1 An offer they shouldn t refuse Attracting investment to UK infrastructure
3 An offer they shouldn t refuse. Attracting investment to UK infrastructure 3 Contents Executive summary 4 Summary of recommendations 5 Infrastructure is crucial to the sustainability of the UK economy 6 Risks must be mitigated to attract private sector investors 10 to infrastructure Pension funds must be freed up to invest in infrastructure 16 The infrastructure product must be right for investors 20 References 22 Glossary of terms 23
4 4 An offer they shouldn t refuse. Attracting investment to UK infrastructure Executive summary The need for investment in the UK s infrastructure is well understood and the government has made delivering this investment one of its priorities for achieving sustainable long-term growth. The challenge lies in securing funding for infrastructure at a time of austerity the state of the public finances means that private investors will need to step in to fill the gap. Successfully harnessing just a 1% increase in the contribution from UK pension funds total investment, or a snippet of the global sovereign wealth fund market, would give a vital boost to our underfunded infrastructure networks. But current levels of private sector investment are insufficient. This is because investors primarily seek returns and currently the risk profile of most infrastructure assets is not sufficiently attractive for investment, especially those that involve construction. This report, therefore, proposes that government action is needed to lift project ratings above investment grade to make the infrastructure proposition more attractive, as well as specific measures to encourage UK pension funds, a 1.5 trillion untapped source of capital, to enter the market. In fact for institutional investors the fundamentals of infrastructure assets are attractive: projects can deliver the long-term, stable returns they seek, and are often inflation-proof. Government tells us it is willing to go the extra mile to attract these investors. However, the attractiveness of infrastructure assets can be undermined by risks that make investment in these assets a more uncertain proposition than it needs to be. In particular, although international investors have been investing in the UK for some time, most UK institutional investors have been slower to enter the market. Most lack direct exposure to infrastructure. But new models are being explored, where banks look to partner with institutional investors, combining the due diligence capabilities of the former with the long-term commitment of the latter. To encourage investment, government needs to do more to help mitigate some of the risks. As a prerequisite, government should ensure that the Solvency II directive at a European level does not deter private investment. Then there must be equal tax treatment for all infrastructure projects: capital allowances must be extended across the board. Beyond this, government should consider a package of incentives to encourage institutional investment into infrastructure, with the approach varying for different types of projects on a project-by-project basis. Most importantly as part of this package, government must use its limited funds smartly, targeting specific risks to enhance the credit rating of projects, making them more attractive. This can be done in a number of ways. For example, by providing first loss debt financing or first loss guarantees. UK institutional investors, particularly pension funds, need to become more adventurous as well. Overseas investors, such as North American pension funds, have for decades now been scouting the globe, including the UK, for infrastructure deals and reaping the returns. The proposed Pension Infrastructure Platform is a start, but more needs to be done to free up UK pension funds to invest directly in infrastructure. The funds themselves need to begin building the necessary skills, whether in-house or through partnerships, and start competing. And as a final option in the package of incentives for pension funds in particular, government should explore introducing a time-limited dividend tax credit targeted at new infrastructure projects. Finally, if government wants reluctant investors to foot the bill for building new infrastructure then it needs to go out there and sell it to them. This means the public sector must commercialise its approach to securing financing, and create a pipeline that allows investors to plan for the long term. This report argues that: Infrastructure is crucial to the sustainability of the UK economy Risks must be mitigated to attract private sector investors to infrastructure The infrastructure product must be right for investors Pension funds must be freed up to invest in infrastructure.
5 An offer they shouldn t refuse. Attracting investment to UK infrastructure 5 Summary of recommendations Government must deploy a package of options to help mitigate some of the risks to attract private sector investors into infrastructure European legislation must encourage private sector investment in infrastructure, not deter it 1 The government must ensure that a workable mechanism that enables investment in infrastructure is introduced in the Solvency II Directive (See page 14) But the domestic tax regime must similarly encourage investment, through simplicity and predictability 2 Capital allowances must be extended to all infrastructure assets (See page 14) Action must be taken to enhance the credit ratings of greenfield infrastructure projects to make them a viable investment 3 Government should look to maximise the impact of public funds for infrastructure by providing credit enhancement to several projects where it is most needed, rather than fully funding individual ones (See page 11) For pension funds in particular, reinstating the dividend tax credit targeted at infrastructure investment would make it a more attractive investment 4 Government could explore reinstating the dividend tax credit on a restricted basis for returns on greenfield infrastructure investment by pension funds (See page 18) Government must also ensure the infrastructure product is right for investors The public sector must commercialise its approach to harness private sector investors 5 Government must commercialise its approach to infrastructure, by using secondees from the private sector, introducing a single access window for infrastructure investors and appointing a single manager for each project who is directly accountable for its delivery (See page 20) Improving the pipeline of upcoming opportunities for investors will allow them to plan for the long term 6 Government should commit to an exhaustive single pipeline pulling together all the projected construction and operation stages of all government-commissioned UK infrastructure (See page 21) Investors themselves will need to become more adventurous A tightening of the bank market means new investment models that include institutional investors need to be developed to fill the financing gap 7 Banks should look to partner with institutional investors to deliver new investment models that allow them to comply with Basel III requirements without jeopardising long-term investment in infrastructure (See page 10) In the long term, however, building in-house teams would be more efficient for large schemes 8 Pension funds should look to overcome market fragmentation by consolidating investment operations in infrastructure. This can be done through the national Pension Infrastructure Platform or new platforms (See page 16) 9 Pension funds should look to build up in-house skills. This can be done through investment syndication with experienced partners in the market, including government for some projects (See page 16)
