Weak foundations

26 Jan 12

Investment in infrastructure is the chancellor’s way of providing a necessary stimulus to the flatlining economy. But how does he intend to find the funds without dipping into the public purse or using the unpopular PFI? Mark Hellowell reports

As Norman Lamont rose to deliver his Autumn Statement in November 1992, Britain’s economy and public finances were in a mess. Growth was negative, the deficit was clipping along at 8% of national income and 3 million people languished on the dole. In his Commons’ speech, the chancellor pointed to global events as the explanation for Britain’s continued economic frailty – and outlined a bold plan for growth. The centrepiece of this was the ‘liberalisation’ of the rules on private financing to allow public capital projects to proceed without adding to the core measures of government indebtedness.

He was applauded by Tory MPs and much of the press for his ‘imaginative approach’ to stimulating growth while controlling borrowing. Perhaps that favourable response was noted by a young aristocrat and junior Selfridges employee by the name of George Osborne. Certainly, today’s chancellor has adopted much the same approach.  Through infrastructure spending, he is providing some politically necessary stimulus for a flatlining economy without compromising his plan to cut government debt by the middle of the decade.

Under proposals outlined at the end of last year, the controversial Private Finance Initiative, used for many major public projects, is to be reformed and £20bn of additional capital from pension funds is to be sought. More generally, the National Infrastructure Plan, published alongside the 2011 Autumn Statement, outlines an intention to tweak regulation and use government guarantees to help the private sector provide £170bn in investment up to 2015 ‘and beyond’.

Projects in the pipeline (see box overleaf) include road and rail upgrades, expansion of mobile networks and energy-supply programmes, airport and bridge improvements, and some funds for school building.  Some of the proposals in the plan, such as Crossrail, are ongoing. Most are not even at the drawing board stage. And there are huge uncertainties surrounding the £170bn figure. Indeed, it is significant that no adjustment for this investment plan was made by the Office for Budget Responsibility in its growth projections to 2016/17, published in November.

Regardless, the investment is certain to create enormous liabilities for British taxpayers and citizens, but precious little of it will appear on the government’s books. Meanwhile, public investment – which does appear on the books – is set to fall by £14bn over the next three years, from £59bn in the last financial year to £45bn in 2013/14.

Osborne’s focus on addressing the headline measures of government indebtedness rather than the economic substance is a familiar motif of British chancellors under stress. But borrowing off-balance sheet is no longer as straightforward as it was in days gone by. The global infrastructure market has never recovered from the crippling impact of the US sub-prime crisis of 2007. This was when the big US ‘monoline’ insurers – which had played a key role in insuring bonds, thus enabling the capital markets to invest in projects – were found to have dabbled excessively in junk mortgages and lost their top-grade credit ratings. That left the PFI market entirely dependent on a diminishing set of large banks that were increasingly reluctant and in many cases unable to lend long term.

As credit dried up, interest rates increased and funding terms worsened through 2008 and into 2009, the then Labour government began to look more sceptically at this model of investment, once much-loved by the prime minister Gordon Brown. A brief rally in the number of commercial banks active in the market restored some interest among coalition ministers in 2010 and early 2011 and PFI contracts with a capital value of £2.6bn were signed last year.

But the euro crisis, added to increasing concerns about domestic and international regulations and anxieties about the quality of bank assets, has since led to another wave of retrenchment by banks and the PFI programme has been allowed to wither.

Following scathing criticism from two influential Commons committees, the Treasury select committee and the Public Accounts Committee, the coalition has finally got the message that the existing PFI model is politically and financially unsustainable. It appears that the £5bn of projects currently in procurement will be the last deals in the UK that carry the PFI branding. Osborne announced in the 2011 Autumn Statement ‘a new delivery model which draws on private sector innovation, but at a lower cost to the taxpayer and with better value for public services’. It is hoped that this model will access a wider range of financing sources, reducing reliance on banks, increasing the flow of capital and cutting costs.

But ministers don’t yet know what the new model will look like. In December, the government issued a consultation document asking for experts’ views on how the PFI could be made cheaper while ‘maintaining] the incentive on the private sector to deliver capital projects to time and to budget and to take ­performance risk on the delivery of services’.

The wording here suggests the ­government would like the project risks to be transferred to private firms as in the PFI. It would also like to retain the off-balance sheet advantages of the existing model in terms of national accounting standards and the European Union’s rules for measuring government debt. In other words, it seeks very much an evolution of the PFI rather than a radical reform.

However, Treasury officials are ­adamant that this will be a genuine reform, and not just a tweak of the old approach or a change of acronym. ­Geoffrey Spence, the chief executive of Infrastructure UK and a former banker with Deutsche Bank and HSBC, acknowledges that the PFI model used before the financial crisis is now ‘broken’ and insists that ministers want a ‘fundamental review’ of the system. He told a conference in December: ‘In terms of the old PFI, Parliament is united in its belief that private finance of this sort is bad value for money. In that light the government had to call a halt to the PFI and seek new models.’

