Political Risk Hinders Investment in InfrastructurePOLITICAL AND REGULATORY RISKS HAVE BECOME CENTRAL ISSUES FOR PRIVATE INVESTORS IN ADVANCED ECONOMIES, AS THE THREAT OF NATIONALIZATION INCREASINGLY LOOMS IN THE UK AND ELSEWHERE. BUT WITHOUT STABILITY IN THE REGULATORY FRAMEWORK, PRIVATE INVESTORS ARE UNLIKELY TO FILL THE GAP OF FALLING PUBLIC INVESTMENT IN INFRASTRUCTURE
by Stefano Gatti, Dept. of Finance, Bocconi
Translated by Alex Foti
Over the last 15 years, infrastructural investment has established itself as an alternative asset class exhibiting very significant growth in terms of return on capital invested. The reason is that investors saw in infrastructure assets an excellent combination of DIY: Diversification (compared to more traditional assets such as stocks, bonds and money market instruments), Inflation protection (infrastructures are often assisted by inflation-adjusted prices) and Yield (infrastructures offer a risk-to-return ratio higher than fixed income securities and are less risky than investments in listed stocks).
Private investors thus consider infrastructure a 'safe haven' for its typical characteristics: high capital intensity, long time horizons, essential services with low demand elasticity to price, monopoly or quasi-monopoly settings, regulated sectors with high barriers to entry.
This last characteristic, that is industry regulation which means public and thus political control of infrastructural investment, has recently turned from being an advantage sought by investors to protect returns on investment into one of the main factors of uncertainty in selecting the infrastructure where one should invest. In fact, regulation is a double-edged sword: on the one hand, it protects the investment of incumbents from competition, which, especially over long time periods, could significantly reduce profit margins and cash generation. On the other hand, an investor who puts capital into a regulated sector is hostage to possible changes in regulations and laws, as well as renegotiations of the terms on which the building concession between public and private actors was based.
Private, industrial, and financial investors have always been aware of the risk in starting and developing an infrastructural project: such risks concern both the engineering aspects in construction phase and those more directly related to operations (demand risk, supply risk, risks of suboptimal maintenance and bad management). However, they have also been able to manage such risks by virtue of their market, management, and operational skills.
Unfortunately, the exogenous variable represented by political risk and regulatory risk cannot be managed, and this makes private capital reluctant to invest in the development of infrastructures. It is not possible, as it has been stated on several occasions, to expect a major role for private capital as a substitute for public investment in the presence of a considerable infrastructural gap (in the European Union alone, this gap is estimated to grow to €12 trillion by 2040) if the regulatory framework does not remain sufficiently stable to enable the development of long-term projects.
In the past, the issue of political and regulatory risk was essentially confined to emerging economies that sought to attract private capital for the implementation of infrastructural projects. Over the last few years, however, the issue has become important also for developed countries, even those most open to processes of privatization of capital markets. The United Kingdom itself is in the midst of an intense political debate which has led the Labour party to declare that in the event of its electoral victory there would be nationalization of the railways and the water industry, two services with decades of tradition under private management.
Under the new framework, as one can easily imagine, it has become more difficult to square the circle with respect to the recent past: investment in infrastructure is lacking and governments are unable to finance the gap, while the private sector has to financial resources and skills to fill the infrastructural gap at least in part, but private business faces a hostile political environment which makes it is difficult to arrive at accords that actually open construction sites.