DRAFT

THE WORLD BANK

Capital Markets Group

Making Capital Markets Workfor Infrastructure Finance

Policy Note

July 2004

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Making Capital Markets Workfor Infrastructure Finance

Acknowledgments..........................................................................................................2

I. Infrastructure Investment Needs in Developing Countries......................................3

II. Two Models for Infrastructure Finance....................................................................5II.A Public Finance Model..............................................................................................5II.B Public-Private Partnership (PPP) Model.................................................................6

III Role of Capital Markets in Financing Infrastructure Investments...........................9

IV. Impediments to capital market financing of infrastructure investments...............10IV.A Public Finance Model............................................................................................10IV.B PPP Model.............................................................................................................11

V. Removing the Impediments to Capital Market Financing of Infrastructure Investments: How the World Bank Group Can Help............................................12

V.A. Public Finance Model............................................................................................12V.B. PPP Model..............................................................................................................13

VI. Practical Examples of Innovative Capital Market Products for Infrastructure......14VI.A Public Finance Model.............................................................................................14VI.B PPP Model.............................................................................................................15

Technical Annexes.........................................................................................................16

References and Bibliography.........................................................................................16

Acknowledgments

This Policy Note was prepared by Varsha Marathe (SASFP), Michel Noel (ECSPF), and Sophie Sirtaine (LCSFF). The authors are grateful for contributions from Lorenzo Costantino (ECSPF).

This Policy Note was prepared for the Finance Forum 2004.

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I. Infrastructure Investment Needs in Developing Countries

1. Over the 2005-2010 period, infrastructure investment needs in developing countries are projected to amount to $ 465 billion annually, of which $ 179 billion in East Asia and Pacific, $ 98 billion in Europe and Central Asia, $ 71 billion in Latin America and the Caribbean, $ 28 billion in the Middle-East and North Africa, $ 63 billion in South Asia, and $ 26 billion in sub-Saharan Africa (See Table I.1 below) 1. These investment needs will be driven by projected increases in population, increased coverage of existing population, repair and rehabilitation needs, and increased compliance with environmental standards.

Table I.1 Expected Annual Investment Needs (1) in InfrastructureEmerging markets – 2005-2010

New Maintenance TotalBy income group US$Mn % GDP 3 US$Mn % GDP 3 US$Mn % GDP 3

Low Income 49,988 3.18 58,619 3.73 108,607 6.92Middle Income 183,151 2.64 173,035 2.50 356,187 5.14High Income 135,956 0.42 247,970 0.76 383,926 1.18Developing Countries by RegionEast Asia & Pacific 99,906 3.67 78,986 2.90 178,892 6.57Europe & Central Asia 39,069 2.76 58,849 4.16 97,918 6.92Latin America & Caribb. 37,944 1.62 32,878 1.40 70,822 3.02Middle East & N. Africa 14,884 2.37 13,264 2.11 28,148 4.48South Asia 28,069 3.06 35,033 3.82 63,101 6.87Sub-Saharan Africa 13,268 2.84 12,644 2.71 25,912 5.55

All developing countries 233,139 2.74 231,654 2.73 464,793 5.47

Source: Marianne Fay and Tito Yepes, Investing in Infrastructure: What is Needed from 2000 to 2010? World Bank Policy Research Working Paper 3102, July 2003Notes:1 Predictions are based on estimated demand rather than on any absolute measure of "need“2 Infrastructure includes roads, railroads, telecommunications, electricity, water and sanitation.3 GDP deflator used is an average of the 2005-10 projections.

2. Across sectors, energy (electricity and power) accounts for about 35 percent, telecommunications for about 15 percent, transport about 40 percent, and water and sanitation for the remaining 10 percent of total investment requirements in infrastructure (See Figure I.1 and Figure I.2 below for sectoral shares in East Asia and in Latin America respectively)

1 Marianne Fay and Tito Yepes, Investing in Infrastructure: What is Needed from 2000 to 2010? World Bank Policy Research Working Paper 3102, July 2003

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Figure I.1. Investment Requirements for Infrastructure 1995-2004 in East Asia

Source: Infrastructure Development in East Asia and Pacific: Towards a New Public Private Partnership, The World Bank, 1996

Figure I.2. Estimated Required New Investments in Infrastructurein LAC 2000-2005

Source: Marianne Fay and Tito Yepes, op.cit.

