Reinvigorating investment

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International financial institutions can help stimulate infrastructure investment through mitigating policy risk and improving local financing, say Erik Berglöf and Alexandru Chirmiciu, European Bank for Reconstruction and Development

Infrastructure is the battle cry of the day. The International Monetary Fund, of all institutions, even made it a theme of its recent annual meetings. In advanced economies with currently very low interest rates, infrastructure investments are viewed as an opportunity for governments to stimulate growth and improve competitiveness, but in emerging economies infrastructure needs are existential – the pressures from high growth expectations, environmental and climate-related challenges, and, in many cases, expanding populations are immense.

At first glance, there seems to be an easy solution. There just needs to be a way to connect the gigantic institutional investors seeking long-term assets with the emerging economies craving such long-term capital. The problem, however, is that financing is only one of the many challenges facing infrastructure investments. These projects require planning and implementation capacity, models for sustainable funding and, perhaps most of all, commitments to a particular policy framework. What can be done to address these challenges? And in particular, what can investing international financial institutions (IFIs) do?

Rethinking infrastructure funding
The planning and implementation of infrastructure investments in emerging economies normally end up within the realm of public authorities, because market-based solutions are too complex and require more coordination than these authorities can handle. Climate change mitigation and adaptation have added yet another layer of complexity, stretching their administrative capacity and governance arrangements. Structuring these projects also requires substantial upfront costs – understandably it is often difficult to incentivise investors to incur these costs before having been granted the contract. Increasing the institutional capacity of the public authorities is key to addressing all these planning and implementation challenges.

Funding normally requires some combination of contributions from taxpayers and market-based user charges throughout the life cycle of an asset. Fiscal capacity is often limited and the willingness and ability to raise incremental tax revenues for infrastructure investments are also constrained. Selling off existing infrastructure assets can be a way to create fiscal space. So-called value capture, where those benefiting from particular investments (such as landowners from railway construction) can be taxed in a differentiated fashion, combines the two approaches. This method has worked well in sophisticated environments, but it places high demands on institutional quality because selective taxation invites corruption and special treatment.
Financing infrastructure is increasingly challenging in the aftermath of the global economic crisis. Infrastructure investment requires long-tenor debt and equity. But the availability of such finance varies across advanced, emerging and developing countries. Since the global financial crisis, banks provide less of such funding and alternative financiers have emerged, such as pension funds and insurance companies with long-lived assets. At the same time, the need for equity has increased as risk levels have been rising significantly. One important way to encourage these investors is to bring down risk levels, particularly policy risk.

Creating a favourable environment
The financing question is closely tied to that of policy risk. Perhaps the best illustration of policy risks is in the energy and climate sector. Obviously, there are risks related to the price of different fuels – both short and long term – and in technological development, but arguably the biggest risks are in the consistency of policies over time. Policy risks emanate from both the cost and the revenue. Returns to investment in this area are very sensitive to policy variables, for example a carbon price floor, feed-in tariffs and various capacity mechanisms. The support for different policies obviously depends on the fuel price. These risks have to be allocated between consumers and producers, or ultimately absorbed by the government or IFIs.

In other words, good projects –  those with an implementable structure, a sustainable funding model and moderate policy risk – can attract finance. However, there are still important financial risks that could be reduced, in particular through the developments of local financial markets. Many infrastructure investments earn the bulk of their revenues in local currency and should ideally be financed locally. Banks and non-bank financial institutions as well as financial markets can play a role in channelling finance to these projects.
What can investing IFIs, such as the European Bank for Reconstruction and Development (EBRD), the European Investment Bank and the International Finance Corporation (IFC), do to facilitate infrastructure investments? To some extent they can help mitigate policy risk by absorbing some risk on their own balance sheets, although the global financial crisis has demonstrated the limits of this option. They can also help structure projects and support project preparation, as the EBRD is now doing with its new infrastructure project preparation facility, combining financing, technical assistance and policy dialogue. The aim is to develop a pipeline of good projects that will attract contractors, concessionaires and financiers.
But perhaps the most important role for the IFIs is to reduce policy risk. Through their unique multilateral governance structure, with recipient countries as shareholders, IFIs can help reduce this risk. Moreover, they can leverage multiple investments in sectors to improve the local policy environment and develop the local financial system to encourage greater local finance. None of this is really new, but the scale and scope of interventions have increased considerably through better cooperation among IFIs in responding to the global financial crisis.
More novel are the mechanisms through which they can leverage their local knowledge and global experience to play an important role in intermediating long-term institutional capital and facilitating transformational finance in transition and developing economies. The IFC has done this through the creation of a special asset-management company that co-invests in selected IFC investments. EBRD has chosen another route, a ‘passive fund’, where institutional investors are offered to co-invest a pre-set share (20-30 per cent) in all qualifying EBRD equity investments – in other words, there will be no cherry-picking of underlying investments and investors will have to rely on EBRD’s own project selection and governance structures.
Most of the investments in infrastructure critical to global growth and climate change will happen in countries with weak institutions, great political risk and limited access to long-term institutional capital. Finding innovative ways to mitigate these risks and to ensure that these investments come about in a way that helps to address the global challenges is absolutely critical. In a shifting global political landscape, reinvented IFIs can serve as vibrant incubators and instigators of institutional innovation.

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