Infrastructure Investment in Emerging Markets – Mitigating the Risks
To meet growing regional demand for energy, transport, and communication networks, investors are financing capital-intensive infrastructure projects in Sub-Saharan Africa, South Asia, and Latin America. Infrastructure projects attract investors on the back of potential returns that can outstrip yields in mature markets. But with opportunity comes risk, particularly in the construction, engineering, and infrastructure sector, which in our survey saw the largest year-over-year increases in fraud incidents (up 7 percentage points to 83%) and cyber incidents (up 16 percentage points to 93%). Security incidents in this sector also increased to 67% (up 4 percentage points).
In this article, we draw on the expertise and experience of our teams across a range of emerging markets and explore the steps that investors can take to identify and mitigate risks.
Delivering infrastructure projects in Sub-Saharan Africa
Successful infrastructure investment requires the integration of projects into the host jurisdiction’s existing network of transport, power generation, and distribution grids. This is not just an engineering challenge. It requires institutional capacity and a functioning legal and regulatory framework to accommodate large-scale, long-term investments.
Many Sub-Saharan Africa jurisdictions lack the planning capacity and resources to link existing infrastructure to new projects. For example, power generation projects fail unless the producer can access a grid to sell energy through a commercially viable feed-in tariff. Pre-investment intelligence-gathering can help clients understand the regulatory environment and the implementation capacity of key government agencies in order to better assess the feasibility of a project.
Many new projects in this region tend to be politically significant and thus potentially vulnerable to non-transparent interference or influence. Politicians promote infrastructure projects to gain popularity within their constituency or as status symbols. Unrealistic expectations about what the project can deliver can also undermine the investment’s commercial viability. For example, if investors in rail freight projects are expected to accommodate passenger transport, the economics of an investment can be distorted.
While investors should be aware of such red flags, they cannot often directly influence them. As a starting point, investors need to understand the motivation and incentives of the project within the context of the country’s political economy.
Infrastructure investment remains a challenge in South Asia
Investors in infrastructure projects in South Asia face a similar set of challenges. For example, over the last three years, private sector infrastructure investment in India has slowed down due to a combination of stretched corporate balance sheets and rising non-performing assets for banks. The pace at which project-related decisions are being approved by various government departments (for example, approvals related to availability of land or environmental clearances) also remains slow.
Investment activity still remains high in certain pockets in South Asia, especially infrastructure. One such example is the renewable energy sector in India, which has seen significant interest from both domestic and international investors. While growth in renewable energy remains a key goal for the government of India, the aggressive push on the agenda (175 GW by 2022) has also resulted in a sharp decline in uptake prices, mainly for solar energy, due to the entry of many players, most of whom have limited or no experience in the sector. This puts immense pressure on local developers to deliver projects at low cost, which in turn affects the quality of material used and the sustainability of such projects. At the same time, companies still need to work with local governments and other stakeholders to ensure they obtain necessary approvals in a timely fashion, which means that the risk of corruption remains. With a sharp decline in tariffs for new projects, the power purchase agreements of existing projects – which have significantly higher costs per megawatts compared to prices being proposed for new projects – also become susceptible to public backlash and administrative scrutiny.
Investors often struggle to understand whether the costs and performance of a project reflect its true health. Given the relatively close nexus between companies, politicians, and bureaucracy in India, businesses often get pushed into practices which are potentially inappropriate and that can directly impact financial reporting. The wide gap between what is reported in the books versus the actual performance of the project casts doubt on the overall integrity of the quality and financials of a project. Other South Asian markets like Bangladesh and Sri Lanka are also exposed to similar issues.
While these challenges pose a risk, the significance of the opportunity often outweighs the cost of the risk. By developing a deep understanding of all the dynamics in the local market, investors can advance with greater confidence and make investments in line with their expectations regarding returns with fewer surprises.
Issues in infrastructure investment in Latin America
In Latin America, recent revelations of large-scale corruption have had a significant impact on infrastructure projects, debilitating sponsor governments and freezing projects mid-construction. The issue was recently highlighted with the investigation and prosecution in Brazil of the region’s largest builder, which has admitted to having paid over $3 billion in bribes in 28 countries – including in particular Peru, Colombia, Venezuela, and Mexico – at the highest levels of government.
Energy, transportation, and communications projects in several of the region’s largest countries, including Brazil, Mexico, and Argentina, also suffer from challenges with the acquisition of land rights. Land reforms in several Latin American countries in the last century have resulted in a legacy of communal land rights and long-standing conflicts over land possession. This creates difficulty and uncertainty in the negotiation of access or possession, and incentivizes shortcuts by pressured developers. For example, efforts to develop a new airport for Mexico City were stymied for decades by conflicts over land rights acquisition. Arm´s-length investors need to understand the risks and how land access or possession rights are acquired. Pre-investment investigation of relationships with land owners and communities, including forensic investigation, can help investors understand and quantify risks associated with the land rights acquisition processes.
As voters in the largest Latin American countries have started to move away from left-leaning and populist governments, new interest has been growing in private-public partnership (“PPP”) investments in the transport and public services sectors. However, larger PPP investments still face scrutiny by incoming administrations, often resulting in reassessment and even cancellation of significant projects whose economic benefits are not overwhelmingly clear. Recently, the development of a combined-cycle electrical plant involved private sector builders and public sector sponsors. After a careful investigation, Kroll’s research and analysis provided one of the private investors reassurance as to the integrity of plant development’s negotiation process, enabling the investor to proceed with the investment.
Infrastructure investors in emerging markets need to deal with a complex set of challenges to successfully finance, develop, and operate projects. With sufficient pre-transactional preparation and with access to intelligence throughout the project cycle, investors can make confident decisions on their investment strategies.
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