6 6 An offer they shouldn t refuse. Attracting investment to UK infrastructure Infrastructure is crucial to the sustainability of the UK economy Significant investment in infrastructure is needed to drive growth and create jobs Only a 1% increase in the contribution from UK pension funds total assets, or a snippet of the global sovereign wealth fund market, would provide vital infrastructure investment But the government must ensure that the infrastructure product and environment are right if they are to remain attractive Renewing and updating the UK s infrastructure is crucial to securing growth in the UK. High quality economic infrastructure will bring a wealth of advantages to the UK economy, its businesses and its people, including tighter supply chains, reduced time-lag and reduced costs. In the short term, construction is estimated to return 2.84 to the economy for every pound spent. 1 But the UK s infrastructure is not fit for the demands of today, let alone the needs of the future. The overall quality of the UK s infrastructure was ranked 28 out of 142 countries in 2011/12 by the World Economic Forum, behind other economic powers such as Germany and China, but also behind countries such as Czech Republic and Croatia. 2 This is not good enough, given the importance that investors ascribe to infrastructure. In 2011, CBI and KPMG carried out their first annual survey of users, constructors, investors and financers of infrastructure. The report gave fresh evidence of the vital importance of infrastructure to investors, confirming that it is a key consideration in investment decisions. Four fifths (80%) of respondents said that energy infrastructure was a significant consideration in their investment decisions, and as many said the same of transport (see Exhibit 1 for survey responses on all five sectors). 3 Although the public and business case for investment in infrastructure is clear, the government s commitment to austerity means that the public sector cannot afford to invest enough to ensure that crucial infrastructure is delivered. So the private sector must step up. But institutional investors cannot be expected to do this for nothing: business is first and foremost concerned about investment return, so the infrastructure offering must be good enough to make it viable. Exhibit 1 Significance of reliability and quality of infrastructure for investment Energy Transport Water 12 Waste Digital/broadband Very significant Significant Not very significant Not at all significant Significant investment in infrastructure is needed to drive growth and create jobs Estimating the exact need for infrastructure construction, renewal and maintenance is difficult. A lot of investment is already committed to infrastructure, and with much more in the pipeline, calculating additional need is a challenge. The government s National Infrastructure Plan (NIP) 2011 estimates that from 2005 to 2010, total investment including both public and private sector investment was 113 billion. 4 It estimates that 250 billion is required to 2015 and beyond. 5 This includes a range of major to small projects in each of the five forms of economic infrastructure: water, waste, transport, energy and digital infrastructure. Just a handful of the major government-commissioned projects in the pipeline add up to over 40 billion (See Exhibit 2). Delivering this investment within the proposed timeline is very challenging. Last year, the government used the NIP to announce that it had earmarked an additional 30 billion for investment in infrastructure, comprising 20 billion targeted from pension funds and insurers, 5 billion capital spend committed across the next spending review period, and a further, additional 5 billion of infrastructure spending this spending review period. 6 While public sector spending commitments are welcome, in itself it is not enough more must be done to attract funding from institutional investors.
7 An offer they shouldn t refuse. Attracting investment to UK infrastructure 7 Exhibit 2 Major infrastructure projects needing investment Exhibit 3 The rate of return profile of infrastructure investment The following are a selection of the major projects that government has commissioned, or is planning to commission using a range of funding approaches: 16.3 billion Cost of the first stage of High Speed 2 from London to Birmingham on current estimates. Including the second phase, expanding this beyond Birmingham to Manchester and Leeds, is estimated to push the total cost of the project to 32.7 billion billion The Thames tunnel, a crucial addition to the sewer system in the UK, is estimated to cost over four billion. 8 1 billion Investment committed by government to the first Carbon Capture and Storage schemes, with several billion more required to launch a full set of pilots. 22 billion Ofwat and the water industry are implementing a 22 billion programme of investment in water infrastructure between 2010 and Only a 1% increase in the contribution from UK pension funds total assets, or a snippet of the global sovereign wealth fund market, would provide vital infrastructure investment There is a broad range of private sector investors in infrastructure that could contribute to filling the funding gap, including private equity, banks, hedge funds, private and direct investors, and expansion of listed companies. But given the size of the task at hand, we will need to look beyond the usual suspects for investment. Two candidates are sovereign wealth funds and Return Greenfield Brownfield Time pension funds. Both have the short-term capacity to invest significantly in an asset, if the circumstances are right, and both have shown early, but significant, interest in investment in infrastructure, as a long-term, stable investment class that closely matches the long-term nature of the funds. The risk and return profile of infrastructure projects makes them attractive to pension funds Infrastructure assets are highly heterogenous: an investment in a new railway line would deliver a very different risk/return profile to investment in the construction of a nuclear power station. However, in general, infrastructure projects are low risk assets with reliable returns, that also have the benefit of being protected from inflation as revenue streams, in terms of cost to the end-user, tend to be pegged to inflation which is not the case with conventional foreign reserves. In addition, although the rate of return profile of infrastructure assets (including both construction and operation stages) often follows a J curve (as illustrated in Exhibit 3), this suits pension funds, who look for an investment profile that matures over time when people retire and pensions are claimed.
