The Case of Public-Private PartnershipsChallenges and Opportunities

Crossover−Urban Water, Transport, EnergyJune 23-25, 2015

Julie Kim, Ph.D.

Senior Fellow, New Cities FoundationP3 Program Director, Stanford Global Projects Center (GPC)

1

2

• I'd like to thank the sponsors of this conference for this opportunity to speak on behalf of NCF and Stanford Global Projects Center, and also call out Cisco, Citi and Arup for their support of our research in urban finance area.

Taking Stock:Can Challenges Be Opportunities?

1. Funding vs. Financing

2. Investor Benchmarking and Incentives

3. Politics and P3 Literacy

4. Greenfield Development Finance

5. Brownfield Leveraging

6. Smart City and Sustainability Initiatives

4

• I have spent almost 30 years of my career in infrastructure business and I’d like to share with you today my thoughts on where some of the most critical challenges are in PPP and whether we can turn these challenges into opportunities.

• In particular, I’ll address 6 key areas of concern: (1) issues of funding vs. financing, (2) difficulty of benchmarking and misaligned incentives on the investor side, (3) PPP politics and knowledge gap on the public sector side, (4) lack of greenfield development financing, and (5) viability of monetizing brownfield assets. Finally, I’ll close my briefing with a few thoughts on financing challenges related to smart city concepts.

There Is No Free MoneySolving Funding Problem Before Financing

1. Oversupply of financing and undersupply of funding

2. Problem is not money, but not enough bankable projects

• Institutional knowledge gap • Lack of revenues (funding)

3. Who pays in the end?

• Taxes: towards usage-based regime (e.g., VMT)• User fees: creating value, public relations • Other big ideas: brownfield leveraging?

4. Reduce costs, reduce funding needs

• Lifecycle approach• O&M efficiency: Green, Smart City, pricing• Financing costs: optimum risk allocation

5

17%

60%

23%

Levers to Reduce Infra Gap

Financing

Revenue/Funding

Institutional

6

• According to a recent study by OECD, the levers that can reduce the global infra gap include not only robust financing tools and smart institutions, but more importantly, identifying clear future revenue streams or funding sources to repay the financing

• We all know by now there is no such thing as free money and there is a difference between funding and financing. There is currently an overabundance of private capital for financing infrastructure projects but, eventually, they need to be backed and paid for by future revenues or funding, which mostly comes from the public sector and which is in short supply.

• The problem at hand is not the lack of financing but not having enough bankable projects, partly because of the lack of institutional capacity and knowledge gap in the public sector but more critically due to the lack of funding to repay the financing.

• In the end, infrastructure has to be paid for by taxpayers and users. In transportation sector, we all know about the inadequacy of current fuel tax base and the ongoing efforts to supplement and/or replace the current tax regime with more usage-based tax directly linked to the actual wear & tear of facilities, such as the VMT tax.

• More and more, these taxes need to be supplemented by user fees and we need to strike a right balance between the two in the long run. It has been proven that users always pay if they see value. User fees are often directly tied to the cost of producing services so perpetual funding shortage can be avoided. In sectors such as water, user fees can be difficult to collect politically. Improvements in service be accompanied by strong and thoughtful public relations initiative in these cases. In addition to taxes and user fees, there are other ways of increasing the funding pool. In particular, I will speak about leveraging of brownfield assets a bit later.

• Funding shortage can be also addressed by reducing costs. Jury’s still out on PPP but one clear benefit accepted widely is its lifecycle approach that integrates construction with operations and maintenance and minimizes the overall project costs.

• O&M costs are a large part of the infra spending needs. Green initiatives, smart city concepts, congestion pricing strategies all help in O&M space with practical efficiency gain and demand management measures to maximize the utilization of the existing facilities

• Finally, reducing financing costs thru optimum risk allocation is another indirect way to reduce the funding gap.

1. Difficulty in investor benchmarking

• Disparate asset “class”: greenfield (real estate), regulated utilities (fixed income), privatized airports (private equity)

• EDHEC-Risk Institute developing new method

2. Misaligned incentives

• Managed infrastructure funds’ short-term/high-return incentives

• Large institutional investors moving towards in-sourcing, peer-to-peer collaboration

3. Tempering return expectations?

• IRRs for APs inching up to those of demand models

• Public service aspects, sectoral differences in degree of “externality” (energy →water→transport→social)

Benchmarking, Misaligned IncentivesNeed to Temper Return Expectations?

8

• There are still lingering doubts about the value of PPP. Setting aside the details, the big ticket item is the high financing costs associated with PPP deals, which can wipe out any lifecycle efficiency gains.

• Oversupply of capital and not enough projects in the pipeline are driving the infra asset prices up on the one hand but there are other systemic issues on the investor side that are causing high return expectations, not commensurate with the risks.

• Infrastructure assets are notoriously difficult to benchmark for consistent investment and allocation decisions. Greenfield projects are like real estate, regulated utilities are like fixed income, and privatized airports are like private equity, all with very different risk-return profiles, all lumped in together as a single asset class. One good news is that EDHEC-Risk Institute, well known for their quality research, is developing a new investor benchmarking by identifying sub-categories and standardizing performance reporting.

