2017/FDM1/008 Session: 3 Long Term Investment: Investment Regulation, Financial Instruments, Risk Mitigation and Risk Sharing Mechanisms Purpose: Information Submitted by: Organisation for Economic Co-operation and Development Finance and Central Bank Deputies Meeting Nha Trang, Viet Nam 23-24 February 2017
LONG TERM INVESTMENT: INVESTMENT REGULATION, FINANCIAL INSTRUMENTS, RISK MITIGATION AND RISK SHARING MECHANISMS APEC FINANCE AND CENTRAL BANK DEPUTIES MEETING, 23-24 February 2017, Nha Trang, Viet Nam André Laboul, Special Financial Advisor and Senior Counsellor, OECD APEC Cebu Action Plan Pillar IV 1. Attracting private sector capital through PPPs to deliver crucial infrastructure; 2. Mobilizing long-term financing for infrastructure, particularly through enhancing member-economies capacity for project preparation and developing capital markets and flexible financial instruments that would attract institutional investors; 3. Demonstrating the importance of and activating longterm vehicles to support long-term investment; and 4. Promoting inclusive infrastructure in urban development and for regional connectivity. 2 1
I. ADRESSING OBSTACLES RELATED TO THE ROLE OF INSTITUTIONAL INVESTORS (with a focus on regulation) II. PROMOTING THE DIVERSIFICATION OF FINANCING INSTRUMENTS III. ADDRESSING RISKS AND THE MEANS TO MITIGATE THEM 3 I. ADRESSING OBSTACLES RELATED TO THE ROLE OF INSTITUTIONAL INVESTORS (with a focus on regulation) 4 2
Engaging institutional investors and capital markets The role of institutional investors as sources of long-term financing Nature of long-term savings is important Defined benefit Defined contribution Insurance Retail markets (mutual funds, investment products) Investment trends and preferences Domestic and foreign sources of capital Address policy barriers to long-term investment by institutional investors 5 Large pension fund and public pension reserve fund assets Total retirement system assets in the OECD, 2001-2014 Source: OECD Large Pension Fund Survey based on OECD Global Pension Statistics, Institutional Investors Assets databases, and OECD estimates 6 3
Trends in asset allocation responding to challenges global search for yield Increase in allocations to alternative investments Co-investment, partnerships in infrastructure and SME finance Also includes other areas such as private equity, real estate, and timberlands Insourcing and expense reduction Credit opportunities Opportunistic strategies, including fixed income Emerging markets Green and social investments 7 Addressing Barriers to Infrastructure Investment Problems with government support for infrastructure projects Lack of investor capability Problems with investment conditions Lack of political commitment over the long-term Lack of infrastructure project pipeline Fragmentation of the market among different levels of government Regulatory instability High bidding costs Lack of expertise in the infrastructure sector Problem of scale of pension funds Regulatory barriers Short-termism of investors Source OECD 2011: Policy Action for Pension Fund investment in Infrastructure Negative perception of the value of infrastructure investments Lack of transparency in the infrastructure sector Mis-alignment of interests between infrastructure funds and pension funds Shortage of data on infrastructure projects 8 4
REGULATORY POLICY FRAMEWORK Preconditions and framework G20/OECD High Level Principles on long term investment financing by institutional investors :preconditions (including predictable regulation, tax, enforcement rules, procurement, competition, governance, accounting etc), long term savings, governance, regulation, financial vehicules, investment restrictions, information, education Related effective approaches OECD Policy Framework for Investment Investment Policy reviews: example Philippines 9 Regulation of Investment Given the important objectives of regulation, there may be scope to examine regulations of pension fund and insurance investment to determine if there are impediments to investment in: Infrastructure in general is this an asset class that is not prohibited? Concentration levels infrastructure assets require large capital investments. Restrictions may apply to concentration (too much exposure to a single asset or country) Foreign investments ceilings on foreign assets, currencies, and credit qualities Geographies allowing investment in emerging markets and diversified regions Financial instruments certain investment funds for example Regulatory scrutiny should strive to balance prudential standards and objectives with the ability of pension funds to choose investments that are best suited to meet their future obligations, which could include investments Challenges: Increasing or removing ceilings may only increase investment proportionally, with little direct effect 10 5
