Global lessons on financing infrastructure

Lagos, August 5, 2013

Infrastructure round table

CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited

McKinsey & Company | 2SOURCE: McKinsey

▪ “A multi-trillion dollar game”: We estimate infrastructure investment requirements (to both cover current gaps and keep up with growth) of ~$60 trillion between now and 2030 –More than estimated value of today’s infrastructure

▪ “Funding facing strong headwinds”: Current funding context is difficult, with tight lending capacity and increasing fiscal constraints, but still many options exist to overcome them

▪ “Money is not the (main) problem”: Lack of funding and financing for infrastructure is a symptom of deeper problems that require action at other, more transformational, levels– Improve infrastructure portfolio/ project selection– Streamlining delivery– Making the most of existing infrastructure

McKinsey & Company | 3SOURCE: Organisation for Economic Co-Operation and Development (OECD); International Energy Agency (IEA), 2011;

International Transport Forum (ITF); Global Water Intelligence (GWI); McKinsey Global Institute analysis

Projection based onexternal estimates

55

Projection based onratio of infrastructure stock to GDP

64

Projection based onhistorical spending

59

Three different methods point to infrastructure investment needs globally of $60 trillion through 2030Estimates of needed core infrastructure investments, 2013–30$ trillion, constant 2010 dollars

Telecom

Water

Power

Other transport

Roads

McKinsey & Company | 4SOURCE: ITF; GWI; IHS Global Insight; Perpetual inventory method, OECD, 1998; McKinsey Global Institute analysis

Infrastructure investment needs to rise to 4.1 percent of GDP on average worldwide and much more in most developing countries

World

4.13.8

1 Estimated need based on projected growth, 2013–302 Weighted average annual expenditure over years of available data, 1992–2011

Spending in core infrastructure (to ensure 70% of GDP in 2030)% of GDP

Brazil

4.9

1.5

Russia

4.03.4

India

6.9

4.7

South Africa

5.1

3.4

Nigeria

7.0

2.5

Actual spend2

Estimated need

8.5

China

6.4

Most developing countries require significant step-upChina is a clear outlier

McKinsey & Company | 5SOURCE: McKinsey

▪ “A multi-trillion dollar game”: We estimate infrastructure investment requirements (to both cover current gaps and keep up with growth) of ~$60 trillion between now and 2030 –More than estimated value of today’s infrastructure

▪ “Funding facing strong headwinds”: Current funding context is difficult, with tight lending capacity and increasing fiscal constraints, but still many options exist to overcome them

▪ “Money is not the (main) problem”: Lack of funding and financing for infrastructure is a symptom of deeper problems that require action at other, more transformational, levels– Improve infrastructure portfolio/ project selection– Streamlining delivery– Making the most of existing infrastructure

McKinsey & Company | 6

Context for infrastructure funding is very challenging

Long-term debt financing is becoming increasingly costly and difficult to attain

Public budgets are tightening up (particularly in the “developed” world) which affects infrastructure spend more than proportionately

No improvement expected

▪ Basel III rules

▪ Banks exiting the infrastructure business (e.g., BNP Paribas, West LB)

Average interest marginsBasis points, transport infrastructure

280

135+107%

20102007

Difficult funding context

McKinsey & Company | 7

Increase in interest rate spreads have particularly hurt developing countries

Loan interest rate spreads1

SOURCE: Public Works Financing database, McKinsey Global Institute

1 Spread over 6month-LIBOR

Brazil, Chile, India, Mexico, Nigeria, Peru’, Thailand Australia, Canada, USA, UK

0

100

200

300

400

500

600

2013121110090807062005

0

100

200

300

400

500

600

201312111009080706052004

bps

McKinsey & Company | 8

Pension, insurance and sovereign wealth funds are projected to grow significantly and show increasing appetite for infrastructure assets

SOURCE: McKinsey Global Banking Pools; McKinsey Global Insurance Pools; SWF Institute; TheCity UK; Preqin

1

7

3

SWF

Pensionfund

Lifeinsurance

22

2000

32

05

41

10

83

106

6% p.a.

20

66

15

52

203025

5% p.a.

28

12

Private infra-structure

Publicinfra-structure

Global funds under management expected to continue to grow …

…and there is solid evidence that infrastructure assets can capture some of that growth

Average infrastructure allocations by fund type Percent

Investors who expect to increase allocations to infrastructure % of total respondents

Global pension, life insurance and SWF assets under managementUS$ trillions

McKinsey & Company | 9

These funds typically prefer less risky assets, but shift towards greenfield projects may signal increasing “aggressiveness”

Breakdown of funds projects and deals in infrastructure. Share of total

1 Includes Secondary stage and Brownfield2 Includes Greenfield (112) and Expansion (12)3 Includes Asset Acquisition, M&A, Brownfield, Privatisation4 Includes all unlisted funds active since 2002. Includes equity invested outside OECD by funds with global scope

SOURCE: Preqin; Infrastructure Journal; Public Works Financing; Infrastructure Investor; Global Insight; McKinsey

Infrastructure fund scope4

Total funds final size, USD bn, Estimates

91OECD

Non-OECD

USD 99 bn

835

58

65

42

175722 283

Projects 2005-10(average p.a.)

