The infrastructure financing challenge
Despite the appetite for a growing pipeline of infrastructure projects, significant barriers remain to the flow of global liquidity into the regional project market
Across the Middle East and North Africa (Mena) region, a growing list of infrastructure projects is in need of funding in the power, water, transport, education and hospital sectors. Simultaneously, international financiers are looking to gain exposure to infrastructure sectors as they seek stable sources of long-term income.
This confluence of interests should provide a “perfect storm” of opportunity, matching demand and supply. Yet major project sponsors highlight significant barriers that are stemming the flow of capital into the region.
As chief executive of power developer Acwa Power, Paddy Padmanathan, told MEED in May, infrastructure and utilities developers need funding over the long term, yet banks are averse to locking away investment capital for long periods. This causes financiers and investment houses to miss out on opportunities. These stem in part from tighter financial regulations introduced following the global financial crisis in 2008.
The sense that limited funds are available to invest in large-scale infrastructure projects is widely felt across the region.
“When you talk about projects over the $1bn mark, there is not massive interest at the moment. We are a long way from the situation in 2008, when international banks were chasing after projects that might have had a 20-year power-purchase agreement backed by a sovereign government guarantee,” says Tom Wigley, an Oman-based partner at law firm Trowers & Hamlin.
While banks, insurance companies and pension funds view with keen interest the prospect of stable, long-term reliable cash flows, regulatory restrictions may be limiting the opportunity.
Most bank assets are invested in government securities such as treasury bills, rather than infrastructure projects. Banks have been forced to reach out to export credit agencies (ECAs) and multilateral and bilateral agencies, with ECA support make-or-break for many infrastructure financings.
When the US’ GE announced it had secured $1bn in financing in May 2019 for Sharjah’s first independent power plant, crucially it enjoyed coverage both from leading private financial institutions and the Japanese ECA, Japan Bank for International Cooperation (JBIC).
JBIC is providing a tranche under its Global Facility to Promote Quality Infrastructure Investment for Environmental Preservation and Sustainable Growth, an initiative to promote infrastructure development projects that contribute to global environmental protection. According to GE Energy Financial Services’ global power leader, Susan Flanagan, the financing rested on GE’s ability to “connect global capital to significant infrastructure projects”.
The problem for the Mena region is that such connections remain the exception rather than the rule. One senior Gulf-based economist emphasises the importance of the region’s cultural preference for real estate over infrastructure.
“There is a systemic misallocation of capital in the region. Some of it is regulatory and some of it is cultural – old habits die hard and too much money is still going into residential real estate. For banks and investors alike, it is seen as the default option when in doubt, and they are in doubt most of the time.”
With the emergence of renewable energy projects in recent years, opportunities are emerging to attract capital. Yet by and large, says the Gulf economist, local lenders are hiding their heads in the sand as they find it difficult to “collateralise” aspects such as rooftop solar or energy-efficiency projects, despite these boasting attractive economics. “It does not fit the usual boxes and the default tendency then is to shy away,” he says.
Equally important in inhibiting the flow of capital into the infrastructure sector are regulatory or institutional capital allocation restrictions that limit how much can be deployed.
The World Bank noted in a 2017 report that global insurance companies still allocate less than 2.5 per cent of assets under management to infrastructure investment, in part because of insufficient understanding of the risk profile of this asset class – linked to investors’ perception of infrastructure as being risky despite the long tradition of regulated utilities yielding low-risk cash flows.
The report highlighted that some global regulatory frameworks require insurers to allocate sizeable capital to support investments in long-term debt, especially for unrated transactions. This reduces the internal rate of return and the profitability of holding these instruments.
European regulators reduced the capital charge on this type of finance on the advice of the European Insurance & Occupational Pension Authority in 2016. The European Commission revised down the standard formula for capital charges on qualifying infrastructure debt and equity investments under the Solvency II Directive, after it came under criticism for curbing appetite for infrastructure investment by insurance companies, because of the need to maintain high capital buffers for long-term assets.
