Private ­Financing of Public ­Infrastructure through PPPs in Latin America and the ­Caribbean Executive Summary Catiana Garcia-Kilroy Heinz P. Rudolph Executive Summary  1 Executive Summary F inancing public infrastructure is an impor- ongoing promising legal reforms and financial inno- tant challenge in the growth agenda of vations for infrastructure finance in the LAC region, the Latin America and the Caribbean as well as in AEs and other regions. (LAC) region. Subject to fiscal constraints, many countries in the LAC region have been looking at Only a few countries in the region have finan- private sector financing as an alternative for financ- cial sectors and capital markets with the level ing public investment. With different degrees of of maturity to support the financing of PPP success, countries in the region have been using programs. Only large- and medium-sized coun- Public-Private Partnerships (PPPs) since the late tries with a minimum level of financial development 1980s. Although the needs of investments in public would be able to afford PPP programs broad in infrastructure vary by country and by sector,1 it is scope and in local currency. This situation contrasts clear that public resources might not be enough. While public infrastructure will continue to be largely with other smaller countries of the LAC region, financed by the public sector in the LAC region, where the financial sector and capital market might significant room still exists for private sector financ- have only the capacity to finance some flagship ing of public infrastructure. In advanced economies infrastructure projects, at the most. The problem is (AEs), such as Australia and the United Kingdom, not only the size of the local financial markets, but PPP projects account for 10 to 15 percent of overall also their level of sophistication and the structure of infrastructure investments.2 incentives to invest in long-term assets. This report analyzes the challenges and policy International financing and development finance options to increase private sector financing in institutions (DFIs) are important complements public infrastructure in the LAC region through to domestic markets. PPP projects benefit not only PPPs. Given the diversity of LAC countries, the from the resources that international banks bring, report takes a conceptual approach and analyzes but also from the technological transfer, especially the different alternatives of private sector financ- in the area of project finance. The report highlights ing of public investments that different groups of that domestic banks in most of the countries in the countries can utilize. This approach also takes stock region have deficiencies in this area, and partner- of the different status and degree of institutional and ships with international institutions are a good way financial development in LAC countries in light of of improving the standards and bringing efficiency to the cost of funding. In addition, DFIs may play 1 See Fay and Andres (2017). an important role in countries with smaller financial 2 See McKinsey Global Institute (2016). sectors and unsophisticated capital markets. Far 1 2  Private Financing of Public Infrastructure through PPPs in Latin America and the Caribbean from becoming the sole lender of PPP projects, the risk assessments, the main risks in well-designed role of DFIs is to help address market failures and PPP frameworks should be properly identified and provide a catalytic role that may enhance participa- priced. tion of domestic and international investors in the financing of domestic public infrastructure. The higher cost of financing PPP projects compared to public provision reflects a mecha- A solid infrastructure finance agenda in LAC is nism of financing based upon the strength of dependent on a decoupling from the political the project cash flows and a more complex cycle and creating strong PPP institutional and financing structure, where risks are priced and financial governance arrangements. This agenda diversified. Conceptually, the all-in economic cost, requires reforms on five critical areas: (1) reinforcing given a certain quality of service and risk allocation, ongoing reforms in PPP legislation and institutions should be lower as a result of efficiency gains in the to ensure a pipeline bankable and fiscally sustain- construction and operation of the service. While in able projects; (2) leveraging on a greater role for public provision, infrastructure is funded at the cost project finance from domestic and global banks; of funding by the government, in a PPP scheme, the (3) developing a flexible and suitable menu of capi- cost of funding reflects the private sector’s assess- tal market vehicles and instruments; (4) address- ment of risks of the project, the sponsor’s credit rat- ing incentives leading domestic pension funds to ing, and the cost of credit enhancement if required. invest with short-term horizons; and (5) introducing Although the latter might be more expensive than a change of mandate for national DFIs so they shift the first, taxpayers do not typically bear commercial from direct investments to catalytic interventions risks, such as construction and maintenance of the addressing market failures. Additionally, multilat- project. Performance standards, including quality of eral DFIs can play an important role in supporting service, are defined so the private sector sponsor is governments in these reforms and with financial responsible for managing those risks. Risk diversi- products to crowd in the private sector, such as fication, efficiency gains, and lower fiscal costs, in credit enhancements and co-investments. exchange for a higher cost of financing may provide significant added value compared to traditional pub- lic provision of infrastructure. Macroeconomic