February 2013 Frontier Economics 1 A DISCUSSION PAPER FOR WATER UK Aim of paper This paper reviews recent developments in the global market for infrastructure finance: project finance activity, supply of infrastructure finance (equity funds and pension funds) and examples of new instruments to attract private capital. This is one of a number of papers commissioned by Water UK to raise awareness and promote debate on issues relevant to the financing of the water sector in the context of PR14. Main findings and implications for PR14 The water and sewerage industry faces strong competition for funds from other infrastructure sectors demanding large volumes of finance; it has to continue to offer an attractive risk / return profile to global investors. The future attractiveness of the water sector in England and Wales will partly depend on the ability of the regulatory regime to address the risk of funding large infrastructure projects as well as the risks of refinancing short-term debt. The risk / return profile of the water sector will determine the sector s attractiveness to different sources of equity finance. Pension and insurance funds remain a promising source of long-term funding and could be attracted to the water sector in the quest for portfolio diversification and low risk / low return investments. Policy and regulatory trends could consider the impact of potential changes in the investor base. Experience indicates that there is an active policy debate in other countries around the best ways to structure infrastructure funding and risk allocation in order to attract global financing. Expected changes in the prudential regulation of banks and insurers will translate into additional capital requirements associated with more risky assets and long-term investments, potentially affecting the cost of finance for the industry given its reliance on long-term bond finance.
2 Frontier Economics February 2013 1 Introduction and context This paper reviews recent trends in global infrastructure, looking at the demand and supply sides of the infrastructure finance market, assessing global activity, and highlighting some of the most relevant issues influencing the availability and cost of finance, in particular, the role of pension funds and new financing instruments. This is one of a number of papers commissioned by Water UK to raise awareness and promote debate on issues relevant to the financing of the water sector in the context of Ofwat s 2014 price review of the water sector (PR14). Infrastructure finance has become a global business. While most infrastructure investments are local, the sources of finance are increasingly global. The aggregate capital raised by unlisted infrastructure equity funds (operating internationally) since 2004 is close to US$200bn ( 124bn). Given that the water industry must finance a substantial amount of investment, it needs to attract domestic and international sources of debt and equity. The water sector faces a series of large scale investment programmes in the future to improve the environmental quality of our rivers (to meet the requirements of the European Water Framework Directive), meeting the demands of population growth, and managing the impact of growth in the demand for water and climate change on the availability of water resources. Defra has estimated that to meet the improved river water quality standards the water sector might need to raise between 30 and 100 billion. 1 Yet the water industry is by no means the only infrastructure sector facing large investment programmes and in search of sizeable finance. The industry competes in the capital markets alongside other infrastructure sectors such as transport, energy and telecommunications for the attention of investors and lenders, domestic and international. 2 Global demand for infrastructure 2.1 Key drivers A vast amount of infrastructure must be built, rebuilt, and retrofitted in the next two decades. In its 2007 report Infrastructure to 2030, the OECD estimated that around US$50 trillion ( 31tn or an estimated 12 times UK s GDP), would be needed worldwide in the period to 2030 to satisfy the global demand for 1 http://archive.defra.gov.uk/environment/quality/water/wfd/documents/ria-river-basin-v2.pdf
