By Nicholas Taylor

The world continues to experience chronic infrastructure shortages in both developed and developing nations. The global ‘infrastructure gap’ – the investment required to sustain and support economic growth – is growing by US$1 trillion annually with no clear solution apparent.  It is well understood that the private sector will play a role in bridging this gap, but significant developments in policy are required before this can occur. The long term nature of infrastructure projects seems suitably matched with investors who have long term investment horizons. As investment trends are outside the scope of this essay, investment by Pension Funds will be its focal point, due to their undisputed long term investment horizons, among other factors. This essay will illustrate the heterogeneity of global infrastructure needs by discussing Canada, Australia and sub-Saharan Africa’s specific problems. Their respective impediments to investment by pension funds will also be assessed.  The essay will culminate in proposed solutions relevant to each case, as well as general multilateral solutions which can be facilitated by the International Monetary Fund (IMF), in particular its Technical Assistance Division.

In the wake of the Global Financial Crisis (GFC), IMF head Christine Lagarde has persistently reaffirmed the IMF’s commitment to restoring enduring, sustainable and inclusive global economic growth.^[1] While impediments to economic growth pervade the global financial system, the world must persist with finding domestic and multilateral solutions to the current unpalatable economic climate.

Infrastructure development is likely to play a pivotal, though not exclusive, role in long term sustainable growth. Infrastructure is inextricably linked to economic growth and productivity. There is significant demand for long term, predictable and stable cash flows offered by infrastructure assets, but investment has stagnated thanks to a bottlenecked infrastructure market.^[2]

Current trends are a cause for concern. While most infrastructure has been both built and maintained with public funds, the average ratio of capital spent in fixed investment (predominantly infrastructure) to Gross Domestic Product (GDP) declined from 1980 to 2005 in member countries of the Organisation for Economic Co-operation and Development (OECD).^[3] Furthermore, the growing reluctance of traditional financial institutions to provide long term financing will remain a major challenge to future projects. Deloitte believes that the current level of investment required for infrastructure exceeds any existing government tax or user fee-based funding schemes. Deloitte strongly advocates a solution integrating the private sector’s capital and expertise.^[4] The willingness of the private sector to assume a significant role in the funding of infrastructure will be predicated on the development of coherent and robust frameworks, both national and international, which alleviate concerns including longevity, liquidity, transparency and risk management.

Firstly, this paper will give a general background as to the importance of infrastructure and the current factors which are preventing its development. Secondly, it will discuss infrastructure in the context of an investment. This will be followed by an explanation as to why institutional investors, namely pension funds, can potentially play both direct and indirect roles in the financing and development of infrastructure. Thirdly, the paper will then move to discuss three cases: Canada, Australia and sub-Saharan Africa, in order to illustrate applicable infrastructure models, shortages and challenges of different natures. Finally, both country specific and general solutions linked to the facilitation of investment by pension funds (among other institutional investors) will be suggested. This will be supplemented by a proposal to elaborate the IMF’s role in global infrastructure. This will encompass the promotion of pre-existing frameworks which have proven to be successful in the delivery of infrastructure projects, in addition to other technical assistance. The IMF is encouraged to assist in the mitigation of risk in infrastructure projects in challenging investment environments, with the intended outcome being the promotion of private sector investment.

Infrastructure: The cornerstone of the global economy

Infrastructure is fundamental to a nation’s economic competitiveness and its ability to provide social services. Neo-classical economists’ emphasis on infrastructure has been recognised by the World Economic Forum’s Global Competitiveness Report, which considers it to be the second of twelve pillars essential to competitiveness.^[5]

The OECD generally defines infrastructure as the system of public works in a country, state or region, including roads, utilities and public buildings used for performing long term capital activities, which provide essential services to the public.^[6] Infrastructure is often divided into two distinct groups, economic and social infrastructure. Economic infrastructure usually relates to transportation, water, energy and communication, whereas social infrastructure encompasses service driven infrastructure, such as schools, hospitals, defence buildings, prisons and stadiums.

Infrastructure is integral to nations wishing to sustain competitiveness, and remains a necessary condition for economic development in “factor driven economies”^[7] – countries driven primarily by natural resources and low-skilled workforces. In many of these cases, however, infrastructure is inadequate or absent altogether. As such, both the quality and extensiveness of infrastructure are fundamental to alleviating income inequalities.

