Financing urban development — windows of opportunity

Writer: Lim Xiou Ann

In light of limited public sector budgets, tightened lending regulations and suppressed amounts of capital in the global markets, cities are increasingly turning to innovative funding models for urban development. We take a look at how authorities can do to persuade the private sector to invest in cities.

Cities mentioned in this article:
Singapore, Medellín

Shanghai stock exchange building © Huerik 2005

While it is common knowledge that infrastructure has a major impact on the advancement of cities, its importance is still largely underplayed. Around the world, assets like transportation systems, energy and water provision, and communication networks – as well as social infrastructure like education and health services – have not been able to keep up with the pace of urbanisation.

Across Asia, for instance, the region must invest US$730 billion a year by 2020 in order to keep up with demand ↗ (opens in new tab), according to the Asian Development Bank, with 68 percent of this figure allocated to new projects and 32 percent used to finance general upkeep. Furthermore, this investment is needed solely for physical infrastructure and does not include facilities like hospitals and other social services. This makes infrastructure a growing opportunity for private companies. Yet investors remain reluctant.

Core challenges

Today’s investment shortfall is the result of two issues. First, the majority of infrastructure projects are incapable of paying for themselves through user fees, as citizens and companies are unwilling to pay extra for the development of city facilities. Second, many municipalities – in particular, those in emerging markets – are not sufficiently creditworthy to access the upfront capital required to develop infrastructure projects. This is further exasperated by today’s limited amount of credit in the financial markets, as well as tighter regulations imposed on bank lending.

In light of these challenges, Bindu Lohani, Vice-President of Knowledge Management and Sustainable Development at the Asian Development Bank, remarks, “Cities are finding it increasingly difficult to secure traditional sources of capital, which have supported their growth ambitions in the past. Authorities are now turning to a number of credit enhancement structures in order to attract non-traditional financing mechanisms, like bond financing, guarantees and credit enhancement products.”

Projects are also unattractive to investors due to poor project preparation and a lack of trained professionals. While advanced cities like Singapore and those in the West boast an array of skills, expertise and talent, municipalities in the developing world fall short in these areas. “Today’s challenge is not only absence of funding for urban infrastructure projects. But more fundamentally the capacity and skills to appraise, structure and develop bankable urban infrastructure projects that can then attract funding,” explains Bindu.

"Today’s challenge is not only absence of funding for urban infrastructure projects. But more fundamentally the capacity and skills to appraise, structure and develop bankable urban infrastructure projects that can then attract funding." — Bindu Lohani (Vice-President of Knowledge Management and Sustainable Development, Asian Development Bank)

Private sector participation

Increasingly, governments are turning to public-private partnerships (PPPs) to fund urban development projects. As an alternative option to support new and ongoing developments, PPPs are gathering momentum in the face of weakened assistance from traditional lenders. Under such agreements, the private sector finances a project in return for fixed revenues or other financial incentives.

Another popular financing mechanism is the build-operate-transfer (BOT) model, where the private sector provides the upfront capital for a concession but transfers project ownership over to the public sector within a set period. “Across the world, civic authorities are increasingly shifting their preferences towards new funding models,” says Jordan Schwartz, Head of Global Infrastructure Facility at The World Bank, adding, “Cities are continuously looking at ways to make projects more attractive to private investors. These include measures that ensure a level playing field for the private sector; transparency in the procurement process; robust governance and institutional structures; and the provision of adequately trained staff.”

A further source of capital is the growing number of infrastructure-dedicated funds managed by private equity, real estate and asset management firms. According to research firm Preqin, more than US$200 billion has been raised globally for investments in infrastructure projects. The bulk of this capital has emanated from institutional investors, like pension funds and life-insurance companies, as these organisations see infrastructure as carrying less risk when compared to stocks and other long-term financing instruments.

"Cities are continuously looking at ways to make projects more attractive to private investors. These include measures that ensure a level playing field for the private sector; transparency in the procurement process; robust governance and institutional structures; and the provision of adequately trained staff." — Jordan Schwartz (Head of Global Infrastructure Facility, World Bank)

Social services

Beyond physical infrastructure, cities are also turning to the private sector to develop municipal facilities like schools, clinics, public spaces and buildings – key contributors in making cities liveable and sustainable, and which have a direct impact on how educated, healthy and content city residents are. Indeed, these are areas where Singapore continues to excel, as the city has for many years been the recipient of awards recognising its high quality of living.

“Infrastructure is not always about concrete. It’s also about services where contracts for these are often long-term and provide good returns for investors,” explains Michael Cooper, Head of Infrastructure Financing at HSBC Malaysia, who cites PPPs and BOTs as mechanisms increasingly used to fund public services worldwide.

According to McKinsey & Company, public entities around the world need more than USD $8 trillion to fund social infrastructure projects by 2020, with more than 40 percent of this figure needed by developing markets ↗ (opens in new tab). While private sector’s interest in funding these projects has increased in recent years, barriers to participation remain. City authorities – particularly those in emerging economies – often lack the capacity and capabilities to plan and execute partnership-based models. The day-to-day managing of social infrastructure is particularly challenging, given the breadth of resources and expertise required to operate public facilities.

Sustainable funding

The city of Medellín © ACI Medellín

Ultimately, cities must find sustainable sources of financing, which is highly challenging in today’s economic climate. Furthermore, banks and other financial services firms are facing increased pressure from shareholders and other stakeholders to invest in projects that not only reap healthy returns, but which are environmentally, socially and economically sound. An added challenge is that there are few forums globally that address today’s funding gap for cities, and best practices in this area are seldom discussed on a global scale.

The biennial World Cities Summit ↗ (opens in new tab) is such an event that brings together city mayors and financiers. Staged in Singapore, the 2014 event saw representatives from the World Bank and Asian Development Bank meet with city leaders and the private sector, in order to encourage greater dialogue between the various stakeholders. More than USD $14.5 billion worth of deals between public and private sector entities were announced at the Summit ↗ (opens in new tab).

Sustainable funding can exist in new and somewhat novel forms. For instance, 2016 Lee Kuan Yew World City Prize Laureate, the city of Medellín in Colombia, developed a unique financing mechanism where the developer is also an investor. With the aim of enabling quality in the delivery of public projects, and against the backdrop of limited access to private funding, the developer-investor receives approximately 15 percent of the profits from the project, and ensures quality and timely delivery of the initiative.

“The most effective way for cities to attract private investors is for authorities to ensure returns,” says Schwartz. “Civic authorities and the finance community must continue to work together to strengthen the regulatory, pricing and project preparation side. In doing this, they will reassure investors that these projects are financially viable and able to generate long-term returns,” he concludes.