Infrastructure Investing: A Primer for African Markets
1.0 A Snapshot into the Infrastructure Financing Landscape in Africa
Africa as a continent requires substantial investment in infrastructure projects to create real and sustained value as these ensure essential processes like industrialisation and urbanisation can be leveraged. However, one of the key questions underpinning this infrastructure challenge is how to finance these projects. Yet, there is a significant vacuum in addressing the mismatch between investor expectations and the actual risk/return profile of infrastructure programmes and projects. New estimates by the African Development Bank suggest that the continent’s infrastructure needs amount to $130–170 billion a year, with a financing gap in the range of $68–$108 billion. Now more than ever, attention is being directed at mobilising, gearing and leveraging finance for infrastructure in Africa. According to the AU’s Agenda 2063: The Africa We Want, the development of local and pan-African infrastructure systems is a key component of the vision set out for the next 50 years of multilateral cooperation.
As a result, flagship initiatives of Agenda 2063 include several infrastructure projects such as a high-speed train network, energy projects and an Africa-wide broadband network. This focus has been reflected on the continent with actual investments which shows a significant growth to date. These investments are being undertaken by a myriad of actors mostly through the public sector but also including private actors. Through aid and commercial financial instruments, these new players are diversifying the actor landscape, and tools used for infrastructure investment. In the public sector, investors include African nation-states, members of the ICA, China, non-ICT bilateral and multilateral organisations, and the Arab Group. Figure 1 below indicates the relative contribution of the different public actors between 2010 and 2017 when data was last recorded by the ICA. It is clear that despite the perception that weak African states are dominated completely by foreign investments, national governments are central players in the sector accounting for between 24% and 44% of spending.
2.0 Defining Infrastructure Finance
Infrastructure finance is defined as the financing of projects or companies involved in infrastructure sectors. It is how governments or private companies that own infrastructure find the funds to meet the costs of developing it. By definition, infrastructure entails the physical and organisational structures needed for society or enterprises to operate. As such, infrastructure investing - at its core - can be defined as the allocation of capital and resources towards the development of these structures to realise profits. The market now exceeds US$100 billion annually, with over a trillion dollars of assets under management and is typically grouped with private equity and real estate in portfolio considerations. However, infrastructure investments tend to provide stable, dependable returns across different economic landscapes including developed and emerging markets.
Conventional infrastructure sectors include social infrastructure such as schools, hospitals, utilities such as water and electricity networks, transportation and energy infrastructure. More recently, newer sectors like digital infrastructure (telecommunications towers, data centres, fibre optic networks) and energy transition infrastructure (e.g., renewable energy, energy storage/efficiency) have gained prominence.
3.0 How to Invest in Infrastructure
A cocktail of strong investor demand for infrastructure and an increase in the deal flow of infrastructure assets has led to a rapid expansion of interest in the sector on the African continent. It has also led to the maturing of the infrastructure to the extent that it can be referred to as a standalone asset class. Primarily, there are three ways for investors to gain exposure to infrastructure investments: direct investment, indirect investments in listed funds and indirect investments in unlisted funds. Table 1 below shows a taxonomy of instruments and vehicles for infrastructure financing.
Table 1: A taxonomy of instruments and vehicles for infrastructure financing. Source: Infrastructure Financing in Africa: Overview, Research Gaps and Research Agenda
Direct Investments.
Direct investments involve the investor directly injecting funds into the infrastructure projects by securing a concession or ownership of the asset. This is to the effect that both institutional and private investors are shareholders of the infrastructure companies. Investors gain direct exposure to the tangible infrastructure without the use of an intermediary. These primarily comprise long-term direct commitment of capital and the management and operations of these assets is paramount.
Whereas this investment strategy is capable of yielding higher returns and rewards, it places a huge operational cost in day-to-day involvement, higher legal and tax complexity, and lengthy planning processes. More importantly, the barrier to entry for most intending industry players is the high minimum capital requirement.
The types of infrastructure projects invested in directly are two: (1) Greenfield projects, and (2) Brownfield projects. It is important to understand each of these types because investors need to gauge the risk-return profile of an investment to determine its viability.