Failure to build, maintain and upgrade infrastructure contributes to the growing infrastructure gap, impeding economic and human development and, at times, exacerbating prevailing social conditions. McKinsey estimates that $57 trillion of global infrastructure investment will be required from 2013 to 2030.^[8]

The challenges in financing infrastructure were exacerbated by the GFC: aversion to public sector debt permeates global politics as constraints on commercial debt increase.^[9] Public money has traditionally built and maintained the vast majority of infrastructure projects. Present trends have, however, seen the reversal of this, with OECD average spending declining from 4 per cent of GDP in 1980 to 3 per cent in 2005.^[10] This has continued post-GFC, with new banking regulations and deleveraging contributing to a decline in new project finance. In the first quarter of 2012, investment was one-third lower than the first quarter of 2011.^[11]

Private sector spending beyond bank lending is not a new phenomenon. To date, private investment has met some of the demand, but targets for infrastructure investment by institutional investors remain unmet. Should the trajectory of current private investment trends continue, and if the existing, conservative targets for infrastructure financing are met, an additional $2.5 trillion in infrastructure capital could result.^[12]

Infrastructure: The long term asset

While not discounting the chance of altruistic intentions, the conclusion that private investors in infrastructure are primarily motivated by a return on their investment is not unwarranted. When infrastructure is referred to as an investible asset, its financial characteristics are said to comprise stable, inflation-linked cash flows paid over long time horizons, with low overall correlation to financial markets and a risk profile akin to stocks and bonds. One report cited that infrastructure exhibits an average expected return of 9.30 per cent with an annualized volatility of 7.90 per cent and an identical risk/return ratio to bonds, of 1.18.^[13] However, the heterogeneous nature of these projects, in terms of magnitude (eg. regional vs national) and category (eg. road vs hospital) limits the applicability of generalisations. The absence of a distinct ‘infrastructure’ asset class has complicated the ability to make comparable assessments of whether infrastructure can achieve investors’ financial objectives. This is no exception for institutional investors. Despite not being a new phenomenon, financial markets still consider infrastructure investment a new field. Consequently, infrastructure is rarely considered as a separate allocation in funds. Instead, it is often pooled into private equity, real estate or fixed income allocations, depending on the security class. Many argue, however, that infrastructure will emerge as its own asset class.^[14]

Over the past decades, institutional investors’ exposure to infrastructure can broadly be categorised as debt, equity and direct investment.^[15] Debt financing has traditionally involved bonds and is essentially a form of lending to those responsible for the development and operation of the infrastructure. Equity exposure can be segmented into two subcategories: investment in listed infrastructure companies, and investment in dedicated infrastructure funds (including publicly and unlisted equity funds). The third form, direct investment, involves equity investment in a single asset project company.

Traditionally, institutional investors have pursued ‘indirect’ investment methods, namely private equity infrastructure funds. However, the fee structures of many of these funds have served as a  disincentive due to the erosion of returns. This has led pension funds to consider and commence more direct methods of investment, which, assuming a continued growth in bankable infrastructure projects should continue. Pension funds occupy eight of the top thirty global investors in infrastructure, with all in the top 15 utilizing direct investment methods.^[16] It is likely that both the direct and indirect methods of investment will continue, since the expertise and specialisation required in evaluating infrastructure projects is likely to appeal most to sophisticated pension funds with dedicated teams, or infrastructure specific funds.

Institutional Investors: The long term solution?

The extent to which institutional investors can solve the financing side of the infrastructure gap remains unclear. Institutional investors interested in infrastructure investments can generally be disaggregated into investors from OECD and emerging markets. The former group is comprised of pension funds, insurance companies and mutual funds, with the latter predominantly made up of Sovereign Wealth Funds. As private pensions and insurance markets are considered to be small in relation to the economies of many emerging market countries, many remain optimistic that this group of pension funds will grow in the coming years.^[17] Such growth would be greatly enhanced if the OECD norm of nationalised pension systems with a funded component were to be adopted in emerging market economies.

