Stakeholder Consultation Paper on the Europe 2020 Project Bond Initiative

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1 10 May 2011 Registration no: European Commission Directorate General for Economic and Financial Affairs Unit R 4 B-1049 Brussels Belgium dg-ecfin@ec.europa.eu Dear Sirs Stakeholder Consultation Paper on the Europe 2020 Project Bond Initiative The IMA represents the asset management industry operating in the UK. Our Members include independent fund managers, the investment arms of retail banks, life insurers and investment banks, and the managers of occupational pension schemes. They are responsible for the management of around 3.4 trillion of assets as at the end of 2009, which are invested on behalf of clients globally. These include authorised investment funds, institutional funds (e.g. pensions, charities and life funds), private client accounts and a wide range of pooled investment vehicles. They are responsible for the management of 1.2 trillion in fixed income assets. The IMA welcomes the consultation and hope that you will accept our apologies for our late submission. Project finance is clearly an area where financial pressures will likely cause difficulties in raising adequate long-term capital. The IMA believes that the response from the Association of British Insurers addresses all the issues and is pleased to be able to support their paper which is attached. Should you have any queries however please do not hesitate to contact me. Yours faithfully Liz Rae Senior Adviser Investment and Markets 65 Kingsway London WC2B 6TD Tel:+44(0) Fax:+44(0) Investment Management Association is a company limited by guarantee registered in England and Wales. Registered number Registered office as above.

2 EUROPEAN COMMISSION: STAKEHOLDER CONSULTATION PAPER ON THE EUROPE 2020 PROJECT BOND INITIATIVE: FEBRUARY 2011 The ABI s Response to the European Commission s consultation The Association of British Insurers (ABI) is the voice of the UK s insurance industry representing general insurance, investment and long-term savings. The ABI was formed in 1985 to represent the whole of the industry and today has over 300 members, accounting for some 90% of premiums in the UK. Underpinning their business activities members have assets under management of 1.6 trillion and, in addition, manage substantial sums on behalf of third parties such as pension funds. Some 50% of the assets under management for insurance funds are in fixed income instruments many of which are of a long-term nature reflecting the nature of the liabilities which client funds have taken on. The ABI welcomes the opportunity to respond to the consultation. Our comments are made from the viewpoint of insurers as institutional investors. The ABI is on the register of Interest Representatives. Our registration number is The ABI s address is 51 Gresham Street, London, EC2V 7HQ General Comments We welcome the Initiative as a marginal but useful contribution to the financing solutions required for European infrastructure. It is not a panacea and the ambitions for the Initiative need to be kept in perspective. We accept that the financing requirements for European infrastructure are substantial and suspect that ambitions are likely to be constrained. Public finances are under stress. The balance sheets of public utilities and infrastructure providers are, in many cases, limited in their capacity to carry new investment projects. Banks are delevering and subject themselves to refinancing issues. At the same time private investors resources are not unlimited and for these finance providers a key driver is allocating funds to assets where there is a clear value proposition. Many areas of infrastructure are natural monopolies or oligopolies where finance through the public purse is appropriate given the scale of requirements and anticipated but often diffuse social benefits. An additional method is finance for utilities operating under a specific regulatory framework, such as the Regulatory Asset Value concept in the UK, drawing on the banking sector and public debt capital markets. At the more disaggregated level finance can be provided to individual projects, based nominally on actual or shadow cash flows, through PFI / PPP mechanisms. As institutional investors we do not favour artificial incentives which unduly distort this mix of funding mechanisms.

3 In our view there is already a vibrant market for finance on a project basis which includes funding models of both an unsupported and supported nature. Key to the provision of private finance is understanding the nature of the institutional investor market. Fund managers operate on the basis of mandates from their clients of whom insurers, pension funds and sovereign wealth funds are significant elements. In the UK insurers have been the lead buyers of project based financial assets. Typical of institutional investors they will seek to place their funds in financial assets which achieve value i.e. the appropriate risk-adjusted reward as set in their mandates. Their universe of investment opportunities can be very wide and there will be no compulsion to invest in infrastructure unless the risk-adjusted reward criteria are met. Given the context described above and noting the project-based market that already exists, the Initiative at the margin will be helpful in widening and deepening that market. Other factors will also be at work. Currently the market for project-based lending is skewed or distorted by subsidised bank lending in the aftermath of the financial crisis. As public support for the banking sector is withdrawn and banks delever under the influence of Basel III / CRD IV, a growth in finance raised from the public debt markets can be expected. But projects which present a real value proposition will face strong demand from sovereign, bank refinancing and property refinancing requirements. In such an environment if the Initiative were to be applied largely to projects which intrinsically are perceived by investors as poor value then its effect will be limited. A further caution needs to expressed in respect of the impact of Solvency II which is still to be finalised. The requirement on insurers to apply a capital charge against specific types of assts may significantly impact asset allocation. Current thinking is that the capital charge for corporate bonds promotes a sweet spot of A rating with 10 years duration. Mandate setters for insurance funds may not be overly influenced by capital charges for particular assets if the expected returns from a portfolio are achieved. However, it would be unwise at this stage to dismiss capital charges as an influence on insurers appetite for project-based assets. The same conditions may apply to pension funds if the characteristics of the Solvency II regime are applied to them in due course. Responses to the Questions 1. Is the chosen mechanism likely to attract private sector institutional investors to the sectors of transport, energy and ICT in particular? If you are an investor, would you be prepared to buy such project bonds? Other things remaining equal the mechanism is likely to attract private sector institutional investors. The key factor for the investor will be the value proposition in the offering, in other words the risk-adjusted reward as primarily reflected in the pricing. However, all things do not remain equal and the various groups of private sector institutional investors are subject to different pressures. Insurers, hitherto a lead

