backThe dramatic fall in crude oil prices has had a profound effect on the fiscal positions of states in the Gulf Cooperation Council (GCC), and a number of infrastructure projects in the region have been delayed for the indefinite future. At the same time, payment periods for projects already under construction have in many cases been lengthened, and it has been reported that advance payments to contractors engaged by government entities in Saudi Arabia have been substantially reduced.
The degree to which GCC governments will allocate budgets to infrastructure development in the near to medium-term will vary from country to country and will be influenced by a number of factors. One school of thought is that the collapse in oil prices will ultimately prove to be a net positive development in that it will promote the acceleration of economic reforms which will result in more diversified economies. In this scenario, state budgets will be buttressed by funds generated by fiscal measures such as privatizations of state-owned companies and other state assets, efficiency gains and savings from decreases in subsidies, and incremental revenues from the planned adoption of value-added taxes. Cautious optimists taking a longer-term view will argue that the successful implementation of these actions, taken together, should ultimately enable governments to support infrastructure development notwithstanding the challenges presented by a very unfavorable oil market that may persist for the foreseeable future.
However, the successful implementation of these reforms will be subject to a number of constraints, and will not happen overnight. Other measures that governments are reported to be taking to address budgetary shortfalls include sales of foreign assets by sovereign wealth funds, sovereign debt issuances and/or capital raising by state-owned enterprises. The ability of GCC governments to continue to pursue each of these avenues may, however, be constrained to the extent that sovereign ratings and foreign currency reserves may, in time and depending on the country, come under pressure. And if one accepts the consensus view that the market environment underlying depressed oil prices is likely to improve only gradually, potentially over several years, it would seem unlikely that increased revenues from hydrocarbon sales will bridge any fiscal gaps for public infrastructure investment in the near term.
HAS THE TIME (FINALLY) COME FOR PPPs?
What does all this mean for infrastructure projects in the GCC region, and in particular opportunities for public-private partnerships (PPPs) for the financing, delivery and operation of public infrastructure assets? Although the challenges of a new economic landscape defined by sustained depressed hydrocarbon prices would at first blush seem to paint a fairly bleak picture, the prevailing narrative of market observers is that most planned critical and/or strategically important infrastructure projects will go ahead, and that it is just a matter of time before governments will finally turn to the private sector for the financing of infrastructure projects in a significant way.
Proponents of this view point not only to economic necessity, but also to a number of projects in the planning or development stages that appear likely to be structured as PPPs. The two key markets generally considered to be the most promising in the near term are Kuwait and Dubai, each of which has recently adopted a legislative framework for PPPs. [1]
To take the case of Dubai, the Dubai Electricity and Water Authority (DEWA) has launched a tender process for the third phase of the Mohammed Bin Rashid Al-Maktoum Solar Park on a PPP basis; the Dubai Roads and Transport Authority (RTA) recently announced its first PPP project, the new Union Square station plaza; and Expo 2020 should provide a platform for a number of potential PPP opportunities. In Oman, it has been reported that that the government plans to develop a PPP framework, with draft PPP legislation expected to be issued later this year. There has also been much speculation that the Saudi government will decide to implement a number of infrastructure projects on a PPP model. In this connection, Taif International Airport (currently in the prequalification stage) is planned to be developed on a PPP basis, and it has also been reported that state utility Saudi Electricity Company is planning to use a PPP model for the procurement of two PV solar projects and a wind farm.
This is not to say that there is no history of infrastructure projects carried out in the GCC on a PPP (or quasi-PPP) basis. [2] In the power and water sector, there have been a number of IPPs / IWPPs (independent power / water projects) structured on a PPP model (notably in Abu Dhabi), and the region has also seen a limited number of infrastructure projects implemented on a PPP basis in utilities (including district cooling, potable water and wastewater), social infrastructure (particularly in education and healthcare) and an airport (the Prince Mohammad bin Abdulaziz Airport in Medina). However, PPPs outside the power and water sector have been relatively few and far between, and several projects that were initially planned to be structured as PPPs were ultimately completed through traditional procurement models.
