Public sector construction risk guarantees are not necessary if scientific portfolio construction methodologies are applied to infrastructure investing, EDHEC-Risk Institute has said, following the ongoing debate in the UK and the growing interest of governments to grow institutional financing of national infrastructure projects, while investors are increasingly looking at long-term assets like infrastructure.

Recent research by the institute, in the context of the NATIXIS Research Chair on infrastructure debt investment, found that such guarantees are likely to be damaging both from a public welfare and asset management perspective. It warned that moral hazard arises from such guarantees, as it can create multi-billion pound liabilities for the tax payer.

However, construction risk is mostly a function of who is exposed to it. It is either the result of unforeseen ‘exogenous’ conditions, such as the weather, or that of ‘endogenous’ incentives created by contracts allocating risks to different parties. Construction risk can be reduced and sometimes eliminated by contracts that create incentives to control cost overruns.

A good candidate to take on this risk would therefore be a construction firm that is given incentives to control costs, has plenty of experience of how much things cost to build, and is large enough to diversify project-specific construction risk, by being involved in numerous projects in multiple locations.

The institute outlined that the construction stage of infrastructure projects does offer investment opportunities, because the construction risk typically attracts higher credit spread, and this stage can therefore be seen as a separate but related investment opportunity in infrastructure debt.

Investing in a portfolio of infrastructure debt that does not include some construction risk therefore amounts to choosing to receive lower returns while possibly taking more risk, EDHEC-Risk Institute concluded. Simply adding some construction risk to an infrastructure debt portfolio would thus increase returns and reduce portfolio risk thanks to diversification, and public sector guarantees are therefore unnecessary.

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