Blue skies ahead for future greenfields?

Infrastructure Australia estimates the total cost of developing Australia’s priority infrastructure projects amounts to over A$91 billion. While bank and equity financing dominates funding for projects at the greenfield stage in Australia, there is growing concern that this model is building up systemic risk that could affect both current and future Australian infrastructure projects.

Introducing alternative sources of funding into the market has strong support from a broad range of participants with local A$ project bonds touted as an attractive option by many.

Ashurst recently spoke to a range of sponsors, banks and investors and asked them to tell us what they see as the pivotal opportunities and challenges facing project bonds in Australia.

In this article, we share with you some of the key views expressed and conclude that, from our perspective, none of the challenges affecting domestic project bonds are insolvable. If necessary support is made available, blue skies may be on the horizon for local A$ project bonds.

The use of local A$ project bonds to fund Australian infrastructure projects at the greenfield stage remains in hibernation. Nevertheless, Australian sponsors and investors would welcome the development of a project bond market despite the dominance of existing bank and equity funding. Doing so would provide an alternative funding source for the wave of major road and rail infrastructure projects on the horizon.

While infrastructure projects continue to be financed or refinanced with bonds at the brownfield or operating phase in Australia, with these securities forming part of the funding mix for recent refinancings for AquaSure (the Victorian Desalination Plant) and the Eastern Distributor, the Australian greenfield project bond market essentially closed upon the demise of the monoline insurers during the GFC, with almost no deals coming to the Australian market since the start of the crisis (the Newcastle Coal Export Terminal and Wiggins Island Coal Export Terminal being two exceptions).

So why haven’t project bonds taken off in Australia when that trend has been so evident in other jurisdictions? We took the opportunity to gather the thoughts of sponsors, banks and investors during a number of meetings recently in Sydney and Melbourne.

The principal reasons, in order of importance, identified through those market soundings were as follows:

1. current pricing, with bank funding currently having a competitive advantage at the 5-7 year tenor;
2. the willingness of local banks, public authorities and sponsors to accept refinancing risk over a 15 to 30 year concession period;
3. concern that bondholders will not accept construction risk;
4. difficulties in implementing effective decision-making procedures for bondholders during the project;
5. negative carry (ie, the higher cost of debt service compared to interest earned by holding the upfront bond proceeds on deposit); and
6. perceived lack of liquidity in the Australian project bond market.

By no means is this list intended to be exhaustive; it simply reflects the messages heard on our travels.

Pricing for bank funding remains at historic lows. Procurement models also offer sponsors no incentive but to use short-term debt and take a view on refinancing margins. Notwithstanding, it seems inevitable that the cost of such debt will increase over time. This will potentially lead to real losses on refinancings if margins widen, and that is before taking account of Basel III and other regulatory costs that may arise. Without funding diversification there’s a concern that a ‘one size fits all’ model is building up systemic risk that may jeopardise medium to long-term financing and procurement of future greenfield projects.

What then of the other issues identified above? In our view, none of these are insolvable.

Take construction risk. A large proportion of Australia’s institutional money is in equities, so there’s no reason why BBB project bond risk (at the low end of investment grade) should not, in principle, appeal to yield hungry investors. Our findings support this. Of course this has always been the case in the United States, is growing strongly in Europe (demonstrated on deals including M8, Alder Hey, Pendleton and Royal Liverpool) and is showing early signs of development in Asia (where a recent project bond presentation in Singapore garnered interest from 80+ market participants).

Counterbalancing the appetite of investors for returns is recognition that this would be a new offering in the Australian market with attendant risks. So some form of credit enhancement may be needed (as in Europe and, with the recent ADB initiative, in Asia) to kick-start the Australian project bond market. Whether Commonwealth or State Governments have sufficient political appetite to consider a support structure that goes as far as, eg, the HM Treasury UK Guarantee Scheme or the EIB 2020 Project Bond initiative (first utilised on the underground gas storage project in Spain, Project Castor) to stimulate capital market financing, either solely or in partnership with the private sector, for large-scale infrastructure projects remains unclear.

Other constraints identified too have solutions. Difficulties in decision making processes can be addressed through structures such as the appointment of a ‘monitoring advisor’, where an intermediary is appointed between the sponsor and the bondholders to act as an adviser to bondholders on the proposed course of action and facilitate bondholder voting. Liquidity can be enhanced by extending the credit curve (eg, through Commonwealth Government Securities issuance with 20 to 30 year tenors). Finally, negative carry can be mitigated through deferred drawdown mechanics, meaning funds are advanced and carry a real interest cost only when scheduled to be needed, something we have seen on recent private placements in Europe (eg M8 and North Tyneside).

Getting sponsors, banks, public authorities and investors to all agree to something is notoriously difficult. One thing that the participants we surveyed did unanimously agree upon though was that further diversification of Australian infrastructure funding sources is required, and some combination of public and private sector credit enhancement or substitution, initially, will be necessary. If that support is made available, blue skies may be on the horizon for local A$ project bonds.