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Financing the future
Building Canadian infrastructure

by John Chenery

Like nature, money abhors a vacuum. That big hole in Canadian infrastructure finance left by 10 years of cutbacks in government spending and borrowing cannot stay empty for long.

Canada's investment bankers, pension fund managers and other institutional investors are ready to walk down the aisle as soon as governments pluck up the courage to pop the big question. In the absence of sweeping reform programs like Britain's Private Finance Initiative or Australia's National Competition Policy, however, the progress of this courtship has been painfully slow.

"Public-private partnership (P3) in this country is limited only by courage and imagination," says Liam Rafferty, head of the project finance group with Société Générale Canada. "The investment community thought this market was going to explode in the mid-'90s. We are still waiting."

Which is not to say that those involved in project finance are waiting idly. Several banks and fund managers are positioning themselves in readiness for the long-delayed P3 boom and the moves being made now could be a preview of how public projects and services will be financed as private sector involvement gains wider acceptance.

One of the more dynamic initiatives is Borealis Funds Management, created by OMERS (the Ontario Municipal Employees Retirement System, Canada's fourth largest pension fund) as its infrastructure investment platform.

"To get started we had to go it alone," says Dale Richmond, OMERS' president and chief executive officer, "but the intention was always to develop a company that would invest in infrastructure with other partners and with an ownership structure that wouldn't just be OMERS." Borealis is jointly owned by OMERS (26 percent), the Canada Pension Plan (26 percent) and several other private sector companies.

"Our relationship with Borealis is that for any given project they undertake, OMERS can take all, some or none," says Richmond. "We also have a contract with Borealis to manage all our P3 projects."

Under a strategic alliance announced earlier this year, OMERS bought a 27 percent equity share of the Canadian investment bank, Dorset Partners, and is combining its interest in Borealis with Dorset to form a new merchant bank that will guarantee OMERS a platform for current and future infrastructure investments.

Richmond says that OMERS' total investment in P3 projects at the moment is "somewhere between $500 million and $1 billion. That's not very big compared with our total assets of more than $35 billion, but it is very big for the projects that we've invested in."

Often hailed as a visionary and a pioneer in financing P3 infrastructure projects, Richmond prefers to view OMERS involvement in terms of practical necessity and public responsibility. "As a pension fund, we feel that there is a real need for infrastructure development in Canada to keep this country's businesses competitive. Voters and taxpayers have told the three levels of government to stop borrowing and going into deficit to finance these investments. As a result, normal spending patterns have been disrupted and infrastructure - water and sewer systems, roads, transit, airports - all the things that good economies need to be productive - have suffered."

Pension funds had always helped to finance these projects anyway, Richmond reasons, by being among the biggest buyers of government bonds. "We should be smart enough to adapt our systems to a new reality where governments don't want to borrow so much but the need for infrastructure is still obvious."

The first OMERS venture into this new reality was in Nova Scotia where the government was looking for a turnkey operator to build and manage 15 new schools. "We stepped forward and came up with a way to finance and build those schools for less than the school boards could do and still get a return over time that justified the investment," Richmond says.

The Canadian Union of Public Employees (CUPE) attacked the deal, calling it "a chilling twist on the P3 story [in which] the deferred wages of public sector workers are playing a role in privatizing Nova Scotia schools." Richmond rejects this, pointing out that OMERS focuses on finding situations where long-term funding is needed to finance new infrastructure or expansion into new activities. "We're there to grow these enterprises. The union that's there when we go into the partnership remains there and its membership expands."

He cites the OMERS/Borealis decision to buy into the Toronto District Heating Company as a 50 percent partner with the City of Toronto, creating a new P3 called Enwave. At the moment, the company provides steam heat to many buildings in Toronto's downtown core. OMERS investment allows Enwave to move ahead with an ambitious program to increase market share as well as move into new environmentally friendly technologies like co-generation and deep lake water-cooling for air conditioning in the summer.

Richmond also sees an important investment opportunity in the deregulation of the electricity industry in Ontario, where many municipalities are reluctant to sell their electricity authorities to big private (and mostly US) utility companies. Borealis has bought an interest in Hydro Mississauga and is talking with several other hydros about a possible amalgamation and funding for their ongoing expansion.

Other recent Borealis investments include providing all the funding to build and equip eight new long-term care facilities (a combined total of 1,100 beds) to be operated by Extendicare for the Ontario Ministry of Health, and buying CN's half share of the Windsor-Detroit railway tunnel.