8 8 An offer they shouldn t refuse. Attracting investment to UK infrastructure This is particularly so for defined benefit (DB) pension funds, a type of pension plan whereby an employer pledges a specified monthly benefit on retirement. It is estimated that assets held by these schemes amount to 101% of the UK s GDP around 1.5 trillion. Of this, about 1 trillion is allocated by trustees, who are advised by investment consultants, while the remainder is largely allocated by fund managers. Approximately 2% of total assets directly allocated by trustees, around 20 billion, is invested in infrastructure projects at the moment. Only a further 1-2% ( billion) would make an important contribution to the private sector funding gap. The long-term, steady returns offered by UK infrastructure projects make them attractive to sovereign wealth funds Sovereign wealth funds (SWFs) also have objectives that suit the risk/return profile of infrastructure. SWFs are the investment arms of national governments. While they have been largely excluded by the EU due to state aid compliance law, there are several large funds from outside Europe, in particular from Asia, sitting on large financial reserves looking to invest in tangible assets outside their domestic markets. For example the China Investment Corporation, China s sovereign wealth fund, has $410 billion assets and manages $200 billion of these directly. The Qatar Investment Authority, Qatar s fund, is estimated to hold in excess of $60 billion of assets. SWFs have two broad aims that should make investment in UK infrastructure attractive. Funds look for means of building up savings for the future, so long-term, slowly maturing assets are attractive. Secondly, funds look to invest internationally for the same reason that government reserves often hold international currency as a means of stabilising the government s funds by reducing their susceptibility to national boom and bust cycles. UK infrastructure investment is therefore an attractive asset, often promising long-term returns in a country with strong macroeconomic stability in terms of currency, inflation and government expenditure. The openness of the UK economy together with its sound legal system and stable regulatory environment have also been key factors in attracting early foreign bids in our national infrastructure. Not only do the SWFs have significant liquidity, but, like pension funds, they have already shown an appetite for global infrastructure investment (see Exhibit 4 for some examples of Exhibit 4 Worldwide pension fund and sovereign wealth fund investment in infrastructure Ontario Municipal Employees Retirement System 2.1bn investment in HS1 Ontario Teachers Pension Fund 27% stake in Northumbrian Water China Investment Corporation 8.68% stake in Thames Water Abu Dhabi Investment Authority 9.9% stake in Thames water Canada Pension Plan Investment Board 49.99% stake ( 700m) in Grupo Costanera s toll road network, Chile China Investment Corporation 2bn in LNG Atlantic liquefaction plant, Trinidad and Tobago
9 An offer they shouldn t refuse. Attracting investment to UK infrastructure 9 cross-border institutional investment across the globe). A tiny snippet of these funds could provide a huge boost to infrastructure investment in the UK. But the UK must ensure that the infrastructure product and environment are right if they are to remain attractive While some infrastructure assets are attractive to investors, many others are considered too risky. But current market data shows that the bulk of the institutional share of the infrastructure market comes after construction at the brownfield, or operational, stage. Brownfield projects tend to attract more investment because they have a lower risk profile, lower financing costs and more stable, predictable, income-like returns which resemble the income streams of government bonds (see Exhibit 5 for an illustration of the risk-return ration of an infrastructure asset lifecycle). For instance, listed utility companies, such as water and energy network companies, provide a reliable revenue stream for equity investors, and any new construction takes place alongside operation, so risks inherent in construction are mitigated by the revenue stream. Airports are another example of brownfield investment that is inundated with interest from a range of institutional investors (see the example of Gatwick Airport in Exhibit 6). The operation of rail is also popular among institutional investors. HS1 the UK s only dedicated high-speed rail line received a strong demand for its lease. The 30-year concession to operate the line was sold to two Canadian pension funds OMERS (Ontario Municipal Employees Retirement System) and the Ontario Teachers Pension fund, for 2.1 billion, after the expected value was estimated at 1.5 billion. Where it is much more difficult to attract financing is greenfield, or primary projects, where assets are generally constructed for the first time at a specific site, such as a new road where there was no preexisting road. Investors accept the higher risk because of the growth potential of an asset in its start-up phase, and the value of growth expected. In contrast, brownfield, or secondary, projects are already operational and/or have a predecessor of some description at the same location. The challenge is that in the UK, investment is needed for greenfield projects as much as brownfield ones. This is why, ahead of the Budget this year, the CBI proposed a new capital allowance for infrastructure assets which do not currently qualify for them. This was aimed at making greenfield infrastructure more attractive, increasing investment. Exhibit 5 Risk-return ratio of an infrastructure asset lifecycle Exhibit 6 Gatwick airport is now owned by a range of different funds futurefund, Australian Government's investment fund 17.3 Private Sector Returns National Pension Service, South Korean public pension fund 12.1 Global Infrastructure Partners, a private equity firm 42 Risks Financing Costs CalPERS, a Californian pension fund 12.7 Adia, Abu Dhabi Investment Authority 15.9 Source: NAO Implementation Operation
10 10 An offer they shouldn t refuse. Attracting investment to UK infrastructure Risks must be mitigated to attract private sector investors to infrastructure A tightening of the bank market means that new investment models that include institutional investors need to be developed to fill the financing gap Action must also be taken to enhance the credit rating of greenfield infrastructure projects to make them a more viable investment and European legislation must encourage private sector investment in infrastructure, not deter it But the domestic tax regime must similarly encourage investment through simplicity and predictability There are a number of structural barriers that continue to undermine the attractiveness of infrastructure as an asset. This makes it difficult to secure finance for projects. Traditionally commercial banks have been the main source of private financing for infrastructure projects. However, the financial crisis led to credit markets drying up quickly, and liquidity has not yet been fully restored. At the same time, existing financing models, such as PFI, have come under increasing political pressure in terms of value for money for the taxpayer. While banks have reaffirmed their interest in continuing to finance infrastructure in the future, deal volumes remain below post-2008 levels and over the last year prices for those finance lines have begun to increase further. This has made the financing of infrastructure projects particularly difficult to secure, and expensive. This market situation is likely to worsen further with the introduction of the capital requirements on banks coming out of Basel III, the EU directive which seeks to strengthen the regulatory regime applying to certain credit institutions. Higher