3. It is estimated that the share of sub-sovereign investments in total investments ranges between 50 percent in energy, 10 percent in telecom, 60 percent in transport and 85 percent in water and sewerage. Based on these estimates and on available data on sectoral shares, required infrastructure investments at the sub-sovereign level across developing countries are estimated to amount to around 240$ billion annually over the 2005-2010 period.

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Telecom11%

Power

38%Transport

39%

Water and Sanitation

12%

II. Two Models for Infrastructure Finance

4. Governments and sub-sovereigns may follow two alternative approaches to finance infrastructure investments, ie the public finance model and the Public-Private Partnership (PPP) model.

II.A Public finance model

5. Under the public finance model, sovereigns and sub-sovereigns borrow on their own account through loans or bond issues. These borrowings are counted against general government debt.

6. Since the beginning of the nineties, general government indebtedness as measured by the ratio of general government debt outstanding to GDP has fluctuated widely across developing regions and, within regions, across individual countries (See Table II.1). Some countries, such as China, Thailand, the Czech Republic and Chile have maintained low indebtedness throughout the period (below 30 percent), leaving ample room for public sector borrowing (both sovereign and sub-sovereign) to finance infrastructure investments. Other countries, such as Turkey, Morocco, and Lebanon have high levels of indebtedness (above 60 percent) and have therefore little headroom to finance infrastructure investments through the public finance model.

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Table II.2.Central Government Debt as % of GDP in Selected Emerging Markets Worldwide

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001East Asia and PacificChina 6 6 5 6 7 7 8 10 13 .. ..Indonesia 37 39 37 37 31 24 72 55 45 .. ..Thailand 13 11 8 6 5 4 5 11 21 23 30Europe and Central AsiaCzech Republic .. .. 19 16 14 12 11 11 13 15 17Poland .. .. .. 68 54 48 47 43 43 40 40Russian Federation .. .. .. .. .. .. .. 138 102 62 49Turkey 32 34 34 44 36 38 44 42 54 51 98Latin America and the CaribbeanChile 41 34 32 26 20 17 15 14 14 14 16Peru 78 80 71 55 51 51 38 39 43 45 44Middle East and North AfricaMorocco 72 84 88 82 81 .. 76 71 73 .. ..Lebanon .. .. 51 69 79 99 103 114 135 .. ..Tunisia 61 55 59 59 58 55 62 60 61 63 ..South AsiaIndia 51 51 53 50 48 47 51 51 53 56 58

Source: World Development Indicators, 2003

II.B Public-Private Partnership (PPP) Model

7. Under this model, sovereigns and sub-sovereigns seek the participation of the private sector in infrastructure through various Public-Private Partnerships (PPPs) such as management contracts, leases, concessions, BOOs, BOTs and divestitures.

8. Concessions, BOOs and BOTs involve the setting up of a special-purpose company that is responsible for investments and operations of the infrastructure service. To the extent that the private investor has a majority stake in the equity of such company, borrowings to finance infrastructure investments are no longer part of general government debt. This also applies in the case of divestitures where private investors take a majority equity stake in an existing infrastructure company.

9. In these cases, the PPP model enables sovereign and sub-sovereign governments to resolve the discrepancy between their large future infrastructure investment needs and limited headroom for general government borrowing, while achieving cost reductions

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through the efficiency gains resulting from the private management of operations and private control over investment decisions.

10. Across developing countries, private participation in infrastructure (PPI) increased rapidly from $ 18.1 billion in 1990 to a peak of $ 127 billion in 1997, but declined significantly in the following years down to $ 47.4 billion in 2002, when it was back at about the 1994 level. (See Figure II.1 below).

