Inflation and P3s

As current inflationary pressure threatens to burst the construction bubble, in the long run could it cause a boom in P3s, asks Deputy Editor Jonathan Davies

As central bankers and governments around the world try to wrestle inflation under control, the infrastructure industry is at the coalface of dealing with its effects. Soaring commodity prices, labor shortages, and supply chain fractures are just a few of the issues fueling a spiraling crisis.

For P3s, there are a multitude of perspectives when it comes to inflation – from anxiety to relaxation. The model is famous as a safe haven for capital during times of uncertainty and volatility: whether through inbuilt elements like index-linked payments or flexible options such as toll price increases, operational assets fare generally well – and even benefit – from a high inflationary environment.

For contractors and public authorities still in the construction phase, however, the cost of soaring prices can be not only destructive, but deadly.

“Can you imagine signing a multibillion light rail project two years ago?” says one North American contractor. “Companies can die on the back of these projects.”

This immediate danger is being felt around the world.

“We have seen a number of our opportunities and projects experiencing hyperinflation in some products and equipment,” says David Swarbrick, Bam PPP’s UK & Ireland managing director. “Essentially, we have to price that in but we have no idea how long the inflation spike will last for or how high it’s going to go.”

Bam certainly isn't the only contractor in this position: in the latest Aecom quarterly report, the firm noted that it had increased its tender prices by 5% over the last year, although it did predict that this growth will slow to 4.4% by the end of 2022.

One source working on a live procurement says they have seen "eye watering price rises" for both labor and material, which has made reaching financial close more difficult. 

“We are not in the world of prices being fixed for six months for financial close, it’s now more like one week,” says one source, who cited increases of 25-40% on tendered costs of a project due to inflation. They point out that there is "no certainty" on what the costs for the supply chain will be until the agreement is signed. "You can't underestimate the impact that inflation - and a lack of resources - will have on projects," they warn.

These rising prices can force a change in the assessment on when to use a P3, and procurements started on pre-pandemic projections may be coming under scrutiny.

“In this market where the public sector is looking for long-term fixed price contracts it’s possible the public sector will question whether they’re getting value for money,” says Swarbrick.

“Securing best value needs a more nuanced approach to risk – which could be something like asking the private sector to take inflation risk up to a certain point and a risk share with the public sector above that level. There are a range of different options on how to manage risk in a way that delivers better value for money.”

These new risk calibrations are certainly out there to be struck, but as always it takes both sides to reach an agreement – and numerous projects around the world have faltered, resulting in early termination, P3 Bulletin understands.

Kim Locherer, director of Fitch’s global infrastructure division, added that under these conditions the private sector was likely to "seek to pass at least some of the same risks back to the grantor", which could lead to affordability issues on public sector procurement and ultimately putting "negative pressures" on the amount of P3s being procured - potentially having a long lasting damage on the industry.

What's more, “the public sector has been slow to adapt to the new risk profiles,” says one investor-contractor. “The private sector has been left to manage those risks.”

While deals are being struck to see projects continue to proceed and be procured under the inflationary atmosphere, the industry is coming up against one of its biggest debating points: the flexibility of P3 contracts.

“This gets to a broader conversation on how the public and private sectors interact on a long-term basis, because there could be really significant cost pressure right now,” says Carter Casady, honorary senior research fellow at University College London and specialist in P3s. “The question is how are they going to react to that and carry the project forward and deal with the repercussions down the line? That’s the relational aspect that has TO come into play.” 

Flexibility and adaptability aren’t words commonly associated with P3s, however today they are being seen as core elements of the “next generation of P3s” that the World Bank is calling for.

That being said, some models have already pioneered a way to absorb large-scale economic changes. Casady points to a version that was popular in Chile which pioneered flexibility by creating an adaptable P3 based on “how things work out in the real world. If demand is underestimated, or there’s a recession, or the project is taking too long to recoup the investment, then the contract will extend until the least present value revenue target is reached, and this can happen in reverse too.”

While the model did struggle to find financial backers, it did allow projects to respond to the ebb and flow of the real world economy and provide a template for a different, closer relationship between the private and public sectors that allowed them to progress.

In the current high inflation environment, building in flexibility would help contractors and P3 programmes not only weather the storm, but build their way out of it.

Furthermore, these risk sharing models offer advantages to public authorities to keep their programmes on track. P3s offer more than just paying for construction, they offer a lifecycle approach, which could be crucial in helping authorities maintain construction amid soaring prices.

“If you’re operating in a higher rate environment and you’re dealing with certain costs to get the project going, it just changes to calculation from ‘how much do I need to spend now’ to thinking about the nature of the contract – the length of the term, and what the economic profile of the project needs to look like so it’s still viable given the economic pressures. It’s a completely different mindset,” says Casady.

While the balance of risk may go through yet another recalibration, the inherent momentum in the P3 market as authorities look to kickstart their economic recoveries with depleted finances means many in the market remain bullish.

“P3s are complex projects, and the risk management is tricky. In addition to the cost of materials and labor, we have to ask what’s the demand on the offtake side of it,” says Greg Hummel, senior counsel at law firm Bryan Cave Leighton Paisner. 

“I’m seeing major players in the region betting long-term that that demand is going to come back, and they are pushing ahead notwithstanding some of the new risks,” he continues. “I do think that at this stage it’s a business risk that can be managed.”

Not only are investors ready to put their hat in the ring, but the high inflation environment could actually lead to a proliferation in P3s, only furthering the scenarios that have ramped up the momentum.

With authorities already under the cosh from the Covid-19 pandemic, inflation is exhausting their coffers even more quickly than usual and returning even less for their investments. “This, in turn, creates opportunity for private equity investment to come in,” says Marcus Lemon, senior counsel at law firm Clark Hill. “P3s can be an excellent remedy to combat inflationary effects on public finance because they offer innovative private financing that can offset the effects of increasing cost pressures, declining tax revenue, reduced credit ratings, and reduced credit availability.  Efficiencies in operation and maintenance derived from P3s can also offset the negative effects from inflationary cost pressures.”

As with most industries, the immediate effects of inflation are not falling equally on everyone’s shoulders. Those in the business of building today are wrestling with its effects that threaten projects and companies alike – but with P3s often a countercyclical economic option, inflation may be further fertilizer for future growth in the market.