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Monday, 23 October 2017

Infra evolution revs up

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Those paying attention may have noticed – infrastructure is back on top of the regional agenda. By Christoph Vojc with Jonathan Robinson and Michael Cooper, HSBC MENA Project Finance

With increasing recognition of the potential for private sector participation in all facets, the (r)evolution has begun. The economic challenges of the last two years have forced a re-prioritisation of increasingly limited capital and put pressure on MENA governments to focus on developing core infrastructure in order to support sustainable economic growth in the region.

A new sense of realism favours essential public infrastructure initiatives such as roads, air/sea ports, mass transit, and utilities projects over the real estate initiatives that characterised many markets across MENA prior to the “liquidity crunch”. In line with the recognition that the infrastructural gaps that have persisted in the past need to be addressed, MENA governments have announced more than US$550bn worth of core infrastructure projects to clear the path for sustainable growth.1

Faced with substantial capital investment requirements amid comparatively constrained budgets, MENA governments are increasingly looking to the private sector to enable the transformational change already seen in the regional power sector. Across the region, the private sector has directly participated in close to 30,000MW of independent power (and water) projects (I(W)PPs) and in the process has mobilised some US$35bn of debt liquidity for the sector.

Kuwait’s recently established Partnerships Technical Bureau is overseeing a large-scale public-private partnership (PPP) scheme to expand the country’s power, water and transportation infrastructure. Abu Dhabi is expanding its use of PPPs for key elements of its US$100bn-plus Surface Transport Master Plan, while Dubai, a long time hold-out of private sector ownership in infrastructure, is working on a new law to enable PPP structures in the utilities and transportation sectors.

Saudi Arabia, Oman and Bahrain, already well established hosts of similar schemes in power and water, are now considering options for private sector participation to develop more and more areas of their core infrastructure sectors.

Not to be overlooked, Egypt, Jordan, Tunisia and Morocco are all embracing some form of PPP structure to catalyse their own infrastructure initiatives. Whether we call it PPP, build, own and operate (BOO), build, own, operate and transfer (BOOT), or build, lease and transfer (BLT), private sector participation in the provision of essential public infrastructure is a key focus on most MENA government agendas.

Although not all infrastructure projects are suitable for private sector participation for political and commercial reasons, we believe as much as US$250bn worth of announced core infrastructure projects across MENA will lend themselves for development under a PPP scheme over the next five to seven years.2

Why MENA? Why now?

Core infrastructure projects require substantial upfront capital investments, historically a significant drain on government finances. PPP structures can relieve governments from the burden of funding such initiatives by engaging private sector capital and subsequently amortising total costs over long concession horizons.

This allows procurers to execute more new projects simultaneously rather than sequentially, a key advantage playing to MENA economies’ needs to build enabling infrastructure as quickly as possible. However, frequently under-recognised are the material benefits from risk sharing, knowledge transfer and operational efficiency that extend throughout the life of the underlying assets.

Construction delays, operational bottlenecks and cost overruns of large infrastructure initiatives can have crippling effects on fast growing economies and rightly represent a significant concern in a number of MENA jurisdictions. PPPs allow governments to “de-risk” projects by outsourcing key construction and operational risks to experienced private sector developers under the heightened scrutiny of their shareholders watching over their investment.

In typical PPP tender situations, private developers bid a defined, non-renegotiable tariff and bear the risk of cost overruns during construction and operation, while their bids also need to withstand the test of rigorous due diligence and monitoring from project finance lenders and other commercial financiers.

The net result from the government procurer’s perspective is a minimisation of construction delay and cost overrun risks, weaknesses for which public sector projects, on a global basis, are notorious. In addition, the unitary payment stream characteristic of most PPP projects provides visibility and predictability for governments on their future infrastructure expenses, which is critical given extraneous effects on government budgets in the MENA region.

Abu Dhabi, Saudi Arabia, and Oman in particular are cases in point where jurisdictions have benefited from substantial interest from the private sector for I(W)PP projects, forcing equity returns and financing margins to levels comparable with many developed markets. The result: many projects have become near commodities with bidders compressing capital and operating expenses to bare minimums.

