The infrastructure finance gap in emerging markets, particularly in countries like Nigeria, has long been attributed to a shortage of capital. However, experts argue that this is not the primary issue. Instead, the real challenge lies in the risk associated with investing in infrastructure projects. A recent example illustrates this point: a mid-sized power project in a fast-growing emerging market with strong fundamentals and a credible sponsor was stalled due to a currency mismatch risk. The project's revenues would be earned in local currency, while debt service would be in dollars, and the country's central bank lacked a deep enough forward market to hedge the required tenor.
The term sheet for the power project had already circulated, and the investment team and economics had given it a green light. However, a currency analyst's note highlighting the currency mismatch risk three weeks before the credit committee meeting brought everything to a halt. Despite the project's strong fundamentals, the risk was now named, and no one had decided who should carry it, on what terms, and at what price. The deal did not die but stalled indefinitely, illustrating the moment that determines more infrastructure outcomes than any pledging conference or capital-raising round.
Risk is an inherent part of infrastructure investing, and no serious investor expects it to be risk-free. Political risk, currency risk, regulatory risk, and other types of risk are common in infrastructure finance. Institutions active in the space price for some combinations of these risks, and credit committees have approved transactions carrying meaningful exposure to several at once. What stalls capital is not the presence of risk but risk that has not been decided or allocated.
The confusion in the infrastructure risk conversation arises from treating four distinct operations as one: risk removal, risk allocation, risk pricing, and risk absorption. Risk removal takes a specific exposure off the table entirely, while risk allocation decides which party in a transaction is best positioned to hold a given risk. Risk pricing puts a number on exposure that cannot or should not be removed, and risk absorption uses concessional or public capital to take a specific risk off a project's economics.
The discipline of identifying precisely which risk in a transaction needs which of these four operations, applied by which party, at which stage of the project's life, is crucial in mature infrastructure markets. This discipline is still being built in many emerging markets. The allocation question has a defensible answer in most cases, though it is rarely applied with discipline. Risks that a party can control or influence should generally sit with that party.
For instance, a government retains regulatory and permitting risk because it is the author of the regulation, while a contractor retains construction risk because it prices and manages the build. Risks that no transaction party can control, such as currency devaluation or sovereign default, are better held by parties built specifically to price and diversify them across many transactions.
The stage of the project also matters, as early-stage development risk is appropriately absorbed by development capital willing to lose money on projects that do not proceed. In contrast, late-stage operational risk is appropriately priced into commercial debt at commercial terms, once the uncertainty that justified concessional support has already been resolved.
Key points
- Risk, rather than capital, is the main obstacle to investment in infrastructure projects in emerging markets.
- The four distinct operations of risk management - risk removal, risk allocation, risk pricing, and risk absorption - are often confused, leading to bad structuring.
- A defensible answer to risk allocation can be found in most cases, but it requires discipline and a clear understanding of which party can control or influence which risks.