• Managed infra funds, both on equity and increasingly on debt side, have played a key role in infra project financing, most of their capital being sourced from institutional investors. The long-term interest of institutional investors, however, have been often at odds with more short-term, high turnover, and high return interest of their fund managers. As their infra allocations increase, Institutional investors are shifting more to direct investing through in-sourcing or to co-investment models thru peer-to-peer collaboration.

• Due to the high return expectations, an undesirable consequence in recent years in the U.S. has been that some AP deals, where private sector takes no traffic risk, have been inching up to the same returns as the demand risk model, thereby discouraging the ability to capitalize on the at-risk private capital to collect user fees

• Finally, there still remains the externality and public service aspects of infrastructure that reflect broader benefits that are difficult to monetize. The high return expectations may need to be somewhat tempered for some sectors depending on the degree of externality as each sector differs in its ability to monetize and assign specific costs/benefits to specific users.

Politics and P3 Literacy Getting Smarter to Adjudicate

1. P3 politics

• Costly with ripple effect

• Wide gaps in public perceptions and scholarly assessments

• Government must play adjudicator role, not private sector

2. P3 institutional requisites

• Enabling policies, laws, institutions, processes, resources (P3 Units)

• Proactive multi-stakeholder outreach

3. Public sector P3 financial literacy

• Designing “win-win” bankable projects

• More leadership/innovations from public sector

10

• In the end, politics trumps everything. • Political risks are costly and have lasting ripple effect. For example, reversals in procurement

decisions not only impact the project being procured but also influence the investment community’s perception of all future projects procured by that public sponsor and the general perception of the PPP market as a whole for that state and for that country, all of which translate into high risk premiums. In renewable energy sector in the U.S., for example, it was found that the states with no history of regulatory reversals attracted 3 times more private investments than those with such history.

• It is interesting to note that infra assessment industry has been growing steadily since the 90s but wide gaps are often found between the scholarly assessments and public perceptions.

• Whether like it or not, the public sector needs to take on the complex role of adjudicating the disparate interests of all PPP stakeholders, which cannot be left up to the private sector.

• Infrastructure development is a long-term endeavor and getting funding and financing in place is only the beginning. They must be accompanied by the enabling institutional capacity to get the job done, including policies, regulations, processes, and dedicated resources such as PPP Units. These building blocks ensure that the financing terms are honored and investors can keep coming back.

• PPP is a complex undertaking. Long-term unbiased perspectives and analytical rigor can add a significant value to the public sector as they take on the adjudicator role.

• Understanding the investor side is also critical in designing bankable projects. The question is how to make the deals more efficient and lower the financing costs, but at the same time create a win-win situation for both the public and private sectors? The key here is balancing the risks with a right set of incentives and coming up with robust, innovative ways of structuring projects.

• The public sector needs to be much smarter and more proactive in identifying and designing bankable projects because, in many ways, they understand infra assets much better than the private sector, especially from political and other key risk standpoint.

1. Need to streamline “development finance”

• Critical gap in greenfield that supports new growth• Blending private and public capital with proper incentives

2. Increasing role of International Financial Institutions (IFIs)

• Re-emerging as critical facilitator, early phase seeding • Credit enhancement tools, e.g., EIB contingent credit lines,

framework loans

3. Institutional investors’ long-term capital ($100T)

• Increasing infra asset allocation, favorable past returns • Long-term, local access (sovereign) for competitive advantage• Infra lending gap from commercial banks (Basel III/Solvency II)

4. G20-OECD Initiative

• Matching IIs’ long-term capital with high infra capital demand• Long-term value creation rather than short-term risk

Streamlining “Development Finance”Takes G20, OECD, IFIs, IIs Working Together

12

• The most critical gap at this juncture is greenfield financing that support new growth and economic development. G20, OECD, IFIs and IIs should work together to establish more formalized and streamlined approach to providing this type of development finance. It should involve the blending of private and public capital together and providing proper set of incentives over the project lifecycle.

• The role of multilateral development banks and other IFIs have been increasing in recent years. They provide technical assistance, act as a facilitator or co-developer, and develop innovative credit enhancement tools. For example, EIB’s infra lending is now as much as $80B annually and, for PPP, they provide contingent credit lines to guarantee debt/service payments of PPP demand risk models in case of revenue shortfalls.

• OECD estimates that the toal institutional investors’ asset under management collectively is as much as $100T. Their ability to hold the assets long-term and the unique local access given to sovereign wealth funds in particular provide significant competitive advantage in infra space. IIs are also filling in the critical gap left by commercial banks in infra lending space due to the increased restrictions imposed by Basel III. There is now a new business model of banks acting as arranger-distributor and institutional investors taking on the buy-and-hold positions traditionally held by the banks.

