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Talking about inflation as one phenomenon is to ignore its true nature. It is a lumpy and diverse problem affecting different places in different ways. Whereas one authority may be suffering with labor issues, another is searching for aggregate - now a scarcity in some places. Whatever the input, the impact is ubiquitous: inflation is everywhere.
“For all projects that we are working on, discussion around inflation is a main topic with public sponsor, partners and subcontractors” says Sarah Schick, head of P3 North America at investor Macquarie Capital. Six months ago, Schick warned P3 Bulletin readers that inflation was here to stay, and now: “It definitely hasn’t gotten better, especially in the US.”
With price rises reaching over and beyond 20% on some projects, their viability is being called into question, particularly on the funding side for the public sector.
“There are a lot of transportation and social infrastructure investments, critical to local government and that were ready to be procured on the market with funding, that now need to be reassessed because the funding is no longer sufficient due to increased inflation. Affordability threshold and funding scarcity is a core issue we are all seeing,” says Schick.
In order to cope with these issues, new relationships have started springing up - changing some of the long-held arrangements and assumptions that the industry is built upon. The talk, and in some case usage, of pre-development agreements (PDAs) and progressive P3s is on the rise.
However, for those already in procurement, contingencies are being worked out at unprecedented scale. “Given volatility and uncertainty of inflation, it is becoming increasing difficult to secure fixed price from contractor over long construction period without large contingencies. The same applies for equity sponsors taking risk on long term revenues and operating costs in P3s, which could significantly decreases value to public owners,” continues Schick. “In some situations, we also witnessed these large contingencies, that we used to think unreasonable, being in line with actual inflation rates and sometime even conservative.”
Where these changes lead is still unclear, with major issues such as the amount of indexing for availability payment contracts and risk allocation still very much up for debate - and touching every corner of the market.
“Inflation risk will need to be shared between public and private partners and while we don't know yet what it should look like, we can definitely see that there is active thinking on the public side to tackle this issue,” Schick says.
In the worst case scenario, this active thinking has resulted in the termination of projects. A case in point is the C$410m Deerfoot Trail P3 in Alberta, which the then Ministry for Transportation Prasad Panda said was simply “not economically viable” due to the volatility. Most recently, Miami-Dade County scrapped a potential P3 for its monorail plan after “prices ballooned” during the negotiation process with a consortium.
However, there’s no need to panic about a sector-wide cull just yet. “If there's been cancellation and challenges, they’ve been for reasonably project-specific reasons and it's hard to generalize,” says Mike Parker, EY’s Americas infrastructure leader, sounding a note of calm.
Part of that process is finding a way to get the projects done: the need for infrastructure is greater than ever and the opportunity that the Infrastructure Investment and Jobs Act (IIJA) has presented is not one many authorities will want to miss. We are already one year into that “once-in-a-generation” cycle of expenditure, so authorities just don’t have time to sit and wait for the market to cool down.
One of the natural places that many authorities, and particularly the private sector, have been exploring is the rebalancing of risk - moving towards a more collaborative method of contracting, instead of the fixed-price contracts many are used to.
This approach has been largely pioneered in Canada, where authorities like Infrastructure Ontario are using progressive P3s to combat difficult risks such as Arctic weather. Using tools such as these to adapt to inflation is looking like a popular choice.
“Because of the limited depth of competition for megaprojects in Canada and Oceania, owners have had to think differently. While the US market is much deeper, the combined opportunities now presented by IIJA, IRA and CHIPs have the potential to stretch the construction sector here too. We expect to see an evolution towards more collaborative models,” says Parker. “What that means or how that’s built into a P3, the market is still working through it.
“There are structures to allocate risk differently than has been done in recent history,” adds Parker. “Different projects are going to have different conversations, and I think it’s healthy to step back and take a look at that right now.”
The good news is that public authorities are becoming increasingly adept at understanding these issues and there are more sophisticated public sector clients now across North America that have a better grip over what risks they should be keeping, and which ones are better left to the private sector.
“Owners are becoming more sophisticated in how they plan these projects,” Parker says. “Given current inflation volatility, and increased general cost estimation risks on megaprojects, we are seeing more contractual relief mechanisms. There also have been significant lessons learned around how compensation relief regimes and disputes play out in practice, and that is informing how clients approach different collaborative contracting models.”
The rethink will take place at all levels of the P3 industry; something we’ve seen in the increasing interest in small-scale P3s coming forward. This rebalancing could spark a change in the way the P3 megaprojects are done as well.
“Most broadly in this environment, owners do need to sit back and think carefully about delivering a megaproject in more thoughtful ways,” says Parker. “In some cases that could mean meeting the market where it is and breaking it up and phasing them or looking at different approaches with balanced risk sharing.
“For many contractors, projects have gotten too large and there are concerns about concentrated risk at a time when there is a lot of opportunity to grow through other means.”
The overall question of whether this is the right time to be investing in infrastructure, with the volatility around, is a valid one despite the encouraging tailwinds that are emerging.
For a start, we are still in a negative interest rate environment in real terms, given that inflation is much higher than interest rates in the near term. That means borrowing money is still relatively inexpensive for public authorities, potentially incentivizing them to commit to near term investments.
“Right now, in the general scheme of things, this is still a relatively good investment environment, it’s just that we’ve been spoiled over the past decade or so,” says Jill Jamieson, chief executive of advisory firm Illuminati Infrastructure. “There are some people that simply have never dealt with this before. With the public sector, it’s simply a reminder that what we’ve been through over the last 10 years is not the norm. Higher sustained inflation and positive real rates will sooner or later become the norm again, so waiting doesn’t make much sense.”
Furthermore, there are a number of ways to navigate this more complex infrastructure investment environment. P3s were born out of economic difficulty and are being used the world over in some of the most complex economic environments.
“There are tools of trade that can be employed to address inflation and other challenges. This is not the beginning of the end,” says Jamieson. “We just need to dust off that toolkit because we haven't had to use it in quite some time.”
She points to tools such as formula adjustment clauses and insurance market products that exist for moments such as these. “It’s an issue of everyone taking a breath and getting back to it.”
She’s not alone in this outlook, with other experienced hands expressing the same calmness.
“I’ve seen inflationary cycles and recessions, I’ll take inflation over recession any day,” says Allan Marks, partner at Milbank. “It’s very important to contrast with what happened in ‘08. This is not a financial crisis.”
“Inflation today reflects robust demand and ample liquidity in the market. Those facts are usually net positive for project cash flows over the long term,” he added.
Having too much money in the system and the painful experience of rate rises drawing some of it back out, is a world away from the investment deserts of 2008. With liquidity still high in the market, appetite is what matters. Numerous sources have told P3 Bulletin that they remain very bullish on the long-term outlook for the market.
“This is not a situation where people are afraid, it’s one where they are concerned. They’re concerned because of the uncertainty,” adds Marks. “We are seeing some investors being more cautious in this environment and that’s a rational response. We will have to wait and see.”