Europe Moves to Bring More Private Capital Into Infrastructure
By Despina Doxak
The European Investment Bank estimates that the European Union will need to invest €2 trillion in infrastructure in the 28 member countries through 2020.
The sheer scale of the capital needed will require governments to find new ways to attract more private sector investment in public infrastructure.
The EU is considering forming a “capital markets union” as one way to do this. A consultation paper calling for formation of a capital markets union by 2019 was presented to the European Commission on September 30. Numerous bodies participated in writing the paper in an effort to find a suitable regulatory framework.
The hope is that project bonds will play a bigger role in the future for financing infrastructure projects.
The bonds may be privately placed or listed on a stock exchange. Payment of interest and repayment of principal are made primarily from the cash flow generated by an infrastructure project. Project bonds are particularly attractive for institutional investors, such as life insurance companies and pension funds, because they can match long-term liabilities, such as obligations to pensioners, to long-term cash flows from projects. Maturities can extend 20 years or more.
The bonds themselves usually offer stable returns at higher rates than similarly-structured sovereign debt.
Wider use of project bonds is critical because other sources of debt are constrained. Punitive capital treatment of long-term bank debt under Basel III and the latest EU capital requirements directive, CRD IV, has largely eliminated banks as a major source of long-term debt to the sector. Loans from multilateral lending institutions have constraints. Export credit-backed financing is limited to specific sectors.
The goal of the capital markets union is to improve access to the public markets for start-up companies, small and medium-sized businesses, and long-term investments like infrastructure projects, to diversify the potential funding sources, and to provide an easier and more efficient way for investors (bondholders) to connect with those seeking funding.
A new framework — called the Solvency II framework directive (Directive 2009/138) — will take effect on January 1, 2016 to regulate long-term investments by insurance companies.
The EU imposed strict capital requirements until now on insurance companies that discourage them from making long-term investments. Solvency II introduces capital charges related to the risk an insurance company can undertake. A capital charge is an amount of cash the insurance company must hold against each long-term investment it makes.
The current framework imposes the same capital charge for all kinds of investments regardless of their structures or their risk profiles. As a result, insurance companies and pension funds have invested only €22 billion in infrastructure projects, representing less than 0.3% of their total assets. At the end of 2014, insurance companies had almost €9.9 trillion invested on behalf of their policyholders. In other words, institutional investment by insurance companies has been an underused source of capital so far. It is estimated that if insurance companies and pension funds were to increase their investments in infrastructure projects to even 0.5% of total assets, this would mean an extra €20 billion of investment. The decision by institutional investors when and where to invest can have a significant impact on the economy.
The European Commission decided to amend the rules under Solvency II to give insurance companies more incentive to invest in infrastructure projects. The commission sought technical advice from the European Insurance and Occupational Pensions Authority, or EIOPA, about how best to amend its existing capital requirements. EIOPA initiated a consultation in February 2015, and the outcome was a report identifying, measuring, categorizing and standardizing infrastructure investment risks. The final version of the EIOPA paper (EIOPA-BoS-15-223) was published in September 29. EIOPA proposed the adoption of less stringent capital charges for investments in infrastructure projects if certain criteria are met.
The existing framework has now been amended to introduce the notion of “qualifying infrastructure investments.” The amendments can be found in the Delegated Regulation 2015/35, which supplements Solvency II.
Qualifying infrastructure investments are a new asset class of safer infrastructure projects under Solvency II. Therefore, the insurance companies may proceed with them while reserving lower capital charges of around 70% of the charges for other debt and equity investments.
A qualifying investment must meet a number of criteria that focus on providing for a high degree of protection and security for investors and predicable cash flows, documented and validated due diligence and ongoing risk management on the part of the insurance company. For investments in bonds or loans, the insurance company must also demonstrate that it is able to hold the investment to maturity. It is not necessary for an investment to be externally rated, but where it is unrated (or if the investment is in equity), then additional criteria must be met. Rated infrastructure debt investments must be investment grade to receive a reduced capital charge.
In order to qualify, the debt or equity must be issued by a special-purpose entity whose only asset is the infrastructure project, and the primary source of payments to bondholders and equity investors must be the income generated by the assets being financed.
These amendments to Solvency II allow insurance companies also to benefit from lower capital charges when investing in European long-term investment Funds (ELTIFs) and in equities traded through multilateral trading facilities (MTFs). This brings the capital charges in line with investments in European venture capital funds (EuVECA) and European social entrepreneurship funds (EuSEF), which benefit from the same equity capital charge as equities traded on regulated markets, lower than that for other equities. Also, a similarly favorable treatment is allowed for investments in closed-end, unleveraged alternative investment funds.
Investments in infrastructure project bonds are treated the same as corporate bonds, even when credit risk is divided up among different debt tranches, instead of being treated as securitizations.
A number of measures are being taken to make it easier for insurance companies to invest in unrated bonds and loans. First, insurance companies investing in unrated bonds and loans can use proxy ratings (for example, the rating of the issuer or of other debt instruments that are part of the same or similar issuing programs). Second, where unrated debt instruments are backed by collateral, the risk-mitigating effect of the collateral on spread risk is recognized. Third, where debt instruments are fully guaranteed by a multilateral development institution, such as the European Investment Bank or the European Investment Fund, they are exempted from any capital requirement for spread and concentration. The thought is that the due diligence and credit enhancement provided by EIB and EIF considerably reduce the riskiness of such investments.
Insurance companies and pension funds have already shown greater interest in investing in infrastructure projects, even before the new capital charge provisions take effect.
Some notable recent investments are a £100 million investment by Prudential in the Swansea Bay tidal lagoon project, a £6.3bn investment by Legal & General in UK property and infrastructure to date as part of an overall commitment of £15 billion and an investment by Allianz, as part of a £4.2 billion consortium, in the Thames Tideway tunnel.
The European Parliament and the European Council have up to three months to object to the relaxation of insurance company capital charges, with the possibility to extend this period for another three months. Thereafter, the new capital charge provisions will be published in the Official Journal of the EU and will enter into force the next day.