By Mark Hellowell
28 January 2010
A long list of essential infrastructure projects
is crying out for attention, but traditional
funding sources are drying up. Mark Hellowell asks whether the new government agency Infrastructure UK can really come to the rescue
The government estimates that £200bn worth of infrastructure investment is needed in the next decade, but many experts believe the true figure is more than twice that. Whatever the actual amount, there’s no denying there’s a long and expensive ‘must-do’ list of capital projects.
In the regulated industries, alternative energy sources are near the top of that list, with ministers committed to building more nuclear power stations and increasing renewable sources such as offshore wind. Then there is cross-party support for high-speed rail lines linking London and the North, while everyone agrees that more powerful telecommunications networks will be essential to economic growth.
In the public sector, waste management projects are mandatory, with European Union recycling targets to be met. And new roads, hospitals and schools are politically necessary, whoever is in power from next May.
But where are the billions of pounds of new investment going to come from? Public spending on capital investment is due to fall to just 1.25% of gross domestic product in 2013/14, from 3.1% this financial year.
Ordinarily (as in the early 1990s when capital expenditure reached similarly low levels), the Private Finance Initiative might be expected to fill the gap. But funding of projects through corporate bonds has been set back by the near collapse of the specialist ‘monoline’ bond insurers, which lost their investment grade credit rating in the US sub-prime mortgage crisis.
As a result, PFI schemes have been left at the mercy of the banks. And, as in most other parts of the economy, the desirability of bank finance for infrastructure schemes has reduced considerably since September 2008.
Most banks will currently lend only on the basis of seven-year maturities, and credit margins are very high – up to six times higher than they were before the collapse of Lehman Brothers in 2008.
All of this leaves in some difficulty the £11.4bn of PFI schemes currently being procured, not to mention the billions more for projects and programmes that have been planned for years but have yet to ‘go to market’. Prominent among these is the £2bn worth of new hospitals announced in 2004 but still waiting for final government approval.
These include £712m of hospital schemes in Merseyside – including a £477m replacement of the Royal Liverpool & Broadgreen University Hospitals NHS Trust and the Alder Hey Children’s Hospital. The chance of getting these projects off the ground in the current financing environment seems remote.
This, then, is the daunting context in which the new central government agency Infrastructure UK has been established. Last summer, its role was mooted as providing strategic thinking on investment in the utilities, transport and technology. But the more detailed plans set out in December’s Pre-Budget Report make it clear that IUK’s writ will run much further. The body will be responsible for co-ordinating the government’s role across the entire infrastructure piece – from improved broadband networks to new hospitals. And it will bring together the three main sources of project finance expertise that exist in central government.
Partnerships UK, the joint public-private advisory firm, will be at the core of the organisation, along with two Treasury units – the PFI policy team and the Treasury Infrastructure Finance Unit. IUK is initially tasked with producing a ‘5–50-year’ strategy for infrastructure provision in time for the Budget, expected in March or April this year.
The aim is to give the government a strategic vision of how the massive investment in renewable energy, utilities and telecommunications that is considered necessary should proceed – what the priorities are and how it might be funded.
In this respect, outgoing Partnerships UK chief executive James Stewart, who is taking the same role at IUK (initially on a seconded basis), has a good deal of know-how. Stewart and his team were instrumental in establishing Northern Ireland’s Strategic Investment Board, the province’s equivalent of IUK, albeit on a much smaller scale.
Partnerships UK is also the driving force behind England’s £40bn Building Schools for the Future initiative, perhaps the largest centrally managed programme in government.
But if IUK is to be judged a success (and if it is to make itself election-proof), it must do much more than provide a list of priorities, however important and challenging this might be. The most pressing issue is the absence of finance – public or private – for the investment required.
There are two main components to this challenge. A priority is to sort out the current regulatory malaise so that new resources actually provide new capital spending. An early job for IUK is to examine how the electricity market framework can provide the low-carbon investment needed. But the organisation’s task is much wider than this.