4 buyer for project debt, will under Solvency II have less incentive to hold long-dated credit for shareholder or own funds i.e. those where the insurance company itself takes the risk. Whether the impact of the mechanism by enhancing the project quality to higher rating, would outweigh the disincentive of the capital charge for such funds in holding assets of this type is impossible to judge at this stage without further details of both the mechanism and the operational characteristics of Solvency II 2. Are there other sectors with large-scale infrastructure financing needs that should be included? In addition to economic infrastructure these are also large scale requirements in the social infrastructure space particularly in education and healthcare. This is a relatively well developed sector in the UK in areas such as hospitals, schools and social housing. 3. Would the credit enhancement facilitate/accelerate the conclusion of financing packages? Typically the institutional investor is presented with the opportunity to invest in a project at the end of a development process undertaken by the project company and its financial advisors. It is not clear why credit enhancement, one element of the financing packages, would if itself, accelerate the conclusion of financing packages. Credit enhancement, by widening the pool of potential investors, should facilitate the conclusion of financing packages. Ultimately the product on offer has to have overall appeal to a sufficiently wide base of investors to achieve successful financial conclusion. 4. What minimum rating of the bonds would be sufficient to attract investors? This is subject to a number of factors. The mandate under which the institutional investor is operating is key. Mandates will generally (but not always) specify a minimum rating level and preferred duration of credit. The mandates of some insurance funds (those subject to Solvency II) may change significantly in the near future. Hitherto insurers have been lead buyers in the project debt market. The decision on whether or not to buy such debt is based on the perceived value of the offering. Purchases are not made solely on the rating, which is merely one input into the decision-making process. However, clearly if the offering is perceived to have value then the higher the rating the wider and deeper the potential market. We believe that in the current market UK insurers interest would be activated at the A rating level, potentially a situation that would be reinforced under Solvency II Overall we would agree that ratings have the ability to extend the market and the liquidity of debt instruments. However the role of the rating agency extends beyond the rating itself. Investors require a forward looking view so forecasts are an important issue. Moreover the rating agency, or some similar independent body, is often required to perform a monitoring role. Absent some agency performing the forecasting and monitoring role the market would require much greater transparency

5 from the project companies themselves, an aspect on which they might show reluctance on the grounds of commercial confidentially. 5. What degree of credit enhancement would be necessary to achieve this rating? It is not possible to set one level or benchmark of credit enhancement as investors will wish to assess and take account of the characteristics of the underlying project 6. What impact would the Initiative have on financing costs and on maturities? For insurer investors this is impossible to assess until the details of Solvency II are available. For investors in general the outcome of the EMIR proposals will also need to be assessed. Both sets of proposals have the potential to provide disincentives to investing in project debt. Notwithstanding the caveat expressed above, theoretically the Initiative if properly addressed should have a positive impact on the financing costs and maturities of individual projects. 7. Is it essential that a single entity acts as controlling creditor? In general it is not essential that a single entity acts as controlling creditor. For example in North America there is a large market of unwrapped project deals. In these cases investor interests are protected by a voting structure which covers material decisions. Within such a culture it can be argued that imposing a controlling credit or would be poor governance through potentially disincentivising investor engagement. Not all projects would fit within this scenario. A project s parameters might require an agent who can authorise many decisions which investors consider immaterial to credit quality. Investors may wish to have an agent capable of processing significant volumes of data, particularly if some is of a price sensitive nature which would put investors off market. In such circumstances investors would welcome a controlling creditor or independent monitoring agent. Senior creditors would probably prefer such an agent purely acting on their behalf. An acceptable alternative might be controlling creditor acting for subordinated creditors with the proviso that subordinated lending has at least the same maturity as senior debt or preferably longer.