Closing the infrastructure gap with P3
After years of neglect Canada is a long last stepping up its efforts to fill its yawning infrastructure gap. Philip Moore reports on how the private sector and the bond market are playing key roles.
When a respected think-tank wrings its hands in despair about “spine-jarring streets and highways”, “mind-numbing and catastrophically wasteful traffic jams” and “unresolved waste treatment problems and countless boil water orders”, it is obvious that something is very seriously awry.
“For at least the past 20 years, alarms have repeatedly been raised about deteriorating public infrastructure in Canada and the threat it poses for the living standards of Canadians in the future,” is how this think-tank — the Canadian Centre for Policy Alternatives — begins its analysis.
Readers from some of the world’s fastest-growing and congested cities may wonder what all the fuss is about. Commuters in Mumbai and Bangkok, after all, could tell Canadians a thing or two about sitting in mind-numbing traffic jams. But Toronto-based bankers and investors also argue that there is nothing unusual about Canada’s infrastructural shortcomings. “I don’t see Canada’s infrastructure gap as being materially worse than many other industrialised countries,” says Cliff Inskip, managing director and head of infrastructure and project finance at CIBC World Markets in Toronto. “Like many other developed economies, we built much of our social infrastructure in the 1950s and 1960s and this is now coming to the end of its natural life cycle.”
That may be. But the Centre for Policy Alternatives report, entitled Canada’s Infrastructure Gap — Where it came from and why it will cost so much to close, makes unsettling reading not just for the taxpayers who have to endure these infrastructural deficiencies. Some say it also has alarming implications for the prospects for inward investment into Canada, although there does not seem to be much evidence that lack of infrastructure is deterring foreign direct investment (FDI).
On the surface, Canada compares reasonably well with its peers as a destination for FDI. In 2011, it ranked sixth out of 16 in the Inward FDI Performance Index, according to the Conference Board of Canada. That was behind Australia but ahead of the UK, the US, France and Germany. The same report adds, however, that since the 1970s, Canada’s ranking on FDI inflows has been slipping. “In the 1970s, Canada scored an ‘A’ on its ability to attract FDI,” the Conference Board says. “This dropped to a ‘B’ in the 1980s and to a disappointing ‘D’ average in the 1990s, rebounding to a ‘C’ only in 2011.”
Canada’s share of global inward FDI stock, according to the same report, fell from an average of 13.4% in the 1970s to an average of 2.9% between 2000 and 2011. The Conference Board’s report does not pin any of the blame for this precipitous fall directly on Canada’s infrastructure. “Multinational enterprises looking for operational efficiencies are dissuaded by Canada’s low productivity relative to its peers,” says the report. “Canada’s low productivity reflects its lower capital intensity and a lack of sufficient investment in research and development (R&D) and other areas that would foster innovation.”
It may or may not be a coincidence, however, that the decreasing appeal of Canada as a location for FDI has dovetailed with a sharp reduction in investment in Canada’s infrastructure.
According to the Centre for Policy Alternatives report: “The difference between the 3% of GDP range that was typical of the 1960s and 1970s and the 1.5% range that became the norm in the late 1990s represents $24bn in missing annual investment in public capital.”
“The cumulative effect of the underinvestment characteristic of the period of the 1980s and 1990s is dramatic,” it adds. “The difference between a capital stock valued at 30% of GDP in the early 1980s and 22% in 2011 represents missing public capital stock with a current value of $145bn.”
The decline in public sector spending on infrastructure was reversed in the aftermath of the global financial crisis, when the government’s Economic Action Plan introduced initiatives such as the $4bn Infrastructure Stimulus Fund. How effective that stimulus was in addressing Canada’s infrastructure challenge is open to question, with one Toronto banker describing its support for all but a handful of so-called shovel-ready projects as “illusory”.
