E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 162 Private Financing Alternatives for Infrastructure of State Owned Enterprises http://dx.doi.org/10.5755/j01.eis.0.12.20858 Ilja Arefjevs Luminor Pensions Latvia IPAS Submitted 06/2018 Accepted for publication 11/2018 Private Financing Alternatives for Infrastructure of State Owned Enterprises EIS 12/2018 Abstract European Integration Studies No. 12 / 2018 pp. 162-171 DOI 10.5755/j01.eis.0.12.20858 Jurijs Spiridonovs Riga International School of Economics and Business Administration Natalja Tocelovska University of Latvia The aim of the article is to examine infrastructure classification and assess private financing alterna- tives for major groups of physical infrastructure under ownership of state owned enterprises in Latvia. Tasks of the research include examining types infrastructure with a focus on physical infrastructure, explaining importance of physical infrastructure to economy of a country and society, studying physical infrastructure financing challenges and problems, conducting a research on a state owned enterprises in Latvia, which own physical infrastructure, conducting expert interviews to reveal key challenges of private financing alternatives for funding of infrastructure of state owned enterprises in Latvia as well as drawing corresponding conclusion. Methods used are structured expert interviews, analytic hierarchy process, monographic method, doc- ument analysis, case study method, and literature review. The empirical research covers ten state- owned enterprises of Latvia, which own physical infrastructure. The major groups of infrastructure covered by the research are transportation, communication and power. Following key private financing alternatives are considered- commercial bank loans, bond issues as well as public-private partner- ships. Seven experts were interviewed to reveal key infrastructure financing challenges faced by state owned enterprises. Out of seven experts, one expert represents the power industry, two experts op- erate in the area of communications and four are financing experts covering all infrastructure areas. At the final stage of the research, preferred alternatives for major groups of physical infrastructure under ownership of state owned enterprises in Latvia derived from expert assessments are presented and corresponding conclusions drawn. Only one company out of ten subject to research is financed not only by bank loans, but also issued bonds to attract funding. None of infrastructure objects belonging to these companies is financed via public-private partnership. The outcome of the article is an expert interview based hierarchy of suitable financing alternatives for studied types of infrastructure under ownership of state owned enterprises of Latvia. KEYWORDS: infrastructure financing, state owned enterprises, corporate governance, public-private partnership, Latvia 163 E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 Modern society demands adequate quality of life, which inevitably translates into high require- ments for infrastructure. Even though infrastructure can be very broadly defined, typically most demanded are electricity, communications and transportation, which represent physical infra- structure. In terms of social infrastructure, potable water as well sanitation prevail while health along with education facilities conclude the list. Additionally, conventional economic theories suggest that infrastructure facilitates economic, social, agricultural and regional development as well as contributes to income redistribution and poverty reduction. Some researchers noted that investment is critically important to infrastructure development (Agrawal, et, al., 2011; Grimseyand, Lewis, 2004). Infrastructure projects are in a need of sub- stantial financing for its key stages, which include planning, designing, constructing, operating as well as further maintenance. Infrastructure funding deficit is a common challenge for academic and business discussions (Eroland, Ozuturk, 2011; Majumder, 2010). Till late nineties of the last century, public sector was the main contributor to develop nearly all infrastructure sectors. Be- cause of shortage of public funding, infrastructure has been in a dire condition in many develop- ing countries. In general, infrastructure investment can be considered to be pro-cyclical rather than evenly spread around economic cycles (Välilä, et. al. 2005). It means that when gross domestic product is at higher levels, so go public infrastructure investments. Nonetheless, one can find instances when government investments were made in a counter-cyclical manner. During severe econom- ic conditions, as already witnessed at the time of the great depression in thirties of the last cen- tury, the public sector heavily increased its spending on various infrastructure objects (Margairaz 2009; European Investment Bank Papers, 2010). Cyclicality of total investments measured as a share of gross domestic product in the recent decade can be largely explained by private finance fluctuations, which were caused by business cycles. On the contrary, public infrastructure investments also measured as a