liquidity requirements that will be required by the directive mean that banks are shrinking their balance sheets to comply in the short term, and are likely to move away from long-term financing deals and looking to tenor for seven to ten years and even five to seven years in the medium term. A new approach is needed, tapping into the huge resources of pension funds to maximise returns and stimulate growth. A tightening of the bank market means new investment models that include institutional investors need to be developed to fill the financing gap Greenfield projects are in most urgent need of financing, as the UK is clamouring for new, up-to-date infrastructure. But achieving a substantial increase in greenfield financing from institutional investors in the short and medium term is going to be a significant challenge. Banks, who often have significant capital reserves and cash flows, are likely to be best placed to continue to finance greenfield projects in the near future. So new innovative investment models are urgently needed to allow banks to continue to finance the greenfield phase while at the same time allowing them to exit projects earlier than in the past. Such models could be built using a split-finance model where banks would be able to finance the construction phase of a project, exiting it once it reaches stable operations and it can be refinanced in the capital markets (see Exhibit 7). A split-finance model would benefit both banks and institutional investors. Banks, with their market expertise, due diligence and risk-bearing capacities, are able to finance the project during the riskier construction phase, and exit it earlier enough to comply with Exhibit 7 Delivering infrastructure financing post- Basel III: the split-finance approach Greenfield phase Bank financing Brownfield phase Institutional investor financing
11 An offer they shouldn t refuse. Attracting investment to UK infrastructure 11 the capital requirements under Basel III. Institutional investors, on the other hand, would benefit from the long-term stable returns offered by the management phase of the project without bearing any of the construction risk directly. One of the main challenges for the split-finance model is that although the institutional investor does not bear any construction risk directly, it could do so indirectly. Any delay or over-expenditure in the greenfield phase can mean the asset entering the brownfield, or operational, phase ends up over-leveraged. One way of avoiding this is for banks to involve institutional investors in discussions over the construction phase of the project. This could be done by structuring the financing of the entire project from day one through a secondary debt structure. The secondary debt structure is a financing vehicle in which two investors commit funds to cover both the greenfield and brownfield phases of a project. In this case, the institutional investors money would not be used to finance the construction phase of the project, which would be covered solely by the bank s share of the investment vehicle. Once the asset enters the operational phase, the bank s commitment ends and the institutional investors funds begin to be drawn down. The secondary debt model allows for an early commitment from investors from the beginning, reducing the refinancing risk for the bank, giving it the certainty that it will be able to exit the project after the greenfield phase, while ensuring the early involvement of the institutional investor in the project to avoid any indirect transfer of construction risk. Over the long term, the objective must be to attract institutional investors to take a greater share of the greenfield market alongside banks. This is only likely to happen once the brownfield market has matured significantly and institutional investors feel more confident about increasing their exposure to risk in exchange for higher returns. Recommendation Banks should look to partner with institutional investors to deliver new investment models that allow them to comply with Basel III requirements without jeopardising long-term investment in infrastructure Action must be taken to enhance the credit rating of greenfield infrastructure projects to make them a more viable investment Infrastructure is only one of several types of investment opportunity available to institutional investors. However, greenfield projects, in particular, are vulnerable to some types of risk that mean they can be a more uncertain proposition than alternative investment options. Action must therefore be taken to minimise the risks to make greenfield more viable for institutional investors. The main risks affecting infrastructure investment include: Political and regulatory risk: the single most important risk faced by individual investors investing in national infrastructure projects is the lack of regulatory certainty. Most parts of infrastructure are highly regulated. The long-term nature of these assets means that it is more likely that political and regulatory opportunism will affect them. A good example of where there has been significant political risk is the utilities sector. In the Electricity Market Reforms, uncertainties remain about the future shape of the market. Of particular concern is whether investors can trust the structure of the feed-in tariff, which could drive up the likely rise in the cost of capital for some projects. On the other hand, getting this right could enhance the rating of greenfield projects by providing an element of revenue certainty. Pricing risk: banks benefit from their due diligence capabilities, but most institutional investors are less experienced in properly assessing pricing risk in infrastructure projects. Research examining 58 rail projects around the world showed that the average cost overrun was 44.7%. Of 25 cases looked at in terms of demand forecast, the average actual passenger traffic was 51.4% below the estimate. 10 Procurement risk: from an investor s perspective the time lag between the bidding for a project and the commencement date, usually around nine to 12 months, entails significant uncertainty. Construction risk: uncertainty surrounds the construction and delivery of a project. This is particularly important for those projects with fixed contracts where the contractor takes losses on any overrun. Crossrail Ltd estimates that a year s delay in the implementation of the Crossrail project incurs costs of more than 1.5 billion. 11
12 12 An offer they shouldn t refuse. Attracting investment to UK infrastructure Refinancing risk: because of the high levels of project risk, for example delays in delivery or over-expenditure, infrastructure suffers from a high degree of refinancing risk. This increases the likelihood that the project constructor will be unable to keep up with payments as scheduled. Liquidity risk: the lengthy construction process means that cashflow is non-existent for a relatively long period of time. Most institutional investors, unlike banks, do not have alternative liquid funds available to sustain themselves through the construction phase. Pension funds cashflow, for instance, relies upon member contributions, which must first finance retirement benefits in payment there is often no cash immediately available. Together, these risks mean that credit rating agencies would not award most greenfield infrastructure projects an investment-grade credit rating of BBB- (see Exhibit 8 for an explanation of how credit rating works). Brownfield projects, because they pose fewer risks, particularly in the construction phase, often attract more favourable ratings. This means that some sort of credit enhancement, through risk mitigation, is needed for greenfield projects to be an attractive offer. Investors would be far more willing to invest in the asset once these risks have been mitigated for instance in cases where failure is guaranteed against or demand has been tested for the operation stage. Exhibit 8 How credit ratings work A credit rating evaluates the credit-worthiness of an issuer of specific types of debt, in particular debt issued by a company or a government. It is an evaluation made by a credit rating agency of the debt issuer s likelihood of default. The credit rating scale is as follows: AAA / AA + / AA / AA- / A+ / A / A- BBB+ / BBB / BBB- / BB+ / BB / BB- / B+ / B / B- CCC / CC / C / D Any rating below BBB- is considered speculative or junk and therefore deemed to not be investmentworthy, making the investment too risky and off-limits for pension funds. During the period between 1996 and 2009 bond financing was the preferred solution for large project financing in the UK 52% of projects with a capital value over 200m and 72% of projects with a capital value over 500m were bond-financed. 