A number of macroeconomic factors linked to the GFC have stimulated pensions funds’ demand for high quality assets. Desirable assets may be those which are income-oriented in nature, with revenue streams linked to inflation as well as a desire to hedge out equity risk through diversification. These trends are evidenced by increasing exposure to alternative assets such as real estate, private equity and infrastructure^[18] as fixed income securities have decreased in yield.

Notwithstanding short term economic pressures, infrastructure can form a vital part of pension fund portfolios for a number of reasons, all which are linked to the revenue streams, and more or less conform to the demands outlined above. Generally speaking, long term assets, with stable yields and predictable cash flows, can limit the extent to which the fund is exposed over a long time horizon. This goes hand-in-hand with volatility, which is generally acceptable given the rate of return. This is predicated on the inelasticity of the demand for the product, and the extent to which the  market pertains to a monopoly.^[19] Typical illustrations include water supply systems and road systems, which provide access to otherwise inaccessible geographical locations.^[20] Along with providing relatively stable cash flows, infrastructure returns generally have a low correlation to equities and bonds and are thus potentially beneficial to diversification. Returns may also be inflation-linked if user fees are linked to CPI or GDP.^[21]

The relative newness and associated problems of direct investment by institutional investors is not the only source of their reluctance. JP Morgan identified two underlying concerns for pension funds, relating to returns and regulatory environments.^[22] Fears regarding the consistency of returns, and the extent to which they can remain low risk and positive over a large time horizon can be neither substantiated nor negated due to an absence of historical data. The effects of governments and regulation are other crucial factors, which will form the basis of discussion in succeeding sections.

The investment strategies of pension funds are to a large extent determined by their fiduciary responsibilities, and the stringent regulations which accompany them. The underlying principle is to limit unnecessary exposure to risk. Whilst investment restrictions are often country-specific, the limitations, whether imposed by self-regulation or otherwise, often fall into three broad categories: limits on pension fund investment in selected assets, limits in ownership of foreign assets and other quantitative regulations.^[23]

Canada, Global best practice with Private Public Partnerships and Pension Funds

Somewhat unsurprisingly, the Global Competitiveness Report established that the most efficient and extensive infrastructure could be found predominantly in OECD and high GDP per capita nations.^[24]

Canada, fifteenth on the list, is worth mentioning as its pension funds are some of the most sophisticated globally and have doubled their infrastructure investments (both at home and abroad) over the past five years. Canada has seemingly championed the use of Public Private Partnerships^[25] (PPP) in developing its infrastructure and has achieved global best practice status. Canada has developed a sound structure which ensures “a certainty of process”^[26] and an unsurpassed understanding and sophistication in procurement, bidding and execution of projects. Some funds have accrued significant investment acumen particularly with infrastructure, to the extent that they not only directly invest but have integrated along the value chain, nullifying a need for external consultants.

Australia

Despite enjoying relatively high levels of economic growth and development, Australia remains no exception to global infrastructure challenges. Most of these challenges are related to extending and enhancing aging and pre-existing infrastructure in order to meet both demographic and industrial demands. The cause has been attributed to underinvestment in the 1980s and 1990s. The government suggests that infrastructure capacity constraints have restricted productivity growth.^[27] Such constraints have been linked to the slowing of multifactor productivity to 0.7 per cent a year, down from a long term annual average of 1.1 per cent and far from the 1990s peak of 2.3 per cent.^[28]  Some of the most pressing issues include congestion in major cities along the East coast, reducing reliance on coal-based energy and addressing water-related challenges for a dry continent with a burgeoning population.

Despite decades of strong resource-driven economic growth, underspending on infrastructure has exacerbated Australia’s infrastructure gap. Australia’s current debt levels also present a challenge to government spending, as local politics has articulated a general aversion towards public debt. In spite of infrastructure initiatives, such as an AUD$37 billion national building plan,^[29] macroeconomic shifts including the recent slowing of domestic growth, a Chinese economy now growing at only single digit pace and forecasts of structural reductions in taxation revenue,^[30] suggest government spending may be restricted in years to come. Banks have also expressed an unwillingness to fund infrastructure over the long term, highlighting the need for alternative financing methods.^[31]

The private sector has already been involved in financing infrastructure for some time now, with more recent “best practice” PPP projects being credited as the M7 Motorway in New South Wales (2005) and the Southbank Institute of Technology in Queensland (2008).^[32] Superannuation fund (Australian pension fund) investment in infrastructure is indicative of their appetite for investing in infrastructure both at home and abroad, and their voracity appears unabated.

