In the last week, the Productivity Commission released its final report into Public Infrastructure in Australia.
The report covers a wide range of issues that both public and private stakeholders face in relation to infrastructure. The issues covered range from industrial relations, the cost of construction trends to financing and bidding issues.
This article focuses on some of the financing and bidding issues discussed in the report:
- "user-pays" model of infrastructure financing;
- relaxation of requirements that bids be fully funded;
- inverted bid model; and
- corporate bond market as an alternative funding source for projects.
Increased use of "user-pays" models
The Commission strongly supports user-pays structures for infrastructure projects (particularly PPPs), noting that projects which derive their revenue from user charges (such as tolls or fares) do not need to be financially supported by the procuring government and therefore will not appear on its balance sheet or affect its credit rating.
The Commission found that despite some past project failures (such as a number of road tunnels in NSW and Queensland) there is no shortage of investor interest in such projects. In relation to the bank market and toll road projects we query this statement by the Commission: banks generally remain reluctant to take patronage risk or construction risk on new toll road projects.
However, user-pays models do not work for all projects. The Commission accepted that there are circumstances in which this model unreasonably allocates risk to the private sector. It noted that availability payments could, in some circumstances, more appropriately align risk to the government than the private sector. An example of this is a project that involves sovereign risk or where a significant public benefit is derived primarily from the existence of the asset and not necessarily from its actual and regular use.
No fully funded bids
In relation to the generally accepted process that bids for infrastructure projects be fully funded, the Commission noted that many participants in the infrastructure sector have challenged this requirement.
The reform proposed by the Commission is to have the funding arranged after the preferred bidder for a project has been selected. The logic underlying this approach is that the preferred bidder could then procure its finance from a wider set of financiers, which could include the bond market (discussed below). Economic benefits may also flow if (as expected) there would be increased competition among the banks, an end result being that potentially the costs of financing would be reduced. Banks may also support this proposal because it would mitigate time/money risks of supporting an ultimately unsuccessful bidder.
The Commission pointed to the obvious risk that if a preferred bidder subsequently failed to secure funding, the government would then be put to additional expense by having to re-engage with unsuccessful bidders. In the current market we consider this to be a low risk for most projects (knowing that that a sophisticated analysis of bidders would also consider their ability to consummate funding requirements). It suggested that to mitigate risk, bidders (as part of their bid) could submit a bond which would be called upon if, after selection, the preferred bidder failed to secure financing. This is not an unknown concept in other parts of the world: in Canada, as an example, bid bond requirements from government are routine. We would expect bidders to require the sizing of these bonds to be capped, to avoid exposing bidders to unquantifiable losses. In any event, we imagine bidders would prefer the option of arranging financing as part of submitting their bid, to prevent their having to lodge a bond and/or the risk of the bonds being called.
The Commission has recommended that governments undertake pilot programs to test this proposal. We would expect that if governments did trial this proposal, they may test such an approach on smaller conventional projects.
Inverted bid model
As a further extension to the unbundling of fully funded and contracted bids, the Commission explored the inverted bid model. In that model, as a first step and even before the structure and design of a project is settled, the government runs a competitive bid process first to select a preferred sponsor. Once preferred, the sponsor then conducts tenders for the D&C, O&M, financing and other components of a project.
While this may appeal to both contractors and financiers because they are submitting bids to a preferred equity provider, the Commission stopped short of issuing a recommendation to pursue this model, noting that debt finance and competition among contractors plays an important role in ensuring that competitive tension is (and relevant price benefits are) maintained for greenfield projects. If the sponsor is selected before the project is sufficiently detailed it may result in a cost of capital contest and, if the sponsor has a guaranteed IRR, this may undermine any incentives for efficiency.
The Commission said that there was some merit in the inverted bid model and suggested a hybrid approach in which, before taking the project to the sponsor market, government could specify certain structural elements, such as the duration of the concession period and a robust equity IRR mechanism which could adjust the equity return as the project progresses.
The bond market
The Commission understood there is a strong perception that the bond market in Australia in infrastructure is not currently being fully utilised (project-specific bonds have not been used as a significant source of government financing since the 1990s) and that following the GFC bank debt has been the predominant source of debt capital.
The Commission also analysed the corporate bond market and discussed whether this market could be used as an alternate way for private sector infrastructure partners to raise capital. It offered some explanations for why the Australian corporate bond market for infrastructure was shallow, and pointed to some existing regulatory reforms (such as the list of fixed income securities on the ASX) which could assist in deepening the market. The Commission stopped short of suggesting any new proposals designed to facilitate access to this funding pool.
The next step will be to see how each of the State and Federal Governments implement these recommendations in their upcoming projects. We will keep you informed.
You might also be interested in...