sleconomics - models for funding infrastructure in south africa - nov 2013

Africa Infrastructure Rollout Conference 2013

Sandton, South Africa 19 November 2013

slEconomics

Economics Consulting in Utilities and Infrastructure

Contact: Dr Stephen Labson [email protected] www.sleconomics.com

Contact: Mtutu Benya [email protected] www.sleconomics.com

Role of infrastructure development

Pubic sector infrastructure investment Funding options

Regulatory and policy challenges

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Macroeconomic drivers

• The South African economy has averaged about 3 per cent growth a year since 2009.

• GDP growth was roughly 2.5 per cent in 2011/13, a GDP growth of 5% would meet the current needs of service delivery.

• There was a modest recovery in job creation during 2011/12 but the unemployment rate remains high at 23.9 per cent.

• The national government’s budget deficit for 2011/12 was 5,2 per cent of GDP and public sector borrowing requirements at 7.1% GDP.

• Total (gross) loan debt was R1.1 trillion as at 31 December 2011, equivalent to 38.6% of GDP.

Infrastructure developments

• Budgeted public sector infrastructure spending of roughly R845 billion is planned for from 2012/13 to 2014/15 of which R300 billion is targeted to the energy sector and R262 billion in transport.

• To 2020 R3.2 trillion is expected to be invested in 43 large scale projects in areas such as:

• Adding 11,719 MW of power generation capacity and 6596 km of high voltage transmission lines.

• Replacing 6405 km of rail freight, coal and ore lines increasing rail network capacity by 149.7 million tons, and procuring 1317 new locomotives and 25,000 new wagons.

• A R100 billion port expansion at Durban.

The infrastructure challenge has been escalated to a priority agenda due to increased demand for service delivery and the need to grow the economy in tandem with population growth;

These challenges are not unique to RSA alone but they are a continental problem and as part of the SADC region together is grappling to achieve economic growth, efficiencies and effectiveness.

Energy and Transport represent the bulk of South Africa’s investment in infrastructure, which is now a significant proportion of total Government borrowings.


Government borrowings (R billion)

2011/12 2012/13 2013/14 2014/15

Public sector borrowing requirement

213,9 235,1 225,3 200,8

General government borrowing

145,7 158,2 147,8 126,7

Non-financial public enterprises

68,2 75,9 77,6 74,1

Source: South African Reserve Bank, Quarterly Bulletin March 2012 (NB 1 Rand = AUD$ 8.41 as of 19/06/12)

South Africa’s public sector infrastructure programme is expected to be funded from a range of sources

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Funding options

• A combination of internally generated surpluses and borrowings from capital markets by public enterprises .

• Direct private sector investment such as the Department of Energy’s 3,625MW renewables Independent Power Producer Procurement Programme currently underway.

• Mixed shareholding, such as that for Telkom South Africa (Government retaining 38% shareholding) and Airports Company South Africa (Government retaining roughly 75% of shareholding).

• Direct government contributions for entities such as Passenger Rail Agency South Africa (PRASA) and Eskom

Source of funds utilised

• Enterprises such as Eskom, Transnet, SANRAL, and ACSA have made use of corporate bond markets and short term commercial paper facilities.

• Multi-lateral institutions such as the African Development Bank; Development Bank of Southern Africa; the World Bank; and the French Development Agency

• Local institutions such as the Industrial Development Corporation and Public Investment Corporation

• Sovereign funds (e.g. China and the Middle East)

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Four broad components for funding public sector infrastructure projects

Debt financing - which can be sourced directly by the public enterprise where a stand

alone corporate entity has been established and/or by government through loans or loan guarantees.

Equity injection - in which government as shareholder can provide cash injections to the sector.

Government grants - whereby government as a policy decision allocates its resources in the development of public works.

Regulated revenue and tariffs - which (outside of government grants) are ultimately relied on to repay capital investment over the longer term.


Debt financing in its various forms represents a significant component of infrastructure funding due to the large capital requirements associated with capacity augmentation, the long term nature of the physical assets, and the (often) stable source of regulated revenue

The availability and cost of funds is of course currently a critical issue with global capital markets under strain limiting the availability of funds and making borrowings relatively more expensive than compared to recent history.

World Bank Group reported that the debt/equity ratios in infrastructure projects reaching closure changed from around 85/15 in 2005–07 to 73/27 in 2008. 14 Projects reaching financial closure in early 2009 had debt/equity ratios of around 70/30.

Both availability and cost of borrowings is directly dependent on the credit worthiness of the

entity acquiring financing.



Theory Government guarantees can support the

amount of borrowings a state owned corporation is able to source and the yield required by debt providers.

However, a government’s cost of capital is

not independent on the level of support provided to state owned enterprises in the form of direct guarantees and/or associated contingent liabilities. For example, where government is

either legally obligated to service the debt of a wholly-owned entity in the case of default – or there is a strong expectation of the same by debt providers – the availability of funds is reduced and the cost is greater than it otherwise would have been

And practice

• The relevance of contingent liabilities is illustrated by recent actions pertaining to SANRAL, whereby in an affidavit to the Constitutional Court of South Africa (21 May 2012) the Minister for Finance stated that if SANRAL was to default on its outstanding loans there would be:

• “considerable risk of negative consequences for the South African Government's capacity to raise funds from capital markets. The credit rating of SANRAL in the money markets will in the first instance be severely affected , since it raises money by issuing bonds. The credit rating of South Africa would also be impacted on negatively, since SANRAL is a wholly government-owned. entity and its standing affects the Government’s standing.” (emphasis added)

Direct equity injections (as opposed to pure government grants), sovereign funds and similar investment vehicles have been used in a number of counties in providing equity capital to infrastructure projects.

