November 2, 2016

Mobilizing Private Investment in Saudi Infrastructure

Power lines on a road in Saudi Arabia (Edward Musiak)
by Lama Kiyasseh

This post is part of an AGSIW series on Saudi Vision 2030, a sweeping set of programs and reforms adopted by the Saudi government to be implemented by 2030.

Accessing diverse funding sources is front and center of Saudi Arabia’s new policy reform, which propelled the kingdom to issue its first international $17.5 billion bond offering on October 19. While this issue is oversubscribed, generating excitement in the market, it is unlikely to meet the growing demand for investments in Saudi infrastructure. Given sustained low oil prices and tighter fiscal management policies called for as part of Saudi Arabia’s Vision 2030, Deputy Crown Prince Mohammed bin Salman is seeking to increase private sector participation. The role of public-private-partnerships (PPPs) as one model for the delivery of infrastructure projects has garnered attention from policymakers, financiers, and the broader stakeholder community.

The development of large public infrastructure projects undertaken with private sector support is not a new trend in Saudi Arabia. In 2002, the Supreme Economic Council passed Resolution (5/23) permitting private sector participation in Independent Water and Power Producers (IWPPs), on a build-own-operate basis. The purpose was to capitalize on private sector liquidity and expertise. Initially, a project company was set up to be 60 percent owned by the private developer, with the remainder split between the country’s quasi-governmental Saudi Electricity Company (SEC) and the Saudi government’s Public Investment Fund. The kingdom’s public desalination company, Saline Water Conversion Company (SWCC), was responsible for the construction of the water delivery systems and the SEC was responsible for establishing power transmission. Both entities received state credit to fund these projects. The government allocated land sites, with a nominal rental charge over the power and water purchase agreement terms. The Water and Electricity Company, formed pursuant to this resolution, was the single off-taker for these IWPPs selling a hundred percent of the water and electricity produced to the SWCC and SEC, respectively. Off-take agreements comprise agreements between the producer (seller) of a resource and the buyer of a resource, whereby the buyer agrees to purchase portions of the future production of the resource. Two such plants that currently operate under the Water and Electricity Company umbrella are Shuaibah and Shuqaiq.

In 2007, the SEC initiated its Independent Power Producers program to attract private (local and foreign) investment in pioneering three IPPs on a build-own-operate basis (Rabigh IPP, Riyadh PPII, and Qurayyah IPP I), with total capital investments exceeding $7 billion. The execution of the initial IPPs was facilitated through government guarantees, and state-owned off-takers, eliminating both the market and fuel risk for the IPP developers. As the developers became more comfortable with the process, these government guarantees were phased out. Investor appetite in this program grew from two consortium bids in the first IPP to six bids in the third IPP in March 2011. However, with the new norm of low oil prices and fiscal tightening the fundamental question is how these PPPs will be structured moving forward.

Saudi Vision 2030 outlines the PPP model as a method to develop the telecom and information technology sectors in the kingdom, yet what remains unclear is how these and other investments in infrastructure might be financed. Bankable PPP contracts have the potential to attract foreign investment, but this relies heavily on fostering an enabling environment that revolves around a conducive and transparent legal and regulatory framework. To date, no PPP law exists in the county.

With the backdrop of this legislative constraint, two additional challenges exist: the large size of funding and the type of funding required for these projects. The private sector will want to know the relevant guiding principles for the PPP program. As it stands, appetite for limited recourse project finance in the kingdom will likely stay strong. Still, the credit worthiness of the Saudi government as the procuring authority is important as it determines the strength of the off-taker’s balance sheet, as well as any sovereign guarantees that may be provided instead. Notably, in February Standard & Poor’s lowered Saudi Arabia’s rating to A-, and in May Moody’s followed suit by lowering it to A1.

Despite these downgrades there has been no shortage of international institutions expressing interest in the kingdom, with some leveraging local project developers. In August 2014, the International Finance Corporation poured $100 million in equity as an investment in Saudi Arabia’s water and power project developer, Arabian Company for Water and Power Development. Intended to build on the developer’s local knowledge and translate it to scalable value in the rest of the Middle East and North Africa (in countries like Morocco and Jordan), this multilateral participation serves to strengthen investment confidence in the kingdom and attract more private investors.

As lenders explore the various types of funding, the challenge is abiding by the kingdom’s sharia law. However Islamic finance has recently emerged as a significant source of funding to fill this gap. Globally, two main Islamic finance instruments have been used for PPP projects: Ijara (lease purchase finance) and Istisnaa (an exchange contract with deferred delivery). In Saudi Arabia, the Qurayyah IPP was partially financed by a Murabaha facility (trade finance based on letters of credit) through the structure of the equity portion. Islamic finance is very applicable to PPPs, given that PPPs have an underlying asset, are long-term investments, and have a risk-sharing aspect.

Increasing cooperation with, and accessibility to, the private sector should improve the public sector shortfall. As stakeholders navigate this emerging PPP market, PPP procurement will also introduce hybrid financing structures from local and international lenders. This would mean a combination of financing sources. In addition to conventional commercial loans and Islamic finance instruments, these could include credit facilities from export credit agencies such as the U.S. export-import bank (EXIM) or the export-import bank of Korea (KEXIM). Export credit agency financing comes in one of two types: covered or direct (uncovered). If covered, the export credit agency provides a guarantee while a foreign bank provides the funding. The latter type involves direct lending to companies.

Mobilizing private investment for the development of infrastructure through PPP models will help relieve some of the fiscal burden that Saudi Arabia is facing and support the delivery of ambitious social and physical infrastructure projects. Several challenges for investors and lenders remain, including the lack of a PPP law, sizeable funding requirements, and complying with sharia law. However, with its track record of having successfully closed multibillion-dollar projects, what is left for Saudi leadership is translating Vision 2030 into actionable steps that will produce effective private sector engagement.

Lama Kiyasseh is currently at the International Monetary Fund, prior to which she was working on public-private-partnerships and infrastructure design at the World Bank.