Based on the work of our Roundtable, we know that there are three interlinked problems with protecting investor rights in infrastructure:

1) Political risk problem - How do you tie the hands of a sovereign? How do you get a host government to make credible commitments? And to keep its promises? And if you can't do this, then you have the...

2) Legal-contracting problem - How do you write a contractual agreement that will hold over successive changes in governments, conditions, and attitudes? So that lenders have reasonable certainty that their loans will be repaid? And if you can't do this, then you have the...

3) Financing problem - How do you get private-sector equity providers and lenders to come in, if they are not assured of a return on their investment? If they do not have absolute certainty?

But, notice that the three problems are not equal. Ultimately it is the political risk problem that leads to the legal-contracting and the financing problems, so the political risk problem trumps the others in terms of importance.

Or does it? Over the past weeks, I have been grappling with this issue and recently it occurred to me that we need take the analysis one level deeper. We need to look at the underlying root cause of different kinds of political risk. Why do governments break their promises?

In some cases, governments break their promises due to changed conditions -- war, famine, or macro-economic shock. And neither investors or governments have much influence over these situations, so this strain of political risk seems to be an intractable form, a ticking time-bomb waiting to happen.

But in other cases, it is changed attitudes that lead governments to reverse policy, and this is perhaps a more predictable and manageable problem.

This second strain of the political risk problem arises from the fact that for political leaders to maintain office, they must be sensitive to the opinions of their winning coalition (see the previous post for a definition of this term). Thus, as the sentiments and attitudes of the winning coalition shift, politicians must follow-suit or they are at risk of losing their base of popular support.

I can think of at least two situations where the opinions of the winning coalition may shift quite dramatically.

The first situation is at election time, when the incumbent loses office to the challenger and both the political leader and the winning coalition change simultaneously, and both likely hold an entirely different set of views and attitudes, and may well be motivated to reverse policy passed by the incumbent's administration.

The second situation is when the existing winning coalition learns that their political leader has either intentionally deceived them or failed to watch out for their best interests.

For example, if the Department of Transport enters into a concession agreement granting a private investor the right to charge a $1 toll to motorists crossing a bridge, and the public later determines that they are paying $0.50 more than motorists on a similar bridge 100 miles down the river, than that politician is going to be under a great deal of pressure from their winning coalition (and from political challengers) to renegotiate the terms of the agreement.

And the US public is very intelligent, they compare the deal that they have in their state or county, with the deals that have been reached in other jurisdictions. So, politicians are constantly under scrutiny and pressure from the public.

Investors ought to pay more attention to the dynamics that underpin this second strain of the political risk problem. Indeed, it is a recurring structural problem and investors ought to be able to identify a menu of strategic management options to deal with it in a more systematic way. This kind of political risk should not come as a surprise, but rather it should be a calculated part of the game of investing in infrastructure assets.

If investors could better prepare themselves to deal with this second strain of the political risk problem, they might be much better positioned to succeed with investments in this challenging asset class.

More to come...

Posted by rjorr at November 27, 2006 2:55 PM