Reducing reliance on commercial banks will not be easy though. Jonathan Portes, the director of the National Institute for Economic and Social Research, argues that from a macroeconomic point of view, pension funds and other institutional investors are the natural funders of long-term, income-earning assets such as infrastructure projects. But as he additionally notes: ‘There has been nothing to prevent this in the past, so the impact will depend on the terms.’ Infrastructure investment by UK pension funds is less than 1% compared with 8%–15% in Australia and Canada. The constraint is that most PFI projects are ‘triple-B’ rated – a notch above investment grade – while pension funds and others require a minimum rating of ‘single-A’. How to move projects from triple-B to triple-A status is the key policy challenge.

The nub of the problem, according to some experts, is the construction stage of the PFI contract, which is seen to represent a higher level of credit risk than the operational phase. Nick Prior, head of infrastructure and capital programmes at Deloitte, is unsure that pension funds will be able to analyse or accept such risk. ‘The business models of pension funds gear them towards low-risk, stable, long-term yields,’ he said. ‘Introducing them to the riskier build and development phases of infrastructure projects doesn’t fit with this outlook. One has to be sceptical that any model transferring these risks to pension funds can be delivered.’

One obvious solution is to divide the financing, so that banks, with their market expertise and risk-bearing capacities, fund the project during the construction phase and then exit the project once it reaches stable operations and can be refinanced into the capital markets. This would capture some of the benefits of bank involvement – such as their due diligence capabilities – while reducing the cost of capital in the long term. In fact, this model is currently being considered by the Scottish Futures Trust as a further evolution of its Non-Profit Distributing Model, the version of the PFI used in Scotland since the Scottish National Party took power in 2007.

If, however, the government wants pension funds and other institutional investors to take on project risk ‘from the word go’, as appears to be the case from the PFI consultation document, this is likely to require some form of credit enhancement. This could be in the form of a government guarantee or the provision of public risk capital to cushion debt-holders. In this context, Osborne’s insistence that the reformed PFI model should ‘strike a better balance between risk and reward to the private sector’ makes sense. Most commentators have suggested the government is seeking to transfer more risk to the private sector. In fact, the opposite is more likely. By retaining more risk, the public sector should be able to enhance the credit rating of these projects, reducing the cost of capital and bringing in a broader range of providers.

It is clear that the government sees non-banking financial institutions like pension funds and insurers not as merely the saviours of the PFI programme, but as big players in the British infrastructure space more generally. The government’s infrastructure plan acknowledges that bank finance is too costly and that much of the infrastructure needed in the next decade presents too high a risk-profile for private investors, notably the energy infrastructure associated with a transition to a low-carbon economy. Similarly, things such as toll roads – which the government also wants to encourage – involve significant market risk that institutional investors can neither assess nor bear. Among the road plans are improvements to the A14 in the east of England, for which fully worked up plans  are due to be announced in the spring. 

Geoffrey Spence has, on behalf of Infrastructure UK, signed a memorandum of understanding with two groups of pension funds – the National Association of Pension Funds and the Pension Protection Fund. The government is also working with the Association of British Insurers to set up an ‘Insurers’ Infrastructure Investment Forum’. The memorandum sets out the pension funds’ desire for infrastructure deals that offer them ‘stable, inflation-linked, longer- term yields and lower leverage’. It states the funds’ view that current investment models do not provide this.

Through the memorandum, the ­pension funds have signed up to helping the government design new ‘investment platforms or conduits’ to allow funds to become big players in infrastructure finance. Both sets of parties have agreed to provide staffing for a new working group. Interestingly, it is the pension fund groups themselves who will lead the development of work on the new models – a rather stunning example of government outsourcing decision-­making in such a key area of policy. A public statement of progress is due to be made at the time of this year’s Budget.

Two local government pension schemes – the Greater Manchester Pension Fund and the London Pensions Fund Authority – have been specifically mentioned by the government as potential players in the infrastructure market. Both groups have acknowledged they are interested in seeing what the government has to offer. However, LPFA chief executive Mike Taylor recently made clear that his fund would be interested in such investments only if they involved a lower level of risk exposure than current models, such as the PFI, and suggested this might require a government guarantee.

The national infrastructure plan says the government will, ‘subject to affordability’, consider using ‘transparent forms of guarantee’ to support projects where this can lead to a cheaper deal. However, this approach has led to concern from some quarters, including the Commons Treasury select committee, perhaps the most incisive critic of off-balance sheet financing just now.

In a statement issued in mid-January, it noted: ‘There are risks associated with the methods proposed by the government which involve taking on further contingent liabilities or providing guarantees, which could crystallise into calls on public funds. The creation by the back door of new forms of financing which carried some of the defects of PFI would not be the right way forward.’

Right way or not, it is an attractive proposition for a chancellor dealing with a flatlining economy, a political need to show some interest in stimulating growth, and a set of rigid fiscal rules that require the sharpest fiscal contraction since the 1920s.

Mark Hellowell is a lecturer at the University of Edinburgh and special adviser to the Treasury Select Committee in relation to its recent reports on the Private Finance Initiative

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