“Everyone should be worried about rising inflation at the level seen over the last years,” says Sarah Schick, senior vice president at Macquarie. “[Inflation] is here to stay and I think we can see for the first time states acknowledge that the industry may need protection against rising costs of materials, labor and rising interest rates.”
Protection against inflation is just one of the many ways it is going to alter the P3 industry. It is a problem that must be dealt with collaboratively by both sides of the public-private partnership.
“The industry will be looking at protection differently than before especially for a long development or construction period,” Schick adds. “The market will change in terms of the protection that is offered to the private sector.”
As she points out, the public sector is starting to acknowledge this need, with the Georgia Department of Transportation telling delegates at a recent industry event for its flagship program that it will take part of the risk due to the escalation. Meanwhile, other authorities are abandoning their attachment to fixed-price contracts in favor of index-linked deals to maintain their attraction and entice wary contractors concerned that inflation will quickly wipe out any profit margin on an offered price today.
While these choppy waters are hard to navigate, some sectors of the industry are more bullish on the potential for P3s to withstand, and even thrive, in this environment.
“From an investor perspective, inflation on materials combined with rising rates is tightening returns, but you can still get these deals to work,” says Jeremy Ebie, co-founder of Phoenix Infrastructure. “I think inflation is an issue for every industry, including P3s. The difference is that because our project terms are longer, we are able to consider the long run of both interest rates and inflation over the life of our agreements.”
For those projects that have already entered the operational phase - and don’t face the challenge of finding a willing contractor to do the construction work - projects can be somewhat insulated from the impact of inflation. “For existing availability payments, the conversation is simple: for the investors it’s about the counterparty. If it’s a concession, we need to understand and analyze the market dynamics driving potential revenue,” he says.
This is undoubtedly having an impact on the types of models that the private sector is preferring to use. When asked whether this is driving Ebie’s decision-making he responds with a definitive “Yes”.
Rising costs will also impact how the public sector approaches projects, however, and it may not be with a long-term view.
“Inflation is going to get in the way of some of the added policy goals for P3s,” says Charles Renner, partner at law firm Husch Blackwell. He points to issues such as Net Zero, which could be deemed too expensive and therefore could be jettisoned from a project’s scope. “We could see challenges on that side as well.”
Nonetheless, experts suggest that rising costs could drive more public authorities to turn to P3s. There has already been plenty of talk surrounding the potential to make federal dollars from the bipartisan Infrastructure Investment & Jobs Act (IIJA) go further through allying them with P3 models. If that federal cash is found to be doing even less because of inflation, the pressure to get more ‘bang for your buck’ will be even greater.
“If you are using TIFIA loans, for example, there could be an advantage because you can borrow loans from the federal loan programs at much lower rates than inflation,” explains Professor Qingbin Cui, academic at the University of Maryland and leader of the US Transportation’s Build America Center. “That motivates the developer and government agencies to borrow money instead of relying on taxation funds for projects.”
When inflation will start to cool is anyone’s guess: a recent report by IFM Investors suggested it will remain high long into 2023 - but the obvious question is what would happen if governments really try to arrest this trajectory?
One of the main levers for this is to raise interest rates, something which the Federal Reserve did by 0.25% in March (it’s first rise since 2018) and again by 0.5% in May - its largest rates rise in over a decade. But even with these hikes, inflation is projected to continue its recent surge.
Some have predicted that the Fed will go further in the months ahead, making a more concerted effort to bring inflation under control, with some experts predicting its biggest increases in almost three decades.
“This would likely stimulate more P3 because the private sector finance expertise is very adept at managing rate risk,” says Renner, pointing to the different available options for debt to be refinanced by the private sector in comparison to public sector bonds.
“The private sector has many tools to find more efficient ways to finance the projects,” he adds. “When things are stable, that’s not value, but when there’s volatility it is very appreciated.”
Fiscally difficult backdrops, whether a pandemic, financial crash or geopolitical tensions, often call for innovative financing techniques such as P3s. Today, the perfect storm of rising inflation and a government staking its political future on renewing America’s infrastructure, could finally turn the old adage of there being more P3 conferences than P3 projects on its head.
“We could end up with a situation, which has not been the case in the US P3 space before, where we have more projects than capacity,” says Roddy Devlin, partner at Nixon Peabody.
“It will flip the narrative,” he continues. “Sponsors and developers could be pickier in what they pursue. They are going to chase the more attractive projects, whether that’s easier ones, which might not be P3s, or ones that offer the potential for higher profits.”
How far down this pathway the industry will go, it is impossible to say - but inflation is changing the landscape of the P3 industry in a way that will be felt for years, perhaps even decades, to come. Those that withstand the headwinds could be on the right footing for a new era of P3.