Greenfield Projects
Greenfield projects are new infrastructure projects and they provide a blank canvas, allowing flexibility in planning and the design of the project. On account of their novelty, investors are required to manage both the cost and revenue risks that come along with these projects. On the cost side, risks are in planning, development, the receipt of approvals and environmental permits, and public acceptance of projects. On the revenue side, the risks of greenfield projects constitute fluctuating levels of demand and price uncertainty given the novelty of the project.
The risk-return profile of greenfield projects is incompatible with the risk thresholds or risk-adjusted return targets of most funds, which then limit their investment in greenfield projects and a preference for brownfield projects as they have very little to no construction risk.
Brownfield Projects
A brownfield asset refers to a site or property that has been previously developed or utilised, although it may still necessitate ongoing financial investment and expansion to fulfil its potential. Distinguishing between brownfield and greenfield infrastructure isn't always straightforward, as many brownfield projects involve substantial development and construction activities. These projects often present opportunities for further growth, enhancement, or retrofitting, blurring the lines between brownfield and greenfield initiatives. This distinction has led to the coining of the term "khakifield" transactions, referring to brownfield deals that offer avenues for expansion, improvement, or retrofitting.
Indirect Investments in Listed Infrastructure Funds
Infrastructure Funds and Public-Private Partnerships (PPPs)
Many private equity funds include exposure to infrastructure due to its characteristics of stability, independence from market fluctuations, and potential for sustained returns. An infrastructure fund, specialising solely in infrastructure investments, operates similarly to a venture capital fund focusing solely on technology.
Traditionally, infrastructure development has been the responsibility of governments, especially in sectors like transportation and water. However, with public finances under strain, Public-Private Partnerships (PPPs) have emerged to bridge funding gaps. The private sector's involvement can enhance productivity and performance, enabling private companies to tackle significant projects, and thereby attracting investments from infrastructure funds.
Investing in infrastructure enriches a portfolio by offering both absolute returns and protection against inflation. Since many infrastructure assets provide essential services, they often have contractual clauses or regulatory mechanisms tied to inflation, ensuring their value grows over time. Additionally, these assets possess intrinsic value that tends to appreciate with inflation, providing a reliable basis for measuring investment returns.
Secondly, infrastructure cash flows typically correlate less with other asset classes, whether public or private equity and debt. Thus, incorporating infrastructure investments into a portfolio can diversify risk and reduce portfolio volatility. Thirdly, regulatory frameworks and long-term contracts spanning two decades or more often secure infrastructure revenue streams. This predictability shields investments from market fluctuations, ensuring steady performance over time.
Listed Infrastructure Securities and Infrastructure Debt
Investing in infrastructure provides a well-rounded strategy for managing investment portfolios, and balancing liquidity, stability, and potential returns across different asset classes. While listed infrastructure securities offer liquidity for easy buying and selling, unlisted investments offer reduced volatility and correlation with broader markets, potentially ensuring stability during market downturns.
Private infrastructure debt, characterised by its superior credit quality and lower volatility, appeals to investors seeking stability and consistent returns. Additionally, the premiums for illiquidity associated with private infrastructure debt can be particularly attractive in low-yield environments, while its decreased volatility and default risk contribute to the potential for favourable risk-adjusted returns in the long term.
4.0 Commercial Opportunities in Infrastructure Investing
Renewables and Clean Energy
Renewable energy continues to outpace fossil fuels in cost-effectiveness. According to an IRENA report, maintaining existing coal-fired power capacity will be more expensive than installing new utility-scale solar photovoltaic systems, with up to 1200 gigawatts affected. This shift not only reflects the environmental and social drawbacks of fossil fuel reliance but also signals its growing economic impracticality.
The International Energy Agency (IEA) emphasises the significance of energy efficiency in stimulating economic growth. By ensuring job stability, diversification, and bolstering local supply chains and construction, energy efficiency initiatives enhance competitiveness and affordability while curbing carbon emissions.
A recent report by the United Nations Economic Commission for Europe (UNECE) and the International Labour Organization (ILO) anticipates that the transition to electric transportation could yield 15 million new jobs worldwide, primarily in electric vehicle manufacturing and public transport infrastructure investment. Similarly, embracing smart, circular, and sustainable construction practices, along with utilising eco-friendly materials, stands to bolster employment across the construction sector and its supply chains. Moreover, it can reduce project costs for owners and end-users. Encouraging policies and stimulus packages are vital for promoting the adoption of sustainable construction materials like green cement, further driving growth in this sector.