Most experts believe that the existing regulatory frameworks for energy and other utilities do not enable investment but instead provide incentives for financial engineering. Infrastructure funds have boomed over the past ten years but much of the activity has centred on buying assets and seeing how much debt could be injected into them, rather than providing new capital spending.
The problem ultimately stems from the system of regulation. Regulators have a duty to ensure that the utilities can finance their business functions. They do this by guaranteeing the utilities a ‘fair’ rate of return on their asset bases, based on an assessment of their cost of equity and debt. But under this model, most market risk is transferred from shareholders to customers. So the new owners of the utilities have simply replaced expensive equity with cheaper debt – and have made a killing in the process, at the expense of their customers. Something needs to change here. For the PFI, too, there is now a growing belief that some form of government intervention might be required to lower the rate of return for the private sector.
The former head of PFI policy at the Treasury, Richard Abadie, now PricewaterhouseCoopers’ head of infrastructure, says this is not only inevitable but desirable.
He told an industry conference last year: ‘If we are concerned about the cost of private finance, and this is now a specifically PFI point, what are we doing to regulate it? My opinion on the cost of finance is that if the concern of government is that you are trying to regulate the cost of finance, and how it is performing, let us regulate it.’
However, new IUK chief James Stewart talks of the benefits of light-touch regulation. He cites the Treasury Infrastructure Finance Unit as an example of how such an approach can produce results. Established in March last year, Tifu has so far lent money to just one PFI project – the Greater Manchester waste deal. Its major role has been persuading the most opportunistic banks – ie, those that have hiked up their margins the most – that the government can intervene to moderate prices.
‘Just the existence of Tifu has had a major impact on market behaviour,’ Stewart argues. ‘If a project is not value for money, Tifu has the ability to step in – and that has made a major difference in moderating the prices of more opportunistic lenders on some deals. That does not mean its role has to be to step in and say that the price must move from 275 basis points to 250 [above the long-term underlying interest rate].’
The second component of what is required has relevance across the infrastructure piece – and this is to bring pension funds and institutional investors back into the financing market. Almost everybody seems to agree that pension funds and insurance companies, which require steady, long-term returns, are the natural investors for infrastructure. Attempts have already begun to gauge the attitude of such firms to greater infrastructure investment and to see which mechanisms might help to get their funds into projects.
Trade and investment minister Lord Davies told an infrastructure conference last week that success in this venture would be a ‘big prize’.
According to Stewart, there are two elements to this effort. ‘We need to continue to make infrastructure an attractive sector for institutions to view as an asset class. So we have to be clearer about the value of these assets as a high-quality, long-term investment. In each sector, we have to ensure we have a sellable proposition for ratings agencies and actuaries. This involves thinking about the risks relating to cash flows.’
In the UK, institutional investors had been involved through buying bonds, with the possibility of default insured against by the US monoline insurers. This market collapsed in the wake of the sub-prime crisis when it emerged that the monolines had been investing heavily in mortgage-backed securities, and they lost their triple-A credit rating. Because of the monoline ‘wrap’, the parts of the capital market that were involved in PFI projects had not had to really understand the deals and their risk characteristics.
Most PFI projects are ‘triple-B’ rated, a touch above investment grade. There is a consensus among institutional investors that they want a minimum of ‘single-A’.
Stewart said: ‘The challenge is, how do we get from triple-B to single-A? In my view, we need greater additional risk capital between equity and debt. There are a couple of funds looking at this – this would provide an additional layer of risk capital. One ratings agency is prepared to look again at projects in the operational phase and re-rate them. If you are of the view that the level of risk on a project is lower in the operational phase, then it may be possible that we can achieve single-A.
‘So the solution may be that banks are there to fund the construction phase of projects and then the capital markets come in the operational phase – so you create a secondary market in PFI senior debt, which should mean that the overall cost of funds comes down.’