February 2013 Frontier Economics 3 infrastructure. investment. Several factors drive the need for so much infrastructure First, global population is expected to reach around 9 billion by 2050, and almost all of this population increase will be in developing country cities which lack modern transport, energy, water and communications systems. At least US$40tn ( 24.8tn), or close to 3% of the world s annual GDP, will be needed for urban infrastructure investments worldwide in the coming 20 years, more than half in water and sanitation networks and services. Second, most countries worldwide have not maintained their infrastructure properly and much stock is deteriorating. A 2009 report by the American Society of Civil Engineers, for example, estimated that US$2.2tn ( 1.3tn), or around 3% of US annual GDP, were needed over the next five years to upgrade USA s infrastructure. Third, new technology requires new infrastructure (e.g. superfast broadband). Also, mitigating climate change calls for low-carbon or zero carbon energy and transport systems. Water systems, for example, must be rebuilt and/or moved as water availability evolves. 2.2 Recent activity Global infrastructure investment activity slowed down as a consequence of the 2007-08 financial crisis and has failed to gain sustained momentum since. The volume of global project finance reached US$91.5bn ( 56.7bn) in the first half of 2012 compared with US$120.6bn ( 74.7bn) in the first half of 2011, a 24% drop. Over the same period, the number of infrastructure projects that reached financial close fell by 34%, from 276 in the first half of 2011 to 183 in the first half 2012. 2 While the Oil & Gas and Water sectors experienced a modest increase in the volume of finance, the number of projects fell by 11% or more across all sectors (see Figure 1). This slowdown is partly due to the global economic recession and weak market for bank loans, which is currently the largest source of infrastructure finance. 2 Infrastructure Journal Global Infrastructure Finance Review H1 2012
US$bn H109 H110 H111 H112 H109 H110 H111 H112 H109 H110 H111 H112 H109 H110 H111 H112 H109 H110 H111 H112 H109 H110 H111 H112 H109 H110 H111 H112 H109 H110 H111 H112 US$bn Deal count 4 Frontier Economics February 2013 Figure 1. Global project finance volumes by sector 40 140 35 120 30 25 100 80 20 15 10 60 40 5 20 0 0 Mining Oil & Gas Power Renewables Social Infrastructure Telecoms Transport Water & Sewage Total deal value Debt value Deal count Source: Infrastructure Journal Figure 2. Global infrastructure project finance by source 120 100 80 60 40 20 0 H1 2009 H2 2009 H1 2010 H2 2010 H1 2011 H2 2011 H1 2012 Equity Bonds Loans IFI Government Support Source: Infrastructure Journal
February 2013 Frontier Economics 5 The sources of funding in the first half of 2012 were bank loans (60%, down from 68% in the same period of 2011), sponsor equity (19%); International Finance Institution (IFI) loans and government support (12%); and bonds (9%) (see Figure 2). Europe experienced most of the drop in finance volumes, and for the first time since 2005 the European market was outperformed by the Americas and Asia. Figure 1 also shows the relatively small level of global activity in terms of volume and number of projects that takes place in water and sewerage sector compared with those of other infrastructure sectors, such as transport, energy or social infrastructure (e.g. schools and hospitals). The implications of its small relative size are that: first, the water sector should be able to finance growth in its investment needs, given the size of the infrastructure market globally; but second, the sector faces strong competition for funds against other infrastructure sectors that demand large volumes of finance, i.e. potential investors have a wide range of options available to them. As a result the water and sewerage sector needs to offer an attractive risk / return profile to continue to attract global investors to the industry. Issue: How does the relatively small scale of the water and sewerage sector compared to the global market for infrastructure finance affect its ability to attract financing? 2.3 Emerging markets Fast growing populations and rising urbanisation rates in emerging markets have also led to a global shortage of infrastructure services such as roads, rail, mobile and fixed line telecommunications, and water and electricity, among others. Recent market trends already show the shift in dominance of the existing markets and market players. Asia and Latin America are gaining stronger footing in the market for infrastructure finance. Last year the investments in infrastructure and deal activity fell significantly in Europe, the Middle East and Africa.