Transportation
Pre-COVID, capital raised for transport-specific infrastructure funds reached a 10-year high of more than $6 billion, with nine funds closed across 2019, per Infrastructure Investor data. In the subsequent two years, things unfolded quite differently as fundraisers faced challenges in achieving even $700 million, with only five funds successfully closing.
Across the first half of 2023, the sector is again on the rebound. Fundraising for transport-specific vehicles hit $3.6 billion in 2022, as two funds closed, while consumer demand for road transport and air travel has roared back to health. By 2050, global investment needs for land transport infrastructure will reach USD 3 trillion per year on average, under current policies. Today’s investments in transport infrastructure present a unique opportunity to meet growing transport demand and development goals while avoiding “locking-in” emissions-intensive development pathways. Transport assets, such as toll roads, often have revenue models that are linked to inflation.
5.0 Trends in Infrastructure Investing
Sustainability and ESG
Increased shareholder activism and a focus on environmental, social and governance (ESG) considerations have pushed significant pools of capital towards more sustainable projects, as climate change impacts are increasingly being recognised as a key risk for private investors.
As the ESG agenda gains momentum, several worldwide standards and frameworks have emerged to facilitate the integration of climate-related factors into investment decisions. These include the guidelines from the Task Force on Climate-related Financial Disclosures (TCFD) and the European Commission’s recently announced sustainability taxonomy and disclosure regulations, which are designed to formalise investors’ disclosure obligations, create positive carbon benchmarks and minimise the potential for ‘greenwashing’ in the market.
The "Environmental" factors impacting a company include climate change, biodiversity, pollution control, and asset decommissioning. Addressing climate change presents risks and opportunities for businesses. "Social" factors encompass human rights, labour relations, and supply chain management, impacting brand reputation. "Governance" is crucial for management strategy, compliance, and overseeing environmental and social initiatives.
Despite the increasing attention on ESG (Environmental, Social, and Governance) factors, investors often struggle to establish a consistent approach for measuring these metrics across various companies and industries. This inconsistency hampers comparative analysis among peers. Additionally, assessing the value of ESG factors in deal contexts proves challenging, as traditional valuation methods don't align well with these metrics. To address this, investors may benefit from establishing a sustainability framework for comparing potential investments.
Infrastructure funds, often backed by controlling shareholders and with a long-term investment outlook, are uniquely positioned to collaborate with management in integrating ESG values into company culture. This approach fosters purposeful investment and unlocks opportunities such as energy transition, diversity, inclusion in boards, and enhanced financial transparency. Many funds incentivise management accordingly to facilitate this implementation process.
Population Growth
Demographics, both rising population numbers and growing middle classes, have been, and will
continue to be the driving force for infrastructure demand in Africa. Today, Africa’s total population is estimated at 1.3 billion. This implies that over the past 10 years, the continent’s population has grown by 300 million people and that more than half a billion people have been added to the population since the turn of the century. Moreover, the UN anticipates that Africa will be home to almost 2.5 Billion people by 2050, which is almost twice today’s number which translates into a quarter of the world’s population. In fact, since over the past decade, one-third of global population growth has taken place in Africa, between 2020 and 2050, half of all global population growth is expected to be driven by Africa. This exerts significant pressure on the existing infrastructure thus necessitating increased investment in infrastructure development.
Digital Infrastructure Expansion
Digital infrastructure is an often underappreciated investment yet it has enormous potential for Africa. According to the International Finance Corporation, the continent’s internet economy has the potential to add USD 180 Billion to Africa’s GDP by 2025 yet there’s barely any robust digital infrastructure to support growth. This lacuna was greatly exposed during the COVID-19 pandemic as internet usage surged and governments worked to close the digital divide and ensure service delivery to the masses. That notwithstanding, the proliferation of affordable smartphones coupled with the expansion of fibre-optic networks and deployment of undersea cables have created a leap forward in internet penetration, mobile connectivity and the adoption of cloud services.
According to the AU’s Digital Transformation Strategy 2020-2030, it aspires to enable universal access and a single pan-African digital market by 2030, and if achieved, there would be a profound impact on the continent. For example, the World Bank estimates that in Africa a 10% increase in mobile internet penetration could translate to a 2.5% increase in Gross Domestic Product. Yet the digital divide across Africa remains a huge impediment as fewer than one-third of Africans can access broadband connectivity, giving credence to the fact that 21 of the least-connected 25 countries in the world are located in Africa.