Figure II.1 Annual Investment in Infrastructure Projects with Private Participation in Developing Countries, 1990–2001

Source: World Bank, PPI Database

11. Across regions, Latin America and the Caribbean (LAC) is the leader in PPI, with 49.4 percent of the total over the 1990-2002 period, followed by East Asia and the Pacific with 24.5 percent and Europe and Central Asia with 13.5 percent. At the other end of the spectrum, South Asia attracted only 5.7 percent and the Middle East and North Africa only 3.3 percent of PPI over the period. LAC’s ability to attract such an inordinate share of private infrastructure investment flows can be explained by the fact that the region was a pioneer in opening its infrastructure sector to private sector participation, perspectives of reasonably high growth, the region’s overall macroeconomic stability and its gradual shift towards greater economic openness.

12. Across sectors, telecom is the leading sector in PPI with 44.2 percent of the total over the 1990-2002 period, followed by energy with 33.3 percent, and transport with 17.0 percent. At the other end, water and sewerage only represented 5.4 percent of total PPI over the period.

13. The decline in PPI in the 1998-2002 period was mainly driven by a sharp contraction in new acquisitions of government assets by investors for various reasons (see after). In 2002, major acquisitions of government assets were limited to IPOs of a mobile operator in China and of two natural gas transportation companies in the Czech and

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Slovak Republics. The remaining PPI transactions were for the expansion of existing facilities.

Table II.2: Private Investments in infrastructure in developing countries: 1990-2002

(in US$ billion)

14. The role of equity and debt in financing PPPs varies significantly depending on the type of transaction. As shown in Table II.3 in the case of water and sanitation projects, the share of equity in PPI ranges from 15% to 50% in BOOs/BOTs and from 25% to 40% in concessions, reaching 75% in the case of one divestiture. Table II.4 shows that in concessions in Latin America and the Caribbean, the share of equity in transactions has varied from 22% to 90%.

Table II.3. Debt/Equity Ratios for Selected PPPs in Water/Sanitation ProjectsProject Site, Type and Date Project Cost Debt/Equity Ratio

Malaysia Concession 1993 US$ 2.4 Bn(US$500 Ml first 2 years)

75/25

Buenos Aires, Argentina Concession 1993 US$4 Bn(US$300Ml in first 2 years)

60/40

Izmit, Turkey BOT 1995 US$800 Ml 85/15Chihuahua, Mexico BOT 1994 US$17 Ml 53/15/32 *Johor, Malaysia BOT 1992 US$284 50/50Sydney, Australia BOO A$230 Ml 80/20England and Wales Full privatization 1989 US$5.24Bn 25/75* Debt/equity/grantSource: David Haarmeyer and Ashoka Mody, Financing Water and Sanitation Projects – The Unique Risks, The World Bank, Viewpoint Note No. 151, September 1998

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Private investments in infrastructure in LDCs

0

20

40

60

80

100

120

140

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2002

US

$ b

n

LAC E. Asia & Pacific Other

Table II.4. Debt to Equity Ratios for Selected Concessions in LAC*    D/E % of E     D/E % of E