and Financial However, not all infrastructure projects are eli- Context of PPPs gible for PPPs. The transport sector is one of the preferred sectors for PPP due to (1) the presence Greater efficiency in resource allocation is at the of economies of scale, (2) the possibility of charging core of the use of PPPs. Although the possibility of fees, and (3) the possibility of enforcing quality of doing off-balance-sheet accounting of public invest- service. PPPs compete with other forms of private ments is perceived by policy makers as an attrac- sector participation, including privatizations. PPP tive incentive for financing infrastructure via PPPs, frameworks offer significant flexibility in terms of their main benefit is in their capacity to diversify planning and changes in future demand, compared risks among stakeholders and take advantage of to privatizations. In addition, since each conces- greater efficiencies and innovations in the private sion has a term and new auctions will need to be sector. While in traditional public provision of infra- conducted in the future for each project, the nature structure, most risks are taken by the taxpayers, of the sector needs to ensure symmetric informa- in the PPP framework these risks are diversified tion for potential participants in order to make the among different agents under the criterion of allo- competitive process efficient. To the extent that the cating them to the party with the greater capacity incumbent can retain relevant information—due to manage it. Compared to public provision where to the complexity of the task—and consequently governments in the region have seldom conducted may win future auctions, it may be better to move Executive Summary  3 to privatization or other forms of private sector are the leading markets in the Caribbean and are participation. now revising their PPP frameworks. Other countries such as Bolivia, Ecuador, Nicaragua, and Venezu- The financial sector in the PPP structure may ela, have not developed viable PPP initiatives. add value in screening viable projects when a “user fee” model is selected. Although selecting Over the past two decades, most countries in PPP projects based on their social and economic the LAC region have improved their legal and benefits is the role of the government, the financial policy PPP frameworks. Nineteen countries have sector could also play a role in assessing the finan- enacted PPP legislation, and their PPP frameworks cial viability of projects and deciding what projects have consistently been revised and improved. For receive financing and move forward and what example, over the years, Brazil, Chile, Colombia, projects not to develop. For this framework to work, Mexico, and Peru have revised their strategies it is essential to present projects with a high level regarding financial guarantees, unsolicited propos- of preparation so financiers can assess and price als, risk allocation, governance and project selec- the main risks of the project, including construction tion, accounting and management of contingent and revenues. The financial sector can conduct liabilities, conflict resolution, and contract renego- this financial assessment using market criteria to tiation. Although 17 countries have in place some the extent that projects are not fully supported with form of PPP unit, significant challenges remain to government guarantees and government payments address the high potential demand for PPP projects. to the concessionary company. Depending on the context, in some countries this could be a way of In addition, governments in many LAC coun- preventing the development of politically motivated tries have put in place comprehensive financial projects with low social returns. In other countries management schemes for assessing contingent with strong institutions and governance frameworks, liabilities and fiscal commitments. Chile, Colom- availability payments could be a relevant model bia, and Peru, for example, have mechanisms in to support projects with high economic and social place to evaluate and account for the fiscal com- returns or to lower the cost of financing. mitments related to PPP projects. For example, Peru has expanded business case requirements to include ceilings on government financial com- mitments, either funding or contingent liabilities. PPP Institutional and Regulatory Since 2000, Chile’s government has put in place a Framework sophisticated model for valuing contingent liabilities of PPP projects. At the subnational level, the state Governments in the LAC region have been of São Paulo in Brazil has created the São Paulo using PPPs as a procurement method since Partnerships Corporation to provide and account the late 1980s, but the evolution and level of for fiduciary guarantees to PPP projects. Moreover, sophistication of the various PPP markets have new accounting standards for PPPs and concession not been uniform. Chile and Mexico are consid- arrangements (IPSAS 32) are starting to be adopted ered the most successful programs in the region, within the region. especially in the transport sector. Brazil, Colombia, and Peru also have an extensive track record on Despite initiatives to improve PPP frameworks, PPP projects. However, all of these markets have challenges remain particularly in the areas of issues to be solved to create a competitive bidding infrastructure planning and project preparation. environment and finance projects using project Only a few countries in the region have developed finance. Argentina has seen renewed interest in project pipelines based on socioeconomic cost- PPPs albeit with no successful projects having been benefit assessments—reflecting political priorities awarded yet. The Dominican Republic and Jamaica before a decision is made on whether to procure 4  Private