This private sector enthusiasm has been met with some regulatory reform. The Council of Australian Governments has worked collaboratively with Infrastructure Australia in developing a pipeline of priority projects as well as the development and endorsement of the first National Public Private Partnerships^[33] Policy and Guidelines in 2008.

Although reasonably robust and arguably “one of the best countries for undertaking PPPs”,^[34] recent strategic reviews have unearthed several barriers relating to efficiency and competition. Most notably, the small number of projects and high bid costs (25-40% higher on average than Canada, for comparable projects)^[35] were of great concern. Superannuation funds have echoed concerns regarding an absence of strong deal flow, but have also voiced their concerns in relation to risk apportionment, especially when investing in new infrastructure, as the earlier stages often exhibit greater volatility.^[36] Investors are also wary of inherent long term risks, with toll road investors incurring losses due to overestimations in revenue.^[37] A lack of clarity regarding the responsibilities and obligations of Australia’s various governments has also inhibited a stream of projects, suggesting that a clarification of both the federal and state governments’ roles and priorities is much needed.^[38]

Sub-Saharan Africa: Basic Infrastructure needs

Sub-Saharan Africa’s situation stands in stark contrast to Australia’s, with infrastructure often inadequate, obsolete, poorly maintained or absent altogether. The region’s infrastructure gap, estimated at $45 billion annually,  reduces growth by as much as 2%.^[39] The inhibiting effect of the infrastructure gap on productivity is comparable with weak governance, extraneous regulation and poor access to finance. The social cost is equally astounding, with 70% of the population without access to electricity and the vast majority of the rural population without sufficient roads.^[40]

Whilst basic infrastructure development is required across the board, much of the present investment has come from mutually beneficial relationships related to commodities and resources, with China playing a key role in developing some of the commercial infrastructure via Joint Venture or PPP. This process has been problematic, with case-by-case frameworks and unclear laws, prompting calls for a stable, universal framework.^[41]

Other serious concerns are also apparent. In addition to atypical project risks, there is also an absence of investor protection and fears of governmental interference. These problems are all compounded by a lack of transparency, a seemingly endemic barrier to investment in many developing nations. Perhaps most obviously, the sheer lack of public funding, and private sector reluctance to invest given the risk levels are likely to persist until robust solutions are found.

Whilst the situation looks dire and an inevitable cycle of poverty pervasive, the $121 billion of private funding between 1990 and 2011 in sub-Saharan Africa coupled with growth rates of 5% illuminates the way forward and is indicative that with effective frameworks, greater involvement by the private sector is not unattainable.^[42]

Solutions to the Gap

The infrastructure gap cannot be bridged by pension funds alone. Reforming the environment within which investment can occur is a good starting point and is of paramount importance.  This essay reiterates the need for policy actions whereby frameworks are politically supportive of long-term investing, generate strong deal flow and robust cooperative risk-transfer mechanisms. Transparency of projects is also necessary, for ensuring the longevity of investment. Frameworks should focus on addressing these overarching problems, rather than tailoring the solutions to pension funds specifically.^[43]

Australia

Australia is well ahead of much of the world in terms of engaging investors in PPP projects, but this process is not without its problems. A clarification of jurisdiction, at federal, state and local levels, will precipitate the development of a clear, strategic and consistent pipeline of bankable projects, which will yield the greatest economic and social benefit. This goes hand-in-hand with the aforementioned transparency requirements, and desires for better risk apportionment. Despite declarations by fund managers that the infrastructure shortages can be solved by the larger superannuation funds,^[44] there is scope to investigate new vehicles through which infrastructure investment could occur. One such proposal may be a reintroduction of tax-advantaged infrastructure bonds.^[45] The tax-advantaged nature of these bonds will add an additional enticement to prospective investors who are presently unable to participate in direct investment. With regard to superannuation, this will also provide an investment avenue for the AUD$496 billion locked in Self Managed Superannuation Funds (SMSF).^[46]

The role of the IMF?