6 Frontier Economics February 2013 A recent study by the Royal Bank of Scotland and Cambridge University 3 forecast infrastructure needs for a sample of 40 major emerging market economies over the next twenty years to 2030 based on an economic analysis of demographic trends. The findings suggest demand for infrastructure will triple to US$1tn annually over the forecast period. Asia will account for the largest share with around US$15.8tn spending needs, followed by emerging Europe (US$1.3tn), Latin America (US$1.2tn), Africa (US$0.7tn) and the Middle East (US$0.2tn). These projected infrastructure spending needs hide a large variation across the emerging market countries analysed in the study in terms of the annual GDP percentages they represent, from less than 1% of annual GDP for countries such as Korea or Qatar to more than 8% of annual GDP for countries such as China, India or Vietnam. 2.4 European PPP market The evolution of Private Public Partnership (PPP) activity during the first half of 2012 provides an indication of the subdued conditions of the infrastructure finance market in Europe. 4 All indicators point at a large drop in activity compared with the levels reached before the financial crisis. The aggregate volume of PPP transactions that reached financial close in the European market in the first half of 2012 totalled 6bn, the lowest record over the last decade. Over the period, 41 PPP projects reached financial close. This is in line with the 44 transactions signed over the first half of 2011 but significantly less that the trend observed over the period 2007 to 2010. The average PPP project was 146mn, below the values for 2011 and 2010. Three large transactions were signed in the first half of 2012, one in the Netherlands (Rotterdam World Gateway port expansion for 720mn) and two in France (Nimes-Montpellier high-speed railway for 1.8bn; and Paris Tribunal de Grande Instance courthouses for 563mn). While these estimates are a manifestation of the recent changes in the market for global project finance and PPPs in Europe, some of them motivated by the financial and economic crises, project finance is only responsible for a small share of infrastructure finance worldwide since much of it continues to be financed 3 See RBS: The Roots of Growth - Projecting Emerging Market infrastructure demand to 2030 (September 2011) 4 EIB- European PPP Expertise Center (EPEC): The Market Update H1-2012 http://www.eib.org/epec/resources/epec_market_update_h1_2012_en.pdf
February 2013 Frontier Economics 7 with public funds or may have public support such as government guarantees. Thus, the health of public finances continues to play a key role in the finance of national public infrastructure. 3 Supply of infrastructure finance This section summarises the fundraising activity of unlisted infrastructure equity funds and the recent evolution of pension fund allocations to offer a view of the global supply of infrastructure finance. 3.1 Equity funds The unlisted infrastructure fundraising market has struggled to regain momentum since the aftermath of the global financial crisis. Increased investor caution and prevailing uncertainty about economic prospects are contributing factors. Infrastructure fund managers now face a highly competitive fundraising market with the presence of a large number of funds seeking capital from a conservative investor base. Unlisted infrastructure fundraising declined by 77% between 2008 and 2009 in the midst of the economic downturn, and although a total of US$32.1bn ( 20bn) were raised by 46 funds that reached final close in 2010, much of this capital was raised pre-financial crisis (see Figure 3). In 2011, 40 infrastructure funds closed having raised US$22.4bn ( 13.8bn) in aggregate capital, a 30% decline on the amount raised by funds closing in 2010. As of September 2012, 22 unlisted infrastructure funds had reached a final close in the year so far, having raised US$10.1bn from investors.