Financing of Public Infrastructure through PPPs in Latin America and the Caribbean through public works or through PPPs. Additionally, effect on the programs’ credibility and brings in in many countries, projects tend to be launched financiers with expertise in project finance. into procurement without adequate project prepara- tion because of (1) the desire to accelerate project delivery and (2) the lack of internal capacity and Banks and Infrastructure Finance budget. The lack of information, particularly detailed engineering studies defining scope and perfor- While banks are the main private sector finan- mance specifications, as well as short timeframes ciers of public infrastructure in AEs, domestic for participants to prepare for the bidding processes banks in the LAC region have little exposure to have resulted in low competitive processes, with infrastructure finance. Banks provide debt financ- participants bidding with wide margins to hedge ing for projects under several ownership models: for unmeasured risks, and incentives to renegoti- purely private sector ownership, PPPs, and projects ate contracts. These efficiency losses have also developed by state-owned enterprises. In the past resulted in costly delays in reaching financial clos- few years, most infrastructure projects developed in ing, and ultimately project delivery. LAC countries have been financed by international banks. Brazilian banks play the largest role of any Improving project preparation and allocat- LAC banks in infrastructure finance, both in Brazil ing risks properly are essential steps to bring and throughout the region. Brazil is the only LAC efficiency to the PPP process. In the presence of country that has a bank ranked among the 100 low-level project preparation, public authorities in initial mandated lead arrangers in 2015. many countries in the region struggle to structure and present to the market bankable PPP projects The project finance market in the LAC region that can attract sufficient interest among spon- has had the strongest recovery among Emerg- sors. A common response for governments in LAC ing Market Economies (EMEs) after the global countries to offset the lack of bankable projects, financial crisis. After a 42 percent annual drop in characterized by low-level proper project prepara- 2009, the region’s volumes have had a fast recov- tion, is to accept more risk than standard and less ery, doubling the precrisis market share in project favorable contractual terms in the PPP contracts. finance in the period to 28 percent at 2015 levels. Although these risk allocations have enabled many Also as in other regions, banks have been the main PPP projects to move forward, such measures suppliers of financing in infrastructure projects in ultimately undermine the potential “value for money” LAC countries in the last five years. for these projects, reduce efficiency, shift back risks to taxpayers, and lead to increased project costs. Strengthening the capacity of domestic banks to become more active in project finance is essen- In the LAC region, many sponsors originate tial to increase private financing for infrastruc- from the national construction industry, with ture in the LAC region. With the exception of Chile limited expertise in the long-term financial and Mexico, project finance has been relatively business of PPPs. In many countries, markets are scarce in the region. Several preconditions need to characterized by a shallow pool of local sponsor be in place for project finance to become relevant, competitors, who are relatively inexperienced with beyond sporadic projects: (1) PPP frameworks and PPP delivery. A weak capital base of these compa- well-structured projects with a risk allocation matrix nies, together with limited or no experience in the that the private sector is able to manage; (2) quality concession business, has contributed to the high project sponsors with financial solvency and cred- rate of contract renegotiation and delay in reaching ibility; and (3) regulations and supervisors sensi- financial closing. The evidence suggests that the tive to project finance-specific features in relation presence of international concessionary companies to corporate lending. In addition, the presence of with experience in the PPP business has a positive Executive Summary  5 international banks with expertise in the area of requirements will be tightening, there is not enough project finance can help in enhancing competition information or evidence for assessing the impact and transferring these skills to domestic banks. of Basel III on the participation of local banks in Development finance institutions (DFIs) can also project finance. However, four risk measures of the play an active role in supporting these policies. agreement have a potential impact infrastructure financing as already experienced in some AEs. The Even in the best scenarios, domestic banks will first one is the liquidity coverage ratio (LCR), which not be able to finance the public infrastructure will be more stringent with contractual “committed needs of the region by themselves. Because facilities” granted to project finance than for other the capital base of domestic banks is signifi- types of financing. The second one is the net stable cantly smaller than the one in AEs, their capacity funding ratio (NSFR), which restricts the maturity to finance public infrastructure is limited. Project mismatch for lending in tenors above one year. finance in international banks is rarely above three Under this provision, banks with limited access to percent of their assets. With a three percent ratio medium- or long-term funding would face strong applied to domestic banks, the needs of LAC public restrictions to participate in project finance requir- infrastructure is unlikely to be