Perhaps the most interesting question here is the role that IUK might play in establishing a new national infrastructure bank. This idea has support from a broad range of influential backers – including the Institution of Civil Engineers, think-tank Policy Exchange and the Liberal Democrat economics spokesman, Vince Cable.
A national bank could be a major fillip for greater pension fund involvement. With a government guarantee removing the possibility of default, such a bank could raise finance from institutional investors at a rate close to that of government bonds. The goal is to establish a body whose liabilities do not score in the national debt figures but whose activities are defined by national priorities, as dictated by IUK.
How that is to be achieved is a question no-one seems able to answer as yet.
Officially, the government has not discussed the possibility of a national bank – except for the specific case of low-carbon investment (about which no details have been provided). However, the inclusion within IUK’s setup of Tifu, headed by former banker Andrew Rose, suggests an investment function is envisaged. Unlike Partnerships UK and the Treasury PFI policy team, Tifu, of course, has the power to lend.
Stewart says there is no firm view in IUK about whether a national infrastructure bank will be necessary, but it is ‘one option’ that will be considered over the coming months. ‘Different solutions might be appropriate in different sectors,’ he says. ‘In water, for example, something like £80bn has been invested over the past 20 years and has been provided by banks and the capital markets – so we don’t see a major problem there.
‘In other areas, like waste, the situation is quite different. For each area, we have to identify where the cash flows are going to come from and then look at the sources of finance. The role of the national infrastructure bank will depend on whether we see problems in the provision of that finance.’
The sticking point, however, would be the nature of any government guarantee. A guarantee would suggest a transfer of risk from the private to the public sector, and the government will be wary of any impact such a move would have on the public borrowing figures.
It is clear that the very existence of IUK creates the potential to address a lot of the problems associated with infrastructure financing. But if the next government is to embrace a body that was created by Labour, IUK must show that it is capable of being much more than a talking shop – and do so quickly.
Mark Hellowell is a research fellow at Edinburgh University
28 January 2010
A long list of essential infrastructure projects
is crying out for attention, but traditional
funding sources are drying up. Mark Hellowell asks whether the new government agency Infrastructure UK can really come to the rescue
The government estimates that £200bn worth of infrastructure investment is needed in the next decade, but many experts believe the true figure is more than twice that. Whatever the actual amount, there’s no denying there’s a long and expensive ‘must-do’ list of capital projects.
In the regulated industries, alternative energy sources are near the top of that list, with ministers committed to building more nuclear power stations and increasing renewable sources such as offshore wind. Then there is cross-party support for high-speed rail lines linking London and the North, while everyone agrees that more powerful telecommunications networks will be essential to economic growth.
In the public sector, waste management projects are mandatory, with European Union recycling targets to be met. And new roads, hospitals and schools are politically necessary, whoever is in power from next May.
But where are the billions of pounds of new investment going to come from? Public spending on capital investment is due to fall to just 1.25% of gross domestic product in 2013/14, from 3.1% this financial year.
Ordinarily (as in the early 1990s when capital expenditure reached similarly low levels), the Private Finance Initiative might be expected to fill the gap. But funding of projects through corporate bonds has been set back by the near collapse of the specialist ‘monoline’ bond insurers, which lost their investment grade credit rating in the US sub-prime mortgage crisis.
As a result, PFI schemes have been left at the mercy of the banks. And, as in most other parts of the economy, the desirability of bank finance for infrastructure schemes has reduced considerably since September 2008.
Most banks will currently lend only on the basis of seven-year maturities, and credit margins are very high – up to six times higher than they were before the collapse of Lehman Brothers in 2008.
All of this leaves in some difficulty the £11.4bn of PFI schemes currently being procured, not to mention the billions more for projects and programmes that have been planned for years but have yet to ‘go to market’. Prominent among these is the £2bn worth of new hospitals announced in 2004 but still waiting for final government approval.
