Aligning Investor and Host Government

Expectations in Private Infrastructure:

Lessons for Mutually Beneficial Transactions

By Katia Karpova
Regional Coordinator,
Europe and the NIS
Institute for Public-Private Partnerships

About the Author...

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.

Introduction

In the past decade, the levels of private investment in infrastructure in emerging markets have fluctuated greatly - from skyrocketing in 1997 to plummeting in half by 2001¹. Yet during this timeframe, approximately 2,500 private investment projects in 132 countries worth $755 billion² took place in emerging markets with varied results. Less than 2% of all projects were cancelled or renationalized, with many more renegotiated (for example, 74% of transportation and 55% of water concessions in Latin America were renegotiated³. ) Renegotiation, however, mainly occurred due to regulatory requirements to review long-term concessions every 3 to 5 years to accommodate change in demand and cost of input materials or insufficient data on assets at the time of investment. Macroeconomic problems such as the financial crises in East Asia and more recently in Argentina have also contributed to the increased need for renegotiation of existing projects.

Despite rather low levels of canceled projects, investors still are demonstrating a lack of commitment in pursuing infrastructure investment opportunities in emerging markets. This trend is coupled with some governments reconsidering private sector options and reverting to the ideas of public provision of infrastructure. However, the main problems that have led to the decrease in private infrastructure investment in emerging markets exist to the same, if not greater, degree in cases of publicly operated projects. In fact, evidence shows that it is the efforts to bring in the private sector that helped to reveal the flaws of economic systems in emerging markets and steer the new ways to fine-tune sector reforms in infrastructure.

While reverting to public provision may seem like a viable solution in the short-term, in the long run, the likely downward spiral of public sector inefficiencies coupled with low cost recovery levels will again lead to further deterioration of infrastructure assets and eventual crisis in the sector. This will again force governments to seek private sector alternatives, where there is a high probability these investments will be made on less-than-favorable terms to the host country.

Instead of returning to the old system of public provision of infrastructure services, which can only "conceal" the inefficiencies rather than solve them, governments have an opportunity to learn from the experience of private sector participation and investment over the past decade and align investor expectations with government expectations. Toward this end, it is important to understand the specific needs and expectations of investors in order to streamline government efforts to get back on investors' radar screens with new and sustainable projects.

Investor Expectations: Case Study in Electricity

A recent World Bank survey of private power investors in emerging markets⁴ has provided some discouraging facts regarding the future of private investment in infrastructure in emerging markets ⁵. According to the survey, over 52% of private investors are either "subdued" about infrastructure investment prospects or are already retreating from emerging markets, with no new investors to replace them. The survey attempted to determine the factors contributing to this trend and analyze conditions that could potentially reverse it. The three most significant requirements sought by investors were (a) better legal protection of investors, (b) enforcement of payment for the services, and (c) guarantees from government or multilateral agencies.

The number one pre-condition in terms of legal protection of investors is contract enforceability. It is important that the stakeholders honor their commitments and ensure open communication to renegotiate or revise contracts with private financing. A framework defining investor rights is essential to create the necessary level of comfort for private financiers. A few recent examples from the emerging markets power industry point to the fact that governments are more interested in attracting investment into the country than ensuring that investors meet their needs once the projects are in place. The consequences of this approach are quite acute: they not only jeopardize existing projects but also instill mistrust in the ways the government is handling similar projects for later generations of investors, making future investments more expensive and difficult to launch. Whether it is to promote private investment, ensure accountability of government and transparency in market rules, or clarify labor laws and property rights, the development of a sound legal framework that is enforced is necessary for both a country striving to bring in private investors or planning to revert to public provision.

Another critical concern is the ability of private investors to collect sufficient levels of tariffs to recover the cost of service provision. Investors cannot single-handedly resolve this issue. For example, an appropriate system of subsidies for the poor or rural electrification may be needed, in combination with service provider authority to enforce payment (by those who can afford it. A common misconception is that higher tariffs and private investment are linked. In reality, there is evidence of both, higher and lower level tariffs with private investment. Many experts believe that the tariff sought by private investors simply states the real cost of service for delivering the service, which, under public provision, can be compensated through revenues of the "general tax basket." Reverting to public service provision will necessitate tapping back into these resources and consequently reducing the allocations for other more worthy social expenditures such as poverty alleviation, disease control, education, etc.

Hidden or actual, subsidies nonetheless are a cost, which needs to be minimized. Enforcing payment by those who can afford to pay and providing targeted subsidies to those who cannot is often difficult to incorporate for political reasons. In most cases, however, it is critical to examine how much of the required subsidy is the cost due to low affordability or unwillingness to pay, and how much of it is the cost of public sector inefficiencies. In a private sector transaction, with the right incentives, reduction of subsidies has proved possible.

The subsidy design graphic above depicts a proven process/strategy private concessionaires use to achieve efficiencies, such as undergoing rigorous demand forecasting, improving service quality (and the resultant willingness to pay), and benchmarking billing/collection levels. Ultimately, this strategy leads to reduced levels of required subsidies.

The third concern on the part of investors is the inadequate guarantees from the government or a multilateral agency that would offer the private investor needed protection throughout the reform transition process. In some cases, investors felt that they do not have a sufficient "backing" from the government and in many cases that governments required investors to take on too much of the project risk. Without reasonable guarantees on part of the host government and demonstrated support, the private sector at times was forced to incur more risk than it was willing to bear. In reality, the cause is the lack of government commitment or capacity to streamline sector reforms, which were not fast enough to put the investment projects on commercial and sustainable footing. Should governments have come through on their commitments, private investors would perceive less risk, since projects would be supported by a more efficient macroeconomic platform.

Conclusion

Evidence points to two opposite trends: growing demand for investment to meet infrastructure requirements and subdued interest by private investors for emerging market investment opportunities. The gap between the expectations of investors and the ability of governments to pursue aggressive sector reforms show that both have underestimated the challenges involved. Inadequate legal frameworks and investor protection policies do not indicate that private provision is a mistake. Rather, it is the efforts to involve the private sector that revealed some of the shortfalls of legal systems, creating opportunities for improvement. Neither can the flawed idea that private investment leads to high tariffs be used in the argument for public provision of service delivery. Private sector transactions mostly reveal the true cost of service provision, while in public provision this cost is not only hidden, but most of the time unknown. Sound subsidy strategies for the poor and enforcement of payments in an attempt to "change the old mentality of nonpayment" need to fill this gap. Private sector settings, however, provide the necessary tools (contractual, for example) to enforce greater efficiencies and reduce the level of subsidy costs. Overall, however, governments must make serious commitments to sector reform, to ensure that projects (with public or private financing) have an opportunity to become commercially sustainable in the long run.

For more information, please contact Katia Karpova at kkarpova@ip3.org

Copyright © Institute for Public-Private Partnerships, Inc. All rights reserved

¹ Private Participation in Infrastructure in Developing Countries, The World Bank, 2003

² Ibid.

³ To learn more about canceled projects with private participations, refer to Public Policy for the Private Sector Note Number 252 "Infrastructure Projects: Review of Canceled Private Projects."

⁴ Private investment in power was one of the most dynamic sectors accounting for 28% of the cumulative investment, following the telecommunications.

⁵Survey 2002 - Preliminary Findings, Private Power Investors in Developing Countries, Ranjit Lamech & Kazim Saeed, The World Bank, Washington DC.