fulfilled. However, the ing long tenors. The third risk indicator relates to role of banks would still be central in project struc- tighter limits for large exposures, which may limit turing and financing certain segments of projects the participation of relatively small banks in project (e.g., tranches of the construction phase) that would finance, as projects are generally large. The fourth be necessary to attract financing from domestic and risk indicator is in the possible elimination of internal international institutional investors. risk-based (IRB) models for project finance. Since external ratings may not be allowed or not be avail- International banks have an important role able, a more conservative capital provisioning may to play both as providers of financing and in be applied. transferring project finance skills to domestic banks. Since the evidence suggests that interna- tional banks get involved in project finance mostly following their clients’ demands, it is important to Capital Markets attract quality international sponsors. The fact that and Infrastructure Finance international banks lend in hard currency, typically Since the 2008 financial crisis, governments limits their eligibility of projects to those in the trad- increasingly have been looking to institutional able sector, in particular, projects that generate hard investors to assist in financing public infra- currency revenues, including ports and airports. In structure. While banks are expected to continue as the absence of long-term markets, governments the largest private sector financiers of PPP projects, may consider the possibility of currency swaps to Basel III might restrict their capacity to lend in long projects that generate revenues only in local cur- tenors. Therefore, attention has turned to institu- rency. Alternatively, governments may create the tional investors to complement volumes, provide conditions for facilitating local currency funding competition, and particularly help fill the gap in the to international banks by allowing them to issue longer tenors. Such investing is expected to grow long-term debt domestically or through lending from substantially in the future as institutional inves- domestic DFIs. tor assets are rapidly increasing in LAC countries. While banks have been the main providers of Globally, new instruments are being developed lending to PPP projects, the implementation that will make these investments more attractive to of Basel III imposes some questions for the institutional investors, and governments are modify- future. Although Basel III represents a challenge ing regulatory guidelines for institutional investors to for the banking industry and capital and liquidity make it easier for them to invest in infrastructure. 6  Private Financing of Public Infrastructure through PPPs in Latin America and the Caribbean Long-term investors should be seen as comple- the longer tenors and rely, in part, on banks’ greater ments, not substitutes, to traditional sources of expertise in infrastructure finance. Projects in the financing from banks and sponsors. Although less risky operation and maintenance phase with long-term investors can contribute to infrastructure stable cash flows can be more easily financed with financing with substantial volumes and debt hold- capital market instruments only. ings with long tenors, financing becomes more sustainable when they partner with qualified banks The challenge in the LAC region is to explore in and professional sponsors. Banks and other part- a more systematic way new unlisted capital mar- ners may provide: (1) highly specialized knowledge ket instruments as an alternative to traditional in project finance and infrastructure; (2) higher risk listed instruments. These instruments would be appetite and capacity to manage certain risks that more suitable for financing infrastructure projects long-term investors might not be comfortable with and be able to attract foreign institutional investors (i.e., construction risk); and (3) more flexibility in and banks. There is already a growing off-shore reacting to project contingencies that may lead into private placement market for international inves- debt restructuring (e.g., delays, cost overruns). tors’ financing infrastructure projects in the region. Instruments with the most promising results include Features of infrastructure assets delivered project bonds, equity, and debt funds, although in through PPPs are generally misaligned with some special cases direct investments may be the investment rules in the LAC region requiring best option. Project bonds are gradually develop- in most countries listed capital market instru- ing in the LAC region, although they are still facing ments. The most important misalignments are: the challenge of evolving into standardized struc- (1) low liquidity; (2) low degree of standardization; tures and credit risk levels acceptable to a broader (3) lack of performance and valuation benchmarks; investor base. The availability of credit enhance- (4) the need for partial drawdowns of funds during ment instruments provided by development banks the construction phase of projects; and (5) a high or multilaterals is important in the initial stages of probability of project contingencies that lead to project bond innovations. Infrastructure debt funds renegotiating project covenants. All these features are showing promising prospects in the LAC region are obstacles to institutional investors, particularly to attract domestic investors and to provide long- pension funds that, in most countries, are required term financing along with banks from the construc- by law to invest in listed instruments subject to tion phase. Infrastructure equity funds are already mark-to-market valuation and that lack the skills present in the region