These cases have illustrated how widespread the infrastructure gap truly is, and that it encompasses many complex elements for both the developing and developed world. The strong evidence in support of infrastructure eliciting better life outcomes provides sufficient scope for the IMF to link certain infrastructure projects with pursuing Millennium Development Goals, most specifically ‘breadth and sustainability of growth’.^[47] As such, it is imperative that the IMF’s Technical Assistance division work closely with countries to develop and finance strategically important infrastructure. The IMF has the capacity to play a fundamental role in assisting the world build the most necessary infrastructure.

Traditionally the IMF has played a role in financing some infrastructure through their lending programs, but this essay would advocate greater and more specific participation by the IMF on a few levels in responding to calls for more innovative funding methods.

By developing a list of globally strategic and important infrastructure, especially in the developing world, the IMF may be able to align some of their goals and objectives with specific infrastructure projects.  This could be done in a number of ways. The IMF could, for example, be able to facilitate and incentivise private sector investment in challenging investing environments through the provision of risk guarantees in collaboration with the World Bank Group’s Multilateral Investment Guarantee Agency (MIGA), which may not presently fall within their existing mandate, or expertise. This risk mitigation and apportionment could be facilitated by the IMF’s own balance sheet, by way of cash guarantees, soft loan (below market interest rate) or even equity up to an agreed level that delivers an effective project over a long horizon.

These less stable environments may also require ongoing oversight and monitoring to ensure transparency and adherence to best practice. There is scope for the IMF to provide services to inadequately equipped public sectors throughout the lifecycle of a project, including the planning, transaction and operations phases of a project.

Applying IMF Solution to sub-Saharan Africa

The IMF’s Technical Assistance is likely to be welcomed by both the private sector and the governments of the sub-Saharan region. An expert division from the IMF’s Technical Assistance division could be used to develop a strategic pipeline of projects. These could be projects central to economic development such as water systems, or those directly linked to core industries, which produce the highest economic multipliers. Assistance could also encompass the facilitation of the projects, strongly emphasising a need for transparency and long term commitments from both the public and private sectors. Some governments may indeed have sufficient knowledge and skills to execute PPP deals successfully, but having the IMF’s Technical Assistance as an option may circumvent several concerns. The IMF may be able to assist in how investors can participate in such projects. There may be tax-advantaged bonds (to induce the more risk averse investors) or scope for indirect equity participation.  There may be scope to investigate the IMF’s capacity to induce investment by harnessing its own funds to provide guarantees over particularly volatile stages of projects.

If the IMF can alleviate numerous concerns regarding the risk associated with investment in sub-Saharan Africa by being an active participant, strong growth rates are likely to put the region on a path to sustainable economic development and self-sufficiency.

Conclusion

Although fixing the world’s $57 trillion infrastructure problem is a gargantuan challenge, the private sector is well positioned to play a central role in solving this problem. Infrastructure has potential to become a sound addition to an investment portfolio, as it contains many desirable characteristics. There are an array of direct and indirect methods in which the private sector already engage in infrastructure investment, but pension funds have been identified as one investor group well suited to direct investment in infrastructure (by PPP or otherwise). Canadian pension funds have demonstrated the success of such deals and are considered the global benchmark. Similarly, Australia has a reasonably successful PPP model, yet a number of factors have contributed to uncertainty in the market which has culminated in a lack of investible projects, despite the availability of finances. Contrastingly, sub-Saharan Africa’s challenges are more severe as insufficient or absent infrastructure has no clear financing solution. Solutions which focus on mutually beneficial scenarios for both the public and private sectors are likely to elicit the greatest outcomes. National reforms are likely to play a large role, but an extrapolation of the IMF’s Technical Assistance division may see a more effective use of their funds and the facilitation of greater private sector involvement. Holistic solutions will not only require the private sector, but the collaboration of governments at all levels.

Nicholas Taylor, 21, is a Bachelor of Commerce (Finance/Management/Marketing) student at The University of Melbourne’s Faculty of Business and Economics. He is a former Head Delegate at the World Model United Nations and is a past participant of the Global Young Leaders Conference. He was a Global Voices delegate to the World Bank and IMF Annual Meetings in Washington DC in 2013. This paper was written as part of his Global Voices fellowship.