Possible Forms of Institutional Investor Regulation 11 Quantitative limits on investments OECD Countries OECD Countries where each type of quantitative limit exists 12 6
Quantitative limits on investments Non-OECD Countries Non-OECD Countries where quantitative limit exists for pension funds, China 13 II. PROMOTING THE DIVERSIFICATION OF FINANCING INSTRUMENTS 14 7
REGULATORY POLICY RELATED TO DIVERSIFICATION OF FINANCIAL INSTRUMENTS FOR INFRASTRUCTURE see G20/OECD Guidance note Modes Infrastructure Finance Instruments Market Vehicles Asset Category Instrument Corporate Balance Infrastructure Sheet / Project Other Entities Capital Pool Fixed Income Mixed Equity Bonds Loans Hybrid Listed Unlisted Project Bonds Municipal, Subsovereign bonds Green Bonds, Sukuk Direct/Co- Investment lending to Infrastructure project, Syndicated Project Loans Subordinated Loans/Bonds, Mezzanine Finance YieldCos Direct/Co- Investment in infrastructure project equity, PPP Corporate Bonds, Green Bonds Subordinated Bonds Direct/Coinvestment lending to infrastructure corporate Syndicated Loans, Securitized Loans (ABS), CLOs Subordinated Bonds, Convertible Bonds, Preferred Stock Listed infrastructure & utilities stocks, Closed-end Funds, REITs, IITs, MLPs Direct/Co- Investment in infrastructure corporate equity Bond Indices, Bond Funds, ETFs Debt Funds (GPs) Loan Indices, Loan Funds Mezzanine Debt Funds (GPs), Hybrid Debt Funds Listed Infrastructure Equity Funds, Indices, trusts, ETFs Unlisted Infrastructure Funds 15 Sources of Infrastructure Finance Source: G20/OECD Guidance Note (forthcoming) 16 8
LINKS BETWEEN REGULATORY REFORMS 17 Infrastructure Finance Instruments PPPs can be useful instruments for projects where revenues are not certain or adequately provided through user fees Widely used across APEC member economies with examples in transportation, power, and telecommunication Ex amples: power plants in Thailand, Build-Operate-Transfer structures in Vietnam, high speed rail in Malaysia Some asset types such as airports, seaports, or renewable energy assets may be economically viable on a stand-alone basis Other models such as direct or indirect ownership through corporate structures or fund structures can be used Renewable energy finance, in this way, has been supported by long-term power purchase agreements Infrastructure finance could benefit from the use of flexible financing instruments Equity funds, investment platforms, listed equity trusts, could invest directly, or through SPVs and PPPs Certain APEC member economies would benefit from deepening domestic equity markets. Singapore, Malaysia, Thailand, Indonesia, and the Philippines have made progress The fund and investment platform model can also combine co-investment with commercial banks, insurance companies, and corporates, leveraging in-house expertise and skillsets while also mobilising a larger amount of capital 18 9
Linking Traditional Infrastructure Finance with Diversified Instruments and Techniques Optimisation of capital structure Efficient risk allocation to the party that is best able to manage risk Commercial banks acting as co-investors; the formation of syndicates Banks as Mandated Lead Arrangers, crowding in institutional investors Promote the development of project infrastructure bonds to mobilise further financing by institutional investors Deepen local corporate bond markets Government partnership in setting up funds MDBs and credit enhancement, risk mitigation MDBs and governments as co-investors Blended finance 19 EXTRACT FROM G20/OECD GUIDANCE NOTE PREAMBLE Establish a strong legal and institutional framework that supports an efficient microeconomic environment, transparency, well-functioning capital markets and ensures regulatory certainty and stability. Promote the development of local currency capital markets (including equity, bonds and derivative markets), and their integration with their international counterparts. Establish a national infrastructure roadmap and long term government strategy, develop a robust and transparent pipeline of investable infrastructure projects, and enhance infrastructure connectivity. 20 10
