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28 Agosto 2012

Project Bond and energy efficiency: new financial tool?

(Fausto Braglia, Consultant, finance and treasury management)

Pros and Cons of a new financial tool for infrastructures and, more specifically, for energy efficiency projects.

In 2011, the EU Commission has launched an initiative to implement its strategy for a smart, sustainable and inclusive growth by 2020: the “Europe 2020 Project Bond Initiative”.

The pilot phase has officially begun on the 10th July 2012 with the approval of the legislative proposal of the Commission by the EU Council.

What does it entail?

The initiative provides new financial tools, the project bonds, to boost the European economy in some key infrastructural sectors: transport, energy, telco and IT (in particular, broadband networks).
As underlined by the Directorate General Economic and Financial Affairs (DG ECFIN) of the Commission, project bonds are a further tool to spur growth and stimulate access to credit for companies and industries which produce goods and services. They represent an alternative modality, compared to spending the EU budget via grants or subsidies.
In their wider meaning, project bonds stand for bonds, debt securities, issued by companies which realize the project in the form of project financing operations.

Project financing is a long term funding operation where the management of the asset to be realized produces appropriate and sufficient cash flows to cover the reimbursement of the funds.
In its narrow meaning, project financing differs from the traditional funding operations since creditors have the right to seize only the cash flows deriving from the project, instead of the overall assets of the company which has been financed.

Compared to traditional bonds, project bonds can finance the realization phase of the asset, when the project hasn’t started yet to produce positive cash flows. Before this initiative, companies could issue bonds only when the asset had already been realized.

The EU Commission explains the concept through an example:

In the case an infrastructure has to be built, such as a railway, public authorities open a call for bids to realize the asset: the group of companies presenting the best project will win (Company 1, 2, 3 in the exhibit). These ones will create a vehicle (Special Purpose Vehicle, SPV), which will finance the realization of the project, partially through Equity, partially through debt. The part of senior debt (which in case of bankruptcy is paid back first) is composed by project bonds, instead of traditional funding. These are debt securities which can be underwritten and exchanged also by institutional investors on capital markets (Investors), such as pension funds. However, they will require a rating for those bonds which must be at least A-.
In case of energy efficiency projects, the structuring process is similar to the one mentioned above. A peculiarity is the fragmentation of the owners of the buildings to be renovated, both private and public ones, and their geographical dispersion in small local areas at municipal and provincial level. It is therefore necessary to bundle different projects in order to reach amounts of investments large and attractive enough to reach capital markets. Furthermore, the ownership fragmentation, especially at private level, requires a careful coordination activity and a scheme of guarantees such that the projects become enough unified and financially sound to be bankable.

The support of the European Investment Bank

During the pilot phase, the European Investment Bank, in order to ensure a project bond rating at least equal to A-, provides a form of financing or guarantee on those bonds which increases the reimbursement probability of the SPV, therefore reducing specific risks which could undermine a smooth cash flow generation, both during the construction phase and the following operative phase.

This funding or guarantee would cover a percentage of the total project bond issuance, up to a maximum of 20% of the overall senior debt, and it could result in a credit line to be used for the bond service, only in the case of a sudden liquidity shortage.
In case of necessity, the credit line would result in the form of subordinated debt, which would be reimbursed through the cash flow generation of the project and only prior to equity. The EIB intervention would be further guaranteed by the budget of the EU Commission.

Aim of the initiative

The objectives of the pilot phase are apparent:
1) to stimulate investment in infrastructural industries which are strategic at EU level;
2) to spur private investments on medium to long term projects, which are stable and which can ensure a cash flow generation capable of paying back and giving an adequate remuneration to the equity invested.

The most notable aspect according to the EU Commission is the achievement of a creditworthiness improvement for the SPV, which can not only get funding at lower rates, but can also gain access to those investors which otherwise would not enter such projects in Europe.
Furthermore, infrastructural projects which fall under this initiative could benefit from other forms of EU funding, such as those under the regulations “Trans-European Networks (TEN) Transport and Energy”, and those in the framework “Competitiveness and Innovation Programme on broadband”.
Eventually, no issuance of public debt would be required to finance infrastructural projects, so as to avoid further burdening on the national budget.

And what about Italy?

EU law, as mentioned above, has been transposed in Italian law through the Decree 24 January 2012, n.1: it modified the article 157 of the “Testo Unico sugli appalti pubblici” (law on public auctions: Decree n. 163/2006), introducing the possibility for companies to issue bonds, under authorization of the supervision authorities. Some dispositions under articles 2413, 2414-bis, 2420 of the civil code on bond issuance for s.p.a. companies are not applicable, meaning that bonds to be issued can exceed the limit imposed by the civil code (the double of the equity and capital reserves), making it possible to finance large infrastructural projects.
Finally, project bonds can be underwritten only by qualified investors and cannot be transferred to other types of investors (for instance, a qualified investor is a pension fund).