While this lack of penetration of PPPs in the GCC region may be attributed to a number of factors, until the recent downward slide in oil prices most GCC states have generally had ample fiscal headroom to fund infrastructure projects from hydrocarbon sales and/or through sovereign debt issuances, with the perception that self-funding would be cheaper than the all-in costs incurred by governments over the life of the project when resorting to a PPP approach. In other words, the PPP model has, until recently and with limited exceptions, generally been viewed as unnecessary and/or as a less attractive alternative than traditional procurement.
Against this backdrop, below are a few themes that may have relevance for PPPs in the GCC market in the context of the challenges presented by a new economic landscape defined by sustained low oil prices.
CURRENT Financing Models and Sources of Funds
The financing model for most PPPs in the GCC region has been project finance that is, financing raised for a defined project on a limited recourse basis whereby the repayment by the borrower will be dependent on the internally generated cashflows of the project. The borrower is typically a special purpose company owned by the developer(s) of the project, and depending on the project and jurisdiction, a government entity may also hold an equity stake. In some cases other parties, such as EPC contractors and/or financial investors, may also have equity participations in the project company.
The external debt financing for regional PPPs structured on a project finance basis has generally been characterized by long tenors, and almost always sourced primarily from commercial banks and, in the case of large projects, export credit agencies (ECAs) through guarantees or direct loans. The involvement of ECAs, particularly for larger projects, became increasingly important after the 2009 global financial crisis and the ensuing implementation of enhanced bank regulation in Europe.
Shariah-compliant financing provided by Islamic banks or conventional banks through Islamic windows has become increasingly important for the project finance market in the region, particularly in Saudi Arabia. To cite a recent example, in 2015 Arabian Company for Water and Power Development (ACWA) closed the financing for the construction of a $2 billion industrial gases project to supply Saudi Aramcos refinery at Jazan Economic City, which is being financed exclusively on an Islamic basis by a group of ten international and local banks.
To date, project bonds have been a source of funding for several refinancings in the region, including by Dolphin Energy in 2009 and 2011 and Ruwais Power Company (the project company for the Shuweihat 2 IWPP in Abu Dhabi) in 2013. However, with limited exceptions, such as Islamic bond ( sukuk) issuances by SATORP in 2011 and Sadara Chemical Company in 2012, bonds have not been part of the capital structure of greenfield project financings in the GCC. For reasons that have been expounded in a number of articles and discussed at a variety of conferences held in the region, project bonds are unlikely to play any substantial role in the project financing of greenfield infrastructure projects in the GCC for the foreseeable future.
WHERE DO WE GO FROM HERE?
Assuming, with cautious optimism, that the trend will be for GCC governments to pursue private sector financing as a way to plug budgetary gaps for public infrastructure development in a prolonged weak oil market, what can be said about the financing options and structures that will likely be most prevalent?
Predominant role of commercial banks and ECAs for larger projects; potential challenges for local banks
It is likely that commercial banks will continue to provide the main source of financing for infrastructure PPPs in the region, with Islamic finance continuing to play an important role (particularly in Saudi Arabia). However, there is also good reason to suspect that local and regional banks will continue to face increasing challenges that may make it more difficult (and expensive) for project sponsors to rely on this financing source to the same extent as has been the case in recent years.
These challenges arise in the context where the weakened fiscal position of most GCC states has already started to have an impact on the liquidity of their respective banking sectors. This correlation between budgetary deficits and decreasing liquidity has manifested in declining deposits at a number of local banks (many of which have significant government shareholdings) over the past several months as oil prices have continued to languish.