EXTRACT FROM G20/OECD GUIDANCE NOTE I. DIVERSIFYING INSTRUMENTS AND OPTIMISING RISK ALLOCATION Promote cooperative, targeted and transparent risk allocation mechanisms amongst the various financial stakeholders active on the infrastructure spectrum, including MDBs and NDBs, banks, companies, institutional investors and governments, positioning the different actors depending on their risk profiles and institutional objectives and favouring joint actions, securitisation and balance sheet optimisation. Promote governmental support to innovative financial approaches, such as asset recycling, land value capture, special assessment districts, and tax increment financing. Encourage diverse channels of debt financing for infrastructure projects, in particular through non-bank channels, including syndication of bank loans through capital markets, the development of a robust project finance market, revival or innovative use of local currency infrastructure project bonds and of subsovereign bonds, securitisation and the formation of lending consortia. Promote the development of alternative instruments for de-risked stagesof projects or hybrid investment vehicles. Encourage the formation of transparent and robust secondary market for infrastructure, and the development of specific products to improve access to capital market financing for infrastructure, including new vehicles to foster investor s participation (equity or debt, public and private) in infrastructure projects and recycling of capital through securitisation. Review the financing needs and instruments of small-scale infrastructure projects, which may be different from large-scale infrastructure. Promote project pooling, social and development impact investment instruments, and building networks of investors with local authorities and partners. 21 EXTRACT FROM G20/OECD GUIDANCE NOTE II. EQUITY INSTRUMENTS FOR THE FINANCING OF INFRASTRUCTURE Facilitate the establishment of robust unlisted infrastructure equity markets. Review the ability of equity funds to access infrastructure assets in the local market, including the suitability of greenfield assets for existing business models, and also the local laws that govern such vehicles. Review the availability of qualifying assets for diverse listed equity instruments, including existing equity business models such as Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), trusts and open- and closed-end funds. Encourage the formation of investment platforms and partnerships where government, NDBs and MDBs can leverage private sector investment. Review risk mitigation and incentives that especially encourage equity investment. Promote synergies between MDBs and NDBs and the broader equity market base, including through cofinancing facilities, insurance pools, wider range of currency hedging tools, and asset securitisation. Review the efficiency of tax policies for infrastructure finance, noting the tax treatment of debt and equity in the capital structure. 22 11
EXTRACT FROM G20/OECD GUIDANCE NOTE III. ENGAGING INSTITUTIONAL INVESTORS AND CAPITAL MARKETS Foster collaborative mechanisms between investors and the creation of pooling of capital especially for smaller investors and between investors and other stakeholders such as banks and MBDs and NDBs. Consider risk mitigation instruments and incentives specifically focused on investors in general, including guarantees, coverage of political and regulatory risks, credit enhancements, and more diversified insurance offerings, while ensuring their efficacy as well as taking due account of the impact on public finances. Review financial regulations that may potentially pose unintentional barriers to infrastructure investment by institutional investors, taking into account prudential, investor protection, and overarching financial stability objectives. Bundling assets to reach relevant scale, appealing for institutional investors, including consortia of small scale PPP projects. 23 EXTRACT FROM G20/OECD GUIDANCE NOTE IV. ADDRESSING THE INFORMATION GAP AND DEVELOPING INFRASTRUCTURE AS AN ASSET CLASS Promote international infrastructure data collection, including with the consideration of a template for a preferred set of information to be collected (macro and micro level) and quantitative data on historical cash flows and performance at the project level and qualitative data covering project characteristics and sustainability issues. Promote standardisation and harmonisation of project documentation and of approaches to infrastructure valuation and analysis. Consider a definition of sustainable and quality infrastructure investment to facilitate data collection on sustainability and resilience factors in infrastructure investment. Support initiatives to create infrastructure benchmarks which will in turn help to describe infrastructure as an asset class. Benchmarks should describe the investment characteristics and properties of infrastructure debt and equity instruments, helping investors complete their strategic asset allocation and liability benchmarking processes. 24 12
