Is the EU’s word its ‘project bond’?

3 Jul 12
Mark Hellowell

Infrastructure projects are to be boosted by bonds backed by European Union funds. There is political will for this to succeed, but what does it mean for future public sector risk?

Everybody knows that major infrastructure projects tend to be managed badly. From the Channel Tunnel to the Edinburgh trams fiasco, estimates of costs and benefits prove absurdly optimistic. Society suffers, but there is little accountability.

However, when it comes to the Private Finance Initiative, something curious seems to be the norm. While expensive for public authorities, due to the high cost of capital and transaction costs, the PFI has an admirable record of project delivery from the perspective of investors such as Carillion, Balfour Beatty and John Laing. These sponsors usually achieve the profit margins they initially thought they would when they signed their contracts.

A recent survey of 118 operational projects by the National Audit Office found that in 75% of cases, investors were earning returns at or above what they had expected.

Their creditors have also had a pretty easy ride. In a study of 805 PFI projects from around the world, ratings agency Moody’s found that lenders had a maximum 0.5% probability of default (defined as a scheduled debt or interest payment not paid within 90 days of the due date) in any given year. Only 18 of the 805 projects surveyed had witnessed a default – and in most of these cases, creditors eventually got all their money back anyway.

Against this background, it is a curious fact that the infrastructure sector is in the midst of a major credit crunch. Almost four years after the collapse of Lehman Brothers, banks in Europe still face capital and liquidity constraints that undermine their ability to provide long-term project finance.

This is highly inconvenient for policy makers in both London and Brussels, whose attempts to stimulate economic growth via infrastructure spending are frustrated. They are anxious to get credit flowing into projects by replacing wounded banks with other, less dysfunctional institutions, such as pension funds and insurance companies.

In a frictionless world, this would happen naturally. Capital is supposed to flow to investments with the highest return. The fact that this doesn’t happen is evidence of a clear case of market failure, normally seen as the best case for state intervention. Given the salience of this issue for growth plans in the UK and the eurozone, it is now receiving due attention.

When Deputy Prime Minister Nick Clegg talks about preparing a ‘massive’ increase in state-backed investment in infrastructure, this is what he means – although his focus is wider than those sectors associated with the PFI. It incorporates other elements of economic infrastructure, such as energy, water and digital networks.

The idea is to use the government’s ‘balance sheet’ – coalition code for its abundant capacity to borrow – to guarantee payments to creditors and thus enable risk-averse players to lend into projects. The trick is to do this without adding to the official estimates of government indebtedness, which means debt must be recorded as a private sector liability, not a public one.

But if the state is standing behind infrastructure projects, the potential to shift the risks and rewards they present out of the public sector is curtailed.

On this difficult issue, the European Commission is playing a leading role. Under its ‘project bonds’ initiative – a new pilot approved by finance ministers at the end of May – EU funds will be used to back new bond issues by the European Investment Bank. The capital raised will be used to provide capped guarantees and/or some risk capital for projects.

Initially, priority is likely to be given to projects with a trans-European focus, but eventually it is envisaged that a broad range of domestic social and economic infrastructure projects could benefit. The aim is to enhance the credit of the project, allowing the bulk of its capital requirements to be financed by bonds, which will then be snapped up by institutional investors. The key to this is to improve the rating of bonds from triple B to single A, for which the market is deeper for a variety of cultural and regulatory reasons.

The complexity of project finance transactions means institutional investors will need to make a substantial investment, but theymight not be willing to do that until they see a market develop.

Clegg and the Eurocrats are struggling to find a way through this chicken-and-egg dilemma, especially after François Hollande’s election to the French presidency. There is a huge amount of political will underpinning the project bond initiative, but no guarantee that it will succeed.

EU taxpayers and citizens should monitor these efforts closely, but perhaps with a degree of caution. Infrastructure investment can be an attractive source of economic stimulus since its effect on demand can be huge.

Well-conceived and well-structured infrastructure projects can also benefit economies in the long run.

But herein lies the problem. Any attempt by states to guarantee project funding will bring risk back into the public sector, reducing the private sector’s motivation to deliver the schemes well – in other words, exactly those disciplines that led to the good record highlighted by auditors and Moody’s.

The plans being drawn up in London and Brussels might, eventually, lead to a functioning infrastructure bond market, not unlike the well-established North American market. But it might also increase the likelihood of deals going ahead that should never have seen the light of day.

Mark Hellowell is a lecturer in health systems and public policy organisation at the University of Edinburgh. He has also been an adviser to the Treasury select committee’s inquiry into the Private Finance Initiative

This article first appeared in the July/August issue of Otsubo7

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