8 Frontier Economics February 2013 Figure 3. Annual unlisted infrastructure fundraising 2004-2012 60 Number of funds raised 52 Aggregate capital commitments ($bn) 50 44.5 46 40 39 39.8 40 34 32.1 30 23 23.2 25 22.4 22 20 10 10 10.1 9.3 10.1 4.4 0 2004 2005 2006 2007 2008 2009 2010 2011 Jan - Sep 2012 Source: The 2012 Preqin Infrastructure Review This gradual fall in annual fundraising is evident from the average size of funds to close during the period; US$698mn ( 432.7mn) in 2010, US$560mn in 2011, and US$459mn between January and September 2012. This shows that although fund managers have continued to raise capital from institutional investors, their vehicles are generally smaller in size, due to the targeting lower and more realistic levels of capital. Therefore, although infrastructure equity sponsors have managed to close a good number of funds year on year since 2010, the aggregate capital raised has been less. Fundraising conditions are expected to remain challenging in 2013. An estimated 143 unlisted infrastructure funds are currently seeking an aggregate US$92.6bn ( 57.4bn), representing 17% more funds than were in market in January 2011 and 8% more in terms of aggregate capital being sought. The infrastructure deal flow carried out by the unlisted fund managers has remained subdued compared to the steady growth of deals completed before 2008 (see Figure 4). The financial crisis placed a large strain on the credit markets, and the on-going volatility and the forthcoming prudential regulations on capital adequacy and liquidity for banks (Basel III) and insurers (Solvency II) have further contributed to the adverse credit conditions. 5 Infrastructure assets 5 See accompanying Frontier paper for Water UK: Impact of recent policy and regulatory changes on infrastructure finance
February 2013 Frontier Economics 9 traditionally require significant levels of long-term debt financing, which has become less available and more costly in recent years. Excessively high asset valuations have also contributed to weaken the level of deal growth. Figure 4. Number of deals by unlisted infrastructure fund managers 2003-2012 350 N u m b e r 300 250 200 193 268 293 277 284 289 o f d e a l s 150 100 80 123 134 50 0 2004 2005 2006 2007 2008 2009 2010 2011 Jan - Sep 2012 Source: The 2012 Preqin Infrastructure Review If, as expected, investor interest in infrastructure increases, and the demand for private investment in infrastructure rises, fundraising will improve in the future although fund managers will have to continue to adapt their terms to compete in a crowded market. The implication of these developments for the water industry is somewhat uncertain. It is possible that increased infrastructure equity fundraising will lead to an enhanced search for both greenfield and brownfield investments, probably channelling some funds to the water sector in the quest for diversification and a low risk / low return profile. The attraction of the sector to infrastructure equity fund managers will depend partly on the evolution of the regulatory regime and the decisions at PR14 in relation to the risk / return profile of the industry. Issue: Could the evolution of the regulatory regime for the water and sewerage sector in England & Wales affect the appetite of equity funds for the sector?
10 Frontier Economics February 2013 3.2 Pension funds A comprehensive asset allocation survey of European pension funds 6 highlights a number of interesting developments. Pension fund allocations to equities have fallen, mainly by reducing domestic equities. Given concerns about the fragile economic recovery, pension fund managers prefer to tackle equity-related volatility without giving up long term returns. Figure 5 illustrates the on-going reallocation in the UK plans. Figure 5. Broad strategic asset reallocation for UK pension plans (2003-2012) 120% 100% 1% 2% 2% 3% 3% 4% 6% 9% 10% 15% 80% 60% 31% 34% 35% 35% 36% 38% 40% 41% 43% 42% Other Bonds Equity 40% 20% 68% 64% 63% 62% 61% 58% 54% 50% 47% 43% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: MERCER Asset Allocation Survey - European Institutional Marketplace Overview 2012. Allocations to alternative assets have increased as pension schemes look to build diversified portfolios. In search of diversifying the streams of future returns, pension plans in Europe have focused their attention on alternative asset classes, including (i) infrastructure albeit still in a relative small share of the alternative asset class; and (ii) emerging markets via both equity and debt mandates and given the relative strength of many emerging economies. 6 MERCER Asset Allocation Survey European Institutional Marketplace Overview 2012. The survey covers more than 1,200 defined benefit pension plans in 13 European countries with total assets of 650bn.