• High on policy agenda for G20 leaders is the critical role long-term institutional investors will play in the future in fostering long-term growth and greater financial stability globally. The G20 leaders are particularly interested in matching the supply of long-term funds provided by these institutional investors with the high capital demand for infrastructure. In the last few years, G20 and OECD working closely together to push this agenda. Their hope is to effect a cultural shift in infra investing that is based on long-term value creation rather than short-term risk management.

1. Limitations of taxpayers and users

• Need “big” idea for “big” problem • Brownfield proceeds as close to “free” money as possible

2. Potential scale matches sheer size of funding gap

• Australia’s recycling: NSW seaports, Queensland Motorways• U.S.: Chicago skyway, Indiana toll roads, $500B funding potential

3. Investor perspective

• Value creation from cash flow vs. capital growth aspects• Transitioning from non-tolled roads

4. Overcoming politics; evoke “privatization” (assets sales)

• Involve public pension funds (e.g., Australia)• Effective regulations as good as ownership

Leveraging (“Recycling”) BrownfieldScale is There but Must Overcome Politics

14

• The sheer size of infra funding gap is beyond our grasp. (In the U.S., we need $3.6T in next 5 years, of which $1.6T is the funding gap we need to fill.) Globally, various sources indicate that we need between $60 to $80T in infra spending thru 2030; this is almost 5% of global GDP, a half of which is money we don’t have and 75% of which is needed by cities and urban areas.

• There is a limit to how much taxpayers and users can take on to pay for infrastructure. Business as usual will not cut it and we need “big ideas” to handle the “big problem”.

• One possible option is to monetize existing brownfield assets. The resulting proceeds come as close to “free” money as possible with no repayment obligations

• Despite much controversy, the public sector fared well financially from Chicago Skyway, Indiana Toll Road and, more recently, ports in NSW and Queensland motorway in Australia.

• This is one of few options that begins to measure up in terms of the scale issue. In Australia, most of their infra assets are already privatized but they project some $200B in additional brownfield proceeds. In the U.S., some estimate almost half a trillion in brownfield proceeds from airports, ports, toll roads, and bridges that are currently in public hands. This does not include water, parking, and many other revenue-generating infra

• From investor standpoint, steady stream of cash flow is a critical part of asset valuation in these transactions. There is also the capital growth component which could further enhance the funding potential, when considering brownfield assets that do not generate revenue currently but could in the future.

• Brownfield leveraging seems to evoke the public controversy associated with full “privatization” and asset sales. In Australia, public pension funds were part of the brownfield transactions, which helped to ease the political tensions associated privatization.

• It is important to note that, historically, effective set of regulations have proven as good as outright ownership, as were the case for energy and other regulated utility and privatized airports and ports around the world.

1. O&M efficiency gains key leveraging factor; scale issues

• Most gains are no-cost or small cost to the public sector

2. Tri-furcated financing needs

• Monetize, if clear cost savings and no scale issues, e.g., LED lighting• Aggregate for smaller projects, e.g., warehouse credit facility• Embed within new developments for larger projects, e.g., Ops Center

3. Benefits of “Big Data”: integrate or not integrate

• This is THE big ticket item: who pays in the end?• Cost efficiency vs. institutional issues (ERP lessons learned)

✓ Need better incremental solutions as an added option?

4. Explore innovative user-investor models• Crowd funding, infra cooperative, permanent fund

Smart City, Sustainability InitiativesSmart Financing for Smart Visions

16

• I’d like to close my briefing with a few thought on Smart City concepts• The O&M efficiency gains are the key leveraging factor for smart city concepts from financing

standpoint. For technology vendors, however, a potential issue is that most of these gains can be achieved through small costs or even no-cost to the public sector, especially if data collection is done thru crowd sourcing.

• There appears to be three distinct types of financing needs: (1) for those concepts where there are clear savings, such as smart LED lighting, they can easily be monetized and costs can be passed on to the users, (2) for other smaller undertakings, such as retrofitting buildings for energy savings, aggregation tools such as warehouse credit facilities can be used, and (3) for the big ticket item, such as integrated wifi network and operations center, the benefits are more broad and difficult to link directly to specific users. If the city under consideration is a new city, financing could be absorbed as part of the larger development costs. This was the case for Songdo Korea, where most of the costs were absorbed by real estate developers who built the new city. Identifying who would put up the initial at-risk capital would be a key financing challenge for these big ticket items, especially for existing cities.

• There may also be some opportunities to capitalize on lessons learned from the past. For the integrated network and the benefits of the “Big Data”, potential economies of scale on the technology and cost side should be weighed against the organizational barriers that make the integration more difficult, as we learned painfully from the ERP systems in not-too-distant past. Perhaps what’s needed here is that, in addition to the totally integrated solution, an incremental solution could be developed in parallel as another option, especially for existing cities.

• We need smart, innovative financing approach to match the smart technology. Because we need to depend more on users to pay for these systems, it may be worth our while to explore financing strategies that involve users on the investor side such as crowd funding, infrastructure cooperative that works like a credit union, or setting up permanent funds that are replenished by user fees.