However, it would appear, based on press reports and other publicly available information, that this reduction in deposit growth (and contraction in public-sector deposits) in a number of GCC banks has not yet been significant enough to materially impact liquidity, and it is possible that liquidity constraints might ease somewhat, at least in the short term. For example, according to press reports, bank deposits in the UAE banking sector actually climbed at the end of 2015. And in a move apparently aimed at expanding liquidity, it was reported that the Saudi Arabian Monetary Authority (Saudi Arabias central bank) informed banks in mid-February that the maximum loan-to-deposit ratio would be increased from 85% to 90%. Nonetheless, should the overall trend of tightening regional liquidity persist in 2016 as many analysts expect, local banks funding costs will go up, and consequently make financing from local banks more expensive.
In certain GCC states, this trend has coincided with an increase in government borrowing, and any significant sovereign debt issuances in local markets might, over time, crowd out lending to private sector borrowers. Depending on how long (and the extent to which) these separate but related trends persist, the capacity of local and regional banks to finance a growing pipeline of infrastructure PPPs might also be negatively impacted when these projects are evaluated in the context of other opportunities where credit may be deployed.
Notwithstanding these challenges, I(W)PPs and other major infrastructure developments that are well structured and benefit from strong governmental support should continue to be financed with a mix of ECA, international commercial bank and local / regional bank involvement. In this connection, the very significant decline in the participation of international banks in the GCC and broader MENA region following the global financial crisis appears to have begun to reverse, with certain European banks that had essentially been absent from the regional project finance market for several years recently returning. That said, some of the Eurozones biggest banks are facing very difficult conditions at the moment, and the durability of the incipient trend of increasing participation of European banks in the GCCs project finance market will be contingent on avoiding a new financial crisis in Europe.
Smaller projects and the role of local and regional banks
In light of current economic conditions, and at a time when perceived geopolitical risk has increased, it would seem unlikely that smaller-scale projects with total capital requirements not exceeding $300 million (which describes a wide range of utility and social infrastructure projects) will generate sufficient interest from international banks to compensate for any potential challenges in obtaining financing from local banks.
Although ECA funding may be available for certain smaller-scale projects, it will be less attractive (and more challenging to obtain) when the capital expenditure does not comprise substantial eligible content for ECA support. Unless ECA financing can provide a major source of funds in the financing plan, it may also be relatively unappealing for sponsors of small to medium-sized projects given its relative increased complexity, and generally longer time needed to reach financial close. This is not to say that ECA financing has not been successfully secured for smaller projects or that contractor financing supported by EPC guarantees may not continue to be important in certain cases, only that it would appear unlikely that ECA financing will supplant financing from local banks for small to medium-sized infrastructure projects.
Accordingly, other than in the case of I(W)PPs and other major infrastructure projects, it seems reasonable to assume that (1) sponsors of small to medium-sized PPPs in the region will likely need to continue to turn to local and regional banks as the principal source of external debt financing, at least where the project is financed on a traditional project finance basis; (2) that this financing will likely become more costly; and (3) if the pipeline of infrastructure PPPs increases as optimists hope will be the case, this financing may be more difficult to obtain for some projects if the demand for longer-term credit exceeds capacity. One knock-on effect of this potential development may be the potential use of mini-perm structures, where tenors are substantially shorter.
Notwithstanding the above, and depending on the extent to which the availability of financing from local and regional banks is impacted by continuing low oil prices, it may also be the case that the region will increasingly see smaller-scale PPPs implemented with (at least initially) lower leverage, if not in some cases entirely by equity. This outcome might be amendable to sponsors with strong balance sheets able to fund their equity contributions with the proceeds of corporate bank debt, which in the case of European, Asian and North American sponsors with access to funding outside the region may be easier than for local sponsors. However, if governments wish to optimize the pricing of bids, depending on the project it may be important for the concession agreement and/or other project documentation to provide for the possibility of the sponsors equity to be repaid by external debt on a project finance basis.
New developers, infrastructure funds and other institutional investors
Anecdotal evidence suggests that there may be a nascent but growing interest in the market from actors that have not traditionally played a significant role in regional infrastructure PPPs, including recently established developers with remits in specific sectors (in particular, renewable energy), as well as financial investors that are prepared to participate in the equity of infrastructure projects. It will be interesting to see the extent to which these players ultimately become instrumental in the financing of infrastructure projects in the region, particularly if liquidity in the regional banking sector evolves in a negative trajectory in the medium to longer term.