One such tender process recently resulted in five bidders’ tariff bids being no more than 9% apart from highest to lowest. While striking the right balance of commercial, technical and financial risk allocation does require an extra upfront investment of time, particularly true in emerging markets, that additional effort when combined with a competitive tender process ultimately pays off, as witnessed by the strong global track record of PPPs for cost effective, on-schedule completion and operational excellence.

MENA governments are well known for their efforts to adopt industry best practice models that introduce new technologies or market entrants when feasible. By catalysing knowledge and technology transfer through a collaborative approach between government procurers and private sector developers, PPPs provide MENA governments with the benefit of learning externalities that would be limited by traditional public procurement strategies. In this context, a PPP strategy can also support government targets to employ more local citizens in private sector companies.

Another consideration favouring the PPP model is the widespread adoption of long-term non-recourse financing structures. These shift debt default and re-financing/roll-over risk, and the negative publicity associated with such, away from governments by placing it on ring-fenced project companies.

Though nay-sayers may claim long-term non-recourse funding is all but dead, the recent track record, notably in MENA, suggests otherwise – with substantial liquidity provided in the 15 to 20-year band. The right model, deployed in the region, can attract significant long-term liquidity – Abu Dhabi Water and Electricity Authority (ADWEA) for example, closed a 22.5 year non-recourse financing at the height of the credit crunch, in October 2009.

Harnessing the potential of PPPs in MENA

Time spent early is exponentially saved later. Leveraging from the experience of other jurisdictions – good and bad – will facilitate the definition of a programme that is realistic and credible for the private sector, and deliverable for government stakeholders.

Identifying a dedicated team drawn from the various host government stakeholders to act as the principle driver of a PPP initiative, and as liaison with external advisers, can be an effective start. Banks, technical and legal experts have an important role to play in the early “concept” stages by supporting the stakeholder buy-in process with considered international perspective and advice.

Choosing advisers is as important as choosing any long-term private sector partner. The wrong adviser for the job means the wrong advice for the programme, and the inevitable mis-direction in risk allocation and commercial appetite – a difficult lesson learnt by some in the region.

Once initiated, there are several notable elements of success for PPP programmes relevant to the region:

First, in order to fully leverage the benefits from private sector developers, MENA governments should define a tender process based on “output” rather than “input” specifications where the private sector takes substantial ownership for, and shared benefit from, a technical and commercial solution that best meets these requirements.

This contrasts with the traditional, input-driven public procurement process that rigidly defines project design specifications and thereby restricts creative and innovative solutions. The extent of philosophical shift – from “build it” to “buy it” cannot be understated in the MENA region, where standard procurement models still prevail in many sectors and jurisdictions. Education, transparency and, ultimately, strong stakeholder support from responsible ministries (including notably, finance) will be critical to embracing this (r)evolution.

Second, PPP projects should benefit from a fair risk allocation between government procurers and private sector participants, guided by the principle that those parties that are in the best position to manage and mitigate the risk should bear the risk. In practice, this means, for example, that private sector developers should be responsible for construction and most operational risks, while procurers should bear a certain level of demand risk, regulatory and force majeure risks.

Unrealistic or over-ambitious risk-sharing expectations on behalf of government procurers will eventually prove counterproductive by negatively impacting on developer appetite for the project and thereby reducing the quality of, and competitive tension within, the developer pool.

Furthermore, developers and operators will need remuneration commensurate with the risk by way of increased returns on equity, while financiers may demand additional reserves and increased financing costs – ultimately contributing to higher tariff expectations. In the worst case, unrealistic risk-sharing can quash commercial interest altogether and/or render a project unbankable. The ensuing negative perception that the procurer is uncommitted can prove lasting beyond a single project and set the PPP ambitions back measurably.

Third, governments should focus on a robust and transparent tendering process that strikes a balance between sufficient detail to allow a level quantitative and qualitative comparison across bids (considering legal, technical and financial elements) but without being overly prescriptive and thus constraining “positive ingenuity”. A well-articulated RFP-package, supported by a suite of financial model bid forms, can aid significantly in this respect.

Fourth, any PPP structure should properly incentivise private sector developers to deliver operational excellence and service consistency over the life of the underlying asset. Procurers should implement clearly defined bonus and deduction regimes against realistic performance benchmarks, as well as rights to review such during the concession period.