February 2013 Frontier Economics 11 The size of allocations to alternative asset classes is also on the increase but remains relatively small compared with traditional asset classes. Allocations of around 3-5% to individual alternative asset classes are currently fairly common including the infrastructure asset class (Figure 6 illustrates the UK). Figure 6. Asset allocation by UK pension plans 2012 25% 23% 20% 15% 14% 15% % plans with an allocation % average allocation to asset class 10% 10% 9% 9% 9% 5% 0% 3% 1% 5% 5% 6% 5% 5% 4% 4% 2% 7% 3% 5% 3% 2% 4% 6% 1% 0% Source: MERCER Asset Allocation Survey - European Institutional Marketplace Overview 2012 Faced with low bond yields pension funds are adopting a cautious wait and see approach to bond allocations. Due to the large purchases by central banks of government bonds and repeated flights to safety by investors, sovereign bond yields in most major developed markets are now at very low levels, which make them relatively unattractive. Demand for inflation-linked assets is expected to remain strong due to concerns about future inflation. This has the potential to benefit sectors, such as water, with a revenue base also linked to inflation. Given the extent of central bank monetary easing in the developed world, many investors remain concerned about the potential erosion of returns through future inflation. Consequently, many investors expect to increase their allocations to inflation-linked bonds over the next 12 months. The implication of these pension fund developments for the water industry in England and Wales could be positive if pension fund managers continue their
12 Frontier Economics February 2013 diversification into alternative assets classes, including infrastructure, and as long as the industry continues to provide predictable and stable returns in a relatively low-risk regulatory environment. Key drivers Pension funds are at the centre of the infrastructure finance debate since they are unanimously considered to be a core source of finance for long-term infrastructure investments 7. Several factors account for the growth of pension fund infrastructure investments: The availability of investment opportunities for private finance capital and therefore for pension funds. Private finance involvement has taken different routes in different OECD countries. The maturity and size of the pension fund market i.e. the institutional capital available for investment. Although the aggregate OECD pension market is large, the size of domestic markets varies considerably, reflecting the mix of public and private pensions, whether participation is mandatory or voluntary, and a variety of investment policy guidelines. The scale of individual pension funds is also important. Large funds can afford greater in-house expertise to research potential investments, secure lower transaction pricing, and have a greater reach across asset classes, geographies and maturities, which result in more diversification and risk reduction. There is increasing evidence that sub-scale pension funds lead to sub-optimal outcomes. The average pension scheme in the UK has 2,500 members compared, for example, with an average of 26,000 members in Australian pension schemes. Pension fund regulations, which explains that the traditional debt exposure (i.e. bonds) of institutional investors to infrastructure in some countries. Complex due diligence requirements. Infrastructure investment involves a steep learning curve given the unique nature of each investment. Investing in the asset either directly or through an infrastructure fund, requires a long lead time to complete due diligence, educate plan sponsors and set up the appropriate structure for investment and risk management. 7 OECD: Pension Funds Investment in Infrastructure A Survey (September 2011)
February 2013 Frontier Economics 13 Pension funds and the infrastructure asset class If pension funds are meant to be major contributors to long term infrastructure finance, it is important to understand their motivation and investment criteria. In particular, it is useful to explore those features of the infrastructure asset class that are attractive to pension fund managers investing in infrastructure. The following are a few of the main characteristics of infrastructure investments that dovetail with the needs of the pension fund investor 8. Asset diversification benefits Investing in the infrastructure asset class can act as a risk reduction strategy for a pension plan due to its low correlation to the traditional public market asset classes. This can serve to reduce the volatility of returns and unsystematic risk of the overall plan. Consistency and reliability of returns another benefit to infrastructure investing is the fixed income nature of the return. For many infrastructure investments, a large part of the return is generated as income (see Figure 7). This provides reliability of the returns over time. Positive cash flow dovetails with the needs of the long-term investor. Also, the returns for many of these investments can be partially hedged for inflation. Figure 7. Illustrative infrastructure returns Asset segment Risk Avg. cash yield % (years 1 5)1 Avg. leveraged IRR (%)2 Capital appreciation potential Private Finance Initiatives (PFI) Low Medium 4 5 6 9 3 Extremely limited Toll roads (Operating) Low Medium 4 6 8 12 Limited Contracted power generation Low Medium 4 7 10 13 Limited Regulated assets Low Medium 5 8 10 15 Limited Rail Medium 8 12 14 18 Yes Airports/Seaports Medium 4 7 14 18 Yes Toll roads (Development) Medium High 3 5 12 20 Yes Communications networks Medium High 4 7 15 20 Yes Merchant power generation High 4 12 15 25 Yes (1) Cash distribution to equity holders as a percentage of equity investment (2) Assumes debt of 50% to 85% and investment periods of not less than five (5) to seven (7) years (3) PFIs generally finance social infrastructure. New development of PFIs may return as much as 10 12%, to compensate for greater risk Source: JP Morgan Asset Management 8 See JP Morgan Infrastructure investments : Key benefits and risks (January 2010)
