HomeAnalysisMaking infrastructure investments work

Making infrastructure investments work

Michael Tichareva
AS African economies recover from the pains of Covid-19, countries need to be ready for major infrastructure development in the years to come.

This requires countries to develop relevant skills among their people for infrastructure development and financing. Actuaries can play a critical role in this journey.

This is an area actuaries cannot ignore, and it is embedded in the Alternative Investments, Banking, Finance, and Enterprise Risk Management (ERM) practice areasas applied to projectfinance, investment, and risk management.

The Alternative Investments Forum of the Actuarial Society of South Africa (“ASSA”) chaired by Actuary Malizole Mdlekeza focuses on investments in infrastructure as one of its main thrusts, and ASSA now has an expanded section on infrastructure investments in the Investments Fellowship notes.

South African actuary Malizole Mdlekeza

ASSA is also currently working on a section in the same notes on Impact Investing–investing with the intent to achieve measurable and sustainable social and environmental outcomes whilst making risk-adjusted financial returns.

As influencers of capital allocation for institutional investors, actuaries should be at the forefront in directing capital where it is most needed, especially towards impact investments. This requires acquiring relevant knowledge.

Over many years of experience in project financing, we have witnessed poor project preparation as one of the main reasons for slow infrastructure rollout in many countries.

Project sponsors need to assemble a competent and experienced team to prepare a bankable project. It can easily take several years to prepare a bankable project, and it can cost anywhere between 5% and 10% of total project costs. Actuaries should certainly be in the mix in such teams.

Feasibility studies
A project must be bankable, and for that, it must have a solid technical and financial feasibility study prepared by a multi-disciplinary team of engineers, finance experts, risk managers, quantity surveyors, project managers, legal advisors, lawyers, and environmental specialists depending on the nature and complexity of the project.

Actuaries should be in the mix especially on finance and risk management.

A project feasibility study considers the appropriateness of the project design relative to the needs to be serviced, including social, environmental, and legal issues.

Issues such as site selection, capacity to implement, phasing of the project, availability of major inputs, project cost, price of the final products to users, and market existence must be analysed to assess commercial viability based on current and projected market conditions.

Additional factors include the potential for unanticipated delays and the project’s operating characteristics such as useful life, reliability, efficiency, required maintenance, and vulnerability of project technology to innovation.

A good feasibility study should focus on both the “hard” construction costs andan initial estimate of the project financing and development costs.

Estimating financing and development costs is a difficult call in the early stages as the interaction between costs and revenues will not have been fully tested yet. However, with experience, a good estimate can be made.

Market, revenue, and costs analysis

Analysis of supply and demand, hence the revenue and costs, under various market conditions is an important step in project preparation.

Assuming that a project is completed on schedule and within budget, its economic and financial viability will depend primarily on the marketability of the project’s output.

Off-take agreements with strong counterparties are important to guarantee revenue.

In the absence of an off-take agreement, the products would be sold directly to the market on an ongoing basis at unknown future prices.

The sponsor would, therefore, need to commission a market study of projected demand over the expected life of the project.

Such a market study must confirm that, under a reasonable set of economic assumptions, demand will be sufficient to absorb the planned output of the project at a price sufficient to recover the full cost of production, enable the project to service debt, and provide an acceptable return to equity investors.

A market study should generally include a review of competing products and their relative cost of production, an analysis of the expected life cycle for the project output, and an assessment of the potential impact of technological obsolescence.

It is also extremely important to assess the impact of potential regulatory decisions on production levels and prices, and ultimately the profitability of the project.

For very large projects, it may be important to obtain certain guarantees from the government for a minimum period to ensure the impact of any regulatory decisions during the life of a project is not adverse. Such guarantees assist in managing regulatory and political risks.

Projects that have a single product, whose price may vary widely, such as most commodity-based projects, are particularly vulnerable to changes in demand and may need to hedge against product price risk.

Off-take agreements from strong counterparties and certain guarantees become particularly important for hedging. There are also risks on the raw material supply side. Projects whose success or failure relies heavily on the price of one raw material may also require an input supply agreement on guaranteed prices.

Financial modeling
Financial modeling is another particularly important aspect of project preparation, especially when engaging investors. A financial model reflects,in dollars and cents, the provisions made and reached in project agreements.

This must include reasonably accurate assumptions about revenue and costs. Metrics such as the internal rate of return, the net present value, pay-back period, debt coverage ratios, and their acceptability must beanalysed.

The financial model often considers, through sensitivity analyses, the impactof construction delays, cost overruns, adverse regulation, the inefficiency of the project relative to existing and projected competition, interest rate fluctuations, unavailability of major project inputs, and major unanticipated inflation and volatility in foreign exchange rates.

Risk analysis  for projects
Actuaries are experts in financial modeling and risk management, but it appears very few are currently applying these in project risk management.

Actuaries should be able to assist in undertaking Risk Analysis and Management for Projects (“RAMP”) exercises using a well-defined and proven framework developed jointly by the Institute & Faculty of Actuaries and the Institute of Civil Engineers in the UK.

Since projects are capital-intensive, with many associated risks in implementing projects, the RAMP exercise seeks to provide detailed risk analysis and mitigation strategies to give comfort to investors. This is essentially ERM applied to projects.

RAMP is a well-established framework for analysing and managing the risks involved in projects and any assignment that may be undertaken.

It aims to achieve better financial returns for sponsors, investors, and lenders, and improve the consequences of projects for the wider community. The RAMP framework could be applied at the organisational level, or the individual project level, or both levels.

The benefits of applying RAMP include:

Avoidance of wasted work, because of the iterative nature of the process.

Consideration of opportunities as well as threats.

Improvement of the credibility of the business case for projects.

Consistency with approaches to ERM in the project sponsor’s organisation.

Greater confidence for those who decide on whether projects should proceed.

Recording and communication of “lessons learned”.

Despite its benefits, the RAMP model is not commonly applied by many investors as it is a specialist model requiring specific knowledge and expertise.

Actuaries can develop that expertise and knowledge to apply RAMP for the benefit of institutional investors to achieve optimal and sustainable outcomes.

  • Tichareva is the executive chairperson of Claxon Actuaries. — michael.t@claxonactuaries.com.

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