Decades of neglect
Irrespective of its impact, the post-crisis stimulus package looks like a sticking plaster in comparison with the requirement created by several decades of neglect. According to the Centre for Policy Alternatives analysis, to close the infrastructure gap by bringing the general government capital stock back to 30% of GDP within 10 years would require an annual investment in general government infrastructure of 4.3% — a higher investment rate than was ever achieved between 1955 and 2011. “In 2013-2014, that would require an investment of approximately $75bn for general government infrastructure alone,” says the Centre for Policy Alternatives.
“Whether the target is an infrastructure base of 25% of GDP ($60bn in 2013-14) or 30% ($75bn in 2013-14), the annual investment in infrastructure required is… substantially higher than the $45bn annual that was allocated to general government infrastructure at the peak of the recession-related stimulus programme in 2009 and 2010,” notes the cautionary report. This means that it is “in a different category altogether from the $20bn-$30bn that was being allocated annually in the mid-1990s.”
Bankers say that this yawning infrastructure gap is being addressed more decisively today than it has been for many years. In very broad terms, the majority of key infrastructure projects now in the pipeline in Canada fall into two basic types. The first are the so-called “megaprojects”, chiefly in the energy sector. KPMG’s most recent update on these developments advises that “there are currently more than 175 megaprojects [in Canada] either on the books or under construction across a multitude of sectors. In total, these projects represent around US$420bn worth of investments.”
The list of sectors is led, says KPMG, by power and utilities, which has nearly 50 projects underway with a total price tag of around $170bn. “Equally prolific in terms of numbers — though slightly less costly — is the mining and natural resources sector which is expecting nearly $80bn in capital spend,” adds KPMG.
Bankers say that for the most part, financings for Canada’s largest megaprojects have been explicitly government-guaranteed. Take the example of key developments such as the Lower Churchill River hydroelectricity projects being developed by Nalcor Energy, Newfoundland and Labrador’s Crown-owned energy corporation, and Emera Inc of Nova Scotia.
According to the government, these projects will allow Newfoundland and Labrador to source 98% of its electricity from renewable sources and eliminate up to 4.5m tonnes of greenhouse gas emissions. This is the equivalent of taking 3.2m cars off the road.
With the projects also creating some 3,100 jobs at the construction peak, it is perhaps small wonder that the Government of Canada has committed to guarantee project-related debt of up to $6.3bn for the Lower Churchill River Projects.
“Although they are popular with lenders, the megaprojects are typically federal or provincial government risk,” says Laith Qamheiah, director of infrastructure finance at BMO Capital Markets in Toronto. “There is no transfer of risk to the private sector.”
This is why Qamheiah echoes a number of other Toronto-based bankers when he says the more interesting batch of projects, as far as investors are concerned, are those in the public-private-partnership (PPP, or P3) space. “Unlike most of the megaprojects, these P3 projects are ones in which the private sector is genuinely shouldering the risk that they are not completed on time and within budget,” says Qamheiah.
The rising use of P3, says the OECD in a recent report on pension funds in Canada and Australia, is a relatively recent development. “Despite closing some high profile projects in the early 1990s (including the Confederation Bridge linking Prince Edward Island and New Brunswick), Canada generally has lagged behind in the past in the use of PPPs when measured against comparable Western jurisdictions such as the United Kingdom or Australia,” notes the report. “In recent years, however, there have been signs of a strong pick-up of the PPP market in the healthcare, road and justice systems sectors which are now considered mature and benefiting from strong competition from equity and debt participants. Opportunities in new sectors such as water, waste water and rapid transit, are also likely to increase in the coming years.”
Bankers echo the view that since the crisis, the emergence of P3 has had a far-reaching impact on Canada’s infrastructural landscape. “Since the financial crisis of 2008/09, the provinces have developed a very effective way of dealing with risk transfer by passing risk to the private sector after a number of contracting and construction landmarks have been passed,” says Peter Hepburn, head and managing director of infrastructure finance at National Bank Financial Markets (NBFM) in Toronto. “The cost of the debt is bought down or repaid and effectively subsidised by the province or relevant government entity, following achievement of these construction milestones, and a smaller amount of private finance then sees the project through the operating period, which is generally 25 or 30 years.”