One potential development may be the increasing participation of infrastructure funds that may act as strategic partners to industrial sponsors in the financing of PPPs. Although the involvement of non-governmental infrastructure funds in greenfield projects in developing markets globally has been relatively limited (and mostly confined to emerging Asia and Latin America), the new macroeconomic environment and constraints on liquidity of banking sectors in the GCC region may spur a limited degree of reallocation of infrastructure funding from local banks to local, regional and, for larger projects, international infrastructure funds and other institutional investors.
Any such reallocation, however, is unlikely to be significant in the foreseeable future in the context where (non-governmental) infrastructure funds generally provide equity capital and seek equity-like returns. To date, participation of private-sector funds in GCC infrastructure development has generally been through equity investments in brownfield projects, with involvement as a co-sponsor in projects in the development phase very constrained. That said, anecdotal evidence suggests that there is increasing appetite from regional institutional investors to make equity investments in infrastructure projects in the MENA region, particularly in renewable energy projects, although not necessarily as yet in the GCC.
Accordingly, it would seem unlikely, at least in the near term, that infrastructure funds or other institutional investors will become significant conventional (or mezzanine) debt investors in GCC greenfield infrastructure developments. But to the extent that this potential development materializes, it will entail these investors getting comfortable with project development and construction risk, and it may be the case that the traditional project financing paradigm will be less attractive for these potential investors unless it can be simplified to make it less complex and time consuming to implement.
CONCLUSION
If the prevailing narrative that a protracted period of low oil prices will lead to a substantial increase in the role of PPPs in the GCC proves correct, there may be a number of prospects for both local and international industrial sponsors, and potentially infrastructure funds and other institutional investors, to invest in an asset class for which opportunities in the region have to date been relatively constrained.
Large, well-structured infrastructure projects in the GCC will likely continue to obtain debt financing from a combination of international banks, local and regional banks and ECAs. However, it is unclear in the current environment whether small and medium-sized projects will be able to attract substantial debt capital from international banks, and for smaller-scale projects financing from ECAs may in many cases be suboptimal from a sponsor perspective, if not unavailable.
In the case of smaller projects, it remains to be seen whether there will be sufficient capacity from local and regional banks to respond to sponsors leverage objectives. It does seem likely, however, that any further pressure on the liquidity in local banking sectors will result in increased pricing, and perhaps shorter tenors, of debt financing provided by local banks.
While only time will tell what the relative mix of funding sources (and financing models) for PPPs will be in this new economic landscape, for the PPP model to gain more widespread acceptance in the region it will be important for market participants to demonstrate to relevant government decision-makers that the perception that PPPs are more onerous and expensive than traditional procurement is not always necessarily the case, and that PPPs can be structured and executed in an efficient manner that offer substantial added value over the life of the project.[1] For an overview of the recent PPP legislation adopted in Dubai and Kuwait, see Middle East PPP Policy Developments: Kuwait and Dubai, Energy Newsletter (February 2016), by Tim Burbury, Usman Ahmad and Timm Smith at http://www.energylawexchange.com/middle-east-ppp-policy-developments-kuwait-and-dubai/.
[2] Substantially all of the PPPs implemented in the GCC to date have been undertaken without the benefit of a specific PPP government policy or legislative framework, and largely on the basis of bespoke contractual frameworks. A number of these projects have also been tendered by government-related entities as opposed to directly by a government ministry or department. Accordingly, it might be argued that it would be more accurate to refer to the paradigm adopted thus far in the GCC as a quasi PPP model. In any event, references to PPPs in this article are intended to capture the broad spectrum of public infrastructure projects that are developed, operated and financed on the basis of a partnership between a public sector body and one or more private sector entities irrespective of whether there is a formal PPP government policy or legal framework in place.