Project financing: challenges, trends and future opportunities
Flavia Micilotta is the Director of ESG Solutions at TMF Group
The current global economic climate is leading to in an increase in opportunities for project finance in general terms. In order to capture those opportunities at best, development finance players need to take into account a series of different parameters that have impacted, and will continue to impact, their structure and their ability to have a meaningful role.
We will debate the extent to which elements around the pure structure of projects and their set-up can influence the results, as well as the management of risk. Another issue we will touch upon is the extent to which sustainability represents an opportunity for development finance.
Indeed, sustainability today is a much needed and strategic tool that has a number of ramifications that are bound to bring a wealth of changes in project finance.
The type of participants and their involvement in project is an issue that sometimes is overlooked but its relevance is coming back in full force as the industry comes under scrutiny to become more efficient and less prone to unplanned risks.
There are quite a number of real challenges when opening up structures to different players and while forming more rounded syndicates for projects in global markets, particularly in those deals that are structured without any development finance institution (DFI) partners.
The absence of development banks can for instance create questions about the embedded political risk of projects that aren’t backed by the development banks that are traditionally seen as important in validating projects in various jurisdictions.
Partnerships with governments, DFIs and other multilateral organisations are gaining heightened importance, but the most vital partnership to be forged is with private capital: commercial banks, institutional investors and even private equity.
Institutional investors are emerging as a particularly liquid source of capital for infrastructure projects. Investment provided from insurance groups, pension funds, and asset manager funds is often naturally aligned with the long-term investments that are deployed to cover the operational phase in project financing (typically tenors of between seven and 25 years, depending on the deal structure and industry).
This leaves commercial banks to cover the financing of the development and construction phases, which is not only much shorter (one-to-three years) but also implies more risk.
While some generalities can be drawn between different types of investors and their risk sensitivities, there is not a single, simple partnership model that can be followed as a default option. Each project needs to be tailored and able to meet the specific available pools of liquidity and expertise, particularly when structuring both debt and equity portions within individual deals.
Several of the larger private equity managers have also taken up the infrastructure mandate, providing a vehicle for institutional investors to invest in without having to manage or oversee the products directly.
The private sector and institutional investors are increasingly looking to diversify their exposure to long-term finance. But the issues around long-term risks often need the involvement of multilateral development banks to provide the guarantees that allow project risks to be viably priced (as well as often co-financing with their own capital) creating an acceptable risk/reward profile for private investors to enter the deal.
This also has practical implications for those facilitating project financing. Greater plurality in syndication creates complexities in aligning the economic and risk control requirements of all players – particularly when incorporating domestic and international players.
Understanding the legal framework (trust-based or otherwise, or specific financial contracts such as Islamic structures) is also a critical aspect to safeguard that deal risk can be successfully passed to the private sector.
The last social and developmental crises have certainly created ample pools of opportunities for the international community, especially in the less developed parts of the world, where demand and needs for better infrastructure systems to support groups in need of basic services have continued to increase.
This need was also steered by an overpowering drive from the private sector to be recognized as catalyst for positive change in development economies and therefore emphasised their willingness to be involved in several relevant projects. This growing pipeline – daunting enough in scale – presents a further challenge by needing to meet sustainable construction requirements.
Sustainability today is a much needed and strategic tool that has a number of ramifications that are bound to bring a wealth of changes in project finance
As a result, the most striking common denominator in the investment panorama ended up being a complex set of challenges requiring greater emphasis on partnerships able of delivering a pipeline of projects that are highly needed in less developed and emerging markets and that are also able to meet a number of characteristics.
Furthermore, heightened fiscal constraints started having a material impact on development banks’ abilities to simply underwrite the majority of a country’s project finance needs. The consolidated public sector primary deficit is expected to worsen in 2023 and the debt-to-GDP is close to 80%.
The pandemic has greatly increased the requirements of the projects, and have become particularly challenging to those thinning aid budgets. DFIs are increasingly also faced with the challenge of not igniting an uneven and divergent type recovery, leaving some countries behind.
At the same time they will need to meet the extra sustainability/green requirements which are today an omnipresent requirement for all types of financial market participants. In short, they will need to demonstrate their ability to support a recovery which is ‘low carbon, climate resilient, inclusive and just’; as well as make investment to strengthen healthcare supply chains capable to withstand future crises and pandemics.
A worthwhile example of this practice happened already in February this year, when DBSA raised €200 million through a private placement with French development finance institution, the Agence Française de Développement (ADA).
The transaction, structured as a green bond, finances projects that contribute to climate mitigation and/or adaptation, and that are aligned to South Africa’s ‘National Development Plan’ objective of an ‘environmentally sustainable and equitable transition to a low carbon economy’, as stressed in the Country Climate and Development Report (CCDR) published in 2022.
This report highlights South Africa’s willingness to develop policies and investments to achieve a ‘triple transition’ that is low-carbon, climate-resilient and just’. This trifold vision depicts the high-level of ambition as the country embarks on this journey.