return 14 Frontier Economics February 2013 Investment time horizon a critical characteristic of infrastructure for pension funds is the long-term lives of many of the investments. Since pension funds are long-term investors due to their long-term nature of their liabilities, investing in assets that generate cash flow over the long term aligns with the pension fund's primary goal of meeting its cash flow obligations. Variety of investment options There are many options for investment in infrastructure, which run across a wide spectrum of choices from utilities (e.g. electricity, water) to facility operations (toll roads, port terminals). The numerous investment types provide flexibility in attempting to match asset cash flow to liability cash flow. Alternative risk/return profiles Not all infrastructure assets have the same risk-return profile: there is a range to choose from (see Figure 8 below): from core assets with a low risk-low return profile including, for example, water and wastewater systems subject to economic regulation to opportunistic assets that may yield returns higher than the core asset type but those returns re exposed to a higher risk. Examples are infrastructure investments in emerging economies where the legal and regulatory framework is less developed than in advanced economies. Figure 8. Risk-return profile of alternative infrastructure assets high Opportunistic low Core - Bridges, tunnels, toll roads - Pipelines, energy transmission and distribution - Water and wastewater systems Value added - Airports, seaports - Rail links - Contracted power generation - Rapid rail transit - Development projects - Satellite networks - Merchant power generation - Non-OECD country infrastructure low risk high Source: Adapted from JP Morgan Infrastructure investments : Key benefits and risks (January 2010)
February 2013 Frontier Economics 15 Concerns about infrastructure investments Given that infrastructure investing is a relatively new asset class for pension funds, there are two major concerns: Whether the consistently positive returns can continue. Although this is a general concern, it is more difficult to gauge the potential volatility of infrastructure due to the limited history of returns in this asset class. Investments in global and, in some cases, emerging markets can be dependent on somewhat unstable regulatory regimes. This indicates the need for detailed, and sometimes complex due diligence. To illustrate these arguments the box Infrastructure and Timberland describes the guidelines used by the Ontario Teacher s Pension Plan (OTPP) to select infrastructure investments. OTPP has US$8.7bn ( 5.4bn) and US$2.1bn ( 1.3bn) invested in each asset class, respectively. Infrastructure and Timberland OTPP s rationale to invest in infrastructure and timberland assets is that they provide stable cash flow, long-term value, and hedge against inflation: (*) We invest in infrastructure assets because they generally offer stable long-term cash flows linked to inflation. We invest in timberland because it is compatible with the plan's lengthy investment horizon and serves as a hedge against long-term inflation. In the case of infrastructure, we began investing directly in 2001, and our portfolio now includes airports, electrical power generation, water and natural gas distribution systems, container terminals, pipelines and a high-speed rail link. The geographically diverse infrastructure portfolio is segmented into three general categories: o GDP-linked assets whose fundamentals are tied to a country's real macroeconomic flows o regulated companies whose revenues are explicitly linked to formal regulatory regimes o contracted assets with a significant percentage of revenues tied to long-term contracts We invest in infrastructure assets because they generally offer stable long-term cash flows linked to inflation. In aggregate, we seek to build a portfolio which will steadily increase in value, provide predictable cash flow and correlate to inflation. Timberland investments consist exclusively of managed plantations that use proven techniques to grow, maintain, harvest and regenerate stock. While the value of timberland assets changes with the demand for wood and paper, if left in the ground, trees continue to grow, noticeably increasing their yield and value over time, unlike other extractive industry assets such as metals and minerals. (*) http://www.otpp.com/web/guest/investments/asset-groups/infrastructure-timberland At the end of 2011, the OTPP had US$117.1bn ( 72.6bn) in net assets in a global, diversified portfolio. It claims to have achieved a 10% average rate of return since 1990 acting as direct investors in companies and real assets.
