Increased appetite for infrastructure investment
In our previous blog post we highlighted the recent market trend in the energy, water and rail sectors towards the use of direct procurement.
Direct procurement is where regulators invite competitive tenders for the design, build, financing and/or operation of projects which previously would have been carried out by the incumbents. The idea behind this approach is to introduce innovation while reducing costs.
The success of direct procurement depends upon there being sufficient investor appetite in the market to invest. Such appetite will be determined by a myriad of factors. Key among these will be investor confidence in infrastructure generally, confidence in the regulatory and policy climate, the type of investment required, the level and duration of the commitment and, of course, the attractiveness of the returns and how quickly they may be realised.
Appetite for investment in infrastructure as an asset class has been growing for some time, with the perceived stability of the regulatory framework being a key factor. Relative asset scarcity has led investors to expand from “core” infrastructure to “core plus” investments. There is a range of investor types, including financial (both equity and debt) investors (such as infrastructure funds, pension funds and sovereign wealth funds), debt providers, and strategic investors (including construction companies and other international companies looking to enter the UK infrastructure market).
The general increase in appetite for infrastructure assets, and the range of different risk positions potentially available to investors suggests that the application of the direct procurement model could potentially be expanded.
Key factors affecting investor appetite in direct procurement
However, investor appetite and project availability are only part of the story. Whether an investment will actually be made will depend on a range of factors explored below.
What does the investment actually involve?
Investor involvement may range from financing to designing and building the project before handing it over to the incumbent, or financing, designing, building and operating the asset, or perhaps only financing and operating. Both debt and equity opportunities typically exist.
For example, the OFTO “finance and operate” and CATO “build, finance and operate” models carry a very different risk profile, so are likely to attract different classes of investor. Under the OFTO regime, investors are currently only involved in the financing and operation of the transmission assets. In comparison, proposals under the CATO regime (which are currently on-ice), could encourage the investor to build the transmission assets, as well as financing and operating them.
While the CATO regime is not progressing at present, Ofgem has signalled a continued interest in direct procurement in onshore transmission. In the recent consultation on Hinkley Seabank, Ofgem proposed the use of either an SPV (special purpose vehicle) model to introduce competition into the delivery of the new transmission assets, or the application of a “competition by proxy” approach. The latter approach involves a calculation (by Ofgem) of the project costs that may have resulted from an efficient competition. Such calculations would be made by reference to benchmarks, such as OFTO tenders. This may have significant implications for regulated companies, without the associated opportunities for investors.
Return and treatment of costs and project duration
Put simply: will the project have the required rate of return over a set period to make the investment worthwhile? What this rate of return may be and what period may be acceptable, will very much depend on individual investment criteria.
For example, for investors such as pension funds seeking stable long-term returns to match their liabilities, it is broadly accepted that long-term revenue certainty is desirable (for example, between 15 – 30 years) for each project. Absent such certainty, it is difficult for many alternative sources of finance to match or beat the typically low Weighted Average Cost of Capital (WACC) of large regulated incumbents. However, other investors, such as PE (private equity) investors (or certain contractors) may conversely be looking for high returns and an early exit in return for taking construction risk.
The treatment of operational costs within the regulated return arrangements will also be a significant consideration for equity investors – to what extent is there a risk transfer to customers for these costs? In existing direct procurement models, the risk of operational cost inflation is dealt with either by treating those costs as fixed (as for OFTOs) thereby providing clear predictability, or allowing them to be open to periodic review (as they are under the High Speed 1 (HS1) model).
To what extent will the investor be regulated and what form will that take?
Involvement of the regulator will be determined in part by the scope for such a model to be adopted within the sector regulatory framework (which differs from sector to sector) and in part by the attitude of the regulator.
There are two main types of arrangement under which direct procurement projects may progress: licences or long-term contracts.
In two recent examples of certain forms of direct procurement (the Thames Tideway Tunnel and the OFTO regime), the preferred approach of regulators has been for the successful bidder to become a licensed entity within the relevant sector, and to have a direct relationship with the regulator.
This contrasts with the contractual model, whereby a successful bidder enters into a contract with the incumbent company and has no direct relationship with the regulator – with that relationship instead retained by the incumbent. Notwithstanding the Thames Tideway Tunnel example, this latter model remains a possibility for direct procurement projects in the water sector.
Both approaches raise different issues for investors and regulated entities. By becoming a licensed entity, companies designing, building, financing and/or operating directly procured projects will, through the project entities, fall under the remit of the relevant regulator. Poor performance may allow a regulator to take direct action under the licence and/or statute. Similarly, any regulatory changes during the term of the project may directly affect the new licensed entity. This can create some uncertainty from both a risk and cost perspective. To the extent that costs are subject to periodic financial reviews, investment returns may fluctuate.
In comparison, pure contractual arrangements may reduce direct involvement of the relevant regulator in the project, and may even offer some protection against the risk of regulatory change. However, the lack of a direct relationship with a regulator may have a negative effect on confidence, particularly regarding certainty of revenues.
In addition, the different operation of direct procurement processes raises issues of risk allocation, both in relation to financial and operating risks. As models for direct procurement develop, parties will need to consider the risk allocation and risk transfer between themselves. Operational risk is of clear concern to regulated entities, where projects interface with broader regulated networks, and have high availability and resilience expectations to meet.
In summary, whilst the licence approach may be burdensome (either requiring legislative change, and/or direct engagement with the regulators), it offers a significant degree of additional stability through the removal of counterparty risk (for both the investor and regulated entity). Separately licensed companies are likely to attract a much lower WACC.
Furthermore, industry-wide feedback on the contractual model indicates that this approach may have an adverse impact on both investor appetite and pricing.
Investors also need to consider what form of corporate vehicle should be adopted for the project. Given the scale of these projects, consortium delivery models are common. Key issues to consider include:
- The most appropriate corporate structure to allow for multiple financing layers and related security.
- Risk allocation relating to the operation, delivery and financing of the project.
- Corporate governance structures and decision making arrangements.
- Cash extraction, re-financing flexibility and exit rights.
Regardless as to the corporate vehicle selected, regulators, whether interfacing through licences or indirectly (in contractual models), will require comfort as to the identity and capability of any entities seeking to engage in direct procurement projects.
The continued development of direct procurement may provide a range of new opportunities for numerous stakeholders, including infrastructure investors. Those interested should watch this space. We will be posting future blogs on other issues to consider, including financing, building and consenting and also, regulatory issues.
This blog post first appeared on PLC Construction Blog on 1 November 2017.