12 This infrastructure bond market in which institutional investors were active participants depended heavily on monoline insurers, which provided compensation against bond default. This type of insurer mitigated risk by providing: Due diligence and structured financing A credit wrap, providing the guarantee necessary to uplift project bonds to AAA investment status Post-financial close services such as acting as monitoring, controlling creditor and taking decisions regarding lender controls. The collapse of the monoline market during the financial crisis put an end to that. Since then only a very few institutional investors have developed in-house capability to structure, negotiate and provide finance for infrastructure projects directly. Without such capability being widespread, or the investment rating needed, the unwrapped bond market has not developed to fill the void. Interestingly, the credit downgrade of the monoline insurers was not caused by their infrastructure portfolios. These have, on the whole, continued to perform through the crisis. This indicates that the terms and conditions required by the monolines in the sector have been effective in protecting investors from losses and therefore if a similar model could be replicated a revival of the infrastructure bond market is very possible. Therefore if government wishes to see more investment from institutional investors in infrastructure, action must be taken to make the investments less risky and enhance the credit rating of those projects. The European Investment Bank (EIB) is already successfully taking measures to affect a credit enhancement mechanism as part of their Europe 2020 Infrastructure Bond Initiative (see Exhibit 9 for more information about the EIB s bond initiative). Moody s, one of the top three credit rating agencies, has already confirmed that the EIB model would enhance the credit rating of bonds from a low investment rating to A-.
13 An offer they shouldn t refuse. Attracting investment to UK infrastructure 13 In the UK, through the NIP, the government stated its commitment to invest an additional 10bn of public funds in infrastructure development, on top of the 40bn from the 2010 Comprehensive Spending Review. Using these funds, and any future available public funds, to enhance the credit rating of projects would significantly increase the attractiveness of greenfield investment for institutional investors. But instead of fully financing single large projects, as has often been the case in the past, government should use its funds to enhance the credit ratings of a number of projects at the same time, enabling institutional investors to finance the rest. David Cameron hinted at using credit enhancement to this effect in his speech on the economy on 17th May 2012, saying we have the credit easing programme for small businesses, we have mortgage help for people who want new homes and then there are the guarantees for new infrastructure projects. I want us to go further, so I ve asked the Treasury to examine what more we can do to boost credit for business, housing and infrastructure. We believe that to boost finance for projects the government needs to find ways to mitigate the investment risk in infrastructure. There are two potential options for this second loss credit enhancement and mezzanine credit enhancement: Second loss credit enhancement government could offer a minority share of the project funding, placing itself lower in the ranking of creditors in case of loss. This would help increase the rating of the remaining share of the needed funding which would be taken up by private sector investors. For example, in the case of a Public-Private Partnership transaction where senior debt may be 85% of the total funding requirement, the concept is that the government would guarantee around 10% of the funding requirement. Under any loss scenario, this tranche would be impacted first. The second loss debt, representing the remaining 75%, is therefore credit-enhanced. The aim would be to take the total project debt with a rating of BBB-/BBB and use the fund to enhance the risk profile of the second loss debt to at least BBB+, and therefore make it attractive to institutional investors. This mechanism would help increase the rating of projects while, as a contingent liability, it would only affect the government s fiscal position in extreme circumstances. Mezzanine credit enhancement government could step in to a project offering additional funding above the level to which a bank or bond market is willing to go to fully fund the project. Both options maximise the effectiveness of government funds while helping to rebuild the private sector infrastructure financing market. Exhibit 9 European Investment Bank bond initiative The Europe 2020 Project Bond Initiative proposes to enhance a bond s credit rating by providing either a fully-funded first lost debt tranche, which means it would be placed lower in the ranking of creditors in case of loss, or an unfunded first loss debt guarantee, protecting those private sector investors higher up the ranking of creditors from incurring any losses. Both mechanisms should be able to cover up to 20% of a project s senior debt and will be provided by the EIB. Subordinated debt ranks below senior debt and above equity in terms of creditor status in the event of losses taking place. The credit enhancement mechanism s objective is to lift European private sector infrastructure bonds out of the lower echelons of the investment grade category (BBB) to A- rating territory, where a larger number of institutional investors will be, in theory, more comfortable buying these bonds. Recommendation Government should look to maximise the impact of any additional funding by providing credit enhancement to several projects where it is most needed, rather than fully funding individual ones
