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Stanford: Infrastructure Project Finance in the U.S.
Written By: Michael Bennon, Managing Director, Stanford Global Projects Center
January 29, 2018
Project finance involves the ring-fenced financing of an infrastructure asset based on the microeconomics of the project itself, as opposed to the sponsor balance sheet, the city, or government's balance sheet. Infrastructure projects have a few distinct tasks that are required to complete them and manage them over the long term. They have to be designed, built, financed, and then operated and maintained.
Under traditional infrastructure procurement, the government hires companies to complete all of those tasks or uses the internal staff. They generally procure them separately and manage the interfaces between those contracts. Under a project finance, also known as a public-private partnership (or P3), the government procures one contract for a private partner to complete all of those paths and then manages the interfaces between them.
Governments usually use the P3 procurement model. The prime driver is to transfer the risk of infrastructure development to that of a private sector partner. Infrastructure projects are some of the riskiest enterprises that governments undertake. There are three risks associated with infrastructure development.
Firstly, procurements can take much longer to build than expected and go over budget, and those are commonly correlated. In addition, it could cost the government more to operate and maintain the asset than originally forecasted. And lastly, for projects that are funded by a user fee, such as a toll road, there could be a lower demand than what the government originally expected that could cause a lack of funding in the future.
Governments generally use this procurement model to transfer risk to the private partner in developing and maintaining an asset. There are a few criteria that we recommend for governments, or project sponsors, to consider when they are assessing a potential project for project finance.
The first factor is scale. Larger projects generally entail more risk, therefore this procurement model is most suited to larger infrastructure projects. The second factor is project risk. There are many questions they have to consider before developing a project. Has the sponsor completed similar projects in the past, and if so, was development risk exposure high? Does the sponsor have experience maintaining a similar asset and if so, was Operations & Maintenance (O&M) risk exposure high? Lastly, could core risks be fully or partially transferred via procurement? After answering those questions, project managers can determine the scale of their project.
The third factor is flexibility. Project managers must also ask themselves whether there is room for flexibility in their project timeline. There are many things they must consider. Does the sponsor require significant flexibility over asset life or have difficulty defining performance based-requirements? Does technology change occur over a relatively short (5-7 year) time frame? Are there other social factors that require sponsor O&M control? If there is a need for flexibility, due to a technology change or other factors, the P3 procurement model might not be a good fit.
Finally, the last factor is innovation. Project managers must determine if there is an opportunity to bundle procurement phases for innovation, as well as an opportunity for value capture via procurement. Because the P3 model combines construction and O&M into one contract, it provides opportunities for the contractor to innovate. It also means that the contractor could make decisions during construction to optimize for lifecycle costs, instead of just the initial cost to build the asset.
After a project is green-lighted, project managers create a special purpose vehicle or an SPV. An SPV is created with the sole purpose of building and maintaining the infrastructure project. It contains equity investors, staff arranging project financing, as well as contractors and/or operators needed to build the project. The vehicle would also include a project development agreement with the sponsoring government.
That being said, the P3 procurement model isn't used in the United States at the same rate as it is used in other developing economies globally. So the question is, why hasn't this model been picked up in the United States? I answer this question and more in the 'Enabling Infrastructure Project Finance in the United States' webinar presented by Stanford.