How Political Risk Affects Infrastructure InvestmentsPublished: November 10, 1999 in Knowledge@Wharton
Corporations are an opportunistic lot. They are willing to travel to the ends of the earth to meet a demand for their services, especially in today’s increasingly global economy. Many rapidly industrializing countries around the world lag behind the U.S. in infrastructure development, which is one reason why companies, particularly utilities, are investing in overseas projects. Telecommunications giant AT&T is an example, as is GPU, the Parsippany, N.J.-based energy company that two years ago announced it was exiting the deregulating generation business to focus on the infrastructure business, or the distribution of power. A good part of its business is now done overseas in such countries as Australia and Britain.
Infrastructure investment is not as seamless, however, as identifying a need and moving to satisfy it. Investors contemplating overseas investments need to consider the political climate there and its future stability. If they don’t, the consequences can be financially devastating. "If you’re talking about telecom infrastructure or an electrical generating facility, you could be looking at upwards of a $1 billion or $2 billion investment," explains Witold J. Henisz, a Wharton School professor and author, along with Bennet A. Zelner of the McDonough School of Business at Georgetown University, of the 1999 study, "Political Risk and Infrastructure Investment."
Henisz and Zelner are in the midst of a multi-year project in the electric utility industry and will soon be traveling to meet with representatives of GE Capital, Duke Power, Enron, AES and other energy companies. Next year, they will extend their research with trips to Latin America and East Asia.
"Infrastructure investments have very long life spans," Henisz continues. "Often, investors do not receive cash or other monetary payments at the time of the transfer of these assets, but they’re involved in some sort of extended financing agreement. In countries where the government’s credibility is called into question, the feasibility and viability of some of these projects are also called into account." Not only potential investors, but also the policymakers in countries that are devising policies to attract investors need to be aware of the political relationships that could jeopardize these deals.
According to the World Bank, annual spending on infrastructure in developing countries exceeds $200 billion and is expected to grow. But while the potential exists, so too does the risk. A Merchant International Group report that surveyed 7,500 multinational corporations found that "84% of operations initiated in emerging markets in the past three years have not met their financial targets." Unexpected risks cost these companies an estimated $24 billion in 1998.
Says Henisz: "Companies are doing the best they can to understand the extent of risks that exist in these countries. But they’re still learning about how these political and regulatory systems work. They go abroad and think they have adequate safeguards. Maybe they’ve brought in a local partner that will help them deal with the government or they’ve brought in the World Bank to secure part of the loan. What happens, though, is that the government is also being strategic and thinking about the best way it can get reelected and stay in power. The new actions they experiment with can lead to diminution in revenue for the overseas firm."
Henisz argues that the better investors understand the relationship between political risk and infrastructure investment, the more sophisticated their risk analyses will be up-front, thus protecting them from entering potentially money-losing ventures. As investors become more equipped to analyze the risks, policymakers will need to provide investors with credible policy commitments - beyond the simple handshake and promise of many happy returns.
Investors’ early analysis, reasons Henisz, must go beyond the typical measures: macroeconomic accounting measures that can spot a likely downturn in the economic climate, and perceptual measures that come from investors’ or country experts’ perceptions about the likelihood of major policy change. Neither one of these measures, adds Henisz, provided substantial warning of the financial crisis in Thailand, Indonesia, Malaysia or South Korea in 1998.
A company looking to invest in a foreign country has to survey not only the market environment, the demand, the income and the existing industry, but also the non-market arena. "The firm has to understand who is going to be competing against it for the attention of the government," Henisz explains. "It also has to consider both the ease with which the government can change the tax rate or the regulatory regime—the level of political constraints—as well as the likely direction of that change." It is crucial, he adds, to extend typical risk analysis in sectors such as electricity generation and telecommunications, which are defined by massive up-front investments by investors, substantial economies of scale and highly politicized pricing.
In their analysis, the two researchers employ a new measure of political constraints developed by Henisz. This measure assesses the ease with which a government can change policies by modeling the structure of a nation’s political system and the preferences of the actors who inhabit the various branches of government. They find that this measure, in conjunction with measures of the level of political competition faced by international investors, can explain a large percentage of the observed variation both across countries and across time in the level of infrastructure investment.
In light of these results, the authors argue that policymakers should devise a political system that includes checks and balances and independent sources of authority over politically charged issues. That will lend credibility to the present and future policy regime.
Henisz acknowledges that the rate of infrastructure investment has accelerated in recent years. Consequently, he adds, the learning is lagging behind the practice. "Both sides are learning how the other operates," says Henisz. "Investors and policymakers thinking about attracting or generating profits from infrastructure investment really need to continue to learn about how the political and regulatory environment works. On both sides, we need to get a better understanding of the specific mechanisms by which investors safeguard themselves against arbitrary government behavior. On the government side, we need a better understanding of from what regulatory or political institutions these risks emanate. By getting down to the project level and talking to some of these managers, we hope to be a part of helping both sides understand what’s going on."