I. Project
Finance
Over the past decade, governments around
the world have been experimenting with a number of financing instruments and
"option" packages to better allocate capital resources and increase the flow of
capital to deserving projects. The appropriate financial instrument used often
depends on the state of the development of the local capital markets, the
creditworthiness of the national or local government entity, political
considerations, the legal and regulatory framework, and the ability of the
government to generate revenues through taxation.
In emerging markets with thin or absent
capital markets, raising revenue through bonds is difficult, and with the
ability of local government or utilities to borrow limited by statute or
balance sheet, project finance often becomes the most viable alternative to
financing important infrastructure development needs.
The most direct method of financing large
infrastructure projects using private capital is via "limited or non-recourse
project finance". Project finance is an arrangement whereby a special purpose
company (vehicle) is created as the bearer of the debt. Project finance is a
highly leveraged transaction, with debt/equity ratio approaching 80 percent in
some cases. In the end, however, the capital structure is conditional on the
profitability of the project, the cash flow projections, and the amount of debt
the sponsors are able to attract while ensuring the lowest cost of capital.
The parties in a project finance
transaction are often called the "sponsors" of the project. They include the
initial project developers, who contribute the equity financing of the project;
the lenders/banks, who contribute the debt portion, or core sum of funds in the
form of loans; the government, which is often required to contribute some
equity to offset the political risk concerns or provide partial or performance
guarantees; the buyers, or the off-takers, who commit to purchasing the
services; and international financial organizations, often contributing equity
(IFC) or providing guarantees (OPIC, MIGA, IBRD). The mechanics of project
finance are complicated, and require extensive financial, economic, and
technical assessments prior to commencing the project.
A. What Do Lenders
Evaluate?
Lenders, primarily evaluate the robustness
of future cash flows produced by the project, rather than the collateral of any
asset, as the single source of funds to service debt; and the debt service
coverage ratio (DSCR), which indicates the ratio of earnings before interest,
taxes, and depreciation to the debt payment for the year. Benchmarks
demonstrate successful projects with a debt service coverage ratio of at least
1.5.
Lenders also carefully examine the
creditworthiness of the sponsors, but even more so of the buyers, (bulk water
purchasers, take or pay power contract, etc.,). This is important in light of
the current issues facing many emerging market countries, where cost recovery
through tariff increases pose political hazards that most countries are
reluctant to introduce, In many cases, tariffs can and should be increased to
reflect more accurately the true cost of service delivery, but in a tandem with
other efforts, aimed at improving collection rates, reducing costs, theft and
losses, and design of social assistance strategies to help the needy
households. Without full cost recovery, private financing will still require a
reasonable rate of return. If governments want to continue to subsidize, they
can subsidize targeted consumers and let the private sector raise the
financing, or they can subsidize the service and incur greater financial
burdens. Eventually, cost recovery and tariff reform must be introduced to
truly allow private financing and service delivery to fulfill its potential as
a useful financing tool for governments. Lenders will look at the environment
for tariff reform very carefully in these times of illiquidity and volatility
in global capital markets.
Lastly, the lenders will look at the
appropriate equity contribution on part of the sponsor, to ensure that the
sponsor is seriously committed to the project and is equally concerned with its
success.
B. What Are the
Benefits of Project Finance?
There are a number of benefits for using
project finance-to-finance infrastructure projects. From an economic
development perspective, project finance helps implement projects that
otherwise would not likely happen, simply because the capital investment
requirements are often too much for government budgets. From a financing
perspective, risk allocation and mitigation strategies spread the risk to the
party in the best position to accept the particular risk, thereby making
lending more attractive to the lenders. Additionally, by nature, project
finance directly links revenue streams to debt payments, instead of transfers
to the treasury, which promotes transparency, prevents wasteful investments and
is consistent with international accounting practices. Finally, project finance
is a transaction linking players from different markets - domestic and
international, equity and debt - opening the doors to globalization and new
opportunities.
Many examples of project finance exist in
the power sector, from which the concept originates. In the United States,
PURPA (Public Utility Regulatory Policy Act), was first to require electric
utilities to purchase power from independent power producers (IPPs), thus
becoming the off-takers of the produced electricity. Today project finance is
used in all sectors of the economy, including electricity, water,
telecommunications, roads and highways, hospitals, technology and housing and
urban services. Employed project finance techniques vary from BOO
(Build-Own-Operate), BOT (Build-Operate-Transfer), to BOOT
(Build-Own-Operate-Transfer), DBO (Design-Build-Operate), and many others.
C. What Factors Help
Ensure a Successfully Financed Project?
There are a number of factors that can
help ensure that projects are financed:
- Governments must do their "homework". It is
critical that governments conduct their own feasibility studies of a project
opportunity. Officials must know both the technical and financial requirements
of the project, from their own analysis and objectives. Governments must also
know what the full cost of service delivery really is in order to evaluate
public versus private financing alternatives. That is the only way to
successfully "benchmark" the government's information with the private
sector.
- Regulation. Appropriate regulation that
balances the needs of the developers and financiers with the needs of consumers
is critical to successful project implementation. Increasingly, investors and
consumers alike will want to be sure that independent regulation is in place to
ensure that quality of service increases are commensurate to increases in
tariff. The regulatory process must be implemented in a transparent and
consistent manner, in accordance with the best practices from international
experience.
- New Technologies. The financing of
infrastructure projects is changing along with innovations in the marketplace.
Financing of new technologies in infrastructure - be it mobile telephones
versus landlines or environmentally safer solar energy systems versus
traditional generators - are increasingly gaining attention from potential
investors. Keeping abreast of recent and upcoming advances in infrastructure
technology and environmental standards is yet another way to attract investors
for long-term sustainable financing.