14 14 An offer they shouldn t refuse. Attracting investment to UK infrastructure European legislation must encourage private sector investment in infrastructure, not deter it The credit-worthiness of projects is also crucial to avoiding regulatory roadblocks. The Solvency II directive, which sets out a new capital adequacy regime for the European insurance industry and imposes more punitive capital levels on investment grade (BBB), long-dated infrastructure bonds. There has been some progress made to reduce the impact the proposals will have on infrastructure, introducing a matching premium so that holding long-term bonds to match long-term liabilities such as annuities are not so costly. The mechanism recognises that since annuity investors cannot cash-in their policies, insurance companies should not be exposed to day-to-day fluctuations in bond prices and therefore higher capital requirements are not needed. However, more needs to be done to ensure that the direction of travel on the matching premium is continued the current matching premium text must be extended to ensure it includes BBB grade investments and maintained throughout negotiations. Even so, the Solvency II Directive would remain a major roadblock to infrastructure investment for the insurance industry. The Directive widely discourages illiquid investment by requiring higher capital deposits to be put aside to cover them. This makes long-term investments, such as the long-dated corporate bonds used by contractors to finance infrastructure projects, less attractive, and with other BBB-rated asset classes delivering higher returns than infrastructure hedge funds or private equity for example infrastructure would be less attractive for investors. These proposals would not only prevent new funds coming into infrastructure, but could also reduce existing volumes as insurance firms move away from long-term deals to reduce their capital requirements. The current fiscal position of EU Member States means that, like in the UK, private sector funding will be essential to ensuring sufficient funding is available for infrastructure development, a major goal of the EU 2020 Strategy. Therefore the UK government must ensure that any legislation encourages rather than deters investment, at the very least by ensuring the matching premium is extended to include BBB grade assets but also ensuring the risk weights set by the supervisory authorities are not too prohibitive Recommendation The government must ensure that Solvency II rules encourage rather than deter investment, at the very least by ensuring the matching premium is extended to include BBB- grade assets But the domestic tax regime must similarly encourage investment through simplicity and predictability On top of legislation at a European level, investors also have the domestic tax regime to contend with, which is one of the pre-eminent considerations bearing on an investment decision. Currently, the tax system affecting infrastructure is unattractive to investors on account of being inconsistent tax varies between debt and equity finance, and between infrastructure assets themselves. The CBI has consistently urged government to make consistent the tax treatment of equity and debt finance, and this is a concern for infrastructure investors as much as any other sector. At the moment, costs of raising debt finance are tax deductible, while the costs of raising equity are not, and this has a distorting effect, discouraging businesses from seeking equity finance even in cases where it is clearly the more appropriate form of finance. In the medium to long term, steps taken to resolve this inconsistency would provide an additional boost to investor confidence.
15 An offer they shouldn t refuse. Attracting investment to UK infrastructure 15 Equally, under the current system of capital allowances, certain structures and buildings do not qualify. In particular, industrial and agricultural buildings no longer qualify for capital allowances (prior to April 2008 they received 4% annual allowances), for example nuclear power structures, waste treatment structures, and airport terminals. Overall, a significant level of private sector annual spending on infrastructure (28% or 11bn annually) is not eligible for tax relief under the current capital allowances regime, including some transport, energy, water and waste structures. The absence of tax relief means that returns on investments in non-qualifying assets suffer a much higher effective tax rate, and therefore require a higher level of profit than investments in qualifying assets to produce a given post-tax return. The lack of any tax relief at all makes it around 20% more expensive to invest in a structure or building that does not qualify for capital allowances, compared to plant receiving standard capital allowances. The CBI proposes a new capital allowance (or fallback depreciation ) to cover infrastructure assets not currently qualifying for capital allowances. This would apply only to future spending, to minimise cost to the Exchequer and ensure that the proposal incentivises new private infrastructure spending. At the outset this would cost an average of up to 200m per year if assets are depreciated over 25 years (4% depreciation rate), or an average of up to 130m per year if assets are depreciated over 40 years (2.5% rate). A new capital allowance for infrastructure assets not currently qualifying would have three distinct benefits. It would help to: 1 Unlock new infrastructure investment: introducing a new capital allowance would reduce the effective cost of investment for the relevant assets by 10% (4% depreciation rate) or 7% (2.5% depreciation rate). This would make a material effect on infrastructure investment decisions, with the aim of unlocking new private sector investment in UK infrastructure 2 Ensure that the tax system treats different essential assets in the same way: a new allowance would help to equalise the tax system in terms of how it affects different investment decisions. 3 Improve the attractiveness of the UK as an investment location: a new capital allowance would help the UK to remain competitive as a destination for foreign direct investment in essential infrastructure projects, which is highly mobile. The current system of zero tax relief on certain infrastructure assets is a uniquely unattractive feature of the UK tax system. Recommendation Capital allowances must be extended to infrastructure assets
16 16 An offer they shouldn t refuse. Attracting investment to UK infrastructure Pension funds must be freed up to invest in infrastructure Measures must be taken to overcome the skills deficit and lack of scale that hold back pension funds from investing in infrastructure In the long term, building in-house teams would be more efficient for large schemes Reinstating the dividend tax credit targeted at infrastructure investment could also make it a more attractive investment While there is much government can do to make infrastructure investment attractive to institutional investors, investors themselves have a role to play. Pension funds, in particular, are ideal investors in infrastructure. The long-term nature of pension liabilities mean that infrastructure as an asset can be very attractive for them. With most defined benefit schemes now closed to new members and increasingly to new accrual, pension trustees are moving towards more stable liability-matching investment strategies, with a strong emphasis on long-term risk management. The long-term stable returns infrastructure offers represents a marriage of interests that is hard to ignore. Overseas investors, such as North American pension funds, have for decades now been scouting the globe, including the UK, for infrastructure deals and reaping the returns. UK pension funds need to get on board. Measures must be taken to overcome the skills deficit and lack of scale that hold back pension funds from investing in infrastructure At a time when infrastructure investment is a national priority, encouraging pension funds to increase their investment in infrastructure must be of paramount importance. In addition to the barriers to all institutional investors, pension funds are constrained by structural barriers of their own, including: Market fragmentation: the UK pensions landscape is heavily fragmented. While there are 1.5tn in assets under management in the industry, these are unevenly distributed among 7,500 schemes. Of that total, 1,000 schemes have assets below 5m and only 190 of them have more than 1bn. 13 This means that most schemes do not have the sufficient scale to be able to invest directly in infrastructure. This is because the large amounts of money needed to invest in a project would mean that too large a share of their total investment would be allocated to a single infrastructure project. Lack of in-house skills: UK pension funds have traditionally outsourced investment management to third parties. This has led to a clear lack of in-house investment skills. This further reduces