but could be further developed and institutional structure to negotiate with project to provide capital to domestic sponsors. sponsors. Robust PPP and project finance frameworks are Capital markets’ financing solutions need to a critical precondition for the success of capital be flexible and open to a range of instruments markets’ financing solutions. With some excep- matching project needs and the different risk- tions, both frameworks have been missing across return profiles of investors. A global trend is the LAC region. In their absence, financing infra- blurring the dividing line between banking and pure structure through capital market instruments has capital market instruments to finance infrastructure. been either sporadic or concentrated in off-shore Hybrid financing structures mixing bank and capital instruments or in structured government bonds that market financing, particularly in greenfield proj- are fiscally unsustainable. ects, are able to address some of the challenges faced by pure capital market solutions. Through Only a few countries in the region can be these structures, banks can provide financing in the expected to mobilize financing for infrastruc- shorter tenors and assume the function of control- ture through capital markets in a system- ling creditor, while institutional investors can take atic way. Prerequisites include the existence of Executive Summary  7 long-term domestic institutional investors and a Contrary to common knowledge, DC pension minimum depth of their government debt market funds are not necessarily long-term investors, providing price benchmarks. Additional enabling and consequently they are not natural buyers of conditions include quality credit rating agencies, infrastructure bonds. Since the regulatory incen- a supportive framework for institutional investors tives promote competition on short-term returns, DC on both the issuance side and the investment pension funds do not necessarily have the incen- regulations, and availability of credit enhancement tives for investing in long-term instruments, such as options to support the initial stages of capital mar- infrastructure bonds, which offer more volatility ket innovations. compared to short-term fixed income instruments. In this regard, the presence of other institutional investors, such as annuity companies, with strong Institutional Investors bias toward long-term maturities may help to pull pension funds into a long-term equilibrium. In the and Infrastructure Finance case of Chile, the depth of the long-term sovereign The significant infrastructure gap in the region bond market and the strong long-term demand contrasts with the portfolio structures of their from annuity companies helped pension funds to pension funds, which remain highly invested invest in infrastructure bonds. The more cautious in government securities and bank deposits. approach of DC pension funds in the rest of the Although the lack of diversification is partially a LAC region toward infrastructure bonds can be problem of lack of financial instruments, the regula- explained not only by the low presence of annu- tory issues tend to bias pension fund investments ity companies, but also from the mixed quality of toward shorter term securities. the PPP programs during the different stages of implementation. Defined contribution (DC) open pension funds are the predominant pension fund model in Regulatory amendments may help to align the the LAC region. These systems exist in Chile, investments of DC pension funds with the long- Colombia, Costa Rica, the Dominican Republic, term objectives of contributors. In the absence of El Salvador, Mexico, Panama, Peru, and Uruguay. long-term liability for pension funds, countries may Pension funds are managed by pension fund man- consider modifications in the investment regulation agement companies (PFMCs), whose only objec- of the mandatory pension funds, by introducing a tive is to manage pension funds. Contributions minimum duration in the fixed income portfolio for are mandatory for all dependent employees, and them. This regulation would need to be aligned with they may shift PFMCs more or less at any time. the available supply of instruments in a way that In addition, legislation in most of the countries would avoid distortions in the yield curve structure. allow PFMCs to offer different pension portfolios Alternatively, the regulatory framework may con- (multifunds), whose investment regulation is well sider the use of long-term portfolio benchmarks defined and structured by type of instruments and for pension funds that take into consideration the exposure. In the DC pension system, pensions are contributors’ long-term objectives. calculated as a function of the value of the assets While DB pension funds are also supporters of accumulated up to retirement. With the exception infrastructure bonds, most of the existing plans of Chile, which has a developed annuity market, in the region are gradually reducing the term of retirement options in the rest of the countries are their liabilities. Brazil has the largest DB pension subject to transition rules or changes, including funds in the region, with approximately 80 percent the case of Peru, which recently allowed contribu- of the assets of the closed pension funds being DB tors to withdraw a large majority of their savings at (approximately US$160 billion). Since most of these retirement age. plans have been closed for new entrants for more 8  Private Financing of Public Infrastructure through PPPs in Latin America and the Caribbean than a decade and their liabilities are shortening projects follow good practices. However, it is essen- over time, their appetite for investing in long-term tial to have in place complete collective undertaking bonds is gradually decreasing. Despite this