- Transaction Advisors. Selecting an
experienced transaction advisor takes projects one-step further towards closing
the deal in a transparent and sustainable manner. Country or international
experience working in similar environments is a great benefit to ensure that
project financing will reach its economic and financial targets.
- Training. In implementing transactions, the
local counterparts will in the end have to make important decisions and work
with the international community of investors, buyers, or guarantors to make
the transaction a success. It is important that capacity building efforts are
undertaken, to ensure that all the key stakeholders are on "the same page" in
negotiating project finance transactions and reaching agreements, and ensuring
effective communication among the stakeholders throughout the project.
II.
Developing The Overall Strategy to Finance Infrastructure
Exploring new private investment
techniques for infrastructure services is consistently on the agenda of many
governments, as they continue to seek better service delivery for current and
future infrastructure needs. Concurrent with the development of local capital
markets, such instruments as general obligation, revenue, and lease revenue
bonds are options that are becoming more and more available for the financing
of infrastructure projects. Pooled financing, in which several agencies jointly
issue public debt to finance the development or rehabilitation of an
infrastructure facility, has also become one of the popular channels to
financing capital investment opportunities. It is becoming more evident, that,
in the end, a well-developed large-scale infrastructure development and finance
strategy, which takes into consideration all possible improvement strategies
and financing needs, seeks synergy in infrastructure finance, and looks at the
entire spectrum of possible efforts - from cost reduction to revenue
generation, - is key to achieving success.
III.
Comprehensive Planning for Infrastructure Finance:
The Case of
California
The State of California is facing a number of
infrastructure finance challenges, due to higher maintenance and repair costs
and the growing need for new infrastructure development. Their proposed
approach builds on a comprehensive effort plan, to include the implementation
of cost-reduction strategies, enhancing of the existing revenue streams,
creation of new revenue streams, and techniques to improve efficiency and
ensure planning across public and private resources. Combined, these efforts
will have the power to influence the "big picture" of infrastructure
development needs in California.
According to the California Commission on Building for the
21st Century, the financial plan combines strategies to maximize return on
existing infrastructure investment, strives for maximum leverage for every
dollar spent, and aims to implement integrated infrastructure finance
strategies, which serve multiple rather than single-purpose needs. In June
2001, the Commission recommended five major funding strategies to address the
financing challenges in California:
- Creation of the California Infrastructure
Fund. The funds will be set aside from the general state funds or other
current infrastructure commitments, with the initial annual appropriation of at
least 1% of revenues from the general fund. While this fund will decrease the
budget for non-infrastructure needs, the mechanism will be suspended should the
revenue growth of the general fund fall below 5% per year.
- Increased Use of General Obligation Bonds.
As the state with one of the lowest indicators for net tax-supported debt per
capita, the recommendation is to issue additional bonds to finance future
infrastructure projects. The Commission made this recommendation based on the
credit rating agencies view of 6% being the maximum allocation of general fund
revenues to debt payments. With 4% in California, this suggestion strives to
maximize the potential debt obligations for the state without hurting the bond
ratings.
- Enhanced Partnerships. The Commission
proposed increased public-private partnerships activity, to include local
governments, community, and non-profit organizations. Technical assistance is
planned to help local governments on cost-effective and innovative financing
strategies.
- Innovative Financing Strategies. The
proposed financing strategies include expansion of demand management and
conservation programs, implementation of real-time pricing mechanisms,
optimization of federal funds by issuing grant application notes, revision of
the state-local government fiscal relationships, identification of new options
to sell revenue-backed bonds, increased experimentation in the management of
infrastructure financing mechanisms, and identification of new revenue streams
through "infrastructure fees" on car rentals and access fees.
- Coordination with the Capital Budget Planning
Process. The proposal also calls for an intensive capital budget planning
process across the state agencies, with the idea that in order to maximize
state resources, infrastructure investments should be linked to the efficient
use of funds across infrastructure categories. This will in turn serve as a
basis for developing a long-term state investment plan.
The State of California's infrastructure financing
strategy is one example of a project finance approach that emerging market
economies can emulate.
IV.
Conclusion
Over the past decade, project finance has played a
critical role in funding billions of dollars of projects in the energy, water,
transportation, and telecommunication sectors in such diversified economies as
the Philippines, India, Ghana, South Africa, Poland, Hungary, Egypt, Mexico,
Brazil, Chile, the United Kingdom, and the United States. Throughout all of
these countries, the key themes to successful project financing included sound
planning and pre-feasibility analyses, transparent bidding and procurement
processes, and strong regulation and monitoring by the government. Funding is
not the problem- it will always flow to good investments in good operating
environments. The oil and gas investment in emerging markets in the 40s, 50's
and 60's is a good illustration of risk tolerance. The key in the 21st century
is for governments to enhance the investment environment for national/state/and
municipal level investment for local and foreign investors, and look to
innovative financing mechanisms that promote local capital markets, private
sector risk, and rely on regulatory systems to balance investor and consumer
requirements.
Public sector financing must be complemented by private
sector financing in service delivery. Public and private financial models rely
on the success of one another to achieve public purposes. As public sector
finances improve, private sector financing will be more prevalent to move into
direct underwriting of projects and risks. If governments can improve
macroeconomic and microeconomic conditions, and thus reduce the costs of
borrowing, private sector financial markets can begin to undertake the types of
forms of financing, both debt and equity, that have made them the "engine of
growth" in high-income countries for over 50 years.
