, which remains uncommon in many emerging market countries. London’s new Crossrail line is being partially paid for using a special increase in business property tax levied since 2011 for the next 24 years on all businesses in Greater London. This is projected to create a fresh revenue stream of £4.1bn of a total of £16bn for the new line. The new funding is being used by the Greater London Authority to service the bond obligations that the GLA has taken on to contribute to the project alongside national government financing.
Despite these limitations, particularly for the transport/urban transport sector (such as urban rail), value capture approaches represent the potential to create a broader pool of projects than would otherwise be possible.
Project preparation
The second bottleneck for infrastructure delivery is the difficulty the public sector has in creating a sustained delivery framework to prepare projects adequately and efficiently. This impacts on the pace of delivery for public infrastructure projects in general, and often makes the development of more complex PPPs impossible.
A sea change must occur in the way project preparation is supported and managed. International financial institutions have a role to play in this. Clearly, a greater number of projects must be properly prepared and structured to become bankable in order to change the dynamic of investment levels. From the EBRD’s point of view, while infrastructure financing needs are high, true progress will not be made in reducing the much-discussed investment gap until the project-related ‘institutional gap’ is addressed. For this to occur, comprehensive technical assistance and institutional strengthening is required, where the goal should be to build a critical mass of local experts in the public sector who are able to present well-structured projects to the market on their own accord using their own internal capacities. This is the ultimate litmus test over the medium- to long-term for the effectiveness of any IFI or bilateral donor.
The EBRD’s experience since the early 1990s working in Eastern European economies has shown that well-structured and well-prepared projects will find financing. With a greater focus on selecting projects with a sound business case, underpinning the investment with revenue generation from users, and the use of sound regulatory tools such as public service contracting, a systemic uplift in infrastructure investment can occur. With the right type of support and approach we believe that this experience can be replicated in other emerging market regions.
