Navigating Geopolitical Risks in Infrastructure Development

Infrastructure development is essential to build global economic growth, connectivity and for an improving quality of life. However, geoeconomic factors have emerged as a threat to the sector.

According to a recent Organisation of Economic Co-operation and Development (OECD) report, it is estimated that there is a cumulative infrastructure investment gap of US$5.2 trillion until 2030, or as high as US$14.9 trillion until 2040, when the achievement of the UN’s Sustainable Development Goals (SDGs) is taken into account.

Driving this are a need for investments to mitigate the climate crisis, energy security issues, and an imperative to accelerate the energy transition, which have become pressing issues for developed and developing countries alike.

In particular, many developing countries lack adequate infrastructure investment, which hinders their participation in the global economy, causing infrastructure development across Africa, Latin America and developing Asia to fall behind.

Despite these acute and growing needs, the infrastructure landscape has been hampered by a global environment made more volatile and riskier by systemic macroeconomic and geopolitical changes. The era of globalization and commerce-oriented policymaking by governments has been sidelined by increasing regionalization, export controls, and a growing number of barriers to trade and finance.

This is compounded by the fact that more than 60 countries, representing at least 40% of the global population and GDP, will hold elections in 2024. This biggest election year in history forces organizations making investment decisions to consider how long term uncertainty caused by geoeconomic competition and geopolitical insecurity may also be influenced by current events.

These concerns permeate the value chain for infrastructure development, impacting corporate and private capital equity investors, providers of project debt, and construction firms, and ultimately impacting governmental authorities of host countries that need such investments.

They are also forcing equity providers, financiers, builders and operators of infrastructure to take account of a host of investment risks that were negligible in the previous era: political and geoeconomic risks.

How does this relate to me?

Developing, investing and operating infrastructure in developing countries was never for the faint of heart. By definition long term, stranded investments in illiquid assets are prone to outsize risks. Yet the returns beckon: a chronic investment deficit across the emerging markets creates opportunity, to meet basic clean water, communications, electricity, food, transportation and other pressing needs for fast-growing populations. All compounded by a need to simultaneously deal with adverse climate events, public health emergencies and the energy transition.

This activity can be rewarding (for the returns) and at the same time challenging (for the risks). In this context, one special category of unpredictable risk has especially held back infrastructure investors, stunted national development and dashed infrastructure investment returns – the political risks.

Whilst some of the business risks are inescapable, these often-overlooked jurisdictional risks can actually be managed. Political risk is the possibility that foreign investors will suffer financial loss, due to political decisions, conditions, or events occurring in the host country or emerging market where they have invested. Unmitigated, such risks can cause the cost of capital – the returns required by capital providers to invest in that country, to be higher than other locations – effectively resulting in a Country Risk Premium.

Specialist insurers can provide Political Risk Insurance (PRI) targeting such threats to infrastructure. From covering simple physical damage loss of assets due to war, civil war & terrorism, to more complex events such as loss of a concession or permits due to government action, or non-remittance of profits becoming stranded due to government currency restrictions. This can extend to insuring the project against breach of key contractual agreements that the government has entered into, such as a power purchase agreement, or a fuel supply agreement.

Cover is provided by investment grade PRI insurers in long term, multi-year, fixed price and non-cancellable policies. In a 2022 study commissioned by Marsh and performed by S&P Global, it was found that mitigating the key risk factors explaining the Country Risk Premium reduces the investors’ cost of capital, bolstering project valuations and investment returns (IRR’s) – even after accounting for PRI insurance cost.

A host of other PRI benefits follow. The susceptibility of infrastructure projects to volatile risks is mitigated, including the need to episodically mark down project values to market. Investors may now select investment opportunities that would otherwise not meet their investment return hurdles due to country risk. Institutional investors can use PRI to strategically raise investor capital, and to facilitate their exits. And a well-protected project may enjoy more favorable financing terms.

For dedicated long term owner-operators of infrastructure in emerging markets, as well as for institutional equity investors such as private equity firms, pension funds, infrastructure funds, and sovereign wealth funds, PRI is truly an invaluable tool to facilitate investment.

Commercial lenders, pension funds & insurance companies, debt funds, capital markets investors and infrastructure funds that finance debt investment into infrastructure projects can face a panoply of challenges ranging from project-specific risks like country risk (in case of projects in Emerging Markets) to credit -specific issues (like limited credit risk capacity for large transactions), and portfolio management concerns, like risk concentrations by borrower, industry or location.