Generally speaking, the provision of equity capital implies a future stream of dividends to shareholder, and is best suited to sectors/projects where there is the expectation of commercial return on investment.

* Brattle Group, “The Cost Of Capital For The Dampier To Bunbury Natural Gas Pipeline” October 1999 9

Return on investment for public enterprises

The cost of capital is broadly defined* as “the expected rate of return on alternative investments of equivalent risk. It is the rate of return that investors require based on the risk-return alternatives available in competitive capital markets” and there is strong argument to be made that this fundamental relationship is equally well applied to competitive capital markets and public enterprises. i.e.

In both market and regulatory environments scarce capital must be allocated to various investment options.

The underlying opportunity cost of capital employed to each investment option (or business) is dependent on the risk characteristics of that investment (business).

This is the case for privately held businesses and public enterprises. For this reason, the commercial rate of return provided for in the capital markets may be seen as the appropriate conceptual starting point in which to assess the appropriate rate of return on investment in public infrastructure.

While government grants often play an important role in infrastructure development, scarce resources must be allocated to meet a range of social objectives.

This can constrain a government’s ability to build major infrastructure projects by way of grants from the fiscus. In this sense government grants may not provide a sustainable way in which to fund public infrastructure.

Broadly speaking, government grants as related to public infrastructure projects are often funded is by way of:

General taxation — the general tax base which revenue is sourced and the expenditure of the revenue raised.

General purpose public borrowing — funds raised by issuing debt securities (e.g. government bonds) on domestic or international markets.

Hypothecated taxes — taxation revenue (usually from specific taxes or levies) directly assigned or ‘earmarked’ to fund designated expenditures.

Intergovernmental transfers - the transfer of finances between different levels of government (e.g. from national to state or municipal governments).


Public Private Partnerships (PPP) as developed in the UK in the early 1990s under its Private Finance Initiative (PFI) are employed extensively in the delivery of public services and building of infrastructure.

It is sometimes seen as an off balance sheet approach to debt funding.

These programs are generally broader than just financing and often aim to gain efficiencies from project design, construction, operation, and risk transfer.

Ordinarily, private sector financing is often a significant component of PPPs or PFIs, and useful to set out as one option for financing public infrastructure.

RSA has since developed its PPP unit with National Treasury.


Long term sustainable outcomes require internally generated funds supported by tariffs.

Proper licensing , monitoring , tariff setting, and dispute resolution mechanisms must be in place.

Tariffs and prices must recover all the efficient costs of supply including a return that is perceived by the investor sufficient to invest his capital in the industry over time.

When the tariff levels are set right, they provide a positive incentive for private investors to invest in the sector.

Tariffs must be set over a long term to provide for predictability by the investors to plan their enterprise performance over time.

The regulated decisions must provide an environment that is consistent over time for sound strategic planning.

The regulated decisions must be flexible to be challenged in court if needs be or be re-opened for review at appropriate cost effective times.


Moody’s provides its approach to rating regulated utilities in which it sets out the following 4 key rating factors and weighting in its assessment of credit ratings for regulated utilities*


Factors cited by Moody’s

• Predictability of regulatory decision making; the level of political intervention in the regulatory process, and the strength of the regulator’s authority over regulatory issues.

• Supportive regulatory environments and cost recovery mechanisms.

• Historic and projected financial performance as assessed by standard credit metrics.

* Source: Moody’s Rating Methodology, Regulated Electric and Gas Utilities August 2009

Moody’s Rating Factor Weighting - Regulated

Utilities

Broad Rating Factors Weighting

Regulatory Framework 25%

Ability to Recover Costs and Earn

Returns

25%

Diversification 10%

Financial Strength, Liquidity and Key

Financial Metrics

40%

Independent regulators that protect the interest both for a sustainable sector over time and the interests of customers for tariff structures that are affordable and are flexible around the different needs.

The balance between cost reflectivity and affordability must be established to the satisfaction of investors and the customers, that is the tariff must be sufficient for investors to provide new investment in the sector and the same time it must make the consumers of the service satisfied that it is value for money.

Regulatory decisions on revenues and tariffs should avoid shocks to the industry and maintain consistency over time.

Regulatory decisions must be exposed to stakeholder consultation before they are implemented and stakeholders must be afforded time to comment in writing or orally.


Fast-tracking policy and regulation reforms for their enhanced implementation - licensing, monitoring, tariff setting, and management of disputes.

Enhanced monitoring of projects for speedy regulatory approvals.

Finalizing the best solution for each infrastructure deficiency - proper load forecasting, demand projections, and supply deficiency estimations.

Facilitation of funding for infrastructure projects.

Guidelines for preparing a finalized infrastructure roll-out plan.

Managing risk in infrastructure projects.

The future for infrastructure financing – long range price trajectory by sector to inform decision making in each sector to ensure sustainability over time.

The importance of proper stakeholder engagement on infrastructure funding.


The regulatory environment is still developing:

Tariff levels have not reached cost reflective levels needed to attract private sector participants

Appropriate regulatory and governance frameworks need to be applied to enable sustainable investment in infrastructure.

Uncertain implementation of pricing frameworks further impends investment in major projects (i.e. Sanral) .

As these challenges are addressed, and with a proven track record of

achievement, ongoing investment in South Africa's Infrastructure will provide the foundation for economic growth and development into the future.


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slEconomics is a boutique economics consulting firm providing

specialised advice to governments, regulators and corporate clients in

the area of utilities and infrastructure. We are based in Sydney Australia

and in Pretoria South Africa, backed by an international network of

associates to bring global experience to local initiatives. www.slEconomics.com

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sleconomics - models for funding infrastructure in south africa - nov 2013

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