How can risk mitigation instruments accelerate private investment in infrastructure?

To close the infrastructure investment gap required to meet climate targets and the UN’s Sustainable Development Goals, governments hope to accelerate private investment in infrastructure by scaling up the provision of credit risk mitigation instruments. In this article, we explain the importance of risk mitigation in mobilising private capital in infrastructure, and how the unique risk profile of infrastructure calls for various instruments to be applied. 

The private sector will invest only when an infrastructure project’s profitability reaches levels that are competitive with alternative investment opportunities. In theory, infrastructure assets can deliver attractive returns, as government planning prevents asset duplication, making infrastructure a monopoly business with high profitability. However, government ownership also ensures social welfare concerns override the desire to maximise profits, with societal pressure imposing upper limits on the prices that can be charged for services. 

Expected to counterbalance the downward pressure on returns, risk mitigation instruments are used to improve risk-adjusted returns on private investments by lowering the risk and enhancing the attractiveness of infrastructure investments for the private sector. With recent interest rate hikes to curb inflation in developed economies where most of the global private capital is located, the pressure to improve risk-adjusted returns on infrastructure has intensified. According to EDHECinfra, the weighted average cost of capital for infrastructure investments increased from 5.6% in March 2018 to 8.1% in March 2023.[1]  The attractiveness of infrastructure investments is often improved through concessional capital, with data showing that it is used in 74% of infrastructure deals involving blended finance.[2] 

Optimal risk mitigation calls for the widespread use of several other instruments (for reasons outlined below), but the complexity of these instruments hinders their scalability and recognition within regulatory frameworks.

Infrastructure’s unique risk profile

1. Infrastructure investment horizons can span decades. The long-term nature of infrastructure amplifies the challenges associated with risk mitigation. Infrastructure projects often have extended timelines, spanning years or even decades, during which economic, political, and technological landscapes can drastically evolve. This increases the uncertainty over expected risk-adjusted returns and introduces difficulties in designing risk-sharing mechanisms that remain relevant throughout the project's lifecycle.

   Several instruments can be applied to mitigate these risks, including political risk guarantees and derivatives to hedge interest rates, foreign exchange rates, and commodity prices.

2. Investment in infrastructure is high in the initial years. In the construction phase, costs, risks, and illiquidity remain high until assets enter the operations phase and start earning revenue. This creates an oversupply of private capital for operating infrastructure assets but an undersupply of investment in construction.

   Instruments such as construction guarantees / insurance, liquidity guarantees, and backstops (payment for the unsold portion of an offering) can mitigate these risks, as can financial innovations such as securitisation, loan syndication, or co-investment.

3. Infrastructure is subject to political and social intervention. Balancing the interests of various stakeholders, including government agencies, private investors, and local communities adds to the complexity. Governments tightly regulate infrastructure assets to preserve social welfare concerns. When an asset enters the operations phase, marginal costs are lower, so politicians and voters are tempted to lower prices, even when the asset is required to recover the initial high investment in project preparation and construction of the asset. National issues such as war or social unrest can also change government cooperation with private investors.

   Instruments such as counterparty guarantees, credit default swaps, non-honouring of financial obligations, political risk insurance, and arbitration awards can curb such risks.

4. Infrastructure is pivotal to the climate transition. It provides foundational systems and networks that facilitate other economic activities. For instance, non-renewable power plants and gas stations have mainstreamed economic activities compatible with greenhouse gas emissions for which large scale markets now operate at low costs. Renewable power plants and charging stations are greatly needed to mainstream a climate-friendly economy, however the revenue potential of the non-renewable economy is currently high, and the uncertainty of returns and lack of clarity on risks create hesitation for first movers, which slows the speed of transition.

   Policy-based credit-risk mitigation instruments that support climate-friendly infrastructure investment are needed to incentivise and accelerate the transition.

Risk mitigation challenges

Identifying, assessing, allocating, and mitigating risk for private investment in infrastructure present a complex set of challenges and a failure to comply with the current banking regulatory standards under the Basel III Framework. This leaves the potential of raising the attractiveness of infrastructure investments for private investors through credit-risk mitigation instruments unrealised, as bank lending plays a key role in lowering the cost of financing infrastructure construction, especially in emerging and developing economies. Whilst greater private investment in infrastructure is needed to accelerate the climate transition, private investors are deterred if the risk allocation is not equitable or if risk mitigation is not sufficient.

The GI Hub’s work on credit-risk mitigation instruments aims to advance regulatory reforms to address these issues and create an investment environment that is more conducive to private capital. To learn more about our work in this area, visit our Treatment of Infrastructure as an Asset Class in Regulations initiative.