Solving the aforementioned challenges is however impeded by a major obstacle: inadequate investment. This obstacle is tackled gradually and some of the most significant investment trends on the continent thus far are discussed hereunder:
a) Fibre-optic cables:
On the entire continent, only three countries–the Central African Republic, Eritrea and South Sudan–lack a fibre-optic connection to the submarine cables circling the continent. It is reported that African countries have rolled out more than 1.389 million kilometres of terrestrial fibre links, approximately 936,000 kilometres of which were already operational in 2018. The 2Africa cable system, which is the largest subsea project, is expected to ring the entire continent with a 23,000-mile-long, high-speed subsea cable, is expected to include 21 landings in 16 African nations and double the continent’s total internet capacity once completed later this year. This notwithstanding, fibre-optic networks have not yet fully penetrated Africa, particularly in land-locked countries and this can be evidenced in the very recent disruption of internet services on the account of subsea cable cuts leading to an outage in West Africa and slow internet connectivity on the rest of the continent. That notwithstanding, a week later, Google announced its project "Umoja” which shall be the first-ever subsea fibre-optic cable directly linking Africa and Australia. This cable is expected to begin in Kenya, snaking its way through several African countries– Democratic Republic of the Congo, Rwanda, Uganda, Zambia, and Zimbabwe– before reaching its final destination in South Africa, where Google’s first ever data centre on the continent is located.
b) Data centres:
As a result of latency issues and concerns over data sovereignty, the tide of data centre localization in Africa is growing. As African countries continue to adopt data protection regulations, there is a growing necessity to store regulated data in local data centres. Currently, Africa accounts for only 1% of global data centre capacity, and roughly two-thirds of that capacity is located in South Africa. For the rest of the continent to match up to a similar density, it would require roughly 700 new data centres of 1,000 MW capacity each.
Therefore, it follows that the continent’s data centre market is expected to grow to USD 3 Billion by 2025. In 2020 and 2021 alone, four major pan-continental deals and investment commitments totalling USD 2 Billion were concluded. Deals such as Equinix’s purchase of Main One (USD 320 million), West Indian Ocean Cable Company’s (WIOCC) investment in Open Access Data Centres (USD 500 million), Digital Realty’s investment commitment to Africa (USD 500 million) and Liquid Intelligent Technologies’ USD 500 million investment into its subsidiary, Africa Data Centres (ADC). ADC received USD 300 million from the US International Development Finance Corporation to acquire and expand data centres and enter new markets, and testament to that promise, has opened a new facility in Johannesburg, is constructing others in Nigeria, Togo and Kenya, with a plan to build ten data centres in ten African countries. Liquid also received USD 259 million worth of investment from the IFC to expand its data centre capacity and roll out fibre-optic cables on the continent. Local telecom businesses including Vodacom, MTN, Rack Centre Nigeria, ADC and Teraco–have been at the forefront of this industry and together own more than 95% of Africa’s data centre capacity. Some international investors have also begun to enter the market. More recently, Microsoft and G42 have inked a deal with the government of Kenya to build a $1 billion geothermal-powered data centre in a bid to boost cloud-computing capacity in East Africa, where power outages are common.
c) Mobile networks:
There has been a significant upgrade in network coverage, mainly from 2G to 3G or 4G networks and network sharing. In 2020, 4G accounted for a paltry 12% of the continent’s mobile phone connections and is expected to grow to 28% percent by 2025. As for 5G connection, only seven commercial 5G networks had been established in five African markets as of 2021.
While data costs halved, average download speeds in Africa doubled between 2015 and 2019. Mobile penetration on the continent is expected to reach 50% with more than 600 million connections, 65% via smartphones by 2025. In turn, average African mobile traffic could more than quadruple to just over 7 gigabytes per month per subscriber, and 5G connections could approach 30 million African users by 2025.
Therefore, we believe that mobile devices will remain the primary method of internet access for people on the continent and better 4G and 5G networks serving these devices shall provide greater bandwidth, lower latency, improved spectrum efficiency and boost the internet products and services available on the continent.
