Session 6 FNCE232 Project Financing.pdf

Session 6: Drivers of Infrastructure Finance: Investment vs Sustainability Project Financing Dr Davin Wang Adjunct Finance Faculty Lee Kong Chian School of Business, SMU 1 Definition of Infrastructure...

Session 6: Drivers of Infrastructure Finance: Investment vs Sustainability Project Financing Dr Davin Wang Adjunct Finance Faculty Lee Kong Chian School of Business, SMU 1 Definition of Infrastructure “… the sum of all material, institutional and personal assets, facilities and conditions available to an economy based on the division of labor and its individual economic units that contribute to realizing the assimilation of factor remuneration, given an expedient allocation of resources” “… the term material infrastructure stands for the sum of all physical assets, equipment and facilities and the term institutional infrastructure points to the norms and rules, which develop and set in a society over time; in addition, the term personal infrastructure is used to encompass the number and qualities of people in a market economy” - Jochimsen (1966) 2 Impact on Economic Development Significant demand for investments in both economic and social infrastructure exist around the world Infrastructure assets like roads, bridges, powerplants, ports, healthcare and education facilities key drivers of any economy Significant infrastructure investments are needed in both developed and emerging countries for economic development within their borders 3  Regional Infrastructure and Investment Needs Projected Infrastructure Investment Needs (2016-2030) 16,000 12% 2% 14,000 12,000 2 12 US$ bm (2015 prices) % % 10,000 25% 8,000 25 6,000 % 61 61% 4,000 % 2,000 0 Central Asia East Asia South Asia Southeast Asia Central Asia East Asia South Asia Southeast Asia Source: Asia Development Bank (ADB) 4 Regional Infrastructure and Investment Needs Infrastructure Investment Needs as Percentage of GDP (2016-2030) Southeast Asia South Asia East Asia Central Asia 0 1 2 3 4 5 6 7 8 Source: Asia Development Bank (ADB) 5 Regional Infrastructure and Investment Needs 6 Impact on Economic Development Financing the construction and operation of international cross border infrastructure facilities is also key for the integration of international economic communities Trans European Transport Network (TEN-T), the Trans-European Energy Network (TEN-E) and the Trans European Telecommunications network (eTEN) HSR project was targeted at increasing economic activities between KL and Singapore before the project was mired in the current uncertainty Most countries have a financing gap, or inability to match the demand for infrastructure finance with the necessary sources of finance, that they need to close to reach their economic targets 7  Infrastructure Financing Gap – PPP Partnership … 2 12 % % 25 % 61 % Source: www.straitstimes.com 8  OBOR Financing Gap - Debt sustainability? 2 12 % % 25 % 61 % Source: www.straitstimes.com 9 Infrastructure Investment Opportunities Developed and Emerging Markets that Investors View as Presenting the Best Opportunities Source: Preqin Investor Interviews, 2018 10 Infrastructure Funds in Asia Top 3 Asia-focused unlisted infrastructure Largest Asian fund managers in the funds closed in 2016 and 2017 unlisted infrastructure market Source: Preqin Global Infrastructure Survey 2017, 2018 Source: Preqin Infrastructure online 11 Infrastructure Investor Distribution and Size Infrastructure Investors' Mean Commitment Size by Investor Type 2019 Sustained investor appetite and strong long-term performance have boosted infrastructure assets past $0.5tn, and the industry is on the way to hitting $1tn by 2023 Source: Preqin Pro 12 Infrastructure Investment Categories Greenfield versus Brownfield infrastructure investments Project development versus operational assets Greenfields defined as assets that are constructed for the first time at a specific site Brownfield projects relate to existing, operational assets that have already gone through the development phase Brownfield projects may involve reconstruction, rehabilitation (renovation) or expansion All the risks relating to approval, permitting, technology and commissioning has been dealt with by the time a brownfield project is involved Some elements of a greenfield project may still reappear in a brownfield project (for example expansion permitting, implementing new technology etc) 13 Infrastructure Investment Categories Well accepted fact that greenfield investments are judged to be riskier than brownfield infrastructure investments because Building from scratch can bring more risk as well as higher costs. For example, a company may have to invest more initially when it decides to build from scratch to fulfil feasibility studies, permitting. There may also be problems with local labour, local regulation, and other hurdles that come with brand new construction projects. Brownfield investments run the risk of leading to buyer's remorse. The infrastructure may require major upgrades, thus increasing investment cost. Old facilities may require high maintenance and upkeep cost There may be operational inefficiencies if the facility cannot adapt to new production needs, or scalability and expansion issues by using already constructed facilities There may be unforeseen tax and regulatory issues Investors have different expectations of greenfield and brownfield investments Financial investors