Institutional investors should “actively seek” the potential rewards associated with construction risk when assessing infrastructure projects, according to EDHEC-Risk Institute.
And in response to a report published by the UK National Audit Office (NAO) last week, which warned that attempts by the government to guarantee against construction risk could see costs passed on to the taxpayer, the Institute said such guarantees were “simply not necessary”.
Construction risk has been the key stumbling block in getting institutional investors to fund new infrastructure projects, with many opting for “safer” completed opportunities instead.
However, EDHEC Risk argued investors could increase returns, reduce portfolio risk and diversify infrastructure debt portfolios by including construction risk.
It said infrastructure project finance becomes predictably less risky as the project is built, ramps up and becomes fully operational – leaving an opportunity to invest in assets with different risk/return profiles and low correlations throughout a project’s lifecycle.
“Investing in a portfolio of infrastructure debt that does not include some construction risk amounts to choosing to receive lower returns while possibly taking more risk,” EDHEC Risk said. “In more technical terms, it is equivalent to investing below the efficient portfolio frontier. Simply 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. 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.”
Responding to the NAO’s concerns, the Institute said construction risk guarantees from the government were “simply not necessary” if scientific portfolio construction methodologies are applied to infrastructure investing. It also warned such guarantees were likely to be damaging not only from a public welfare perspective but also from an asset management one.
“Moral hazard arises from public sector guarantees: large projects that receive blanket (95% to 100%) guarantees of the debt financing create multi-billion pound liabilities for the taxpayer (e.g. Metronet)”, the Institute said.
“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.”
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