Diversifying financing for infrastructure: leveraging government, donor and FDI resources with local private capital 25 Addressing the information gap and developing infrastructure as an asset class Principal/agent problems and asymmetric information Investment mandate ambiguity The need to describe with strong empirical evidence the role of infrastructure investments in the portfolio Benchmarking infrastructure investment Can include sustainability goals Legal and regulatory Accounting standards, pension/insurance supervision, solvency, governance Improving the quality and availability of information for investors to determine whether infrastructure makes sense as part of their long-term asset allocation 26 13
III. ADDRESSING RISKS AND THE MEANS TO MITIGATE THEM 27 Risk and Returns Mapping risks in Infrastructure Public Sector Private Sector Risk Categories Development Phase Construction Phase Operation Phase Political and regulatory Macroeconomic and business Technical Environmental review Rise in preconstruction costs (longer permitting process) Ca ncellation of permits Contract renegotiation Change in tariff regulation Currency convertibility Termination Phase Contract duration Decommission Asset transfer Change in taxation Social acceptance Change in regulatory or legal environment Enforceability of contracts, collateral and security Prefunding Default of counterparty Refinancing risk Financing availability Liquidity Volatility of demand/market risk Inflation Real interest rates Exchange rate fluctuation Project feasibility Archaeological Governance and management of the project Environmental Reliability of forecasts for construction costs and delivery time Technology and obsolescence Force Majeure Qualitative deficit of the physical structure/ service Termination value different from expected Source: OECD Taxonomy 28 14
REGULATORY POLICY RELATED TO RISK MITIGATION Type of Measure Instrument 1. Minimum payment, paid by contracting authority 1. Guarantees, realised directly by Government or by its own controlled agency or development bank 2. Guarantee in case of default 3. Guarantee in case of refinancing 4. Exchange rate guarantees 2. Insurance (private sector) 1. Wrap insurance, technology guarantees, warranties, commercial and political risk insurance 3. Hedging (private sector) 1. Derivatives contracts such as swaps, forwards, options etc. 4. Contract design, paid by contracting authority 1. Availability payment mechanisms 2. Offtake contracts 1. Subordinated (junior) debt 2. Debt: 5. Provision of capital, realised directly by Government or by its own controlled agency or development bank 2.1 at market condition 2.2 at lower interest rate 3. Equity: 3.1 at market conditions 3.2 at more advantageous conditions 1. Lump sum capital grant 2. Revenue grant: 6.Grants, generally delivered by contracting authority, even if some dedicated fund at national level may exists. Tax incentives can be delivered by national or local authorities 2.1 Periodic fixed amount (mitigating the demand risk) 2.2 Revenue integration (it leaves the demand risk on the private player) 3. Grant on debt interests 4. Favourable taxation schemes for SPV 5. Favourable taxation schemes for equity investors 29 Crowding-in private capital: Could effectiveness of DFI interventions in risk sharing be enhanced? 30 15
Risk Mitigation Instruments in ASEAN Member States Insurance, guarantees, credit enhancement are particularly important for access to debt financing and to mitigate political and regulatory risks Allows for longer tenors and lower cost of financing Covering political risks and contract risks Example; Indonesia Infrastructure Guarantee Fund; bond guarantees in Malaysia Multilateral development banks as Lead Arrangers, providing credit enhancement Supply of private sector insurance coverage varies across ASEAN Significant gaps remain in coverage in some countries, particularly for breach of contract and adverse regulatory changes Commercial risks related to construction, exchange rate, demand and counterparty risks constrain equity and debt financing Contractual arrangements can be an effective strategy for transferring and mitigating commercial risks In Malaysia, project companies increasingly bear traffic risk on toll roads, Indonesia and Philippines increasingly seeking to shift demand risk to project companies Joint ventures or alliances with local companies can also help to mitigate commercial risks Availability of foreign exchange risk mitigation instruments Currency hedging or currency guarantees 31 Leveraging the role of MDBs by catalyzing private resources / more bang for the buck Leveraging MDBs balance sheets while maintaining their AAA rating Making portfolios of MDB assets available to private investors MDBs finance initial project development and sell project (brownfield) debt Reorientation of MDB asset-exposures moving from loans to risk-sharing; credit enhancement for project loans and bonds; guarantees for take-off agreements, targeted loan guarantees (for the construction phase) 32 16