EUROPE – Construction-risk guarantees for infrastructure projects would be damaging from both a public welfare and an asset management perspective, according to research by EDHEC-Risk Institute.
The institute said large infrastructure projects that received "blanket guarantees" on the debt financing – say between 95% and 100% – simply created multi-billion-pound liabilities for the taxpayer.
EDHEC based its comments on a report published earlier this month by the UK National Audit Office (NAO).
At the time, the NAO expressed concerns that if the UK government, in its desperation to attract pension funds to the infrastructure sector, gave large construction-risk guarantees for new projects, substantial liabilities could arise for the British taxpayer.
"This is an ongoing debate in the UK, but it highlights an issue of global relevance," EDHEC said.
"Numerous governments are now pushing for the growth of institutional financing of national infrastructure spending plans, while investors are increasingly looking at long-term assets like infrastructure."
EDHEC argued that, giving such "extremely naïve" guarantees – in the words of the NAO – is a failure to recognise that construction risk is mostly a function of who is exposed to it.
Infrastructure construction risk should not rely on public sector guarantees, EDHEC said, but should instead be based on a scientific portfolio construction.
"Construction risk is either the result of unforeseen exogenous conditions such as the weather conditions or that of endogenous incentives created by contracts allocating risks to different parties," the institute added.
"Contracts that create incentives to control cost overruns can reduce and sometimes eliminate construction risk."
EDHEC went on to argue that a construction firm that is given the incentive to control costs, has experience of how much projects cost to build, and is large enough to diversify project-specific construction risk can easily take on the construction risk associated with infrastructure projects.
"This is exactly what happens with standard project financing, from £50m (€60m) school projects to $4bn pipeline projects," it said.
"Construction risk is reduced by risk transfer in project financing as opposed to being increased by public sector risk guarantees."
However, the institute also noted that, while construction risk is to a large extent project-specific and thus diversifiable, it is still rewarded since construction risk typically attracts higher credit spreads until projects are built and operational.
EDHEC argues that adding some construction risk to an infrastructure debt portfolio would thus increase returns and reduce portfolio risk thanks to diversification.
"It follows that investors in infrastructure debt should actively seek to invest in construction risk," it said.
"Moreover, if construction risk can be used to build efficient infrastructure debt portfolios, there is little need to push it out of sight and into new public sector liabilities."