share of gross do- mestic product was found to be rather stable within the European Union at an aggregate level and even increased tom some extent in 2008 and 2009 (European Investment Bank Papers, 2010). Private sector players in late nineties of the last century started to enter the infrastructure mar- ketplace with considerable funding opportunities and strong operating skills that helped mini- mise risks related to infrastructure projects (Agrawal, et, al., 2011; Grimseyand, Lewis, 2004). Private infrastructure investments evolve from various sources. One of those, public-private partnerships, is gaining popularity in the world (Majumder, 2010). Quite similar findings are pre- sented by European Investment Bank (European Investment Bank Papers, 2010), stating insti- tutional and private investors have become very active investments into public infrastructure in recent years. Recently, many infrastructure linked financing products have been established by the financial industry in response to demand for the new asset class, which would offer a number of differ- ent investment characteristics. Nonetheless, many private investors are still reluctant to make investments in infrastructure because of high risk, low returns and extra-long payback periods. Investors reconsider the whole spectrum of available debt investments since many still prefer stable yields provided by infrastructure investments compared to high growth of capital. Ac- cording to credit agencies, infrastructure projects typically expose investors to very low default rates (Chambers 2007). Taking a long-term perspective, the appropriate risk-return profile of infrastructure as an asset class is not yet clear. Till now, history offers very limited guidance while a relevant finance theory was not designed yet (European Investment Bank Papers, 2010). Introduction E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 164 Grimsey and Lewis (Grimseyand, Lewis, 2004) believe that identifying infrastructure is easier than describing it. So far the term infrastructure included different things in it. “The definition that makes the most sense from an economics standpoint consists of large capital intensive natural monopolies such as highways, other transport facilities, water and sewer lines, and communica- tions” (Gramlich, 1994). However, it has to be noted that the definition cover called economic in- frastructure. In particular, these are physical structure objects, which are used to produce goods and provide services demanded by many industries (Chan, et. al., 2009). A broader definition of infrastructure should also include so-called social infrastructure. Typical- ly, such infrastructure is needed in education, health and other sectors of economy, which are serving society at broad. Important to mention that social infrastructure is involved in provision of services which, in contrast to output by physical infrastructure, are used indirectly by many industries. However, investments in both economic and social infrastructure are considered to be suboptimal in case of no public funding available. Therefore, infrastructure is typically classified into two main groups provided key differences in its use: _ physical or sometimes also referred to as economic infrastructure _ social infrastructure. A detailed chart of various types of infrastructure with a further breakdown is provided in the Figure 1. Physical or so called economic infrastructure is responsible for subsectors, which are directly linked to production and economic activities (Ghoshand, 1998; Majumder, 2010; Singh, et. al., 2007). Social infrastructure covers subsectors, which are responsible for facilitating develop- ment and quality of life of the society (Ghoshand, 1998; Grimseyand, Lewis, 2002; Majumder, 2009). The physical infrastructure directly assists production functions and contributes to eco- nomic development. Summing up, broad infrastructure includes roads and bridges, tunnels and railways, harbours and airports, tramways and subways, irrigation networks and dams as well as canals, water Figure 1 Types of infrastructure (Kumari, Sharma, 2017) Infrastructure 165 E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 pipelines and water purification, potable water supply as such, powerlines and power plants as well power distribution grids, oil and gas pipelines, sanitation and sewage facilities, health and housing services, communications (including telecommunications) networks (Prud’homme, 2005; Sinha, et. al., 2012). Economic or physical infrastructure is estimated to account for about 75% of total infrastructure investment in the European Union leaving around 25% for social infrastructure. The research (Alegre, et. al., 2008) showed that transport can be responsible for the biggest infrastructure investments. In Europe Transport related infrastructure was found to have a share of more than 50% of total infrastructure investments while utilities came at the second place (European In- vestment Bank Papers, 2010). Debates on whether financing should be bank-based or market- based took place for a long period of time. Langfield and Pagano (2016) concluded that since early nineties of the last