711

Infrastructure fund deals 2005-10(average p.a.)

190

Projects since2010

Greenfield

Mature1

100%=

McKinsey & Company | 10

PPPs can make up 20-25% of infrastructure spend, in both developed and developing countries

35

100

76

100

90

13

7

21

411

2010

118

8958

56

84

18

96

100

20

36

52

82

964

1028

26

47

481

6616

15644

SOURCE: HM Treasury, United Kingdom; Planning Commission, India; McKinsey Global Institute analysis

Planned public, PPP, and private investment in core infrastructure Ratio per sector

United Kingdom2011–15100% = $257 billion

India2007–11100% = $485 billion

Public

Public-private partnership (PPP)

Private

64%(164)

23%(59)

13%(33)

17%(82)

19%(92) 64%

(310)

Transport

Energy

Communications

Waste

Water

Electricity

Roads

Telecom

Rail

Water

Ports

Airports

Percentage. $ billion

McKinsey & Company | 11

While public purses are tight, there are several funding alternatives available to governments, with some representing unexploited potential

Detail on following pages

SOURCE: McKinsey Global Institute

Public capital

Financial instruments

Capitalrecycling

Property value capture

Divesture LeaseOther financial schemes

Alternative funding sources

Tax User charge

Public cash flow sources

1

2

It includes structured instruments like bonds and loans or plain vanilla like simple cash flows

Underlying revenue sources to fund the financial instruments

McKinsey & Company | 12SOURCE: Moody’s Investors Service, Transportation research board, McKinsey Global Institute

Financial instruments: long-term public debt financing can take different forms

1

Revenue bond1

Limited non-system bonds: backed by revenues not originated by the funded infra system

System revenue bonds: Backed partially or totally by system user charges

NYMTA: In December 1998, issued $317 million in principal amount of Transit Facilities Revenue Bonds

New York City MTA: 1998’s $396 million issue supported by the state’s petroleum business tax

SFO link: A $500 million issue of grant anticipation bonds to help connect San Francisco to the airport., backed by ability to issue sales tax bonds

Financial instrument Examples

1 Can be issued with tax-exempt feature

General obligation bond

GO bonds: backed by the full faith and credit of taxing authorities

San Francisco BART: $ 413 million general obligation bonds at ‘AA+’ (secured by an unlimited ad valorem tax levied on all taxable property within the BART counties)

Secured and un-secured loan agree-ments

Commercial Bank Loans: backed by public entity credit capacity + (collateral for secured loans)

Ghana Shared Growth Development Agenda (GSGDA): US$3 billion loan from China Development Bank to finance infrastructure projects

Loans from construction firms N/A

Direct loans from Government Capital providers: backed by public entity credit capacity

Missouri Transportation Finance Corporation [MTFC]: Backed by the Missouri Dept Of Transport, aims at providing financial assistance to accelerate or add projects for the State’s transportation system

McKinsey & Company | 13SOURCE: Moody’s Investors Service, Transportation research board, McKinsey Global Institute

2

Acquisition and sale of excess land: Public sector acquires land around an infrastructure project and sells it at a profit when project completed and land value enhanced

Outer-ring highway in Changsha, China: The Ring Road Investment Corporation acquired 200m strips of land on both sides of highway and borrowed against anticipated value of improved land to obtain financing from China Dev. Bank and commercial banks

Instruments Examples

Impact fees: Developers pay the cost of system-wide infrastructure expansion needed to accommodate growth

Phoenix, USA: Impact fees paid when construction permit issued, depending on type of infrastructure, type of land use, building and lot size, water meter size, distance from infrastructure trunk lines, and other locational features.

Options for property capture value

Public-private partnership: Developer installs “public” infrastructure in exchange for land

Madinaty real estate project, New Cairo, Egypt: New Urban Communities Authority agreed to supply the developer with free land, in return for the developer’s provision of basic infrastructure.

Betterment levies: Public sector taxes away a portion of land-value gain resulting from infrastructure projects

Bogotá, Colombia: ~US$1+ billion municipal works (mostly street, bridge, and drainage improvements) financed from 1997–2007 through betterment levies, graded so that betterment levies fall more heavily on commercial-industrial uses than on residential use

Developer exactions: Developer installs onsite and neighborhood-scale infrastructure at own expense

United Kingdom: City councils empowered to secure contributions from real estate developers to cover services, infrastructure and amenities in a piece of land (Section 106 of the Town and Country Planning Act 1990)

Scale

of

pre

vale

nc

e

McKinsey & Company | 14SOURCE: McKinsey

▪ “A multi-trillion dollar game”: We estimate infrastructure investment requirements (to both cover current gaps and keep up with growth) of ~$60 trillion between now and 2030 –More than estimated value of today’s infrastructure

▪ “Funding facing strong headwinds”: Current funding context is difficult, with tight lending capacity and increasing fiscal constraints, but still many options exist to overcome them