"We are now involved in all the infrastructure areas where investment has been lacking - education, transportation and health care," says Richmond. "We think that opportunities in this area will continue to expand. Other pension plans and other types of investors will join in; the projects will get bigger."

Other pension plans are indeed eyeing the P3 possibilities but, without the huge financial resources of OMERS, Ontario Teachers and their ilk, they see as many roadblocks as opportunities. Morgan Eastman, chief investment officer with Ontario Public Service Employees Union (OPSEU) Pension Trust, says that for the small- to medium-sized funds the problem is a lack of expertise, including the ability to carry out risk analysis on the different types of assets involved.

"Most pension funds, apart from the very large ones, generally don't have the staff to analyze these infrastructure investments; they rely on consultants," he says. "And who are you going to ask about these direct investments? It's not a public market or a publicly traded instrument. It's a very specialized product."

Eastman believes that the ideal solution is an infrastructure fund along the lines of the real estate closed end funds - a package of infrastructure projects selected and managed by experts. "Where you have this level of complexity and specialized expertise required, it is much easier for pension fund trustees to do due diligence on a management group that has put a fund together than on the individual projects. There is definitely a lot of interest in this kind of initiative. It is economically targeted legitimate investment and if the returns are there and it meets the pension plan's risk-return profile then I think we are obliged to find a way to participate."

Fortunately, at least one banker in Toronto agrees with Morgan Eastman and has decided to do something about it. "To develop these projects you need a big team of people to analyze the deal, make the bid, negotiate the documents and then close the deal," says Peter Salisbury, managing director of Macquarie North America Ltd. "The issue for a pension fund is whether it wants to hire a team of 12 to 15 people or put the money in a fund and use their expertise."

Macquarie North America, the Canadian subsidiary of Australia's Macquarie Bank Ltd., is currently establishing an infrastructure fund along the lines of the vehicle described by Morgan Eastman. While reluctant to go into a lot of detail until arrangements are finalized, Salisbury did allow this much: "We're getting a group of investors together and pooling the money. We'll manage the money, find the investments and manage them once they are made."

What sort of investments? "We're thinking initially at least it will probably focus on electricity, gas pipelines, maybe some telecom assets." Macquarie already knows a thing or two about that sector, having put together and underwritten the AltaLink consortium that recently paid $850 million for TransAlta Utilities Corporation's electricity transmission business in Alberta.

"A lot of energy assets that we want to buy are already owned by the private sector," says Salisbury. "We are not setting up this fund to concentrate on [P3s] although there are certainly P3 projects that we'll be interested in. We are having a very close look at the Toronto airport rail link, for example."

Salisbury says he is "reasonably confident" there is a lot of money waiting to go into infrastructure investments. "The experience in Australia supports that. It's an investment that will produce a reasonable return, nothing spectacular, at relatively lower risk profile than your typical stock market investment. You don't invest in infrastructure to get rich quickly. You have to be a committed long-term player."

Rafferty shares the view that there will be no dearth of investor interest in P3 infrastructure projects. He even thinks he knows where the hottest action will be. "Across Canada, you've had years of municipalities deferring major maintenance, never mind expansion of their water/wastewater systems. That will be the key market for major P3 financing innovations in Canada in the short to medium term.

"If we actually had a public sector entity here that would say: 'We're not shying away - we are doing a DBFO [design, build, finance and operate]; there will be a big breakup penalty if we lose our nerve; come at us with your most aggressive bid,' there are 25 cities in Canada where you could have a dynamic international competition on a water system and no one would need to be persuaded that it was a 'flag' investment. You'd be there because it would be a stable 10 to 11 percent annual return. Safer than houses."

So why isn't it happening? Richmond says there are problems on two fronts. "The private sector hasn't quite calibrated all the risks associated with doing business with the government - the reputational risk, the delay risk, the possible cancellation risk. And Canadian governments aren't doing enough to promote the process. They have to change their processes to lower pursuit costs so you can get involved without committing millions of dollars that you might lose if your bid is unsuccessful. A lot of things need to be adjusted. What needs to happen in the longer term is for the financial markets to adjust sufficiently so that there's a standard way of delivering infrastructure with equity and debt components that are acceptable to governments, taxpayers and financial institutions. It's moving from a structure that's been in place for a long time - government borrowing - to a new regimen with a different financial model where all can participate."

John Chenery has worked as a journalist and editor for national newspapers in Australia and the UK. Before moving to Toronto from Costa Rica, he was Director of Communications with the Earth Council.



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