Energy concessions     Water concessions      

Light Brazil 278% 26% Aguas Andinas Chile 23% 82%

Coelce Brazil 81% 55% Valparaiso Chile 78% 56%

Coelba Brazil 124% 45% Essbio Chile 22% 82%

Electropaulo Brazil 234% 30% Sanepar Brazil 134% 43%

Edesur Argentina 39% 72% ILLIMANI Bolivia 190% 34%

Edenor Argentina 69% 59% Aguas Argentinas Argentina 223% 31%

Edelnor Peru 46% 69% AP Santa Fe Argentina 224% 31%

Edegel Peru 31% 77% Triple A Colombia 354% 22%

Egenor Peru 17% 86% Aguas de Cartagena Colombia 197% 34%

Electropaz Bolivia 76% 57% Salta Argentina 340% 23%

Central Puerto Argentina 68% 59% Sector Average 179% 36%

Central Costanera Argentina 133% 43%  

Sector Average 78% 56% Telecom concessions  

    Embratel Brazil 80% 55%

Transport concessions   Telecom del Peru Peru 88% 53%

Autopista del Sol Argentina 219% 31% Telecom Argentina 93% 52%

Coviares Argentina 128% 44% Telefonica Argentina 74% 58%

Autopista del Sol Chile 146% 41% Telmex Mexico 72% 58%

Manzanilla Panama 176% 36% CTC Chile 82% 55%

Sector Average 167% 37% Entel Bolivia 11% 90%

    CanTV Venezuela 55% 64%

  Sector Average 69% 59%

            D/E % of E

Overall Min         11% 22%

  Max         354% 90%* (average over concession life)

III Role of Capital Markets in Financing Infrastructure Investments

15. Capital markets can play a critical role in mobilizing resources for infrastructure finance, in allocating resources among infrastructure finance programs and projects, and in mitigating the risks of private participation in infrastructure projects.

16. Capital markets broaden the spectrum of risks available to investors and thereby encourage savings and investment and improve the efficiency of savings and investments. This has a powerful impact for the financing of infrastructure investments, as capital markets can accommodate the wide array of risks encountered in the sector, including equity risk in sovereign and sub-sovereign PPI finance, public debt finance for sovereign and sub-sovereign infrastructure program finance, and structured debt finance for both sovereign and sub-sovereign infrastructure program finance and for PPI finance.

17. Capital markets act as allocators of resources among alternative infrastructure investment programs and projects based on their respective risk/return profile. The roles of infrastructure private equity funds, bond underwriters and credit rating agencies are key to this dimension.

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18. Capital markets can also provide risk mitigation products to facilitate PPI, by providing cover to sovereign and sub-sovereign policy risks, including political risk, convertibility risk, transfer risk and sub-sovereign breach of contract risk.

IV. Impediments to capital market financing of infrastructure investments

IV.A Public finance model

19. For infrastructure investments whose cash flows are in local currency, debt financing in local currency is the preferred option. For sub-sovereigns, this is the only prudent option in the absence of a developed swap market in the vast majority of developing countries.

20. For sovereigns, access to the domestic debt market for the financing of infrastructure investments depends on the development of a meaningful domestic government bond yield curve. The main impediments to the development of a government bond yield curve are the following:

Lack of stability and predictability in macroeconomic and fiscal policies;

Lack of coherent government strategy in developing money markets, in particular repo transactions;

Lack of coherent government strategy in developing government bond markets, in particular lack of development of benchmark issues at progressively longer maturities, and lack of transparency in government bond auctions;

Deficiencies in market infrastructure resulting in unsound securities pricing and volatility;

Immature markets driven by speculative plays resulting in high volatility;

Limited development of institutional investors (pension funds, insurance companies, mutual funds).

21. For sub-sovereigns, access to the domestic debt market for the financing of infrastructure investments is hampered by the following impediments:

Deficiencies in the legal and regulatory framework for sub-sovereign borrowing. In many countries, sub-sovereign budget constraints are soft, and sub-sovereigns benefit from government bailouts in case of default, creating moral hazard on the sub-sovereign debt market;

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Segmentation of markets for sub-sovereign issues, resulting in inefficient pricing and volatility;

Limited capacity of institutional investors to manage sub-sovereign risk;

Lack of credit enhancement instruments. In the vast majority of developing countries, sub-sovereigns do not have access to bond enhancement instruments that would improve the attractiveness and risk profile of sub-sovereign issues for institutional investors

Insufficient volumes and investor base to create significant secondary trading.

IV.B PPP Model

22. The sharp contraction in PPI has at its root the withdrawal of traditional investor/operators from equity transactions in PPPs for local infrastructure in developing countries. Private equity funds have not stepped in, limiting themselves to a limited number of large transactions, especially in the telecom sector.

