McKinsey&Company – How to mobilize private-sector financing for sustainable infrastructure, January 2016

McKinsey&Company – How to mobilize private-sector financing for sustainable infrastructure, January 2016

CICA Summary

The world made a collective commitment to respond to climate change. To invest in sustainable infrastructure (defined as projects that are socially inclusive low carbon and climate resilient) must be part of the answer. A “triple win” is: i) reduce emissions and climate risk, ii) spurs economic development, iii) increases returns for investors.

The world is spending $3 trillion a year on infrastructure, half of the $6 trillion a year required from 2015 to 2030. There is a huge need to increased private-capital mobilization for long-term infrastructure investment, already financing half part of these spending.

It is possible to increase private-sector investment in sustainable infrastructure, to be mainly redirected toward developing and middle-income countries, already financed by local or south-south investors/lenders up to 60%of the total needs. This can be done if there is added value for investors.

Demand for infrastructure

The McKinsey Global Institute identified three ways to improve productivity:

  • Smart selection of projects, with an emphasis on those that address clearly defined needs and that are Well Prepared;
  • Investing in the design and planning stages to reduce project changes, transaction costs and delays;
  • Increasing asset utilization, improving maintenance planning, and refining demand management for existing assets.

Implementing these measures could reduce the required outlays by 40 percent.

The supply of infrastructure finance

To understand the dynamics at work, it helps to break down institutional finance into three parts: players, products, and places. Based on motivation, risk profile, and regulatory status, institutional investors and lenders can be divided into eight groups: banks, investment companies, insurance companies and private pensions, public pensions and superannuation plans, sovereign-wealth funds, infrastructure operators and developers, infrastructure and private-equity funds, endowments and foundations. Banks provide the most important source of debt for infrastructure projects. They can act as the lead arranger, or they can participate through syndicated loan market. The total assets under management (AUM) of the eight groups amount USD 120 Trillion.

These investors are increasingly investing directly in infrastructure projects rather than as limited partners in infrastructure funds. They are setting more aggressive portfolio targets both for infrastructure and for sustainability.

Private-equity and infrastructure funds are the most likely to invest in equity, rather than debt; they also seek the greatest returns. They are also getting more active in upstream project shaping.

Numerous developers and operators are large corporations. They can shape the amount and timing of capital expenditure and assume construction risk. Many successful developers and operators get involved early in the life cycle, often at conception. An increasing number of governments accept unsolicited PPP bids.

In a review of more than 3 700 infrastructure financings from 2000 to 2015 that used both debt and equity, the debt averaged was 70 percent of the total capital. Most infrastructure investors tend to invest in their home region because they have a better understanding and greater control of the physical environment, government policies, or overall business climate.

PPPs are particularly important because they allow the blended-capital structures and reduce private investors’ perception of policy risks.

Defining the sustainable infrastructure gap

Increased institutional private-sector investment could close more than a third of the spending gap. Such projects often feature long-term returns, steady cash flows and can help investors to safely diversify their portfolios. The default rate for infrastructure-project-finance debt since 1998 has been 1.5 percent, compared with 1.8 percent for rated corporate issues.

On average, companies whose business are toed to infrastructure assets require rates of return on total capital employed of 5 to 10 percent for new investments: 5 to 6 percent for power and water utilities, 7 to 8 percent for energy companies, and 9 to 10 percent for engineering and construction companies.

Challenges to increasing financing to sustainable infrastructure

Five common major barriers that inhibit financing going to infrastructure in general can be identified:

  • Lack of transparent and “bankable” pipelines: there are three related issues:
  1. governments often fail to develop long-term plans so infrastructure needs and priority are unknown;
  2. even when they are long-term plans, the pipelines may not be well communicated.
  • many infrastructure projects are not primarily “bankable”. These kinds of pipeline problems make it more costly for investors to raise funds and invest in infrastructure.
  • High development and transaction costs: inefficient project preparation, inadequate bidding and procurement processes discourage private investment and increases transaction time and costs.
  • Lack of viable funding models: many infrastructure projects cannot deliver the 10 to 15 percent rates of return private investors expect. Users being unwilling or unable to pay high enough charges to allow full cost recovery plus a return on investment of this size.
  • Inadequate and or uncompetitive risk-adjusted return: amplified by new technologies leading to higher up-front costs.
  • Unfavorable and uncertain regulations and policies: Governments tend to use cash accounting standards that do not differentiate between long-term investment that add value and near-term consumption. Uncertainty around tax and customs policies, particularly in middle- and low-income countries, has a depressing effect on infrastructure investment because it makes it difficult to project long-term net cash flows with a particular focus on the medium-long term financial strength of public bodies to repay tariff and rent.

Creating the conditions for more investment in sustainable infrastructure

Sectorial policies, institutions, and capital markets are the most important elements in creating the enabling the institutional, legal, regulatory and contractual environment that sustainable infrastructure needs.

Six ways to improve financing for sustainable infrastructure, with a consideration of their feasibility, limitations, and possible impact:

  • Scale up investment in project preparation and pipeline development: establishing common legal and design standards can reduce costs and make doing business easier. Project-preparation facilities should be also used to create standard legal frameworks, investor materials, and request-for-proposal templates that are only modified as needed;
  • Use development capital to finance sustainability premiums: i) development capital includes capital from multilateral, bilateral, or national development banks as well as from climate-finance organizations. ii) Improve the capital markets for sustainable infrastructure by encouraging the use of guarantees. [i]
  • Encourage the use of sustainability criteria in procurement: including sustainability as well as cost criteria in procurement would drastically change incentives for the private sector. Adopting a TCO (Total Cost of Ownership) approach rather than a low-cost bid process could generate long-term savings and shift selection toward sustainable projects that are Net Present Value (NPV)-positive but have higher up-front costs. The basic problem to overcome is that many governments assume that adding sustainability criteria will increase costs, increase construction time, and potentially exclude local suppliers who do not have the skills to meet the new criteria. To overcome this will require a combination of political will, regulatory skill and professional training either of public agents or local workers.

Increase syndication of loans that finance sustainable-infrastructure projects: i) syndication can help to raise private-sector capital while reducing balance-sheet exposure for development banks, ii) increasing loan syndication allows development banks or other primary lenders to recycle their capital for more sustainable-infrastructure investment, thus increasing the number of projects financed, iii) adapt financial instrument to channel investment to sustainable and Well Prepared infrastructure Project and enhance liquidity: While infrastructure investments offer portfolio diversification, low volatility, and long-term horizons, high transaction costs and other barriers, such as inaccurate prudential regulations (Basel III and Solvency II) have restricted capital flows towards sustainable infrastructure.

[i] See also: “How the mobilization of private capital can bridge the financing gap for infrastructure”

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