Cracks in the Foundation
By: Madeleine Cavadias & Cristina Osorio
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Bridges are falling, highways are crumbling, and water and wastewater systems are operating over design capacity. Over the last 40 years, cash-strapped governments of developed countries have lived off the legacy of past investments, failing to keep up with growth or in some cases even necessary maintenance. Thus the question, how will governments pay for desperately needed upgrades? With a mounting debt burden, rising entitlement costs, and opposition to tax increases from the electorate; their hands may be tied. Enter private sector investors.
Fortunately, infrastructure assets are in demand. The long-term, stable, recurring cash flows offered are particularly attractive to pension funds as they match their liabilities well. This has led pensions and other sovereign wealth funds to increasingly invest in infrastructure – OECD private pension funds increased their infrastructure investments from US$10.7 trillion to US$17.0 trillion between 2001 and 2009, representing 6% compound annual growth. Canadian pension funds are no exception; they have increased their portfolio allocation in infrastructure from 1.9% ($15.9 billion) in 2007 to 4.6% ($42.1 billion) in 2011. This trend is expected to continue going forward as Canadian pension funds are targeting an average allocation of 7.5% towards infrastructure.
Currently in developed economies, especially North America, opportunities to invest in infrastructure are scarce. While some countries, like the UK, have divested many of their assets to the private sector, most others are reluctant to fundraise in the same manner. This has forced some investors to look to developing economies. Although these countries offer higher returns, only the most risk tolerant private sector investor will invest in these regions as properly quantifying the associated risks is challenging. For example, Bechtel, a US corporation, was forced out of its water investment in Bolivia due to a consumer rebellion. Bechtel increased water rates by 50% to achieve a projected IRR of 16%. The increase ended up being too costly for the impoverished country and forced the government to terminate the contract. Despite inherent risks in developing economies, immense global competition for assets is pushing down returns, further worsening assets’ risk-return profile.
This presents a problem for Canadian pension funds such as AIMCo, Ontario Teachers’ Pension Plan and in particular, for Canada Pension Plan Investment Board (CPPIB). Currently with assets of $192 billion, CPPIB is expected to grow to more than $700 billion in the next 30 years. To remain sustainable, CPPIB must deliver real returns of at least 4%. Investing in infrastructure plays a key role in delivering these returns. CPPIB must deploy over $45 billion of equity capital by 2040 into infrastructure in order to keep up with the capital deployed across the entire portfolio. Including leverage, CPPIB must find $80 billion to $120 billion in investment opportunities. Yet, CPPIB has not closed an infrastructure investment in 18 months, indicating it may be losing out on global asset sales. If it is to effectively scale and meet its investment objectives, CPPIB needs to actively create its own investment opportunities. If it, it will be forced to accept returns below its hurdle rate or else face being locked out all together.
Oh, Canada
To date, Canadian governments’ fiscal budgets have been dominated by health, education, and social services. Investments in infrastructure have been inadequate and failed to keep pace with the growing population, increased urbanization, threat of natural disasters, and deterioration of assets. This underinvestment in public infrastructure has created an estimated infrastructure gap of CAD $50 billion to 125 billion, which, if continued, could cost Canada up to 1.1% of real GDP.
This infrastructure gap provides a large opportunity for CPPIB if it can convince governments to privatize underfunded assets. Generally, the public is less wary of domestic pension funds than traditional private investors, whom they suspect might cut corners in the pursuit of profits; they believe what’s good for the pension fund will be also good for them. This alignment of interests gives domestic pensions a strategic advantage when investing in Canada. If Canadian governments and their constituents can be convinced that asset sales will benefit them, domestic pensions will create a large infrastructure market with certain structural protections, leaving them a market unto themselves.
Faced with little political license to increase taxation, governments may have no option but to look to the private sector to finance their capital programs either through asset privatization, or through public-private partnerships (PPP). Given existing consumer expectations regarding the role of government in providing certain inalienable services (water, wastewater, etc.), it will take time before large-scale, wholesale privatizations can be achieved. Until then, smaller scale PPPs present an attractive early-entry opportunity.
A PPP is an approach to procuring assets where the private sector works alongside the government to construct and at times operate assets according to a predetermined contract. In this scenario, the private sector assumes a large portion of the financing and construction risk, while being compensated based on service delivery performance. PPPs are not new to Canada – 92 projects have been completed since the 1990s, most of which were after 2009. The majority of these projects have been small but as the infrastructure gap widens, larger opportunities will become available. Although opportunities will not be immediate, CPPIB is well positioned to enter this market, especially in the $500 million to $2 billion equity range.
Opportunities Abound
Ultimately, success in privatization will hinge on pension funds’ abilities to convince voters that they will operate more cost effectively than government and that their billing will be more equitable to the regular user. (E.g., in wastewater, usage based billing will keep residential users from subsidizing large industrial users). In order to achieve this, governments will need to decouple the cost of assets from an opaque tax regime that obscures the true cost of the service by implementing a usage fee based model alongside privatization.
With investment opportunities in nearly every infrastructure asset class, CPPIB needs to narrow its scope to those areas that are most likely to prove successful. Due to the potential ongoing deal flow, the high number of assets still available for private sector involvement, and the lower risk nature of the assets, wastewater is particularly attractive. Wastewater assets are monopolistic in nature and are generally unaffected during economic cycles, unlike typical market-based infrastructure investments. Additionally, there has been very little private activity within the wastewater sector since it is considered an inalienable service. However, private sector involvement in wastewater assets has recently gained momentum through PPP Canada and various municipalities.