23. Reviving the PPP model as a viable option for infrastructure investment finance in developing countries will require to create the conditions for attracting private equity funds as well as traditional operators/investors in local infrastructure transactions. Based on a recent review of investors’ attitude surveys2, the key impediments to private investor participation in local infrastructure in developing countries are the following:

Inadequate tariff policies affecting cash flow level and variability. In many countries, the transition to cost-recovery tariffs creates access and affordability problems for low-income households, translating into low political sustainability of tariff policy agreements between governments, sub-sovereigns and utility companies, and resulting in cash-flow problems for investors;

Weakness of contractual environment (contract enforcement, dispute resolution). In many countries, contract enforcement is weak; mechanisms for out-of-court contract dispute resolution are weak or inexistent; and court procedures are inefficient and/or corrupt;

Lack of political / regulatory risk mitigation instruments. Few countries have developed policy risk mitigation instruments, especially at the sub-sovereign level;

Lack of exit opportunities. Because of the narrowness and shallowness of domestic capital markets in the vast majority of developing countries, private equity investors lack exit opportunities that could convince them to book equity

2 Noel Michel and Jan Brzeski, op.cit. pp.

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investments in local infrastructure transactions. There is an absence of second-round investors to open-up exit opportunities to first-round private equity investors.

V. Removing the Impediments to Capital Market Financing of Infrastructure Investments: How the World Bank Group Can Help

24. The World Bank Group is uniquely positioned to help governments and sub-sovereigns to remove the impediments to capital market financing of infrastructure investments, both through the public finance model and through the PPP model.

V.A. Public finance model

25. The World Bank Group can help remove the impediments to infrastructure finance under the public finance model through a set of mutually reinforcing instruments:

At the sovereign level, design and implementation of coherent strategies for money market and government bond market development, including repo markets, issuance strategy for government bonds. This could be supported through IBRD/IDA capital market adjustment loans and TA;

At the sovereign and sub-sovereign level, design and implementation of securities markets infrastructure strengthening programs. This could be supported through IBRD/IDA securities markets infrastructure loans and TA;

At the sovereign and sub-sovereign level, design and implementation of reform programs to strengthen the legal and regulatory framework for sub-sovereign borrowing, including tightening of sub-sovereign budget constraints and establishment of sub-sovereign bankruptcy frameworks. This could be supported through IBRD/IDA capital market adjustment loans and TA;

At the sub-sovereign level, design and implementation of enhancement instruments for sub-sovereign bonds. This could be supported through IBRD/IDA partial credit guarantees and TA and through a new Group entity.

26. Enhancement instruments for sub-sovereign bonds could take the form of partial credit guarantee (PCG) facilities, both with and without sovereign counter-guarantee. Partial credit guarantee facilities with sovereign counter-guarantee would be aimed at sub-sovereigns with relatively lower credit rating. Partial credit guarantee facilities without sovereign counter-guarantee would be aimed at sub-sovereigns with intermediate credit rating up to below the sovereign. 27. Under the first scenario (secured facility), the IBRD would guarantee the repayment of a bullet bond in local currency at maturity on a non-accelerable basis. The coupon would remain the risk of the investors. Depending on market conditions, such

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facility would translate into a spread reduction and maturity extension for the bond. The facility would be used as long as its impact on spread reduction and maturity extension is larger than the price of the guarantee for the sub-sovereign. Access to the facility would be governed by strict ex-ante criteria. In case of default, the World Bank would repay the principal of the bond at maturity and would exercise its counter-guarantee agreement with the government. The government would repay itself through a transfer intercept with the sub-sovereign, thereby aligning the latter’s incentives with repayment discipline. IBRD support would take the form of a partial credit guarantee facility, with a one-time up-front approval by the Board and individual applications for guarantees subject to approval by Regional management (See Russia PCGF example in Section VI below).