16 Frontier Economics February 2013 Issue: What are the opportunities for increased infrastructure investment by pension funds? What are the main challenges to address in developing this opportunity? 3.3 New policy instruments Tight controls of public expenditures, weak financial systems, and the continuous search for efficiencies have renewed the interest of policymakers worldwide to search for channels of increased private sector participation in infrastructure. In Australia and Europe policy instruments intended to attract private finance are being actively considered. Australia An expert advisory panel established to provide advice to Infrastructure Australia on infrastructure finance policy issues recently published their advice. 9 Their recommendations encompass funding, planning and financing issues. Recommendations to making the market for infrastructure finance more efficient, enhancing the pool of private finance available, include the following: On demand risk Governments should take a more flexible approach to the allocation of risk, including demand risk, for high net public benefit projects that have the capacity to generate revenue streams from users. On re-financing risk In the short term, governments should adopt a flexible approach to refinancing risks, as the tenor and cost of debt pose an on-going challenge to greater involvement by the private sector. On pension funds The structure, regulation and taxation of retirement income products and the way in which they may impact on the demand for long-term investments should be re-examined to encourage financial institutions such as superannuation funds to further invest in long-term assets such as infrastructure. On private bond market The Government should remove unnecessary regulatory barriers that currently impede retail corporate bond issuance in Australia as a way to diversify the sources of debt. These recommendations reflect the public policy debate that is taking place in Australia regarding infrastructure finance and the scope of policy interventions 9 See IFWG Infrastructure Finance and Funding Reform (April, 2012) http://www.infrastructure.gov.au/infrastructure/iff/files/ifwg_report.pdf
February 2013 Frontier Economics 17 that can be used to increase private financing of infrastructure. The recommendations are also relevant for the infrastructure sector in the UK and reflect similar concerns by the UK government in its attempt to improve market confidence, and attract finance from new sources 10. Europe The investment requirements of the transport, energy and digital broadband sectors in the European Union are approximately 2tn ( 1.67tn) over the next decade (or 1.6% of EU s GDP per year). Until recently, the European infrastructure market relied to a large extent on project finance debt provided by commercial banks and/or public financing institutions such as the European Investment Bank (EIB). Since the onset of the financial crisis, commercial bank debt has become more difficult to secure and lending terms (pricing, tenors, loan volumes) have worsened. To stimulate a revival in project financing, the European Commission is proposing to provide support through the EIB via its Europe 2020 Project Bond Initiative, which aims at attracting finance for major infrastructure projects by enhancing the credit rating of the senior debt (see box below). Europe 2020 Project Bond Initiative (*) This policy initiative aims at attracting finance for major infrastructure projects by enhancing the credit rating of the senior debt of project finance companies: The mechanism relies on the capacity to separate the debt of the project company into tranches: a senior and a subordinated tranche. The provision of the subordinated tranche increases the credit quality of the senior tranche to a level where most institutional investors are able to invest for a long period. The subordinated tranche namely the Project Bond Credit Enhancement, provided by the EIB can take the form of a loan, which is given to the project company from the outset, or a contingent credit line which can be drawn upon if the revenues are not sufficient to ensure senior debt service. The support will be available during the lifetime of the project, including the construction phase. As subordinated debt, it will target an up-lift of the project rating to A-AA rather than AAA. Only target the EIB s core business, i.e. infrastructure financing. (*)http://www.eib.org/attachments/press-news-the-europe-2020-project-bond-initiative- 07112012-en.pdf 10 See NAO: HM Treasury - Planning for economic infrastructure (January 2013)