6.0 Risks Linked to Infrastructure Investing
Risk is defined as a case where there is a range of possible outcomes that are associated with an objectively or subjectively ascribed numerical probability. Essentially, it is the measurable probability that the actual outcome will deviate from the expected or most likely outcome. This therefore means that risk is composed of two essential aspects: exposure and uncertainty, exposure being the more important aspect as the recovery rate on say a debt depends on credit exposure and resolution of defaults.
For infrastructure investors, economic losses can be incurred in two ways: either through a reduction of expected cash flows as a result of both macro and micro factors, or through the default of a project counterparty to meet obligations of the investment agreement. However, the various financial instruments linked to infrastructure projects expose investors to underlying infrastructure risks at differing degrees. For the most part, risk mitigation strategies–which may target particular aspects of infrastructure projects such as operations, cash flows or financing channels–either alter exposure to risk and reduce the potential severity of losses, or reduce uncertainty. In turn, these strategies may also increase prospective returns for investors thus providing an acceptable compensation given at the respective levels of risk.
Two cases in point are an investment with a public guarantee on debt and an investment which is insured. The former may not reduce the probability of default, but it alters the exposure to losses by ensuring either a complete or partial compensation of the debt owed. The latter does not reduce the risk of an event occuring, but it does cover the losses that come with catastrophic events which would otherwise jeopardise the realisation of investment returns.
Classification of Risk in Infrastructure.
Risk in infrastructure investing is divided into three broad categories namely: Political and regulatory risks; Macroeconomic and business risks; Technical risk. Before we delve into an explanation of these risks, it is imperative to note that these risks are encountered in the different development phases as demonstrated in Table 2 below.
Source: OECD
Political and Regulatory Risk
Political risk is defined as the risk to infrastructure investments arising from political change or instability. It has been reported that infrastructure investments are prone to political risks as at ex-ante, governments offer strong incentives to attract investment which they tend to strongly renege on these commitments ex-post of infrastructure investment. With respect to regulatory risks, these are risks which are created as a result of government actions such as change in policies or regulations that adversely affect the investments. These may be in blanket format or more specific to certain industries or Public Private Partnerships. Table 2 lists the associated risks at the various stages of the infrastructure project.
Macroeconomic and Business Risk
These risks arise from the possibility that the industry or economic environment is subject to variation. They include macroeconomic variables such as inflation, real interest rates and exchange rate fluctuations. As illustrated in Table 2, the aforementioned risks cut across all the stages of development of an infrastructure asset. The other risks are specific to the development stage. Take for example at the development and construction phases, there are risks of financial availability to kickstart the project. At the operation phase and termination phases, the most preeminent risks on account of default of the counterparty are liquidity risks, refinancing risks and the risk of a volatile market.
Technical Risks
These risks are as a result of the skill of the operators, managers and related to the features of the project, the degree of complexity, and the construction technology deployed. At the first three development stages, there is a risk of poor governance and management of the project, obsolescence of the technology deployed and environmental risks. Down to the development phases, there is a risk of the project being unfeasible in the development stage, construction delays and cost overruns in the construction phase, and a qualitative deficit of the physical structure in the operational phase. Lastly, in the termination phase, there is a risk that the termination value can be different from the expected value.
7.0 Risk Mitigation Strategies.
In the mitigation of some of these risks, the objectives of the risk mitigants and incentives are to correct certain market failures and inefficiencies in the procurement of infrastructure investment and delivery of infrastructure assets by private entities, or in the financing of investments. The most important stakeholder in the mitigation of risk is the government. Through economic development schemes, African governments can help to mitigate the risks described in table 2 with a mix of instruments and techniques.These in turn are expected to provide compensation that increases returns to investors, making infrastructure investment attractive. We explore some of the above mentioned risk classifications and their mitigation strategies below.
a. Political and Regulatory Risk Mitigation Strategies.
First, governments can mitigate political and regulatory risks by creating a favourable investment climate. This can be done through making credible commitments to honour the terms of the respective agreements, developing reliable guidance on development and construction costs and tariff and demand definition and trends. Specifically, this would be more helpful for projects in planning and construction phases. Some of the actions government may take are:
Create a long term plan for infrastructure development with enhanced certainty and social acceptance of novel infrastructure development approaches by:
Enhancing transparency of the infrastructure pipeline
Making feasibility studies reliable
Commiting to giving necessary authorisations promptly
Availing necessary guidance on environmental reviews.