28. Under the second scenario (unsecured facility), the World Bank Group would establish an Entity that would back partial credit guarantee facilities established in developing countries to enhance bonds issued by sub-sovereigns in local currency without the counter-guarantee of the sovereign. A detailed feasibility study and business prospectus would need to be prepared by the Group for consideration by the Board to analyze all the legal, financial and portfolio risk management dimensions of this instrument and the alternative institutional forms for the proposed Entity. Terms of reference for such feasibility study are attached in Technical Annex I.

V.B. PPP model

29. The World Bank Group can help remove the impediments to infrastructure finance under the PPP model through four groups of mutually-reinforcing instruments:

(i) Strengthening regulatory framework for PPPs

Design and implementation of reforms of the regulatory framework for PPP contract enforcement and dispute resolution, including contract transparency and monitoring systems. This could be supported through PPP framework adjustment loans and TA.

(ii) Supporting transition to cost-recovery tariffs

Design and implementation of output-based subsidy schemes to ease the transition to cost –recovery tariffs for low income households. This could be supported through IBRD/IDA budget loans and TA

(iii) Mobilizing equity for PPP transactions

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Design and implementation of World Bank Infrastructure Fund (WBIF) based on equity return sharing and buy-back structure. This could be supported by a IBRD loan to the Fund (See WBIF description in Technical Annex II)3

Design and implementation of first-round private equity funds focusing on the turnaround of local infrastructure companies. This could be supported by IFC through equity, quasi-equity and debt

Design and implementation of second-round Local Infrastructure Investment Trusts (LIIT) to buy-back equity stakes from first-round private equity funds or from the WBIF and hold these stakes over the longer-term. Such funds would be marketed to domestic and international institutional investors. This could be supported by IFC through equity, quasi-equity and debt. (See LIIT Description in Technical Annex III)4

(iv) Mitigating policy risks

Design and implementation of political/ regulatory risk insurance (PRI) facilities or partial risk guarantee (PRG) facilities to cover investors in utility companies against sub-sovereign breach of contract risk. PRI facilities could be supported by a MIGA facility, and PRG facilities could be supported by a IBRD/IDA PRG facility(See example of Peru in Section VI below).

The PRI facility would be unsecured and would be targeted at transactions with sovereign or sub-sovereigns presenting a medium policy risk profile. The PRG facility would be secured by a sovereign counter-guarantee and would be targeted at transactions with sovereign or sub-sovereigns presenting a high policy risk profile.

VI. Practical examples of innovative capital market products for infrastructure

VI.A Public finance model

Example: PCG Facility for domestic regional bonds in Russia

VI.B PPP model

3 See Sirtaine, Sophie, op cit

4 See Noel, Michel and Jan Brzeski, op. cit

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Example: Investment Promotion and Finance Facility in Bangladesh

Example: PRG Facility for domestic utility bonds in Peru.

VMarathe/MNoel/SSirtaine 7/21/04

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Technical Annexes

Technical Annex I: Sub-sovereign Guarantee Corporation (SGC): Terms of Reference for Feasibility Study

Technical Annex II: World Bank Infrastructure Fund (WBIF): Concept Description

Technical Annex III: Local Infrastructure Investment Trust (LIIT): Concept Description

References and Bibliography

Costain, Juan and Mark Dutz, Investment Promotion and Finance Facility, Concept Note, World Bank mimeo, June 2004.

Izaguirre, Ada Karina, Private infrastructure: Activity Down by 30 Percent in 2002, Public Policy for the Private Sector, Note 267, World Bank, February 2004

Fay, Marianne and Tito Yepes, Investing in Infrastructure: What is needed from 2000 to 2010? World Bank Policy Research Working Paper 3102, July 2003.

Noel, Michel and Jan Brzeski, Mobilizing Private Finance for Local Infrastructure in Europe and Central Asia: An Alternative PPP Framework, World Bank Policy Research Working Paper, forthcoming, August 2004.

Sirtaine, Sophie, and De La Plaza, Luis World Bank Infrastructure Fund, World Bank Policy Research Working Paper, forthcoming, date

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