cen- tury, the banking system of Europe expanded rapidly while its capital market experienced only moderate changes. Thus the financial structure became mostly bank-based. Another wave of academic interest of the financing topic is observed in mid-2010. Reflections from the financial crisis as well as Capital Market Union initiatives driven by the European Commission facilitated academic discussions. Generally, it is considered that a financial system of the country brings together lenders, borrowers, financial markets and financial intermediaries with the aim to channel financial resources from the financial market participants with the excess to other financial market participants, who have shortage. Mishkin (2009) defined two flows of financial resources between borrowers and lenders: _ through financial markets or direct finance _ through financial intermediaries or indirect finance. The practice of dividing market and bank financing is typically used to characterise entire economy. In case of the bank-based financial system, the role of banks is central in redistributing financial resources. On the opposite side, in the market-based financial system, securities markets com- pete with banks in attracting private savings to companies (Demirguc-Kunt and Levine, 1999). Governments around the globe used to be only investors in public infrastructure for centuries. Responsibilities for construction, implementation, operation, maintenance and further repair of infrastructure were with governments (Guptaand, Sravat, 1998; Singh, et. al., 2007). However, because of several reasons, public funding started to be replaced with private financing increas- ingly more often. Private investment can be seen as transferring responsibilities for infrastruc- ture development from the public sector to the private sector (Grimseyand, Lewis, 2004). In1991 infrastructure in many countries was depleted. Private financing could take over the responsibil- ity of the infrastructure sector from the pure public funding. Therefore, private financing played an increasingly more important role to meet increasing demand for infrastructure funding. Private financing can take various forms such, for example, bond and equity issues, bank loans, deliveries of alternative services, public–private partnerships and finally foreign direct invest- ment should not be forgotten as well. Foreign direct investment conventionally means funds, which were made available by foreign entities, however within a strict supervision framework of such investments (Rathand, Samal, 2015). Because domestic investments were insufficient, majority of developing countries experienced infrastructure facilities not being up to date. Public-private partnerships have gained a lot of attention in academic literature (Agrawal, et, al., Private financing and infrastructure E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 166 2011; Grimseyand, Lewis, 2004). Public-private partnerships are considered to have following key characteristics: _ Private financing is supposed for construction, operation, maintenance and overall develop- ment of infrastructure sectors. _ A long standing contractual arrangement is in place between public and private sectors for development of infrastructure sectors. _ Public-private partnership provides infrastructure related services to population on behalf of the public sector. Public-private partnerships are becoming popular because they ensure adequate funding as well as enable design, planning, scheduling, construction, maintenance and completion of infra- structure projects within defined periods of time (Devan, 2005; Eid, 2008; Elhance, et. al., 2013; Ke, 2010 ; Li, et. al., 2005; Reeves, 2013; Sharma, 2012; Steijn, et. al., 2011; Wojewnik-Filipkow- ska, Trojanowski; 2013). Public-private partnerships also were criticised for relatively higher financing costs per unit compared to government debt, which received a label of the so-called public-private partnership premium. The figures presented for difference in costs vary a lot. In particular, cost of capital attracted under public-private partnership projects can be two to three hundred basis points higher compared to cost of public funding (Yescombe, 2007, p. 18). Nonetheless, public-private partnerships are considered to be the most promising vehicle for infrastructure finance in future. Enterprise name Balance value, euro Fixed assets, euro Type of infrastructure Latvenergo, JSC 3 517 372 000 190 461 000 Power Sadales tīkls, JSC 1 310 085 000 101 885 000 Power Latvijas dzelzceļš, JSC 1 014 784 000 241 632 000 Transportation Lattelecom, LLC 319 050 150 29 557 564 Communication Latvijas Mobilais Telefons, LLC 251 115 715 43 021 517 Communication Starptautiskā lidosta Rīga, JSC 186 027 759 27 020 460 Transportation Rīgas siltums, JSC 164 022 813 15 464 845 Power Augstsprieguma tīkls, JSC 107 187 707 1 489 533 Power Latvijas valsts radio un televīzijas centrs, JSC 104 402 677 7 543 231 Communication Latvijas Pasts, JSC 91 701 752 1 178 955 Communication Source: www.valstskapitals.lv Table 1 State Owned Enterprises with Physical Infrastructure included in the research Quite substantial part of infrastructure