Meanwhile, in developed markets – such as the continental EU – supranational banks (eg. EBRD and EIB) continue to be selectively active in pursuing project financing. In contrast to the challenge in Latin America and Africa – funding enough capital to green-light a swathe of attractive developmental projects – the Europeans’ challenge is a lack of attractive investment opportunities in EM within its region.
The search for diversification and yield has led several institutional investors focusing to make allocations to infrastructure. While this trend has continued it has supported governments’ efforts to mobilise institutional capital for sustainable and resilient infrastructure investment, in order to address the need to renew or build infrastructure, especially in emerging markets most in need of such projects.
The attractive positives that can originate from infrastructure investments need to be carefully balanced out particularly with a certain kind of risks, which, if not carefully managed and mitigated, may ultimately impact the performance of an asset and the rate of return for investors.
These are sustainability, also referred to ESG – risks, particularly focused on Environmental, Social and Governance criteria, that today are inherent in most investment analysis and that have crucial interdependencies and impacts on results.
Sustainability is clearly able to give rise to new opportunities as we witness increased rapid growth in demand and supply of sustainable finance solutions. There are, nonetheless, significant type barriers to effectively channel capital to sectors within countries that need it the most.
For instance, in 2021, only about 21% of green bond issuance originated from emerging markets, with Least Developed Countries (LDCs) being largely left behind. Moreover, the majority of the investment interest has been focused primarily on mitigation-related financial risks which can overlook the need for climate resilient aligned finance needed to adapt to and manage the physical risks from climate change.
Sustainability means also addressing needs that go beyond climate change. There is increasing attention towards other urgent environmental crises and their links to finance, including primarily the global loss of biodiversity and ecosystem services.
The rate of species extinction is accelerating; an IPBES report finds that around 1 million animal and plant species are now threatened with extinction, which represents a significant economic loss. The OECD estimates that ecosystem services provided by natural capital assets offer expected benefits between US$125-140 trillion per year.
These considerations and relative benefits need to become part of valuations within financial markets. There are already some notable examples being spearheaded by Central Banks both in Europe and other continents (the Netherlands, France, Mexico, Brazil, and Malaysia), which are leading the way by undertaking initial assessments on biodiversity-related financial risk.
Infrastructure investments that cover structural systems like healthcare, water transport, and energy have in themselves already a strong ESG component because the investments they underpin have strategic bearing on livelihoods and essential economic rights.
Apart from having an inherent ESG potential, such investments are also quite prone to ESG risks such as extreme weather and climate related events, disruptions due to poor maintenance and mismanagement, their potentially adverse impacts on local communities, etc.
These characteristics need to be carefully considered by investors such as pension funds or insurance players in order to be able to anticipate and preferably avoid those risks altogether.
ESG factors can present risks across the infrastructure lifecycle – from the pre-construction phase through to the operational phase – and present challenges for all the stakeholders involved, though particularly for investors. Important considerations are also to be made around those more indirect and ‘ESG related’ risks that impact the investment cycle and which pertain to regulatory, legal and reputational risks as well.
Several international standards and tools have been developed in order to integrate sustainability into infrastructure development and integrate ESG considerations in infrastructure investment analysis. These typically cover a broad spectrum ranging from sustainable to impact investment.
Among the most used ones we find: the Sustainable Development Goals (SDGs), the IFC Performance Standards, Sustainable Accounting Standards Board (SASB). The characteristics and specificities of the investment typically determine the framework selection. The SDG framework is of the highest relevance given the potential of the goals for sustainable development and their close correlation to infrastructure projects, which are linked-in to most goals.
In truth, aligning infrastructure projects to SDGs help unleash the sustainability potential of the investments while crafting valuable synergies across stakeholders which can originate stable and innovative private public partnerships.
Indirectly ESG also spells out another variable linked to transparency and accountability. In an update report published last month a debate has opened towards the need for Development Finance Institutions (DFIs) to increase the level of transparency on what and how they fund projects.
This could significantly improve the scale and attempts to crowd in private capital judging by the results presented in the latest update on concessional finance and the private sector involvement.
The report1, involving the International Finance Corporation (IFC), African Development Bank (ADB), European Investment Bank (EIB) and the Association of European Development Finance Institutions, found that in 2021 DFIs financed long term projects with a total volume of US$13.4 billion supported by blended concessional finance. The report shows that no significant level of increase of private sector finance was registered as part of concessional funds committed to DFIs projects.
Nevertheless, the report might not be giving a full picture of how much DFIs have mobilised from private third-party financing. It has been reported by external sources that the private mobilisation figures did not include any DFI own-account funds, or any public funds.
Because sponsor contributions are not collected as a separate item, it is not possible to determine what percent of the private mobilisation numbers are due to sponsor contribution and what percent are due to bank finance or other finance.
More transparency about the origins of the contributions and the dataset around the investments and what they can deliver could help significantly in terms of bringing blended finance to the fore as a major opportunity also for private investors (large pension funds) who might not be considering these possibilities today.
Endnote
1. DFI Working Group on Blended Concessional Finance for Private Sector Projects JOINT REPORT, MARCH 2023 UPDATE