Pros of the project bonds

As specified by the Vice Minister Ciaccia, the adoption of project bonds in Italy can show the following advantages:
1) reduction of interest rates applied to project bonds as compared to traditional forms of funding (such as loans), if a strong scheme of ratings and guarantees is provided (for instance through the intervention of insurance companies for the bond guarantee);
2) longer funding durations compared to traditional loans;
3) limited impact on national budget, in case public support is needed.

Under Italian law, up to the management phase of the infrastructure by the franchisee, bonds issued by the SPV can be guaranteed by the financial system, foundations and other private funds. This implies that bonds can be guaranteed during the construction phase of the asset, which is the period when the project has not started yet to produce positive cash flows, the most risky part of the project.

From a fiscal standpoint, the decree 83/2012 (so called “decreto sviluppo”, development decree) introduced for project bonds a fiscal rate equal to the one on government bonds, i.e. 12.5%, together with a tax deduction for interest expenses of project companies and a fixed quota of other specific taxes (registration tax, mortgage tax, land register tax) to be paid by the project company.
These measures can benefit also foreign investors who have not to pay the Italian taxes, but only their own country taxes. Project bonds would therefore become equal to bonds issued by listed companies, but they would offer a better tax rate, 12.5%, equal to the one on Italian government bonds.
The favourable fiscal provisions are applicable only to bonds issued during the 3 years following the date when the decree comes into force.
Project bonds can be issued even to refinance debt previously incurred to realize the infrastructure.

Finally, the Vice Minister highlights that project bonds can improve the rating of the project company, even above the rating of the country.

And the cons…

The aforementioned provisions on project bonds created an incentive on the development of infrastructural projects. However, some crucial aspects come forward and must be monitored, in case a further intervention by the legislator becomes necessary.
Indeed, project bonds may require the participation of many expensive actors in the project’s realization:
investment banks involved in the project’s valuation, and in the origination and distribution of the project bonds;
institutional investors which are surely interested in the initiative, but which may require a very high level of guarantees;
rating agencies which issue the ratings for the bonds and other insurance agencies to guarantee the bonds (such as national guarantee funds or private agencies).

If projects are complex, as the energy efficiency ones, which are often fragmented at local level and suffer from structurally low returns with long term horizons and break-evens, then the solution of using project bonds could be a further element of complexity and cost increase for the project. It is noticeable the level of fees that for instance investment banks require for their services, computed as percentages on total investments or total bond issuance of the project.

Moreover, as highlighted by an article in the Italian newspaper Sole24Ore, published on the 13th of June, 2012, institutional investors would rather have a public intervention in terms of guarantees on the construction risk of the asset. This is also true for local investors.
Therefore, the structure above would be complemented with public money, requiring a public intervention to make a complex financial structure hold.

I underline also how comments are adding up on a “necessary” revision of the decree to open investments also to retail clients (small to medium non-qualified clients) in order to realize a more liquid and efficient market for project bonds. If such an amendment passed, it could already portend the next speculative bubble: the project bonds’ bubble.


If the objective of public authorities is to boost the economy of Italy and Europe, linking infrastructural projects with private investments, this is a great opportunity to bring banks back to long term financing.
Even institutional investors could be involved in a more direct funding of such projects without the intervention of other intermediaries. Surely, public guarantees are necessary, but this way a direct participation of equity and debt investors would be granted. Their valuation, structuring and realization of projects constitute an incentive for a risk reduction and for a greater stimulus towards a straight and timely delivery.
Otherwise, the usual model of projects run by investment banks is proposed in a different fashion: investment banks structure large bond issuances, they package them for institutional investors, they pay rating agencies to get a seemingly impartial rating of the bonds, and they practically run their business on fees on bond sales, instead of funding the real economy.

Some energy efficiency projects are already being realized in Italy, others are being structured (see for instance the case of the Province of Genova).
If project bonds are a valid alternative, then may the EIB and the qualified institutional investors valuate these operations and the creditworthiness of the projects directly, without rating agencies or investment banks as intermediaries, since they often generate conflicts of interest in the transactions and an increase in the already high costs of the projects.
Surely, such a proposal questions an economic and regulatory system which is based on funding the economy through bank loans and valuation of the creditworthiness via rating agencies. However, isn’t it time for change?

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La pirateria editoriale è reato ai sensi della legge 18 agosto 2000 n. 248
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