their ability to assess the attractiveness of projects and has led to them having to invest in infrastructure through third parties, usually private equity houses, which leads to them having to pay higher premiums to enter the market, reducing the attractiveness of infrastructure returns. Infrastructure investment through a third party usually incurs a hedge fund-style fee structure with a two percent fee on the overall investment committed and 20 percent on any return above initial investment. To be able to compete internationally for infrastructure contracts with overseas institutional investors, UK pension funds, both large and small, need to pool resources to gain scale to put together attractive bids (Exhibit 11 (overleaf) illustrates the differences in size between UK and overseas pension funds). Merging pension funds, which are often employer-specific, is extremely difficult due to regulatory and administrative barriers. Individual employers are responsible for any pension promises made to their employees, so merging would potentially make unrelated employers liable for other employees benefit payments. Pooling investment through an external platform avoids that roadblock. But, in the long term, large pension funds should look to build in-house infrastructure teams in order to avoid missing out on lucrative infrastructure investments. The Pension Infrastructure Platform is a step in the right direction To address the issue of market fragmentation, the government signed a Memorandum of Understanding (MoU) with the National Association of Pension Funds (NAPF) and the Pension Protection Fund (PPF) to explore the possibility of setting up a Pension Infrastructure Platform (PIP). This was announced in the Autumn Statement in November The PIP would offer pension funds the opportunity to pool resources to invest in infrastructure. It is looking to secure 2bn in starting capital by early 2013 from a selected number of founding pension schemes.
17 An offer they shouldn t refuse. Attracting investment to UK infrastructure 17 Exhibit 11 Assets under management of major UK and overseas pensions funds Ontario Teachers Pension Plan (Canada) 73.2bn APG (Netherlands) 227.8bn CalPers (United States) 135.5bn BT Pension Scheme (UK) 35bn Airlines Pension Scheme (UK) 6.7bn Universities Superannuation Scheme (UK) 33bn The PIP is certainly part of the solution to the problems of fragmentation and lack of skills, as it both pools resources and will permit pension fund access to specialist skills. However, in order to effectively overcome these barriers, the PIP must not introduce a minimum investment threshold, allowing all UK schemes to participate, regardless of size. Equally, the PIP should not restrict investments to UK infrastructure only, to ensure diversification in the long-term to avoid cyclicality. but more also can be done at the local level to pool assets In addition to the PIP, smaller local pension funds could pool resources to invest in their local area subject to this being aligned with scheme rules and trustees fiduciary duties. In this area, local government pension schemes are showing what can be done (see Exhibit 12). Pension fund investment in local infrastructure, with their knowledge of their own areas of operation, could help provide a boost to the local economy by catering to local business and prospective investors demands for better capacity, maximising the potential for economic growth. Exhibit 12 Investing locally: local government pension funds lead the way The Greater Manchester Pension Fund (GMPF) groups ten local councils and hundreds of small employers such as academies and housing trusts and has 11bn in assets under management. The Fund currently invests about one per cent of its funds locally 20m spent and 120m of commitments but it is planning to increase that amount to five per cent in the next few years. Currently GMPF has around 56m invested in infrastructure. Other local authorities are looking at the GMPF model carefully. Earlier this year, the London Pension Funds Authority and the Local Government Association announced they were exploring with local boroughs the possibility of setting up a joint London Pension Mutual that would hold over 30bn in assets. The consolidated fund would earmark 2.5bn for investment in local infrastructure.
18 18 An offer they shouldn t refuse. Attracting investment to UK infrastructure In the long term, building in-house teams would be more efficient for the very largest schemes Ultimately, however, building in-house skills is the best way of ensuring individual pension schemes make the most of infrastructure investment opportunities. This is because investment would be tailored to the needs of the scheme as well as eliminate intermediary fees. A way to achieve this could be by gaining exposure to infrastructure through cooperation with experienced players in the market, such as private equity houses or indeed through co-investing with government. This can be done through syndication, for example a private equity firm would bid for a brownfield infrastructure asset on behalf of a group of institutional investors, including pension funds. The firm would lead in the day-to-day management of the asset, while the pension funds gain experience in the running of infrastructure assets by sitting in the board as non-executive members. This is a model that has worked well at Gatwick Airport (see Exhibit 6 for more information). Recommendation Pension funds should look to overcome market fragmentation by consolidating investment operations in infrastructure. This can be done through the national Pension Infrastructure Platform or new platforms Recommendation Pension funds should look to build up in-house skills. This can be done through investment syndication with experienced partners in the market, including government for some projects Reinstating the dividend tax credit targeted at infrastructure investment on a time-limited basis could make it a more attractive investment In general, the risk-averse nature of pension funds means that increasing contributions to infrastructure is a difficult task. The pensions regulatory environment in the UK requires the sponsoring employer to make up any deficit in its pension scheme as a way of guaranteeing member benefits going forward. While the CBI supports the current regulatory regime, by placing the employer as a funder of last resort, the regime encourages trustees to be conservative in their asset allocation. Moreover, the fiduciary duties of trustees to protect members benefits mean that they are less prone to invest in riskier assets. Therefore government must look to use any of its additional funding to make investment in infrastructure by pension funds more attractive. As part of the package of options open to government, which includes extending capital allowances to all infrastructure projects and providing targeted credit enhancement, one way to do this could be to reinstate a time-limited dividend tax credit for pension funds, but targeted solely to direct investment in greenfield infrastructure projects. The credit would be available for investment in projects during a five year period and it would apply to the entire life of the investment. This would have the double positive effect of enhancing project credit ratings as well as giving infrastructure a competitive advantage over other types of assets. The dividend tax credit would make infrastructure more attractive to pension fund trustees and their advisers. Equally, private sector pension funds have told us that they are often out-competed by overseas investors in the bidding process, as due to their scale they are willing to reduce their profit margin in exchange for securing the contract, pushing competition off the market. The dividend tax credit would allow UK pension funds to reduce the margin of profit up front to secure bids.