objects in Latvia is owned by enterprises, which are still under direct state control. Out of ten biggest state owned enterprises with physical infrastruc- ture, only two telecom operators (i.e. Lattelecom, Latvijas Mobilais Telefons) went through a process of partial privatisation. However, the Latvian state still keeps control in these compa- nies. Power sector state owned enterprises cannot be privatised (except Rīgas Siltums, which provides heating services for natural persons and companies in the city of Riga) because of law amendments, which were adopted in 2000. The list of state-owned enterprises with physical infrastructure covered by the research is provided in the Table 1. State owned enterprises of Latvia with physical infrastructure 167 E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 Companies with physical infrastructure and balance value of at least 100 million euro were in- cluded in the research. Latvijas Pasts, which is a national postal service operator, does not reach a balance value of 100 million euro, however was still included in the research because it is a systemically important infrastructure operator. All companies covered by the research use bank financing via loans and leasing arrangements while only one company, Latvenergo also attracted financing via several bond issues. None of the companies included in the research is engaged in public-private partnership projects. Expert Organisation Position Mr Indars Aščuks Nasdaq OMX Baltic Chief Executive Officer Mr Guntars Baļčūns Latvenergo JSC Chief Financial Officer Mr Jānis Bokta State Radio and Television Centre of Latvia JSC Chief Executive Officer Mr Jānis Dubrovskis Blue Orange Bank JSC Corporate Finance Director Mr Elmārs Prikšāns OP Bank Latvia Branch General Manager Mr Andris Nātriņš Latvijas Pasts JSC Member of the Supervisory Council Mr Nauris Kļava Ernst & Young Baltic LLC Partner, Advisory Table 2 Selected experts with knowledge on infrastructure financing alternatives Source: prepared by authors In order to assess funding alternatives, authors conducted expert interviews, which had a struc- tured part, for which the analytic hierarchy process (AHP) was used as well as an open-ended part, which added to the qualitative findings of the research. AHP is considered to be a recog- nized tool for structured decision making. Decision making, for which we gather most of our information, became a mathematical science today (Figuera, et. al., 2005). The evolving problem is that decision making may involve booth many criteria as well as sub-criteria to be used to rank decision alternatives (Saaty, 2008). Conventionally, data subject to research are gathered from decision making experts corresponding to a hierarchic structure. Further, a pairwise com- parison of alternatives on a qualitative scale is conducted as described below. (see Table 3). In the course of the analytic hierarchy process, experts can rate the comparison as equal, marginally strong, strong, very strong, and extremely strong by using a nine point Likert scale where “1” means that alternatives are equal while “9” stands for absolute superiority of one alternative over another. A set of pairwise comparison matrices was constructed in accordance with the overall hierarchy of the process. The hierarchy of the alternatives for preferred pri- vate funding sources of infrastructure of state owned companies is presented in the Figure 2. Experts were chosen taking into account their knowledge and competence in infrastructure fi- nancing matters in the sectors covered by the research. Out of seven experts in total, four experts represent various institutions playing a role in the infrastructure funding value chain- a stock exchange, a bank (loan issuer), a bank (debt underwriter) as well as a major advisory and con- sulting company. These experts are considered to possess wide knowledge on all sectors of the research since companies being studied operate in the same country. Three more experts rep- resent specific industries covered by the research- power, communications and transport. Thus, in total a selection of seven experts can be considered to be balanced between industry profes- sionals and financing professionals with no anchoring to a specific industry. A list of experts as well as organisations they represent and positions they take is provided in the Table 2 below. Expert Assessment of Preferred Financing Alternatives E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 168 Within the unstructured part of interviews, experts mentioned following reasons for commercial bank loans being the most popular financing alternative while bond issues and public-private partnerships staying largely unexploited: _ In Europe, bank-based financing is more popular in general _ Highly competitive corporate banking marketplace in Latvia, high degree of flexibility and availability of funding for state owned enterprises in particular _ Corporate governance and internal procedures very often need to be improved to meet higher transparency requirements for listed companies _ Credit rating is needed to go for bond issues _ Resistance to change a regular routine in general _ Public-private partnership