Corporate Governance Issues in Infrastructure Finance

1. Corporate Governance Issuesin Infrastructure Finance World Economic Forum - Financing for Development Workshop Tuesday - Wednesday, March15 -16, 2005 Hong Kong J. Robert Sheppard, Jr. projfin@bellsouth.net

2. Infrastructure Finance vs Corporate Finance • Typically, most corporate governance issues concern publicly-held corporations, but most infrastructure projects are financed using: • Special purpose, project-financed entities • Subsidiaries of foreign corporations • Joint ventures between major corporate partners • Corporations that finance new investments using their own balance sheet may engage in a wide variety of businesses, but infrastructure firms are typically limited to one line of business • Corporations that finance new investments using their own balance sheet offer products or services that vary across a wide spectrum of price and features/quality, but infrastructure firms typically offer products or services that are: • Regulated so as to reduce possible pricing strategies • Standardized with respect to features and quality J. Robert Sheppard, Jr. projfin@bellsouth.net

3. Infrastructure Finance vs Corporate Finance • Decisions regarding new investments are hidden from public view when new projects are financed using the corporation’s balance sheet: • Project costs may not be disclosed • Rates of return for individual projects are unlikely to be disclosed • Decisions regarding new infrastructure investments can and should be made publicly • Standards for service are public • Regulatory regime is a governmental activity • Competitive bidding processes can be widely used • Operating period inputs for infrastructure can sometimes be benchmarked to publicly-available indices • Conventional, broadly available technology for most infrastructure services permits meaningful comparisons of cost among different countries and time periods J. Robert Sheppard, Jr. projfin@bellsouth.net

4. Non-Transparent Costs of Infrastructure Finance • Risk premium for fixed-price construction contract that includes performance guarantees • Typical form of contract used to arrange non-recourse financing for privately-financed infrastructure projects • May be necessary for projects sponsored or owned by host-country governmental units • Risk premium for infrastructure project financing • Project-financed entities command a premium compared to corporate borrowers issuing comparably-rated debt of the same tenor • Host-country lenders may require a larger risk premium for non-recourse financings than lenders in US or European markets • Country-risk premium applied for financing arranged in international markets • Tenor of project financing is one of the most significant factors affecting cost of service • Available tenors may vary significantly depending upon financing approach • Where financing is arranged by private supplier of infrastructure services, public knowledge of financing arrangements may be very limited • Revised project economics following a restructuring occasioned by financial distress • It is important to distinguish between increased project costs based on risks borne by third-parties and increased project costs resulting from above-market equity returns J. Robert Sheppard, Jr. projfin@bellsouth.net

5. Regulatory Regime Considerations • Risk allocation, objectivity of service standards, and tariff adjustment mechanisms can significantly affect: • Required returns of infrastructure equity investors • Risk premium demanded by domestic and international lenders • Risk allocation and specification of standards of service: • What risks are private investors required to bear? • Are these risks controlled by the private investor? • Can they be hedged, insured or otherwise transferred to a third-party? • What penalties are applied for a failure to meet required standards? • Are penalties financial only or do they threaten loss of a concession or franchise? • Do the penalties adversely affect only equity returns or do they also threaten the interests of project lenders? • Tariff adjustments: • What index or indices are used? • Can anticipated changes be borne by the public? Renegotiation risk? • Ability of tariff adjustment mechanism to reflect changes in project costs? • Existence of hedging, insurance or other risk-transfer mechanisms to cover mismatch risks? • Frequency of tariff adjustments? • Certainty, fairness, objectivity of adjustment process? J. Robert Sheppard, Jr. projfin@bellsouth.net

6. Infrastructure Process Design Considerations • Sequencing of projects can significantly affect success of a development program • Sizing individual projects is important – promote modest size, not mega projects • Average size of international projects has always been significantly larger than for US projects – size increases project-specific risks in situations where country risk is already a concern • Modest-sized projects offer a number of advantages: • Spread risk among a larger number of equity investors • Provide more comparable projects for cost and operational comparisons • Easier to audit • Can more readily enable the host-country to build a track record of success • Use competitive bidding but understand its limitations • A successful track record is the most important factor in reducing the risk premium demanded by equity investors and project lenders J. Robert Sheppard, Jr. projfin@bellsouth.net

7. Competitive Bidding Considerations • Appropriate design of bidding process requires a legal, financial, and engineering consultants • Risks to be borne by contractor, including price and performance guarantees, must be an explicitly-designed component of the RFP • Alternative risk allocation structures may facilitate identification of additional costs incurred by transfer of certain risks to the contractor • Alternative risk allocation structures can also lower expected project costs • Ensure competitive bidding or benchmarking of all major project components • Avoidance of new technology is easy in most infrastructure projects and will promote a broader market of bidders and verifiable cost estimates, as well as reduce project risks • Benchmark standards for costs to be borne by the public, such as fuel costs • Eliminate cross-subsidy opportunities, e.g., contractors that are also fuel suppliers, etc. • Structure tariff adjustment mechanisms that facilitate long-term financing and that ensure that an appropriate portion of benefits from cheaper or longer-term financing are passed through to the public • Understand that negotiations with the winning bidder will unavoidable resemble sole-source procurement in many respect J. Robert Sheppard, Jr. projfin@bellsouth.net

8. Success Means…. Aside from adequate service at an affordable price, attributes of success will include: • Declining returns required by equity investors and project lenders – with returns being driven down by a track record of successful projects • The corollary of this attribute is that later projects will make earlier projects appear to have above market costs – even though these earlier projects – at their pricing – were a necessary step in reaching the more attractive later projects • Equity investors who want to re-invest in the host country • Capital markets issues to finance infrastructure projects that maintain investment-grade ratings on a long-term basis • Capital markets debt issued by infrastructure project should be significantly de-linked from the host country’s sovereign rating and should not automatically be downgraded to below investment-grade in the event of an economic crisis that does not directly affect the project • A successful result, not necessarily a pretty process • The history of international infrastructure development includes: • Large public subsidies and many bankruptcies for US railroads in the 19th century • The US nuclear power industry in the 1960s and 1970s • Overbuilding and financial distress in US merchant power and telecommunications in the 1990s • Developing countries can do better but it’s important to ask: “Compared to what?” J. Robert Sheppard, Jr. projfin@bellsouth.net

9. Recommendations for Action • Design a regulatory regime that can survive macroeconomic stress and that will not require renegotiation of project economics after commencement of operations • Require competition, but structure each competitive process to reveal the premium that the public must pay for risk assumption by third parties • Understand the impact of financing costs and tenors on tariffs paid by the public and attempt to reduce the required risk premium and to facilitate long-term financing • Build a track record of successful projects to drive down the returns required by project sponsors as well as local and international lenders J. Robert Sheppard, Jr. projfin@bellsouth.net