Governments should ensure that there is certainty of rules ranging from public procurement, permits, expropriation, taxation, litigation and tariff determination
Governments should sign bilateral investment treaties and protection agreements that provide international law protection from non-commercial risks associated with cross-border direct investment.
b. Macroeconomic and Business Risks
These risks should ideally be managed by private players both in the PPP projects and under the private projects. Governments may however introduce specific instruments for a specified range of assets, to make infrastructure investments more appealing and financially viable to private investors.
c. Technical Risks
These should be better mitigated through the technical expertise of specialised operators and as a result, generate an incentive when shifted to the private sector. However, archaeological and environmental risks are external to private sector control and as such, could be retained by the public sector without compromising performance. An example is in a PPP concession, where it is expected that the authority is aware of the condition of the designated land for development.
d. Mitigating Risk on Infrastructure Project Cash Flows
Upon the analysis of project risks, the risk management process should identify mitigation strategies of risk on project cash flows. This process is mostly important in project finance since lending facilities are often solely based on the ability of the asset to generate cash flows.
Firstly, well-designed internal risk procedures are one such great option to control the risk by trying to limit its effects on infrastructure. Risk retention as a risk management strategy is more effective for corporations than for Special Purpose Vehicles (SPVs) in an infrastructure investment. The simple justification for this is that it is much easier to diversify operational risk in corporate finance over the entire portfolio of real assets managed by the firm. This is however different in SPVs as it is only dedicated to a single project.
The other risk management strategy is risk transfer. This is the most used strategy in project finance and is based on an intuitive principle. In this strategy, key contracts signed by the SPV such as agreements with regulatory authorities, supply, purchase and others, allocates rights and obligations to the SPV itself and to its respective counterparties. The contracts can then be used to mitigate business risk if the counterparty who is in the best position to control and manage risk is considered responsible for the effects of the risk occurrence on project cash flows. In the event that the risk occurs, some form of indemnification must be paid to the SPV. If a risk arises and it has been allocated to a third party, this party will bear the cost of risk without affecting the SPV or its lenders.
e. Risk Mitigation Instruments and Techniques that can be Deployed by the Government
In this section, we explore the specific policy actions and tools that may be employed by governments and where necessary, the private sector, to mitigate risk and attract capital into infrastructure projects. We group these actions into six main categories and are specifically poised to eliminate the demand risk, increase or stabilise cash flows and sustain the projects’ bankability. Each measure is then articulated in specific instruments. Table 3 below summarises the measures and instruments.
Source: OECD.
We explain each of the measures in table 2 above in detail hereunder:
Public Sector Guarantees
These are offered in many forms such as credit guarantees on debt instruments, revenue guarantees, or export credit guarantees and may be disbursed either by governments, or sub-sovereign entities like Multilateral Development Banks.
One such guarantee is a minimum revenue guarantee (MRG). This is suitable for projects considered commercially viable, but when uncertainty about revenue substantially reduces the available financing. Under this guarantee, the amount of revenue usually covered under it is the amount necessary to cover debt payments. However, an MRG may not be appropriate if it is clear that the project cannot generate enough revenue to be viable.
MRGs can be used for transportation assets such as toll roads where high traffic uncertainty may make the project unattractive to long-term investors since they assume a credit exposure to the guaranteeing authority. To alleviate this, certain tariff subsidies such as those on user fees by contracting authorities are given. In effect, this boosts revenue but unlike in an MRG, the project company still bears usage risk.
Besides MRGs, public entities can issue guarantees, letters of credit, and insurance contracts on infrastructure finance instruments. These credit guarantees are packaged in two main forms: full credit guarantees (FCG) (wrap guarantees) and partial credit guarantees (PCGs). As for the former, FCGs cover the entire amount of debt service in the event of default, or the entire amount of specific tranches of debt. Turning to the PCGs, these cover a portion of debt service up to a certain amount in the capital structure of an SPV. These are also known as pari-passu guarantees, where private lenders and public sector guarantors share in credit losses up to the guaranteed amount.
Private Sector Insurance and External Credit Enhancement.
These are similar to public guarantees and come in many forms including revenue, credit on debt instruments (wrappers) or insurance against political and regulatory risk, but are mainly provided by private actors. The distinction however, is the manner in which payments are settled. The process is rather straightforward and payments are disbursed quickly unlike the long procedure in the public guarantees.