consid- agreements, such that the responsibilities of the eration, Brazilian DB pension funds are potentially general partners are properly defined. strong supporters of investments in public infra- structure and have the necessary volume to kick- start a more active role of institutional investors in The Role of DFIs in Infrastructure the financing of infrastructure. The main regulatory Finance challenge is to design investment vehicles that may address their risk appetite, in particular regarding DFIs can play a supplementary role in infra- their aversion to construction risk and difficulty in structure financing.3 DFIs should be able to dealing with the J curve. provide additionality in cases where market failures inhibit financial sector participation, but as enabling For institutional investors to participate in the conditions improve, they should be prepared to financing of infrastructure, it is essential that backtrack and let the financial market stand on its financial vehicles reflect acceptable risk-sharing own. As a consequence of different circumstances arrangements. The contractual arrangement (e.g., degree of development of that particular should specify the type of risks that bondholders are market or lack of skills), private financiers in some willing to take. For example, pension funds typically markets might not be prepared to assess or man- are not comfortable with engaging in the construc- age the risks involved in a PPP framework. In these tion phase, but they are comfortable in taking opera- circumstances, DFIs may play a catalytic role in tional risks. Liquidity risk is, in most of the cases, a bringing private sector financing into infrastructure. significant risk for DC pension funds. In addition, DFIs may support PPP authorities by helping to improve the quality of project prepara- Standardization of the financial vehicle can tion. To fulfill these tasks, it is essential for DFIs in facilitate the investment of DC pension funds the region to align their mandates and governance in infrastructure. Because regulation requires structures with these objectives to ensure the addi- them to take only minority participation in the issu- tionality of their interventions. ance of shares and bonds, pension funds have a strong preference for instruments that can reach The credibility of DFIs needs to be supported a minimum level of liquidity. To the extent that on a solid capital structure and adequate gov- infrastructure bonds resemble, in structure, other ernance. The catalytic role of DFIs will be effective bonds in pension portfolios, including sovereign and only to the extent that it is perceived by the market corporate, and risks are properly priced, pension as an independent institution from the government. funds can add significant demand for these assets. Based on arm’s length principle, and good gover- Although the standardization of the instrument may nance, DFIs can be instrumental in leveraging pri- help in increasing volume, it does not imply greater vate sector participation in cases of market failures. monitoring capacity. Market failures that justify the presence of DFIs in infrastructure financing are limited to a handful of In addition, investments through intermediar- reasons: ies, such as investment funds, may increase the capacity of the institutional investors to moni- tor the projects. As pure portfolio managers, DC pension funds in general have limited capacity to 3 With the exception of Chile, most of the other PPP programs in monitor each project. Thus, the presence of infra- the region have been supported by DFIs. A credible Chilean PPP program with a relatively strong institutional capacity and support structure funds with strong managers may help to from domestic and international financiers helped the country to mitigate project selection and ensure that selected rely on private sector financing for infrastructure projects. Executive Summary  9 a. Lack of expertise by the domestic financial e. Lack of preparedness of the local conces- sector in project financing structures based sionary companies. A common feature in the on no recourse to the sponsor’s balance LAC region is the limited capacity of the con- sheet. This is an area common in many coun- cessionary companies to deal with sizable PPP tries in the region, and DFIs can play a role in programs. Through the provision of technical providing technical capacity to banks and other expertise with the support of strategic part- private financial institutions. ners, and by fostering private capital into these companies, DFIs can play a significant role in b. Lack of size, depth, and sophistication of preparing local concessionary companies for the domestic financial sector. Because insuf- competitive biddings. Strengthening the techni- ficient financial sector development affects the cal and financial capacity of local concessionary capacity to provide financing to projects with companies is especially important in cases of long tenors in the LAC region, DFIs can support limited participation by foreign sponsors. the provision of long-term funding to projects through different means: second-tier long-term f. Lack of a long-term currency hedge market. lending to banks; long-term loans complement- Currency risk is one of the most challenging ing banks shorter term loans; or partial guaran- areas in project financing in the region. While tees crowding in institutional investors, rather participation of foreign financial institutions than providing direct financing to projects. might be needed, they might be reluctant to finance projects that generate revenue in local c. Asymmetric information in early or revised currency. Larger markets, such as Brazil and phases of the PPP framework implementa- Mexico, might be an exception, but smaller tion. Support