These include £712m of hospital schemes in Merseyside – including a £477m replacement of the Royal Liverpool & Broadgreen University Hospitals NHS Trust and the Alder Hey Children’s Hospital. The chance of getting these projects off the ground in the current financing environment seems remote.
This, then, is the daunting context in which the new central government agency Infrastructure UK has been established. Last summer, its role was mooted as providing strategic thinking on investment in the utilities, transport and technology. But the more detailed plans set out in December’s Pre-Budget Report make it clear that IUK’s writ will run much further. The body will be responsible for co-ordinating the government’s role across the entire infrastructure piece – from improved broadband networks to new hospitals. And it will bring together the three main sources of project finance expertise that exist in central government.
Partnerships UK, the joint public-private advisory firm, will be at the core of the organisation, along with two Treasury units – the PFI policy team and the Treasury Infrastructure Finance Unit. IUK is initially tasked with producing a ‘5–50-year’ strategy for infrastructure provision in time for the Budget, expected in March or April this year.
The aim is to give the government a strategic vision of how the massive investment in renewable energy, utilities and telecommunications that is considered necessary should proceed – what the priorities are and how it might be funded.
In this respect, outgoing Partnerships UK chief executive James Stewart, who is taking the same role at IUK (initially on a seconded basis), has a good deal of know-how. Stewart and his team were instrumental in establishing Northern Ireland’s Strategic Investment Board, the province’s equivalent of IUK, albeit on a much smaller scale.
Partnerships UK is also the driving force behind England’s £40bn Building Schools for the Future initiative, perhaps the largest centrally managed programme in government.
But if IUK is to be judged a success (and if it is to make itself election-proof), it must do much more than provide a list of priorities, however important and challenging this might be. The most pressing issue is the absence of finance – public or private – for the investment required.
There are two main components to this challenge. A priority is to sort out the current regulatory malaise so that new resources actually provide new capital spending. An early job for IUK is to examine how the electricity market framework can provide the low-carbon investment needed. But the organisation’s task is much wider than this.
Most experts believe that the existing regulatory frameworks for energy and other utilities do not enable investment but instead provide incentives for financial engineering. Infrastructure funds have boomed over the past ten years but much of the activity has centred on buying assets and seeing how much debt could be injected into them, rather than providing new capital spending.
The problem ultimately stems from the system of regulation. Regulators have a duty to ensure that the utilities can finance their business functions. They do this by guaranteeing the utilities a ‘fair’ rate of return on their asset bases, based on an assessment of their cost of equity and debt. But under this model, most market risk is transferred from shareholders to customers. So the new owners of the utilities have simply replaced expensive equity with cheaper debt – and have made a killing in the process, at the expense of their customers. Something needs to change here. For the PFI, too, there is now a growing belief that some form of government intervention might be required to lower the rate of return for the private sector.
The former head of PFI policy at the Treasury, Richard Abadie, now PricewaterhouseCoopers’ head of infrastructure, says this is not only inevitable but desirable.
He told an industry conference last year: ‘If we are concerned about the cost of private finance, and this is now a specifically PFI point, what are we doing to regulate it? My opinion on the cost of finance is that if the concern of government is that you are trying to regulate the cost of finance, and how it is performing, let us regulate it.’
However, new IUK chief James Stewart talks of the benefits of light-touch regulation. He cites the Treasury Infrastructure Finance Unit as an example of how such an approach can produce results. Established in March last year, Tifu has so far lent money to just one PFI project – the Greater Manchester waste deal. Its major role has been persuading the most opportunistic banks – ie, those that have hiked up their margins the most – that the government can intervene to moderate prices.
‘Just the existence of Tifu has had a major impact on market behaviour,’ Stewart argues. ‘If a project is not value for money, Tifu has the ability to step in – and that has made a major difference in moderating the prices of more opportunistic lenders on some deals. That does not mean its role has to be to step in and say that the price must move from 275 basis points to 250 [above the long-term underlying interest rate].’