versus strategic investors 14 Regional Infrastructure and Investment Needs Target Net IRRs of Unlisted Infrastructure Funds Source: Infrastructure Institutional Investor Trends for 2016 Survey, Probitas Partners 15 Infrastructure Investors - An Overview Unlisted infrastructure assets under management reached $582bn as of June 2019 (the latest available data). This is an increase of $59bn in just six months, the fastest rate of growth the industry has ever recorded. Given the average pace of growth since 2015, AUM is due to hit $700bn by the end of 2020, and $1tn by the end of 2022. Funds closed in 2019 secured $98bn from investors, the fifth consecutive record annual total. This included Global Infrastructure Partners IV, which became the largest ever infrastructure fund at $22bn. Eighty-four percent of investors intend to maintain or increase their allocation to infrastructure in 2020 compared to 2019. There are 253 funds in market at the start of the year to meet that demand, collectively seeking $203bn. Infrastructure funds have returned 8.7% annualized on average in the 10 years to June 2019, meeting or surpassing the S&P Infrastructure and S&P Oil & Gas Indices. In the three years to June 2019, infrastructure funds returned an average of 10.6%. Among alternative asset classes, this is second only to private equity funds (17.5%). Looking ahead, 86% of investors expect performance in 2020 to equal or surpass that of 2019. Source: 2020 Preqin Global Infrastructure Report 16 Types of infrastructure investors Financial investors in infrastructure investments include the following Infrastructure investment funds o Listed and unlisted funds Pension funds Multilateral sponsored funds Sovereign funds Driven by financial return and would look to exit the investments after a period of 5 to 10 years Strategic investors are typically corporate sponsors who invest in infrastructure projects as part of their business and expansion strategies Motivated by market penetration objectives which can be both geographical or product based Investments may be held for the long haul 17 Types of infrastructure investors Strategic and financial investors both compete and collaborate to invest Fund Manager Views on Whether They Are Seeing Fund Manager Views on the Level of Competition for More Appetite for Infrastructure from Different Investor Capital Compared to 12 Months Ago, 2016 Investor Types Compared to 12 Months Ago vs. 2017 Source: Preqin Fund Manager Survey, November 2017 18 Types of infrastructure investors Strategic and financial investors both compete and collaborate to invest 19 Infrastructure Investments Interest in infrastructure investments have been rising amongst pension funds, insurance companies, sovereign funds, foundations and investments Australian and Canadian pension funds first to gain extensive experience in this asset class and now invest up to 15% of their assets in infrastructure Australia future fund, Ontario teachers pension fund, Canada pension fund Investors attracted to infrastructure investments because of the various factors Potentially stable income stream Conservative risk return profile Social and political benefits European financial investors started to become interested in infrastructure much later but have also caught up 65% of European institutions made commitments to the asset class, allocating on average 4.6% of their assets to infrastructure Middle Eastern and Chinese investors of late has been active in this asset class 20 Portfolio Diversification with Infrastructure Investments Like any other asset class, infrastructure can be a source of diversification Diversification is achieved by the following Combining uncorrelated asset in the portfolio (i.e. assets which tend to change in value independently of each other) Combining assets that have different risk return characteristics and an asset price with different economic drivers Correlation analysis is straight forward for infrastructure assets because of their relatively long operating history and track record Studies have looked at both cross sector correlation of infrastructure assets (different types of infrastructure assets) as well inter-asset correction (infrastructure vs other classes of assets like bonds and equity) and have showed low correlation effects 21  The Future: Same Same but Different? Investors are hunting for deals in a wide range of ‘infrastructure-like’ sectors Source: PwC analysis; Infrastructure Series Report 3 22 Sustainable Infrastructure Investing Investment approach that explicitly acknowledges environmental, social and corporate governance (ESG) risk factors Integrates them into an investment process that enables a positive, lasting, impact on society Also known as socially responsible investing or impact investing ESG risk factors includes Environmental: climate change risk (physical and regulatory risks), hazardous waste, contamination, resource scarcity (water and natural resources), environmental degradation Social: human rights, labour rights, consumer protection,local communities Governance: governance structure/management systems, rule of law, government relations, corruption, compensation structures (management, employee, incentives) 23 Sustainable Infrastructure Investing For example, investors adopting impact investing look at infrastructure investments that provide both a competitive return and provide environmental and/or societal