19 An offer they shouldn t refuse. Attracting investment to UK infrastructure 19 A targeted reinstatement of the dividend tax credit for a 1 per cent allocation in greenfield investment with an expected average rate of return of 3 per cent of eligible pension fund assets ( 1tn) would mean an estimated additional cost to the government of 300m. By providing an incentive through a dividend tax credit, the regime rewards success, rather than offering indiscriminate exemptions to all projects independently of their viability. Reinstating the dividend tax credit for greenfield infrastructure investment would not be difficult from a compliance perspective. Firstly, all pension schemes and HMRC are already familiar with it as the credit was available for all pension fund investment pre-1997 when it was abolished. At the same time, because it would only be available for direct investment, only pension funds registered with the Pensions Regulator would benefit from the tax exemption, rather than intermediaries. Finally, government would determine which projects benefit from the exemption by designating them in the national project pipeline. As pension funds are not for profit, there are unlikely to be any state aid issues. UK pension funds are a 1tn untapped source of capital for infrastructure. Credit enhancement, co-investment and a fairer capital allowance for infrastructure all have the potential to incentivise further investment. However, the return of a dividend tax credit on a time-limited basis would provide a more targeted means of boosting pension funds entry into the infrastructure market in the short-term, getting them over the first hurdle. Recommendation Government could explore reinstating the dividend tax credit on a restricted basis for returns on greenfield infrastructure investment for pension funds
20 20 An offer they shouldn t refuse. Attracting investment to UK infrastructure The infrastructure product must be right for investors The public sector must commercialise its approach to harness private sector investors Improving the pipeline of upcoming greenfield and brownfield opportunities for investors will allow them to plan for the long term Fund managers habitually look for an excuse to say no to an investment, rather than positive reasons to say yes. Economic infrastructure needs to compete with these alternatives, such as bonds, shares in publicly listed companies and private equity funds, if it is to increase the contribution from these investors. A large part of this competition takes place on the basis of risk or return. However, there is also competition on the basis of the packaging, marketing and the selling of assets, and at the moment, the UK is struggling to compete in this domain. If the UK government wishes to compete for private sector funds for investment, it must be better at commercialising the infrastructure offering. The public sector must commercialise its approach to harness private sector investors The role of the public sector in national infrastructure development is changing. Now that it is fiscally challenging for government to fund infrastructure directly, its behaviour must adapt to facilitating the private sector to play a greater role. Competing for funding alongside private sector investment opportunities will require a reassessment of government s approach to how it sells infrastructure. International trade missions are a great example of where government is already making headway going out to sell the UK as a destination for international infrastructure investment but much more needs to be done. In particular, this will require: A single, simple cross-government shop window for infrastructure projects Economic infrastructure cuts across several government departments, and a potential investor must navigate each department s access points (website, phone, staff) in order to access details about each government-commissioned project. This is challenging for institutional investors: they are concerned about the investment features of the project, such as the planned timing for each phase (construction, post-construction, operation), forecast demand and risks, rather than being interested in the particular type of infrastructure or department that is the subject of that investment. A single-access, web-based window for infrastructure investors could collate information from across departments about investment opportunities in governmentcommissioned infrastructure. Fresh approach to marketing Infrastructure investment is an attractive proposal for many different types of institutional investors, but the government cannot expect investors to approach them for investment opportunities given the range of options available to them. Infrastructure UK and other project planners must take a fresh look at how it markets infrastructure investment opportunities in governmentcommissioned infrastructure. This should include, but not be limited to, marketing at domestic and international trade fairs (such as the Shanghai Expo). Government departments, such as Infrastructure UK, are already benefitting from private sector skills, knowledge and experience through secondments from industry. This approach must be expanded to really commercialise the UK s infrastructure. The government s trade mission to China and other UKTI missions are also good examples of this approach, where it looked to encourage further investment in business in general and UK infrastructure in particular. But these cannot be isolated cases. Dedicated project managers Streamlining the access point for investors would also profit from project managers dedicated to one project being appointed for major infrastructure projects commissioned by government. Dedicated project managers could ensure that all available information regarding an investment opportunity can be easily accessed, and would also benefit from making an individual in the civil service accountable for its delivery. These must be easily visible and reachable by investors. Recommendation Government must commercialise its whole approach to infrastructure, by using secondees from the private sector, introducing a single access window for infrastructure investors and appointing a single, visible manager for each project who is directly accountable for its delivery
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