18 Frontier Economics February 2013 4 Implications for the water industry The recent trends in infrastructure described above provide an opportunity to reflect on the water industry in England and Wales, on its place in the context of the global market for infrastructure finance, and the implications of those trends on the financing of the industry. The following assessment is intended to stimulate further debate: Comparative advantage While the water and sewerage sector commands a small proportion of the global activity in the market for infrastructure finance, the water industry in England and Wales may still continue to offer a risk / return profile that is attractive for long term infrastructure investors (equity and pension funds). The attractiveness of the risk / return profile of the industry will also depend on how Ofwat captures the potential impact of the uncertainty regarding the availability and cost of long term finance in its regulatory framework and the allowed cost of capital in PR14. Examples of recent water deals At the beginning of 2013, Sumitomo Corporation, a Japanese trading company bought UK water utility Sutton and East Surrey Water Group (SESW) from the Aqueduct Capital consortium, a group of infrastructure and pension funds. Sumitomo acquired SESW for around 305 million (US$478m), including 164.5 million of equity and an existing debt facility of 140 million. The acquisition was made off balance sheet. At the beginning of 2012, the China Investment Corporation, a Chinese sovereign wealth fund bought an 8.68 per cent stake in Thames Water, the UK s largest water utility. Shortly before the Thames Water transaction, the Hong Kong-based investment firm Cheung Kong Infrastructure (CKI) acquired Northumbrian Water for 2.4 billion. Prior to completing this transaction CKI sold Cambridge Water to HSBC to avoid competition issues. In December 2011 Abu Dhabi Investment Authority, one of the world s largest sovereign wealth funds, acquired about 9.9 per cent of Thames Water from a consortium of investors led by Macquarie, an Australian investment bank Attractive investment features Despite the degree of uncertainty related to changes in economic regulation, the water industry still offers a good investment opportunity for long term investors (e.g. pension funds) in terms of the following features: portfolio diversification; steady returns (based on RAB);
February 2013 Frontier Economics 19 cashflow linked to GDP; and a hedge against inflation. Financial sector regulation The changes in prudential regulation of the financial market players, such as banks (e.g. Basle III) and insurers (e.g. Solvency II) might change appetite for long-term bonds, due to the additional capital requirements associated with more risky assets and longterm investments. This could have a material impact on the composition of infrastructure finance 11, which can affect the cost of finance for the water industry since it relies on long-terms bonds as an important source of debt finance. Global competition The market for international finance is subject to competition worldwide. Long term investors will always like to keep a share of their alternative asset class in infrastructure assets in well-regulated and safe jurisdictions. For example, both stability and predictability of the regulatory environment are key factors in Moody s Global Regulated Water Utilities rating methodology. The framework of the water sector in England and Wales currently scores at Aaa, reflecting Moody s assessment of the regulatory regime as independent and well established, with a more than 20- year track record of being predictable, stable and transparent. 12 At the same time there are other equally highly-rated issuers of infrastructure finance available for investors to choose from. Sector reforms and the investor base Market reforms in the water sector could drive opportunities, making it attractive for some investors to enter the water sector. The corollary is that market reforms may change the risk profile in ways that influence the appetite for the sector from existing or new investors. Ofwat will need to consider carefully how market reforms, the proposed changes in regulation and the new price limits to be set in PR14 combined may affect the risk / return investment profile of the industry. International experience Australia has been at the forefront of the policy debate and innovation in the infrastructure space. The current policy debate about how to attract private finance and make the market more efficient 11 The impact of changes in financial sector regulation are examined in more detail in an accompanying paper by Frontier for Water UK Impact of recent policy and regulatory changes on infrastructure finance 12 See Moody s Investors Service: UK Water Sector: Stable Despite Changes to Regulatory Environment (October 2012)
20 Frontier Economics February 2013 suggests some features that can offer food for thought for the water industry in England and Wales; for example: the important role of flexibility in the design of regulations and policy instruments; the benefits that emerge from policies and regulations that take into account, and thus can adapt, to changing market conditions; the advantages of governments (national or regional) that promote policy debate, including the development and implementation of innovative solutions.