▪ “Money is not the (main) problem”: Lack of funding and financing for infrastructure is a symptom of deeper problems that require action at other, more transformational, levels– Improve infrastructure portfolio/ project selection– Streamlining delivery– Making the most of existing infrastructure

McKinsey & Company | 15SOURCE: McKinsey Global Institute

Several characteristics of infrastructure make it challenging to govern, leading to fundamental productivity issues

Infrastructure characteristics Governance challenges

▪ Long asset life-time

▪ High capital intensity, invest-ment complexity

▪ Political interference with short election cycles and lack of technical expertise regularly leading to bad planning

▪ Network effects and external spill-overs

▪ Scattered ownership and governance across regions and asset classes leads to sub-optimum infrastructure systems

▪ Mono-/ oligopolistic structure

▪ Badly defined public vs. private sector interface, incl. market structure, regulatory and pricing framework

19890

90

100

110

120

130

Rest of economy

Construction

Evolution of productivityPercent

McKinsey & Company | 16

Three ley levers can result in significant improvements

Making the most of existing assets

▪ Increased asset utilization▪ Reduced transmission and distribution losses▪ Preventive maintenance▪ Demand management

SOURCE: McKinsey Global Institute

Making better decisions about project planning and selection

▪ Clear socio-economic objectives▪ Standard cost-benefit analyses▪ System-wide decision-making

Streamlining delivery

▪ Streamlining approvals and land acquisition▪ Better tendering and procurement▪ Design optimization and planning▪ Application of lean construction techniques▪ Advanced contractor management▪ Construction sector development

1

2

3

Exemplified

McKinsey & Company | 17

1 Private Infrastructure Investment Center of Korea; 2 Public Investment Management Center; 3 Public & Private Infrastructure Management Center

High cost and time overruns… … by establishing PIMAC…reduced…

SOURCE: IEEE Transactions on Engineering Management, KDI, Construction & Economy Research Institute of Korea, APA Journal

Project selection: System wide decision makingKorea enhanced the efficiency and transparency in infrastructuredevelopment by establishing an objective supervisory organization

Example: Mega project construction cost$ billion

Seoul-Busanhigh-speed rail

Incheon International airport

18

5

7

3

AdjustedPlanned

Cost overrunPercent

41

After ’99Before‘99

122

Overrun

Between 1999 and 2006, ~60 $ billion saved (~1% of GDP) and allocated for other uses

Projects rejectedPercent

▪ Amended infrastructure projects to be assessed by a central organization for budgetary decisions (PIMAC)

▪ Developed detailed description of methodology and procedures of Preliminary Feasibility Study

▪ Formed multi-disciplinary PFS team that involves 3 or more organizations to sustain objectivity, consistency, and transparency

97

5446After ’99

Before ’99 3

Rejected

1

McKinsey & Company | 18

Sufficient investment in up-front planning and engineering is keyto controlling construction cost and schedule

SOURCE: Build India report, based on interviews and McKinsey analysis

5

2

6-9

“In a roads project, a temple was adjacent to the site of a proposed flyover. This aspect was overlooked in the DPRphase. The flyover got built, and subsequently erased due to local pressure”

“In a thermal power project, the DPR firm quoted an abnormally low price, then did not deploy enough resources to prepare the DPR. The resulting design & cost estimate was heavily bloated, and the nodal agency saved 10-20% on it by doing the DPR again”

Scope changes

High project costs

Illustrations of impact of bad DPRs in IndiaRelationship between spend incurred on Detailed Project Report (DPR) & cost overruns – roads sector

DPR spendAs % of project cost

Cost overrunsPercent

8

6

24

Streamlining delivery: Design optimization and planning2

McKinsey & Company | 19

0.1

Infrastructureneed

2.7

0.61

0.4

0.1

Making the most of existing infrastructure

1.7

Optimizedneed

0.2

0.2

Improving project selection/ optimizing infrastructure portfolios

Streamliningdelivery

Global infrastructure investment need and how it could be reducedYearly average, 2013–30$ trillion

Acting in these three levers can result in a $1 trillion-a-year savings in infrastructure investment

SOURCE: McKinsey Global Institute analysis

1 Telecom investment need beyond the scope of this paper.

Demand management

Operations and reduction of transmission and distribution losses

Optimized maintenance

~$1 trillion/ year saving in infrastructure

McKinsey & Company | 20SOURCE: McKinsey Global Institute

Good chance of following infrastructure best practices only if the right system, governance, and enablers are in place

Data and accounting Technocrats vs. politicians

▪ Infrastructure balance sheets to overcome issues of scattered, incomplete, and inconsistent data

▪ While politicians need to set the objectives, technocrats need a level of independence for planning and evaluation

Capacity and capability Private sector orchestration

▪ Leadership and vision at the top and a sufficient number of high-quality project managers and planners below

▪ Opportunities to create more competitive markets

▪ Private sector can help originate and improve planning proposals

Stakeholder engagement Coordination between institutions

▪ Establish transparency and trust early on to avoid bad decisions and delays

▪ Orchestration of decision makers across regions and types of infrastructure

Thank you!

Lagos, August 5, 2013

Infrastructure round table

CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited