Corporate Governance and its Impact on Financing Infrastructure Development

by
Katia Karpova
Regional Coordinator for Central and Eastern Europe, IP3
and
David Young
Program Manager, IP3

About the Authors...

Katia Karpova is the Regional Coordinator for Central and Eastern Europe for IP3. She is a frequent trainer in IP3 courses on topics such as financial analysis, tariff structuring, and financial modeling for private sector investment in infrastructure projects. David Young is a Program Manager for IP3, where he is responsible for designing and managing training courses on such topics as "Utilities Restructuring", "Contract Compliance and Performance Monitoring," and "Legal Agreements for Infrastructure Projects".

Introduction

Recent developments in project finance are shaping the ways investors perceive risk and make investment decisions. The most vivid trend is a more complex and advanced approach to infrastructure investments. Digesting a year's worth of market instability, investors are becoming more selective and demanding in their approach to investment opportunities.

Among the top critical issues for investors are an improved and predictable legal and regulatory environment, a strengthened dispute resolution system, proven transparency of transactions, and evidence of corporate governance¹ . Investors are demanding uniform standards across the map, forcing governments to be responsive to the "new rules" of the game.

Corporate Governance as Investment Criterion

In addition to more traditional requirements, a new trend is evident in investors' increased attention to sound corporate governance practices. Firms in today's infrastructure market, be it in an emerging market or developed country, are now assessed with two new criteria: do they have sound or poor corporate governance practices? In respect of emerging markets, not long ago, investors looked primarily at the legal and regulatory environment, and financial investment packages as key factors in making investment decisions. The new trends put a much greater responsibility on the shoulders of companies themselves, forcing investors to use standards of corporate governance as an important indicator of success.

McKinsey & Company's Global Investor Opinion Survey of 2002 reports that effective "corporate governance" is investors' key priority in making an investment decision, even when compared to project's financials, profit performance, and growth potential² . According to the survey, investors are willing to pay hefty premiums for good corporate governance, constituting between 12% and 30% in various projects from North America to Asia, Latin America, Africa and Eastern Europe.

The popularity of sound corporate governance often follows economic cycles, which makes it cyclic in nature. However, sound corporate governance can only be beneficial and meaningful when practiced effectively over the long run. This discrepancy in the application of corporate governance creates further misconceptions and missteps about what constitutes good corporate governance.

The next generation of infrastructure investments will see new and improved corporate governance models, including those that are mandated by law as well as voluntary measures. Improved corporate governance requirements will drive new financial disclosure standards, which will in turn help fine-tune international accounting standards- all leading to the still-hoped for global single unified accounting system. Investors will increasingly demand more independent boards and effective (and transparent) board practices, and the introduction of clear compensation-for-performance mechanisms for directors and management. The infrastructure for training of new corporate directors is already being put in place, as evidenced by a recent development of a number of Corporate Directors' courses by the Stanford Law School, among others.

Strengthening of shareholder rights, especially of minority shareholders, and investor responsiveness will also be at the forefront of corporate governance reforms. Effective policies will be ones that ensure equitable treatment and enable shareholders to make informed decisions and participate in a company's activities through proper voting mechanisms.

In addition to mandatory corporate governance, companies will be expected to develop and implement corporate social responsibility (CSR) strategies, which are already commonplace in developed markets but have further progress to make in emerging and developing countries. Many companies view CSR as a combination of long-term strategy for success, an opportunity to support social change and a technique to create a dialogue with affected stakeholder groups. This corporate governance mechanism, falling into the category of "voluntary" measures, signals a company's overall corporate culture and values, and readiness to be proactive in creating viable and long-term business.

The key concerns for investors will remain the enforcement of corporate governance models and adherence to a company's corporate governance strategy. Unless investors clearly recognize the signs that corporate governance is a priority and measures are being taken to improve it, project and infrastructure financings will continue to bear the costs of poor corporate governance.

Going Forward

Looking into the "crystal ball" for 2003, the renewed focus on effective corporate governance will lead to the development of more viable, legally strong and transparent infrastructure projects that meet the higher investor standards. Sound dispute resolution mechanisms will become more important than ever, and corporate governance will be viewed as one of prerequisites for investment. Emerging market projects will have to find ways to conform to increasingly uniform investment standards, and investors will be requiring not only the existence of an effective regulation and legal framework, dispute resolution procedures and corporate governance, but also the evidence of enforcement and practice of these standards. In addition to improving legal and regulatory reforms and investment enabling environments, emerging markets need to move faster in incorporating new corporate governance procedures, which already serve as benchmarks for investment decisions around the globe.

Useful Links

¹ Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance", OECD April 1999

²Global Investor Opinion Survey: Key Findings, July 2002, McKinsey & Company