‘Bonds Are A Good Way To Diversify Funding Sources’

Vivek Pathak, Regional Director for East Asia and the Pacific, IFC has been a veteran of 18 years with the global funding organisation. Based out of Hong Kong, Pathak, in his current position since 2014, leads IFC’s advisory and investment operations across 18 countries. Prior to this, he served as IFC’s Director for Investment and Credit Risk in Washington, overseeing global coverage of credit risk, investment risk, integrity risk, pricing and credit/equity training, and as in charge of IFC’s portfolio in the Middle East and North Africa, and the outfit’s business development efforts in frontier markets like Afghanistan, Iraq and Iran. He spoke to Divakar Prakash on IFC’s infrastructure projects, efficacy of the public-private partnership (PPP) model and much more on the sidelines of the South Asian Diaspora Convention in Singapore recently. Excerpts:

Can you throw light on some of the key stakeholders in IFC’s infrastructure projects?
Infrastructure projects have four main stakeholders: the state or country, investors and lenders, suppliers and consumers. The state is the grantor of concessions to build and operate any infrastructure facility. Investors, whether public or private, have expectations of earning reasonable returns on investment (RoI) for the capital supplied. Suppliers provide the inputs to construct, operate and maintain the infrastructure for the service. The consumers are the people – households, communities and citizens -- who ultimately benefit from the project in terms of accessing critical resources such as water, energy or transportation. Their chief concern is to have reliable and affordable access to the service provided by the project.

What are the services and sectors covered by infrastructure projects?
Our infrastructure projects include power (including renewables), utilities (water and waste management), transportation (such as airports, roads, ports, rail and urban transport), telecommunications, as well as ‘soft’ infrastructure such as health and education. We provide these to communities that lack adequate services.

What are the key challenges in the PPP model?
Risks need to be allocated to the party that is best placed to manage them and in a way that optimally shapes incentives. As these are long-term contracts involving several parties, a clear and predictable regulatory environment with a robust conflict resolution mechanism must be in place. There should be a balance between predictability and flexibility built into the contract and an appreciation of the incomplete nature of long-term contracts. Affordability is also critical, and requires a balance between pricing and providing a reasonable return to investors. The government’s ability to manage and regulate contracts and provide sustained political will in the long term is also a key challenge. This highlights the importance of investing resources and time in adequate project selection, project structuring and tendering of the private partner to ensure a sustainable long-term partnership.

What are the ways to enhance productivity?
We have to invest in the bankable projects and develop a better system to identify, structure and tender bankable projects. The domestic bond market is one opportunity that needs to be leveraged. We need to consider infrastructure as an asset class and introduce institutional investors into the ecosystem. Cross-border finance through bonds in local-denominated currency can hedge currency risks. Governments play a central role in developing a clear and predictable enabling environment to ensure contracts are binding, which, in turn, gives confidence to investors and reduces inherent contract risks.

Inter-governmental coordination and collaboration are becoming increasingly necessary in this region. We need to be competitive while also working together.

What do think of the role of regulators in infra projects?
Clear contracting regimes are needed to specify the allocation of finite natural resources, the selection criteria for concessions, accountability measures for on-going contracts, and for swift adjudication. Efficient arbitration mechanisms are also key. There is a need to ensure fair risk-reward while keeping public good in mind.

What potential do you see for bond financing?
Bonds are a good way to diversify funding sources and tap into a new asset class.The question is how can we promote infrastructure bonds in emerging markets? Infrastructure bonds can also be issued in the local currencies to hedge currency risks.

Strong and clear legal frameworks, bureaucratic efficiency and contract enforceability are key factors, as they strongly affect the rating of infrastructure bonds and therefore the attractiveness for investors. The emergence of a domestic institutional investor base will further spur the development of infrastructure bond markets. In addition, several policy initiatives have been taken to provide infrastructure bond insurance in emerging markets, such as the Credit Guarantee and Investment Facility (CGIF) 2016 in Asia.

In many countries, project bonds are typically issued by a Special Purpose Vehicle (SPV), which retains the incentives for stakeholders to push for the effective execution of a project. Another option for emerging market economies is to issue infrastructure bonds off-shore to tap into international capital markets.

Can you explain the planning phase of the infrastructure finance?
The backbone of the structure relies on the project finance where there are two sets of contractual arrangements. First is the creation of a legally and economically self-contained entity (SPV) against which all the legal contracts are written, and the second is the contracts that define the partnership and imbibe the distribution of risks and returns. The SPV creation and limited recourse nature of project financing allows the contractual pledging of cash flows to creditors and the distribution of risks among the contract partners. It solves agency related issues, as promoters and owners cannot divert revenue from the project to other entities. This is an example of an extremely robust structure. The degree to which the private sector is involved is determined in contractual arrangements. These can take many degrees and forms from management contracts to part or full private ownerships.

What are your views on the efficacy of the PPP model?
The involvement of the private sector can be a boon for efficiency as well as a means to give more fiscal space to governments.The achievement of efficiency gains as compared to pure public procurement should be the priority. Simply trying to achieve financial gains would be inefficient as the funding costs for the government (through sovereign bonds) are very often lower than private sector financing.

If projects are structured properly, efficiency gains from the private sector involvement can easily outweigh additional funding costs. Private sector funding should be seen as a process to ensure that infrastructure projects are built and operated in the most efficient way possible. This requires the structure to optimise the incentives of each partner – and the incentive structure of the investor is entirely a function of the risks and returns defined through the series of contracts. The type and degree of private sector involvement can take many forms but the type of private involvement should match the risks that are transferred to the private sector.

What are your views on the fallacies in distributing risks between public and private partners?
There is a huge cost implication when the risk transfers in infrastructure projects are ill structured. Risks need to be transferred to the party that is in the best position to manage them. An imbalance is created by transferring too much risk to the private sector, creating wrong incentives and therefore inefficiencies.

Construction, operations and management risks are typically incurred by the project sponsors and therefore they are best placed to manage these risks. Every project has risk particular to its context – this highlights the importance of the structuring phase such that all risks are identified and that they are adequately mitigated contractually.

What are your suggestions for establishing PPPs?
There are very different types of projects entailing various risks. With PPPs, a few fundamental rules must be followed to ensure the appropriate sharing of risk between public and private investors. First, as PPPs are long-term contracts they make sense for projects where there is a potential to make efficiency gains. They should be seen as a way to procure infrastructure services more efficiently and not just focus on the construction of infrastructure alone.

Benefits accrue from a PPP structure if it’s structured in such a way that there is a lifecycle view of costs and quality that meet user service requirements in a way that service objectives are met throughout the entire contract period. Compensation to the private investor should be based on performance and indicators of service quality. This implies that the associated risks and responsibility to achieve quality goals should lie with the operator. In addition, the level of control should be based on the responsibilities and the risks the contract parties bear. The financing options available to a project depend on the available revenue stream and the legal structure of the project. Structuring the project adequately upfront will help minimise the need to renegotiate projects at a later stage.