from DFIs may help to reinforce markets are in a difficult position. With the credibility in new concessions, considering technical support from DFIs, governments’ the less successful experiences of private Treasuries might be required to provide hedge sector financing in previous PPP programs or products able to address foreign exchange projects. DFIs can help to mitigate those risks risks, including long-term currency swaps, while by providing independent assessments of the markets mature. These products would need to new risk framework and by co-investing in be priced in a way that reflect best estimates of public infrastructure with other private sector long-term prices. partners. In addition, DFIs can contribute to support d. Counterparty risk from central or subna- governments in improving project bankability tional governments with low credit ratings. when, for technical reasons, project preparation Although larger countries in the LAC region and information are below marketable stan- with an investment-grade credit rating have dards. Problems in the quality of project prepara- counterparty risks that are typically manageable tion are widespread in the LAC region to different for investors, some of the smaller economies degrees depending on the country. Projects are with credit ratings below investment-grade and often tendered without a sufficient degree of prepa- shallow financial markets may find it difficult to ration, even in countries with solid PPP frameworks. attract international investors in the financing Multilateral and domestic DFIs can provide valuable of their PPP program or projects. DFIs can be assistance with both funding and expertise. They instrumental in supporting early stages of PPP can also help transfer knowledge about experi- framework implementation through the use of ences with project preparation among countries, partial guarantees in all phases of the project recommend best practices, and help to standardize cycle while the PPP framework is tested and procedures for appraising and structuring PPPs and consolidated. concessions in LAC countries. 10  Private Financing of Public Infrastructure through PPPs in Latin America and the Caribbean Table ES.1: Infrastructure Finance in the LAC Region in a Snapshot Number of LAC countries with a PPP legislation 19 Number of LAC countries with a PPP unit 17 Average period between commercial and financial close (months) 9–12 Awarded contracts that get renegotiated 50–80% Project finance targeting infrastructure finance (2015) 28% Commercial bank finance of PPPs 39% Project finance loans in banks’ balance sheet (2015) 0.74% International project finance bank flows received by top three countries (1997–2015) 73% Number of countries with no project financing from international banks 12 Project bonds in total project finance debt in LAC countries (2013–2016) 19% Infrastructure finance provided by DFIs (2011–2015) 30% Note: Data for 2016 unless otherwise noted. Percentages relate to totals under each item. This report is divided into six chapters. The first The last chapter analyzes the role of development chapter provides a macroeconomic and financial finance institutions, their role in addressing market context for the PPP schemes. Contrary to common failures, and their upstream contribution in project belief that PPP schemes are simply a mechanism preparation, when needed. Table ES.1 provides a for government to off-balance the investments in snapshot of some basic indicators of infrastructure infrastructure, this chapter argues that efficiency finance in the region. These indicators are further is the most valuable outcome of PPP, given an elaborated in Appendix 1. adequate risk allocation. Chapter 2 provides an institutional and regulatory framework of the PPP in the region and benchmarks the region against AEs. References Chapter 3 provides an analysis of the strengths and weaknesses of the banking sector in the region and Fay, Marianne, and Luis Alberto Andres. 2017. its ability to provide funding to PPP projects. Chap- Rethinking Infrastructure in Latin America and the ter 4 analyzes the domestic capital markets and the Caribbean—Spending Better to Achieve More. instruments and financial vehicles that can facilitate Washington, DC: World Bank. nonbank financing. Chapter 5 analyzes the role of domestic institutional investors, their constraints, McKinsey Global Institute. 2016. “Bridging Global and incentives for investing in public infrastructure. Infrastructure Gaps.” McKinsey&Company. June. Key Conclusions W hile PPPs are typically perceived as an different trade-offs. User-fee models, when appro- off-balance-sheet mechanism for public priate, can prevent the implementation of politically investments, their main advantage is to driven projects with low social returns. attain higher efficiency and quality through risk allo- cation to public and private stakeholders. Large foreign concessionary companies might be instrumental in bringing financing from international While financing costs might look higher compared banks. These institutions might play an important with pure public financing of infrastructure, the PPP role in transferring project finance technologies to premium reflects the risk transfer away from tax- local financial institutions. payers, including construction, performance, and revenue risk, among others. In exchange, PPPs are Currency risk is a major constraint for international expected to offer better quality of service and over- banks to participate in financing of public infrastruc- all lower all-in cost compared to public provision. ture projects. Under certain circumstances, the provision of long-term currency hedges by the gov- PPPs are not for all countries and all sectors. Only ernment might be justified. Alternatively, countries large- and medium-sized