The second component of what is required has relevance across the infrastructure piece – and this is to bring pension funds and institutional investors back into the financing market. Almost everybody seems to agree that pension funds and insurance companies, which require steady, long-term returns, are the natural investors for infrastructure. Attempts have already begun to gauge the attitude of such firms to greater infrastructure investment and to see which mechanisms might help to get their funds into projects.
Trade and investment minister Lord Davies told an infrastructure conference last week that success in this venture would be a ‘big prize’.
According to Stewart, there are two elements to this effort. ‘We need to continue to make infrastructure an attractive sector for institutions to view as an asset class. So we have to be clearer about the value of these assets as a high-quality, long-term investment. In each sector, we have to ensure we have a sellable proposition for ratings agencies and actuaries. This involves thinking about the risks relating to cash flows.’
In the UK, institutional investors had been involved through buying bonds, with the possibility of default insured against by the US monoline insurers. This market collapsed in the wake of the sub-prime crisis when it emerged that the monolines had been investing heavily in mortgage-backed securities, and they lost their triple-A credit rating. Because of the monoline ‘wrap’, the parts of the capital market that were involved in PFI projects had not had to really understand the deals and their risk characteristics.
Most PFI projects are ‘triple-B’ rated, a touch above investment grade. There is a consensus among institutional investors that they want a minimum of ‘single-A’.
Stewart said: ‘The challenge is, how do we get from triple-B to single-A? In my view, we need greater additional risk capital between equity and debt. There are a couple of funds looking at this – this would provide an additional layer of risk capital. One ratings agency is prepared to look again at projects in the operational phase and re-rate them. If you are of the view that the level of risk on a project is lower in the operational phase, then it may be possible that we can achieve single-A.
‘So the solution may be that banks are there to fund the construction phase of projects and then the capital markets come in the operational phase – so you create a secondary market in PFI senior debt, which should mean that the overall cost of funds comes down.’
Perhaps the most interesting question here is the role that IUK might play in establishing a new national infrastructure bank. This idea has support from a broad range of influential backers – including the Institution of Civil Engineers, think-tank Policy Exchange and the Liberal Democrat economics spokesman, Vince Cable.
A national bank could be a major fillip for greater pension fund involvement. With a government guarantee removing the possibility of default, such a bank could raise finance from institutional investors at a rate close to that of government bonds. The goal is to establish a body whose liabilities do not score in the national debt figures but whose activities are defined by national priorities, as dictated by IUK.
How that is to be achieved is a question no-one seems able to answer as yet.
Officially, the government has not discussed the possibility of a national bank – except for the specific case of low-carbon investment (about which no details have been provided). However, the inclusion within IUK’s setup of Tifu, headed by former banker Andrew Rose, suggests an investment function is envisaged. Unlike Partnerships UK and the Treasury PFI policy team, Tifu, of course, has the power to lend.
Stewart says there is no firm view in IUK about whether a national infrastructure bank will be necessary, but it is ‘one option’ that will be considered over the coming months. ‘Different solutions might be appropriate in different sectors,’ he says. ‘In water, for example, something like £80bn has been invested over the past 20 years and has been provided by banks and the capital markets – so we don’t see a major problem there.
‘In other areas, like waste, the situation is quite different. For each area, we have to identify where the cash flows are going to come from and then look at the sources of finance. The role of the national infrastructure bank will depend on whether we see problems in the provision of that finance.’
The sticking point, however, would be the nature of any government guarantee. A guarantee would suggest a transfer of risk from the private to the public sector, and the government will be wary of any impact such a move would have on the public borrowing figures.
It is clear that the very existence of IUK creates the potential to address a lot of the problems associated with infrastructure financing. But if the next government is to embrace a body that was created by Labour, IUK must show that it is capable of being much more than a talking shop – and do so quickly.
Mark Hellowell is a research fellow at Edinburgh University