This will ensure best efforts from private sector developers to optimise operations and maintenance of the project asset as deviations from the base case will directly affect equity returns. It will also improve the condition of the asset at the end of the concession period, which ultimately increases the asset’s post-concession longevity and therefore residual value efficiencies.

Fifth, bidders should be required to demonstrate significant financing commitments in support of their bids. This mitigates financing risks such as changes in material terms and conditions, or prolonged delays in closing or in the worst case, failure to close, post-selection of a “preferred bidder”.

Procurers and their advisers, therefore, need to carefully evaluate the robustness of financing proposals with respect to conditionality (soft vs. hard underwriting, market flex, material adverse effect, etc), dependency on refinancing during the concession period, experience of the financiers with regional project finance practice, and the level of engagement from Export Credit Agencies (ECAs), at the time of bid submission.

Regional practice varies widely from no minimum commitment to fully underwritten commitments and while, prima facie, a fully underwritten, unconditional financing may sound like the obvious solution, such has to be weighed against unnecessarily constraining liquidity for a broad competitor pool. No party benefits if one or two bidders lock-up the financing market. We believe a mid-point where 50% of total financing required is committed at bid submission strikes a sensible balance for all stakeholders.

Finally, MENA governments should consider whether they want to take direct equity stakes in the project companies. Such investments ensure a continuing level of sovereign ownership and ostensibly “control” in the project – an important political consideration in many MENA jurisdictions.

Direct equity stakes also create an alignment of interests with private sector developers, thereby contributing to the perception of a “fair deal for all” and underscoring what should be a collaborative approach between procurers and developers. Government equity stakes can also improve the bankability of infrastructure projects, as commercial lenders view such commitments as a mitigant to political risks.

Opening the vault

While PPP models continue to increase in popularity among MENA governments, the question remains whether, in a comparatively liquidity constrained market, infrastructure projects will be able to capture a sufficiently large proportion of liquidity going forward. A snapshot of the current financing market may help to answer this question:

Judging by the volume of closed project finance transactions, bank liquidity for regional transactions in the first three-quarters of 2010 has recovered to more than double the levels in 2009, though it is still well below pre-liquidity crunch levels. Average financing amounts per project have stayed remarkably resilient and large project financings continue to achieve financial close, albeit at higher debt margins. Finally, credit enhancements from ECAs have become key drivers, and often determining success factors, in a number of post-crunch project financings.

Financiers forced to “triage” their balance sheets will naturally gravitate towards projects offering the best risk-return proposition. The generally lower perceived risk inherent in many PPPs implies that infrastructure projects will be well positioned to benefit from the liquidity pick-up in the commercial bank market. Moreover, given that these projects often entail significant civil works, they are well placed to benefit from local currency liquidity from the domestic bank market in order to supplement the traditional international and regional bank financing.

The next natural evolution, true capital market liquidity, will come in time, and will initially target brown-field assets providing a conduit for banks to redeploy capital to the greenfield arena. Finally, in the aftermath of the “credit crunch”, infrastructure projects have moved higher up on the agendas of multilateral and bilateral development agencies, which are already familiar with the sector. Though their lending ticket sizes tend to be smaller compared with ECAs, their commitments are not tied to content sourcing as is typically the case with ECAs.

In conclusion, the MENA region is poised to extract significant benefits by applying the best practices honed from older infrastructure markets and established PPP models to the burgeoning demand for greenfield assets in the region. I(W)PP projects have already become relatively commoditised and easily replicable, which saves time and money for the development and financing of new projects.

The challenge for PPP projects remains when the structure is untested or introduced to a new market, such as is the case for core infrastructure projects including ports, roads, and railways where suitable and replicable precedents have yet to be designed for the MENA market.

However, given the willingness of the private sector to embrace infrastructure financing, the ground work laid out by the power market, and the marked recovery of the financial markets, PPPs provide a proven and viable procurement mechanism that can deliver strong results in MENA into the long term. And given the liquidity constraints and budgetary challenges of regional sovereigns, PPPs will in due time become, in the words of the United Nations, a “strategic necessity rather than a policy option” for many MENA governments.


Footnotes

1 - HSBC estimates

2 - HSBC estimates

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