Wastewater deals to date have been small, despite the need for upgrades in urban cities. CPPIB already has successful experience with water and wastewater assets through holdings in Anglian Water in the UK. Although wastewater is considered an inalienable service, in the minds of Canadians it is an outbound item, similar to garbage collection. The perceived risk of service disruptions is not as severe for outbound items as it is for inbound items (i.e. water to your home, electricity, etc.), thus decreasing the risk of public outcry over private sector involvement especially that of a pension fund like CPPIB.
In particular, Toronto poses a great opportunity. The city’s investment backlog of linear infrastructure and waste treatment facilities is larger than any other major Canadian urban centre. In 2012, this backlog was estimated to be valued at $1.6 billion, representing 6% of Toronto Water’s total asset value. The average age of these systems is approximately 50 years, with 5% of the assets being over 100 years old. Flooding this past summer, climate change, rapid urbanization, and sewage overflows into Lake Ontario have emphasized the need for upgrades. The Don River and Central Waterfront Project (DRCWP) has been identified as a project that would improve Toronto’s current wastewater system, one of the priorities of the current municipal government.
The goal of this project is to improve Toronto’s wastewater by building new underground infrastructure systems and facilities. This project’s construction is broken down into four different stages with an estimated 25 years until completion. Currently, the project has progressed onto Stage 1. The second and third stages, though undersized ($203 million and $109 million respectively), pose an opportunity for CPPIB to begin building a relationship with the government, laying the groundwork for involvement ahead of Stage 4. This stage is the most attractive for the pension fund and is set to commence in 2023. The estimated total capital cost for Stage 4 is $850 million. The combined equity cheque for the overall project (consisting of all three stages), assuming 80% debt financing, would miss equity investment threshold, the PPP strategy is intended as the first step in a strategy to privatize Toronto’s entire water and wastewater system, valued at $28 billion. Further, diligence into early stages of the project would decrease the investment costs for subsequent stages, somewhat justifying the deviance from current asset sizing strategy. Regardless, a shift to a more active sourcing strategy will carry increase costs over the current strategy; however, the potential for increased deal flow at attractive risk-adjusted returns should more than offset the increased transactional costs at early stages of implementation.
By constructing the fourth stage, CPPIB is also afforded the flexibility to structure the deal as a concession, with CPPIB operating and maintaining the asset for additional years after construction is complete. Additionally, Toronto is one of the few municipalities in Ontario that has yet to convert its water and wastewater payment systems into a full-cost pricing model. Stage 4, beginning in 2023, also provides an opportunity to negotiate for a change in the billing structure for wastewater assets, a necessary step for privatization.
But how?
While CPPIB stands to benefit from asset privatization within Canada, its ability to affect change in government policy is constrained by a relative lack of lobbying experience. Thus, CPPIB must identify other stakeholders that it can rally to its cause and lobby the government and public on its behalf.
There are many parties that stand to gain from improvements to Toronto’s wastewater infrastructure, with the insurance industry being near the top of that list. Flash flooding during the summer of 2013 in Toronto placed a large burden on insurers as insurable damages amounted to an estimated $850 million. Not only will Canada be dealing with more frequent natural disasters caused by climate change, but the effects of these unanticipated events will be amplified by aging municipal infrastructure; a trend that would adversely impact insurers financial performance, making them a strong potential ally.
Other stakeholders, such as the Public Interest Advocacy Centre (PIAC), a non-profit organization that researches public consumer services to ensure alignment with the best interests of Canadians may prove effective partners, as CPPIB’s ability to deliver wastewater services at a potentially lower cost than the government in the future would benefit consumers. Looking at the different stakeholders, PIAC has the most influence over the municipal government, and the municipal government ultimately decides how to structure such a deal. CPPIB should pursue the support of PIAC to lobby the Toronto municipal government.
The Bigger Picture
In the future, it is likely that Toronto’s pricing model will be modified to align with neighboring municipalities’ full-cost recovery systems. Historically, the municipal government has used tax dollars and subsidies from higher levels of government to fund the day-to-day operations of these assets. Using this revenue model and a PPP structure for the DRCWP, the added average monthly cost per residential household would be approximately $15. This extra cost would cover upgrading and renovating the existing assets and would allow CPPIB to operate and maintain the assets for a 40-year concession period with constant re-evaluation and government oversight.
While this investment is only $1.2 billion, Toronto’s overall water and wastewater system has an estimated asset value of $28 billion. There is plenty of room for potential future acquisitions within Toronto Water for CPPIB. Using the DRCWP investment as a trial run, CPPIB should piece by piece begin to privatize the entire asset. While the process will not be easy or quick, CPPIB has a long investment time horizon and the potential benefits are large. Further, there will be opportunities for CPPIB to purchase neighboring municipalities’ water assets, offering opportunities or cost rationalization. Finally, CPPIB can use the DRCWP as a project template for other wastewater and infrastructure deals across the country.
While infrastructure investors seek ever-further corners of the globe, with ever increasing risk, in the pursuit of returns that only continue to fall, CPPIB has the opportunity to break from the pack. With the abundance of aged infrastructure in different asset classes and geographies within Canada, CPPIB can gain access to a wide array of attractive investment opportunities that other global players will have difficulty accessing. While it will require a new approach to sourcing deals, it may be the only approach that CPPIB can take to find investment opportunities in infrastructure with sufficient risk-adjusted rewards.