A frequently used argument against a P3 structure, says Hepburn, was that the provinces enjoyed low funding costs and could provide more value for taxpayers by funding projects themselves. But with many provinces committed to an accelerated delivery of essential public infrastructure while balancing their books sooner rather than later, it has become necessary for them to explore alternative funding solutions. Hence the preference for transferring risk and splitting the financing between the public purse and the private sector.
Around 200 P3 projects with a value of more than $60bn have now reached financial close across a range of sectors, and bankers say that by virtually any yardstick, Canadian P3 has already earned its spurs. “Rather than reinvent the wheel, Canada has done a very good job of adapting the UK PFI and Australian models, setting up dedicated procurement agencies, for example,” says Qamheiah.
Even the unions
The results have been impressive. A Conference Board of Canada report published in August reports that 83% of P3 projects in Canada have been completed early or on time.
The efficiency of the P3 model also appears to have won round the general public. According to the Conference Board, “opinion polls show that support for private sector delivery of public sector of public services in partnership with government has increased from 60% in 2004 to 70% in 2011.”
The Canadian public has not always been so keen on handing responsibility for developing social infrastructure projects to private enterprise. Mistrust of the 407 Express Toll Route (ETR) Highway north of Toronto, leased to a consortium for a 99-year period, is one well documented example of popular opposition to private ownership of key transportation infrastructure. “There was originally opposition to 407ETR because there was a perception that the government was giving away the asset on the cheap,” says Hepburn at NBFM. “Governments have learned the lesson that it is best to stick to projects with 25 or 30 year lives, rather than 99 year concessions where it can look as though they’re giving away the keys. There is now a much better understanding among the general public that private operators and sponsors will run assets on a temporary basis and that they are handed back in good order to the government at the end of the concession period.”
Even the unions, say bankers, have abandoned their opposition to P3 projects, and in some cases even invest in them via their pension plans. “The unions have recognised that these projects are creating huge improvements in working conditions for their members,” says Qamheiah. “Many are being moved from older hospitals to brand new, state of the art facilities as a direct result of P3.”
Foreign banks creep back in
As well as being increasingly well regarded by the general public, the P3 model has become extremely popular among bank lenders. “The evolution of the Canadian P3 market has created a large construction period financing opportunity for banks,” says Hepburn at NBFM. “Given that most of this demand is for three to five year loans, these are ideal projects for Canadian banks which seldom lend beyond seven years. As P3 borrowers and projects are generally investment grade and the risks are well understood, there is plenty of appetite among bank lenders for construction phase lending.”
Until recently, Canadian banks had most of the market to themselves. “Most of the European banks which were very active in the US as well as in the Canadian infrastructure market pulled out after the crisis and are still deleveraging,” says John Kirwan, the London-based managing director and global head of infrastructure finance at Scotiabank Global Banking and Markets. “We’ve seen some of the European infrastructure specialists pulling out of overseas lending altogether, with many banks tending to focus on their home markets.”
That may be starting to change. “Overseas banks are returning to this market and lending alongside the Canadians on a selective basis,” says Hepburn at NBFM. “Japanese banks in particular have been more active in some of the larger facilities.”
This is having a clear impact on pricing. “We’ve seen pricing on three to four year construction period loans come in considerably over the past 12 months,” says Hepburn.
Project bond success
The success of P3 in Canada has also helped to nurture a highly efficient and increasingly liquid market in privately placed project bonds, which are now regarded as an asset class in their own right. “When the substantial completion payments have been made, what is left is a long term tranche of debt that is generally rated in the BBB+ to single-A range,” says Hepburn. “Dealers such as NBFM are comfortable underwriting large tranches of this debt, for which there is plenty of institutional appetite.”
“From the perspective of institutional investors, infrastructure is a very popular asset class,” says Inskip at CIBC. “Before the credit crisis, European banks in particular were very willing to lend up to 30 year money to Canadian projects and institutional investors were effectively crowded out of the market.”
“Now virtually all the DBFM [design, build, finance, maintain] P3 deals are being structured as bonds which are either widely distributed or narrowly placed, mainly with life insurance companies and pension funds,” adds Inskip. “These are very attractive assets for institutions looking for long dated assets to match their liabilities.”
A good example of the increased institutional appetite for ultra-long infrastructure-related debt, says Inskip, was investors’ response to a recent 50 year bond issued by Toronto Hydro. This was priced at 152bp over the government benchmark, which was at the tight end of guidance, and was increased from $150m to $200m in response to strength of demand.
One of the principal attractions of P3 bonds to domestic institutional investors, says Inskip, is the stable cashflows associated with availability-based assets. In contrast to infrastructure assets such as toll roads, which are subject to potentially unpredictable passenger numbers, availability-based assets are so-called because as long as they remain available for use at no charge to the public, the government or quasi-government sponsor will continue to pay for them. In other words, as long as the asset meets basic quality and performance standards, payment for them comes from the tax base.
Canadian PF bond magic
A key difference between Canada’s P3 bonds and those that financed European infrastructure through, for example, PFI in the UK, is that the Canadian market is not supported by credit wraps.
“The recurring question that comes up at conferences about Canadian finance is how the market has grown and flourished, taking on construction risk without the support of guarantees from the monoline insurance companies, and how other countries can replicate Canada’s success,” says Kirwan at Scotiabank GBM.
“Be it in Europe, the Middle East or elsewhere, people are fascinated at how Canadian projects can raise long term bond finance without third party credit enhancement,” he adds. “For many European procuring authorities, the holy grail is to promote demand for broadly marketed bonds with construction risk.”
Kirwan says that there are a number of explanations for Canada’s success in this area. The first is that as project finance has a relatively strong and successful history in Canada, domestic institutions have recognised the value of dedicating substantial resources in terms of time and personnel into analysing infrastructure as an asset class. “Over time, that has allowed these institutions to become much more comfortable with the legislation and the structure that underpins these projects,” says Kirwan.
This process, he adds, initiated a virtuous circle within the Canadian financial community several years ago. “Five or six years ago we started to see a marked increase in interest in this asset class among dealers, driven by investor demand, deal size and the pipeline,” he says. “Consequently, dealers and P3 advisors have expanded their underwriting commitment and deployed even more resources to managing each stage of the process — including getting transactions rated.”
As the movement snowballed, there was a conspicuous increase in the number of investors participating in the market. Inskip at CIBC says that there are now perhaps 50-60 institutions that buy P3 bonds. “That is a significantly higher number than several years ago, when the project market was still dominated by banks,” he says.
Rising institutional demand
Rising institutional demand, coupled with the unblemished track record to date of P3 bonds, has pushed pricing down in recent years. Inskip says that typical pricing for long dated bonds has declined from a peak of around 300bp over the Canada curve three or four years ago, to a sub-200bp spread today.
That compares with ballpark pricing of around 150bp over the government bond for 30 year issuance from the top utilities.
Given that provincial governments ultimately pay for availability-based projects, some investors may regard P3 bonds as offering quasi-provincial risk at an appealing pick-up. But bankers caution that P3 bonds are priced at a spread to provinces for good reason, given that they are generally unrated, privately placed and are often illiquid as they tend to be held to maturity.
Besides, both in the P3 market and for many public utilities, there is no typically no explicit federal or provincial government guarantee. “Investors may regard these borrowers as providers of essential services, but while bond issuers like Toronto Hydro, which is owned by the City of Toronto, and Hydro One, owned by the Province of Ontario, they are not guaranteed by their owner,” says Inskip.
