The UK has for many years been heralded as a treasure trove of investable infrastructure assets. Core infrastructure equity has been generating double-digit internal rates of return and, according to ratings agency Moody’s, there has only been one instance over a 34-year period of an A-rated UK infrastructure bond defaulting, compared with 10 in the US.
However, sceptics fear this may be coming to an end because of three potential developments. Firstly, the opposition Labour Party has stated its wish to renationalise all infrastructure assets should it come to power. Secondly, water regulator Ofwat and energy regulator Ofgem have said publicly that infrastructure asset owners should not be making such large profits off the back of their investments into core UK assets.
The third development on the horizon is Brexit. Many market observers believe that the UK’s impending departure from the EU will not have a disproportionate impact on domestic investors’ demand for the country’s infrastructure assets. However, currency volatility could scare off foreign investors seeking the low-volatility and highly predictable cashflows that infrastructure usually offers.
Threat of renationalisation
In its 2017 election manifesto and subsequent policy announcements, the Labour Party has said that if it wins power it will renationalise some or all of the water, energy and rail sectors, along with Royal Mail and a number of private finance initiatives.
There have been varying estimates of how much it would cost to renationalise all of this infrastructure. Right-of-centre thinktank the Centre for Policy Studies has estimated that it would cost more than £55.4 billion ($72.4 billion; €64 billion) for energy, £86.25 billion for water, £4.5 billion for Royal Mail and £30 billion for PFI, though it notes the latter figure is particularly uncertain.
Figures from the UK government’s National Audit Office show that since PFIs were first introduced in 1992, there have been 716 operational projects with a total capital value of £59.4 billion.
Independent thinktank the Social Market Foundation, in a study commissioned by a group of water companies, estimated that the upfront cost of renationalisation would be £90 billion. This would include a “typical” acquisition premium of 30 percent.
“Even if the budgets for interest on debt are reduced, it will affect the equity owners’ profits rather than the returns for debt holders”
The disparity in the estimates stems from several factors. These include whether the government would pay the regulated asset value or the enterprise value for the equity component – values that can differ significantly depending on the sector and the asset. Even for assets that do not have a regulated asset value, equity valuations can vary markedly depending on the calculation methodology and the assumptions used in the modelling. This makes the acquisition price for an equity asset especially uncertain, particularly where there is a bilateral negotiation with a captive buyer and not a competitive bidding process.
Conversely, debt to private infrastructure companies is facilitated through bonds or loans. These debt instruments are legal contracts between two parties that clearly outline the principal and interest payment schedules, so there can be no room for negotiation on the value of the debt. The main risk for debt holders is if the debt is prepaid before the end of the agreed term and there is no protection for such an outcome. If a future Labour government were to renationalise an asset, it might elect to prepay the debt early, as it might be able to refinance it more cheaply through the issuance of government bonds.
There has been a lot of discussion over the performance of strategic UK water and electricity assets versus the profits taken by their owners.
The main criticisms have been around the prices set for consumers and the assumptions in the cost. These have led to large profits being paid to the equity owners at a time when some consumers argue that the services they provide are sub-par. Another point of contention has centred around companies structuring their finances with offshore lending facilities, thereby reducing or negating the level of corporation tax they pay. This is in part a consequence of tax deductions on interest payments to these offshore vehicles.
When Ofgem and Ofwat set energy and water prices, they factor in the costs of servicing debt. Some sceptics argue that the regulators have been too generous when setting funding costs that have historically been less than budgeted, thereby increasing profits for the asset owners. Regardless of whether this is true, it is fair to say that even if the budgets for interest on debt are reduced, it will affect the equity owners’ profits rather than the returns for debt holders, as debt returns are contractual and equity dividends are not.
We do not believe that Brexit will affect demand for core UK infrastructure. A key feature of infrastructure is that it relates to an essential service that is generally not transportable between countries. So, whether the UK remains part of the EU or not, this should not affect the country’s need for water, energy, social housing and so on. However, where Brexit has already had an impact is on the UK’s currency, the pound sterling.
“Fewer foreign investors lending to the UK could actually lead to an increase in returns on infrastructure debt”
At the start of 2016, £1 bought €1.358. On 15 April 2019, a pound only bought €1.157, a fall of more than 14 percent. Given that Brexit’s final outcome has yet to be determined, many foreign investors are waiting before committing to an increased exposure to the pound.
For equity owners, we have seen a tendency to hold on to UK assets until Brexit passes and other investors have become more comfortable with the pound. This has reduced the supply of investable equity assets in the UK, which in turn will work to the advantage of those equity owners that have the luxury of being able to wait out the storm.
For debt, as it has a legal maturity date, it needs to be refinanced regardless of market conditions. Fewer foreign investors lending to the UK could actually lead to an increase in returns on infrastructure debt, particularly if the European Investment Bank stops its historic practice of providing 50 percent of the debt to UK infrastructure assets. The reduction in liquidity could prove profitable for those investors still willing to lend in the UK, either as they have sterling liabilities or if they are able to hedge their currency exposure (or withstand it).
The potential risks and rewards of investing in UK infrastructure have clearly changed significantly over recent years, and investors will need to rethink how they approach such assets. The main developments we have identified in the industry – potential renationalisation, regulatory reforms and Brexit – may all pose significant risks for UK infrastructure equity owners. Conversely, these challenges may actually increase the opportunities for investors in debt that are willing to lend to UK infrastructure assets.