Why Doesn’t the Private Sector Invest In Infrastructure Projects?

As explained in the previous articles, the infrastructure sector is facing a significant funding gap. There is an urgent need to double the spending on infrastructure projects. One of the ways to fulfill this gap is by increasing the participation of the private sector in infrastructure projects. At the present moment, the private sector is not participating in infrastructure projects because of several reasons. Some of these reasons have been listed down in the article below.

Lack of Project Pipelines

Identification of viable financial projects which can be pitched to the private sector is a significant problem. Developing countries fail to identify infrastructure projects which are viable financially. If these projects are identified on time, they can be pitched to global investors, and funding can be generated. This problem is not confined to developing countries alone.

Even in developed countries i.e., the G-20 countries, less than 50% have a formal mechanism in place to identify projects which need to be pitched to global investors.

After all, investors cannot invest in projects which they don’t know about. A lot of time-critical needs stay unfulfilled because of this communication gap.

Countries that have set up a formal mechanism of creating a project pipeline i.e., a way to identify and rank projects, have seen a remarkable increase in the private sector participation in infrastructure funding projects.

Lack of Controls

The private sector can only help if they receive some surety that their capital will be protected once they make the investment. The problem is that a lot of time investments have to be made in third world countries where there is a significant law and order problem. Africa is a perfect example of this.

A lot of sub-Saharan African countries face problems with water. People have to walk miles to gain access to clean water. However, it is very difficult to get the private sector to fund infrastructure projects, which would improve access to clean water. Financial viability becomes a problem. This is not because the project is inherently unviable.

Rather, this is because of the fact that there is a lot of leakage in the supply chain. Unmetered supply of water and even thefts are very common. If a better system is created, where investors have more control over their projects, the amount of funding can increase by leaps and bounds.

Lower Adjusted Rate of Return

Governments all over the world claim that infrastructure projects have very little risk. However, private investors have a different point of view. There have been numerous cases wherein entire projects and investments made by the private sector have got stuck due to change in government policies.

Also, many infrastructure projects have significant legal hurdles, as well. In many cases, land acquisitions get significantly delayed, and environmental clearances are hard to come by. In such cases, the gestation period of the project gets prolonged, and the returns do not increase proportionately. This ends up reducing the annualized yield for the project.

Infrastructure projects are notorious for high levels of corruption, and hence, there is an additional risk for the investors involved. It is for this reason that investors seek a higher rate of return. This return is higher in nominal terms. However, where the additional risk is factored in, the returns can be considered to be normal.

Another problem is that infrastructure projects all over the world are under a lot of public scrutiny. Hence, if a firm is seen as taking advantage and gaining a higher rate of return, it could cause damage to their reputation. The lower IRR’s provided by the government are not very attractive for the private sector in the absence of any special tax incentives.

Unstable Regulatory Environment

A lot of investor demand for infrastructure projects is created by providing tax incentives. Banks are also given certain concessions in their capital adequacy ratios if they invest in infrastructure projects. However, the problem is that if the demand can be created by policies, it can also be taken away by a change in the policies.

This has happened multiple times in different parts of the world, and investors are quite aware of the possible impact. Basel III and Solvency II norms have already impacted investors who had invested in infrastructure projects. Hence, investors are wary of such changes. Infrastructure projects require investors to put in significant sums of money upfront. As a result, investors are not comfortable unless they are reasonably certain that the policies which are working in their favor will not change drastically during the course of the project.

High Transaction Costs

Private investors have to pay up a lot of money to obtain the right to work on an infrastructure project. For other investment classes, the transaction cost hovers around 2% of the project cost.

However, in the case of infrastructure projects, the transaction cost may go as high as 10%. This is because a lot of advisory fees, lawyer fee, and the official’s time has to be invested in bidding for a project. Higher transaction costs eat into the annualized return making the project less viable.

Since private sector funding is the need of the hour, governments all over the world should try to reduce the impact of the above-mentioned problems. This will help increase the flow of funds to the cash-starved infrastructure sector.