Insurance contracts are useful in the mitigation of exogenous risks and uncertainties that are difficult to price into infrastructure finance. Risk such as sovereign risk, force majeure and project related political and regulatory risk can be mitigated by insurance contracts.
Hedging: Derivative Contracts
Derivatives such as swaps, forwards can provide flexible alternatives to alter the payment profile on debts. They can be used to hedge certain interest rate exposures and facilitate long-term planning security of future cash flows. Just like insurance, the buyer of interest rate protection pays a premium to hedge risks.
Also, key in African infrastructure projects are currency derivatives such as swaps, forwards, futures or options to reduce financial risks in infrastructure by hedging currency exposures. These instruments help fix the possibility of a mismatch occurring between revenues and liability payments. Moreover, derivatives can be used to hedge market exchange rate fluctuations and convertibility risks.
Credit derivatives such as credit default swaps (CDS) can hedge credit risks borne by both debtors and creditors on a particular project. CDS work like a type of insurance where the buyer of a CDS contract pays a premium to hedge an event of default.
Contract Design: Availability Payments and Off-take Contracts
Availability payments are used by governments in cases where the underlying infrastructure asset does not offer predictable direct revenue. A case in point is when end users do not pay for the use of a public facility via a user fee, but rather via the tax pool. In such a situation, the contracting authority pays the counterparty for the provision of the facility, and the availability payment is complemented by deeds paid by a public entity to ensure delivery in the event that a private entity is contracted to maintain and operate the facility.
Such payments are normally used in the social infrastructure sector for example hospitals, schools and social housing plans. However, they can also be used for economic infrastructure when the end user does not pay a usage fee (some railways, roads). Demand risk is thus assumed by the public authority from the private partner. In such instances, “shadow tolls' '--which are a payment agreement where the user does not pay directly for the usage of a facility, but the private company responsible receives payment from a public authority based on usage volume–are used.
With respect to offtake contracts, these are contracts that allow the project company to supply output at a pre-agreed price, which can help to reduce future revenue uncertainties. They are mainly used in power & water generation and any other infrastructures that “produce” outputs. The economic rationale for this form of contract is not only to mitigate risks, but also to deal with the monopoly position of companies that provide utilities. Furthermore, In addition to limiting monopoly power, another significance of offtake contracts is that they lock-in an agreed upon rate with regulators, thus protecting the value of the infrastructure investment from the depreciation that comes with difficult economic headwinds.
Provision of Capital
Capital provided by governments or MDBs plays a significant role in mitigation of risks by making equity or debt available to virtually all infrastructure sectors for investments alongside private players, and by offering favourable financing terms to investors so as to avoid the high levels of leverage.
Moreover, properly financed projects that use a mix of debt and equity without excessive leverage can effectively mitigate many technical and market risks as discussed above. For example, debt instruments with amortising structures can reduce refinancing risk, equity or debt instruments issued below market rates can enhance profitability, in effect offsetting some business and macroeconomic risks. On the political and regulatory risks side, MDBs that offer credit support through subordinated and mezzanine debt can mitigate such risks given their sovereign immunity from the jurisdictions of national courts and systems.
Grants and Taxation
While not a risk mitigation instrument per se, a grant can reduce or offset objective risks in project finance but does not eliminate risks entirely. By definition, a grant is a payment made by the contracting authority to the entity executing the project free of charge or subject to a concession or other type of fee and are typically paid out at any time during the project life-cycle, thus reducing the financing costs during the development and construction phases or even stabilising revenue in the operation phase. Normally, they can be lump-sum payments, tied to project revenues or also tied to certain milestones to be achieved within the lifecycle of the project.
Taxation is also another powerful tool used to increase the attractiveness of an infrastructure investment. Significant reduction or waiving of property taxes on investment revenues can subsidise projects throughout their lifecycle. In effect, taxation as a fiscal tool has the capacity to either enhance revenue directly, or reduce outlays needed at project inception.
8.0 Conclusion
In conclusion, there is still a lot that needs to be done by African governments and private players to improve the infrastructure investment climate on the continent and close the existing infrastructure gap. We believe that the continent is still very much alive to nascent ideas in infrastructure investment and new strategies which can be ably deployed by the investors as aptly discussed in this article.