benefits Projects that are suspected of causing harm damage to the environment (e.g coal power projects which adversely air pollution will not be considered by such investors) Projects utilizing child labor or engaging in labor exploitative policies will also be screened out by investors Investors that pursue sustainable infrastructure investment strategies will instead focus on environmentally friendly renewable projects like wind and solar power projects Lower risk and equal or better long term of ESG investments over conventional ones Growing number of investors now include ESG performance result in superior risk return profile factors into their investment processes Multilateral lenders like the World Bank and ADB also consider ESG risk factors for project financing 24 Sustainable Infrastructure Investing Fund Managers that Consider ESG Factors as Part of the Deal-Making Process Source: Preqin Fund Manager Survey, November 2017 25 Sustainable Infrastructure Investing A stronger case for investing in renewable energy Source: Preqin Global Infrastructure Report 2018 26 Green Project Financing Policymakers can play a key role on of how to mobilise sufficient debt and equity capital to finance the transition to a low-carbon and climate-resilient (LCR) economy. Debt currently finances the majority of LCR infrastructure investment. Challenge will be to shift away from emissions-intensive investments while scaling up LCR investment despite constraints on traditional sources of capital (including governments, banks and corporates). Bonds connect investment needs with the latent demand for sustainability-themed investments from institutional investors, Green Bond = Regular Bond + Environmental Benefit 27 Green Bonds Idea: Connect sustainable investors with issuers pursuing projects that contribute to environmental sustainability, resulting in better access to long-term project financing Green Bond Principles (GBP) define: Use and management of proceeds, project evaluation and selection, and regular reporting; voluntary guidelines, usually verified by a third party A green bond has an identical claim against the issuer as a non-green bond, the same credit rating / default risk, and therefore typically offers the same yield and similar performance Issuers benefit from access to a fast-growing audience of sustainable investors, who typically are long-term oriented, and at the same time are able to highlight their sustainable activities Green bond market volume ~USD 690bn; largest issuers are utilities, banks and public sector agencies; most bonds are denominated in EUR and USD Investable with individual bonds and a growing range of diversified investment products 28 Categories of Green Projects Renewable energy Energy efficiency Pollution prevention and control Environmentally sustainable management of living natural resources and land use Terrestrial and aquatic biodiversity conservation Clean transportation Sustainable water and wastewater management Climate change adaptation Eco-efficient and/or circular economy adapted products, production technologies and processes Green buildings 29 Green compared to non-green bonds A regular bond… …that carries environmental benefit Same claim against the issuer in case of Climate-related targets of the bond generally laid insolvency (no project risk) out ahead of issuance Same credit rating / default risk Use of proceeds is targeted for listed new or existing Same yield and risk premium green projects Green bonds are part of traditional bond A second opinion may be provided to verify indexes alignment with the Green Bond Principles (optional) Separate, appropriate tracking of proceeds Annual reporting may be provided Why companies accept extra cost to issue a green bond, even if yields do not differ: Audience for green bonds is broader, is growing in size, and is long-term oriented, adding to funding source diversification and stability for an issuer. Green bond reporting provides a great marketing opportunity for issuers to highlight their climate- friendly activities 30 Similar returns as broad benchmark indices Less-cyclical sector composition of the green bond index reduces volatility compared to corporate bonds Source: ICE BoAML, UBS, 26 November 2019 31 Green bond market is less cyclically exposed Green bond index compared to corporate bonds and the broad market Source: ICE BoAML, UBS, 26 November 2019 32 Valuation drivers and Market Liquidity The sector and rating composition of the green bond market is more defensive than for traditional corporate bonds, resulting in outperformance of green bonds during times of widening risk premiums (and vice versa). Over a cycle, green bonds are likely to outperform the broad bond market (including government bonds). Demand for sustainable investing is growing rapidly and many large bond investors are allocating funds to climate-friendly investments, where green bonds are a preferred choice. Despite growing new issuance, demand continues to outgrow supply of green bonds. Demand may be boosted by government policy and regulation. Greater transparency for investors through indices and dedicated segments on exchanges is also supportive. Benchmark-sized green bonds exhibit sufficient market liquidity. However, contrary to the typical liquidity concerns in bonds, green ones are harder to buy than to sell (i.e. bids are firm). 33 Categories of Green Projects 34 Concluding Remarks Q&A 35