Bankers say that a key potential test of appetite for project bonds will be the Eglinton Light Rail scheme, which is still in the early bidding stages and is part of an $8.4bn project which represents the largest light rail transit expansion in Toronto’s history. In terms of its size, which is on a par with the so-called megaprojects, this could lift the bar in the Canadian P3 market. “As it will run into several billion dollars, it remains to be seen how easily the Eglinton Light Rail project will be absorbed by the market,” says one banker.
Its prospects appear to be good, given that P3 is becoming an increasingly popular funding mechanism for urban light rail systems in Canada. In February, for example, the Rideau Transit Group (RTG) consortium closed a $440m financing on its 35 year design, build, finance and maintain (DBFM) PPP for the Confederation Line in Ottawa.
Total project costs are in excess of $2bn, of which the federal government, the Province of Ontario and the City of Ottawa are providing the balance of public funding.
The private financing tranche, meanwhile, includes a $215m loan provided by National Bank, Scotiabank, and BTMU and SMBC of Japan, alongside a $225m underwritten private placement, led by National and SunLife.
Edmonton is also using the P3 model to finance the construction of its 13.2km light rail system. In March, the city announced that a private sector proponent would be selected to design, build, finance, operate and maintain the new light rail transit project over a 30 year period.
Beyond the transportation space, bankers report that there is no shortage of projects in the pipeline in a diverse range of sectors. “At NBF alone, we are working on a two year infrastructure pipeline that will require total public and private funding of about $30bn, and that does not include municipal projects,” says Hepburn.
Pension funds look elsewhere
That pipeline, say bankers, should be digested straightforwardly enough. But they add that two groups that are not yet meaningful players in the market are foreign investors (bar a small handful of US accounts) and — for the most part — Canada’s deepest-pocketed public pension plans.
The good news is that Canadian pension plans are prolific and very sophisticated investors in infrastructure. According to the OECD, the average allocation to infrastructure among large pension funds in Canada is 7%-8%. “Canadian pension funds such as Ontario Teachers, Caisse de Depot et Placements du Quebec (CDP), Omers, the Canadian Pension Plan Investment Board (CPPIB), Alberta Management, British Columbia and OPTrust are active investors in the infrastructure market,” says the OECD report. “Over the years, these investors have been able to acquire the knowledge, expertise and resources to invest directly in infrastructure.”
The bad news, as far as Canada’s so-called infrastructure gap is concerned, is that the local pension funds have turned much of their attention — and channelled many of their assets — into opportunities outside Canada rather than into the domestic market, for several reasons. “It’s not that the largest public pension funds don’t have an interest in the local market,” says Qamheiah at BMO. “But P3 deals aren’t structured with the large equity tranches that these pension plans are looking for. They’re typically looking to write $500m or $1bn cheques for big-ticket projects such as airports and other similar long term transportation infrastructure.”
Qamheiah adds that Canadian pension plans also generally look to invest in operating assets rather than greenfield projects, as the funds themselves confirm. “We’re not there for altruistic reasons,” says Neil Petroff, executive vice president and chief executive officer at the Toronto-based Ontario Teachers’ Pension Plan (OTPP), which had net assets of $129.5bn at the end of 2012, $9.6bn of which was in infrastructure. “We’re there to make good risk-adjusted returns for the teachers of Ontario, which is why we always have to ask ourselves if we’re being paid for the risk we’re taking. In the case of Canadian infrastructure, pension plans generally want to invest in existing, brownfield projects, whereas the government is aiming to attract investment in greenfield developments, which carries considerable construction risk,” he says.
This does not mean that pension funds are entirely absent from the domestic infrastructure market. Hepburn says that some, such as Caisse de depot et placement du Quebec, are playing an increasingly active role in the market, as are specialist investors such as Fiera Axium Infrastructure and Fengate Capital Management.
As far as Canada’s infrastructure is concerned, the more investors the better, because as the Centre for Policy Alternatives says, the stakes are high. “A decision to revert to pre-recession levels of investment will leave our infrastructure stuck at a crisis level indefinitely, and is clearly a recipe for disaster,” it warns.