2.3.1 Business Risk
The first TICCS® pillar is the business-risk classification of infrastructure companies. Broad families of business-risk or business-model profiles can be identified on the basis of how stand-alone, investable infrastructure is created using different forms of long-term contracts. In turn, these are fundamental drivers of the financial structure and total risk profile of the companies. TICCS® business-risk profiles are found across various industrial activities classifications (the second TICCS® pillar).
Academic Insights
While infrastructure assets are usually understood to be tangible assets – physical structures of steel and concrete – from the point of view of financial economics, infrastructure investment is better defined as a high-sunk-cost, long-term investment in immobile, relationship-specific assets. It is contracts, not concrete, that matter.
In other words, the physical characteristics of tangible infrastructure only determine the need for long-term contracts, which in turn determine a company's investment profile. Outside of contractual and regulatory relationships, tangible infrastructure assets have no or little value. This is what fundamentally differentiates infrastructure from other so-called real assets: infrastructure is almost never a store of value. It needs to be used to have value. And its usability is entirely determined by a combination of long-term contractual commitments.
The contracts that allow infrastructure investment to take place are characterised by risk-sharing mechanisms embodied by their revenue model. While numerous risk-sharing agreements can be envisaged, in practice, three types of contractual arrangements are used:
The first type is contracted or availability-payment schemes, by which a public- or private-sector client commits to paying a fixed income over a pre-agreed period, typically in excess of two decades. In exchange, the investor accepts more or less unlimited responsibility for the investment, operating, debt, and equity cash flows incurred to invest in the delivery of an infrastructure service, according to an agreed output specification. Terminal value can be set to zero, and control of the physical assets is returned to public-sector clients at the end of the contract. This model is typically used to deliver social infrastructure projects like schools, hospitals, or government buildings. It is also common in the energy sector, such as renewable energy projects, but it can also be found in a range of other sectors, including transportation projects such as roads or port terminals.
The second type of arrangements are merchant or commercial schemes, by which the public- or private-sector client enters into a similar long-term contract with an investor but in exchange for a risky income stream. This is typically the case with tolled transportation projects, for which an investor is granted the right to collect tolls/tariffs from users. Likewise, the terminal value is frequently zero. This model is typically used for transport projects with real tolls but also energy projects connected to a competitive power or gas market, as well as privatised airports or certain rail projects. Merchant telecom companies are also common.
Regulated schemes are typically associated with large network industries that benefit from a natural monopoly, such as water or gas utilities or power distribution networks. They require regulation in order to ensure efficient operations at a reasonable cost to end users, who are typically captive and receiving 'essential services' from the companies in question. Terminal value may not always be set to zero; for example, privatised utilities own tangible assets outright and in perpetuity. Regulators set tariffs to achieve multiple economic and financial objectives and often aim to mimic competitive market forces through so-called yardstick competition. Such schemes exist because of the universal tendency of monopolies to overcharge and underinvest (irrespective of public or private ownership). They also create up- and downside limits on business risk, which sets them apart from contracted and merchant infrastructure companies.
For a detailed discussion of these three types of arrangements and of the related academic literature, see Blanc-Brude (2013). For a discussion of the role of contracts in infrastructure finance, see Brealey (1996). An empirical analysis of the difference in cost of capital and credit risk between contracted and merchant infrastructure business models is provided by Blanc-Brude (2007) and Blanc-Brude (2018). For a detailed discussion of regulated infrastructure, see Gomez-Ibanez (2003).
The TICCS® Business-Risk Classification
Using the insights above, TICCS® includes three business-risk classes. Each business-risk class can be further divided into subclasses.
BR1: Contracted infrastructure companies
BR10: fully contracted infrastructure companies
BR11: partially contracted infrastructure companies
BR2: Merchant infrastructure companies
BR20: variable-income infrastructure companies
BR3: Regulated infrastructure companies
BR30: Rate-of-return regulated infrastructure companies
BR31: Price-cap regulated infrastructure companies
The table below describes the TICCS® business-risk classification.
Table: TICCS® business-risk classification | ||
Code and Definition | Code and Definition | Synonyms |
BR3 - Regulated: The regulator can set allowable limits on tariffs, rate of returns, or revenues. Also referred to as “discretionary regulation.” | BR30 - Rate-of-return regulation: The regulator is expected to set tariffs high enough to cover the costs of an efficient firm, including operating-expense depreciation and a reasonable return on invested capital. | Cost-of-service regulation - Commission regulation (US) |
BR2 - Merchant: Merchant infrastructure firms are mostly or fully exposed to market risk (price and demand risk). | BR20 - Variable income: Merchant infrastructure firms collect fees and tariffs from end users as a function of the effective demand for service. | Real toll roads - Merchant power plants |
BR1 - Contracted: Contracted infrastructure firms enter into long-term contracts to pre-sell all or most of their output at a pre-agreed price. All or the majority of market risk (price and/or demand) is transferred to a third party. The contract is for a significant period of the investment's life, typically one or several decades. | BR10 - Fully contracted income: Fully contracted infrastructure firms enter into a long-term contract by which they will provide a service or product corresponding to the entirety of their activity. Hence they do not engage in any other activity during the life of the contract. | Availability-based infrastructure or project - Take-or-pay off-take agreement - Capacity agreements - Tolling agreements - Large-scale generation certificates (LGCs) and small-scale technology certificates (STCs) |
BR31 - Price-cap regulation: The regulator sets a multiyear price cap typically defined in terms of the rate of inflation minus an expected rate of productivity improvement. Firms can increase their profits by cutting costs between regulatory reviews, thus creating incentives for efficiency gains. | Incentive regulation | |
BR11 - Partially contracted income: Partially contracted infrastructure firms commit to deliver a certain level of service or output below their full capacity level. | Shadow tolling arrangements - Partial capacity agreements - Partial power purchase agreements - Feed-in tariff | |
Blanc-Brude, F. & Strange, R. (2007). How Banks Price Loans to Public-Private Partnerships: Evidence from the European Markets. Journal of Applied Corporate Finance, 19(4), 94–106.
Blanc-Brude, F. (2013). Towards Efficient Benchmarks for Infrastructure Equity Investments. EDHEC-Risk Institute Publications.
Blanc-Brude, F., Hasan, M., & Whittaker, T. (2018). Calibrating credit risk dynamics in private infrastructure debt. Journal of Fixed Income, 27(4).
Brealey, R.A., Cooper, I.A., & Habib, M.A. (1996). Using Project Finance to Fund Infrastructure Investments. Journal of Applied Corporate Finance 9(3), 25–39.
Gomez-Ibanez, J. (2003). Regulating Infrastructure. Monopoly, Contracts and Discretion. Harvard University Press.