However, the Mena region is not able to take advantage of this favourable treatment as it is limited to investments in member states of the European Economic Area and the Organisation for Economic Co-operation & Development.
If Mena states are to attract such institutional funding from insurance firms, they may need to mimic the Solvency II model as a regulatory framework. Here at least, there is some progress to report. In January 2018, the UAE became the first Gulf state to fully implement a model based on Solvency II, and Saudi Arabia is expected to follow in its wake with a new supervisory framework from the Saudi Arabian Monetary Agency. Such regulations should make it easier for foreign institutional investors to gain exposure to infrastructure funding schemes in those countries.
Nonetheless, other hurdles remain. Capital adequacy requirements are another challenge for lenders considering greater exposure to the infrastructure sector. Although Mena banks have traditionally maintained high capital levels, their preparation for Basel III – which stipulates a minimum capital adequacy ratio of 8 per cent – has invariably constrained the availability of financing for infrastructure projects.
Moreover, the new regulatory realities may limit the scope for financial innovation. “Collectively, the industry is still adjusting to Basel III and the new economic realities. Growth has slowed and margins are under stress, and we are not in a frame of mind for aggressive innovation,” says the economist.
Regional banks’ capacity to lend to infrastructure projects has traditionally been hampered by asset-liability mismatches, reflecting the relatively small size of their balance sheets. The Basel requirements, while necessary to strengthen banks’ capital positions, have not helped.
“Where the capital adequacy rules have an impact is in limiting the size of the projects that banks can go for, and that has driven them to chase after the ECAs,” says Wigley.
The case for a thorough overhaul of insurance company regulations, asset location regulations and pension fund regulations is growing more compelling.
Mena capital markets, meanwhile, need to continue to mature and deepen, ensuring that there is greater aptitude for long-term fixed income instruments suitable for infrastructure projects.
Pressure is growing for regional financial institutions to consider more innovative funding mechanisms. The emergence of renewable power projects is a case in point.
Ratings agency S&P noted in February of this year that the green finance market in the GCC is still in an early stage of evolution and lacks the kind of institutional investors – such as pension funds – that are common in more developed capital markets.
S&P argues that a combination of sukuk (Islamic debt securities) as well as conventional green bonds could provide the substantial funding support required for the realisation of the region’s sustainability targets. In particular, new and conventional green finance vehicles could lower the cost of capital for overseas cross-border financing and open up a wider pool of capital from Islamic and conventional investors.
Changes under way
Gulf governments have made some preparations for this potential funding pool. In October 2018, legislation came into force in the UAE that provides a framework for sovereign bond and sukuk issuance in order to facilitate development of its primary and secondary green financial markets.
The Dubai Green Fund from Dubai Electricity & Water Authority could play a significant role in financing green projects and providing concessionary loans for investors. It is aiming for $27.2bn in green assets under management.
Regional institutions are also teaming up with Western asset managers to craft funds that target infrastructure schemes. In February 2019, Bahrain-based private equity group Investcorp teamed up with the UK’s Aberdeen Standard Investments in a bid to raise up to $1bn for a fund that will invest in social and core infrastructure projects in the GCC.
Similarly, in October 2018, US private equity firm Blackstone announced a partnership with a management team led by a former head of infrastructure equity investments at the UK’s CDC Group, called Zarou. The Egypt-based outfit will develop, finance, construct and operate projects in Mena and neighbouring regions, focused primarily on thermal and renewable power opportunities as well as water assets.
Multilaterals are also doing their bit. In 2016, the International Finance Corporation, the private sector arm of the World Bank, launched the MCPP Infrastructure platform to mobilise infrastructure investment in emerging markets from global institutional investors. It aims to generate $5bn by 2021 and Mena markets will likely figure prominently.
Such moves should help to redress the obstacles that have hitherto stymied the flow of capital into the Mena region’s infrastructure sector, but as long as institutional investors are disincentivised from putting money into such projects, realising the full potential will be an uphill task.