Specialist insurance risk capital provided by investment grade insurers can help catalyze debt investment in each of these cases, by way of matching term, multi-year, fixed price and non-cancellable policies of two types:

Non-payment insurance for lenders

Is an unfunded credit risk transfer tool used by banks and other lenders to mitigate the non-payment risk of a counterparty (loan borrower or debt obligor). It is a recognized source of Basel III-compliant capital relief for regulated lenders and also helps project lenders “punch above their weight” to make larger loans in support of infrastructure debt funding. NPI (Non-payment Insurance) solves limit management issues caused by “tall trees” and other risk concentration issues.

NPI is a powerful instrument for credit and portfolio managers (CPM) allowing lenders to bolster their competitiveness while prudently growing the loan book. Using NPI helps lenders to mitigate their risk by sharing single transaction or credit portfolio exposure with a pool of natural, non-competing syndication partners (insurers) who are uncorrelated to the underlying risk.

NPI insurance covers failure or refusal of a counterparty for any reason whatsoever to pay an amount owing under a financing agreement. This includes all commercial and political risks connected with private or sovereign borrowers. Coverage is non-cancellable and fixed price, and can be used to cover short, medium or long-term payment risk in both emerging and advanced economies.

Insurers’ risk appetite has broadened in recent years to include a variety of financing structures and asset classes: both “mini-perm” and long-term project and infrastructure financings, for both greenfield and brownfield assets, including quasi-merchant exposures, and acquisition financings involving operational assets. Industries covered span a broad range including power and energy (and renewables), waste & water treatment, transportation (airports, roads, ports, etc.) and technology & telecom – including data centers and cell towers.

Political risk insurance for lenders

PRI for Lenders is a variation on NPI that covers failure to pay of a counterparty on a loan or other contract if the payment default was caused by specified political risks. It is used frequently in Emerging Markets infrastructure debt finance where the project lenders are comfortable with the basic economics of a project, but not with its jurisdictional risks.

PRI for Lenders provides a means for lenders to share an infrastructure project loan’s political and country risks with professional, investment grade specialist insurers, whilst keeping exposure to the loan’s basic credit and market risks. Thus, PRI for Lenders can help lenders navigate idiosyncratic concerns like the risk of governments cancelling critical permits and concessions, war and political violence risks, currency restrictions blocking debt service, expropriation of project assets, and breach of contract by Host Government actors on critical project agreements (such as a Power Purchase Agreements, Gas Transportation Services Agreements, or Minimum Revenue Guarantees).

Engaging in construction projects abroad can be a complex and challenging endeavor. One of the key risks that EPC firms and equipment suppliers face is political instability in the host country of the project. This can include changes in government policies, civil unrest, embargo, or even currency controls. All of these events can then in turn negatively impact contractors and suppliers in many ways: interruption of contract execution, non-payment of amounts due, calling of bonds and even confiscation of assets.

To mitigate these risks, it is crucial for EPC contractors and suppliers to have political risk insurance in place, to protect against financial losses that may arise due to political events beyond the EPC contractor's control.

In practice:

Contract frustration insurance

This will protect against financial losses incurred in performance of an EPC or supply contract due to political and/or credit risks. These risks involve the frustration of a contract due to decisions or actions of the host governments, license cancellation, or unilateral termination of the contract by a public buyer. It can also involve non-payment of invoices by the buyer, non-payment of termination fees according to the contract, or non-payment of amounts due following an arbitration award. Depending on the project, Contract Frustration can include protection against financial losses due to fair or unfair calling of bonds (advance payment bonds, performance bonds, bid bonds …) by the beneficiary of those bonds. This insurance is targeted at domestic contracts in OECD countries or cross-border contracts in emerging markets.

Contractor’s comprehensive plant and equipment insurance (CCPE)

This will protect a contractor against loss or damage of mobile equipment used on site of projects in emerging markets due to political risks. It covers events such as confiscation, requisition, seizure, and willful destruction by the government or due to political violence. Additionally, the insurance provides coverage for forced abandonment of the contract execution location due to insecurity and non-reexportation prevented by the local government or license cancellation. This cover can be extended to various types of equipment, such as cranes, trucks, diggers, tunnel boring machine. It is targeted at cross-border projects.

Podcast

Navigating Geopolitical Risks in Infrastructure Development