projects expose top management to political risks. The structured expert assessment results according to the AHP process findings were processed by the authors while its summary is presented in the Table 3. Figure 2 The hierarchy of alternatives for financing of infrastructure of state owned enterprises companies according to AHP (prepared by authors) Alternative/Criterion C1. Transportation C2. Communication C3. Power A1. Commercial bank loans 0.24 0.63 0.28 A2. Bond issues 0.33 0.25 0.62 A3. Public-private partnership 0.43 0.12 0.10 Total 1.00 1.00 1.00 Source: www.valstskapitals.lv Theoretical preferences of experts clearly tend to exhibit overall anchoring towards certain type of a financing alternative for each sector. For example, banks loans were chosen as experts at the preference number one (i.e. overall score 0.63) for communication (telecoms and postal systems) while bond issues (scored at 0.25) and public-private partnerships (score of 0.12) were considerably left behind in expert assessments. The underlying logic for such a distribution of preferences was that life span of equipment in the communication sector is relatively short and specific know-how as well as competence is normally included in purchase conditions. Some projects can be also financed by using industrial leasing offered by subsidiaries of banks. Bond issues gained the highest assessment in the power industry related projects (scored at 0.62). One of the arguments was a longer maturity of funding (i.e. advantage compared to bank Table 3 Expert assessment results for infrastructure financing alternatives 169 E u r o p e a n I n t e g r a t i o n S t u d i e s 2 0 1 8 / 1 2 loans) as well as no critical need for public-private partnerships since joint ventures are much more common in the given industry. Finally, public-private partnerships received decent recognition by experts (score of 0.43) for financing transportation related infrastructure projects. The key driver for such an assessment was a need to get an access not only to project funding, but also to know-how and competence in relation to running and maintenance such projects. The problem can be especially relevant for small countries like Latvia is since there is lack of knowledge and experience in implementation of transportation related projects in some areas (i.e. railroads, roads and potential improvements in running airport facilities). As a final remark it has to be noted that a dispersion of financing alternative assessments for the communication and power sectors is very similar and much bigger that for the transportation sec- tor. According to expert assessments, the transportation sector might need a very well-balanced approach of funding, which also includes a big part of know-how and competence possible to be accessed via public-private partnerships with financially and technologically strong partners. Conclusions _ Latvian state owned enterprises with physical infrastructure have been primarily relying on loans from commercial banks. Bond issues as well as public-private partnership projects as alternative private financing sources largely remain unexploited. _ Overall expert assessments showed that commercial bank loans can be prevailing over other private financing means because of a general anchoring towards bank based finance in Europe, highly competitive banking landscape in Latvia, less requirements for corporate transparency and smaller top management exposure to political risks (especially compared to public private partnerships). _ Expert assessments made in accordance with the analytic hierarchy process revealed the most preferred private financing alternative for each sector of infrastructure companies covered by the research, making commercial bank loans as a justified choice only for communications. _ Power infrastructure companies were assessed to be in the highest need of market based financing via bond issues due to long project payback periods, which can match maturity of debt securities. _ Infrastructure companies operating in the transportation industry were given the closest distri- bution of alternatives with public-private partnerships topping the list. 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BA School of Business of Finance Fields of research interests Finance, investments Address K.Valdemara 161, Riga, LV1013, Latvia, Tel. +37126547036 E-mail: ilja.arefjevs@inbox.lv About the authors SPIRIDONOVS JURIJS Dr.oec. RISEBA University of Business, Arts and Technology Fields of research interests Public services, economic development, energy sector Address 3 Meža Street, Riga, LV-1048, Latvia, Tel. +37129234414 E-mail: j.spiridonovs@gmail.com TOCELOVSKA NATALJA PhD Student University of Latvia Fields of research interests Finance, financial markets, securities, bonds, corporate bonds Address Aspazijas bulvaris 5, Riga, Latvia, Tel. +37129138802 E-mail: natalja.tocelovska@sseriga.edu vol.89(4), 1235–1252. https://doi.org/10.1111/ j.1467-9299.2010.01877.x Välilä, T., Kozluk, T. and Mehrotra, A. (2005). “Roads on a downhill? Trends in EU infrastructure invest- ment”. EIB Papers, (10:1), 19-38. 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