countries with a minimum may aim for the provision of local currency funding development of financial development would be to international banks via the capital market or by able to afford PPP programs broad in scope and in domestic DFIs. local currency. Other countries in the LAC region may use PPP for financing flagship projects. While banks have been the main private sector financier of infrastructure, the introduction of the Improving project preparation and allocating risks Basel III agreement opens questions about the properly are essential steps to bring efficiency to capacity of banks to continue providing long-term the PPP process in the LAC region. It is essential financing. to avoid practices that offset a low level of project preparation with riskier and less favorable contrac- Capital markets, through a range of instruments, tual PPP terms for the public sector. can play a significant role in complementing the financing from banks by channeling investments The risk allocation of PPP projects should create into longer tenors. Hybrid financing structures are the incentives for the financial sector to assess the being instrumental in attracting financing from some financial viability of projects in both user-fee and domestic and international institutional investors availability payment models. Depending on the into greenfield projects. country and project context each model would have 11 12  Private Financing of Public Infrastructure through PPPs in Latin America and the Caribbean Institutional investors in the LAC region are mostly By addressing market failures, development finance defined contribution pension funds. Because they institutions can be instrumental in bringing private compete on short-term returns, they may not neces- sector financiers into infrastructure sarily behave like long-term investors. Development finance institutions may also play an Natural long-term investors, such as defined benefit important role, as an independent advisor, in sup- pension funds, such as the one present in Brazil, porting the government in project preparation, when and annuity companies, such as the one present in needed. Chile, can be catalytic in bringing other institutional investors into long-term financing. The credibility of development finance institutions needs to be supported on strong governance stan- Standardized investment vehicles that can bench- dards and clear objectives. mark against long-term Treasury bonds could make infrastructure bonds a core asset of the defined contribution pension industry. Key Recommendations PPP Institutional and Regulatory Banks and Infrastructure Finance Frameworks ❖❖ Create the conditions to attract competition from ❖❖ Comprehensive programs of well-prepared foreign concessionaries and foreign banks in public infrastructure projects, accompanied PPP programs. with solid PPP frameworks offering an efficient risk allocation among stakeholders, are key for ❖❖ Equalize the regulatory framework for banks on attracting the attention of financiers. project finance vis-à-vis traditional mechanisms of financing (corporate financing). ❖❖ Strengthen project preparation with adequate and symmetric level of information to stakehold- ❖❖ Monitor the potential impact of the implementa- ers, complete PPP contracts, and set in place tion of Basel III on project financing. transparent procurement processes that allow sufficient time for preparing quality bids and competition from international sponsors. Capital Markets and Infrastructure Finance ❖❖ Standardize PPP contracts to facilitate private sector participation and lower transaction costs. ❖❖ Capital market solutions (such as hybrid financ- ing structures) need to be flexible and open to ❖❖ Ensure that the provision of availability pay- a broad range of instruments matching project ments and public guarantees are not substitutes needs and the risk-return profile of investors. to deficiencies in project preparation. ❖❖ Explore in a more systematic way new vehicles ❖❖ Assess in each country and project context and instruments as alternatives to traditional which risk allocation matrix, including the rev- listed capital market instruments: project bonds, enue model “user-fee” or “availability payments” equity, and debt funds. would create the best incentives for the private sector to deliver the best quality service, assess ❖❖ A parallel agenda on the capital markets— the financial viability of the project, and proceed enabling environment is required, including a at the lowest possible financing cost. reliable government bond long-term yield curve 13 14  Private Financing of Public Infrastructure through PPPs in Latin America and the Caribbean to be used as benchmark, domestic institutional Market Failures and the Role of DFIs investors, and issuance and investment regula- in Infrastructure Finance tions supportive of infrastructure finance. ❖❖ Align mandates and governance structures with market failure justifications to ensure the addi- Institutional Investors and tionality of DFI interventions. Infrastructure Finance ❖❖ Ensure DFIs have the capacity to provide a ❖❖ Amend regulation aimed at incentivizing long- menu of financial products (e.g., partial guaran- term investments, including minimum dura- tees, co-investment, standardized investment tion of fixed income portfolios in DC pension vehicles) to crowd in private financiers and ide- schemes, to help channel long-term invest- ally offer at market rates. ments of pension funds toward infrastructure. ❖❖ DFIs can play an important role in supporting ❖❖ Overcome regulatory barriers to develop the PPP authorities to improve the quality of project annuity market. preparation. ❖❖ Develop standardized financial vehicles that reflect acceptable risk-sharing arrangements to attract pension fund investments.