The right delivery model – but how do we fund it?
May 2013 | EXPERT BRIEFING | INFRASTRUCTURE SECTOR
Public infrastructure delivery is in a state of flux globally. In the period post global financial crisis (GFC), much has been said about the inability of traditional sources of bank led funding to meet global infrastructure needs and many have speculated about potential alternative sources of funding and the means by which future projects will be delivered.
Against this backdrop, the UK government has recently set out its own plans for future infrastructure delivery. The new initiative, known as PF2, represents a refinement of the former ‘Private Finance Initiate’ or ‘PFI’ model. The changes proposed are likely to catch the attention of many outside of the UK given the influence that the PFI model had on many other countries in the development of their own PPP programs.
PF2 is generally an iterative change to PFI and therefore it is a ringing endorsement of most of the principles of PFI. With focus on government austerity measures post credit crisis, the PF2 proposals have at their core a desire to generate better value for money for the public sector, something which the new coalition felt was missing under the existing PFI model. It is clear, however, that the proposals also recognise a need to bridge the funding gap and put in place mechanisms that can help to attract long-term financing to these projects from a variety of sources.
From a value for money perspective, the proposals contain some interesting new proposals. First, a requirement for periodic review of service provision and the implementation of private sector continuous improvement plans (the robustness of which will be evaluated during the competitive bidding process), each of which are intended to generate savings and align service provision with the real-time needs of the end user.
Second, the re-allocation of key risks back to the public sector where in the past contingent pricing by the private sector failed to represent value for money given the low likelihood that the relevant risk would occur (e.g., capital costs arising from general changes in law during the operating phase).
Third, efficiencies and cost savings to be generated through centralised procurement of projects through experienced commercially focused central government units, as opposed to local authorities having little or no experience in delivering major infrastructure.
Fourth, a minority equity stake (up to 49 percent of total) to be taken by central government in all projects with a view to generating a more collaborative approach between the private a public sectors and importantly providing the government with a seat at the table when key decisions are being made regarding the operation of the project.
Finally, the PF2 proposals also provide that there may be a call for funding competitions for a proportion of the equity not being taken by the public sector. Whilst this may generate savings, it is a controversial step since it could mean that the original sponsors may be partly priced out of the project to be left with a minority interest only having taken the risk in securing preferred bidder status. At this stage, it is not clear how this proposal will work from a practical or a procurement perspective.
Of course, the precise way in which the above proposals will be implemented will only really be understood once the first wave of PF2 procurement is underway. The strength of the deals pipeline will be the real test of the UK government’s confidence in PF2; at the moment this is non-existent with only Priority Schools making a hazy appearance on the horizon.
Perhaps of greater interest (particularly to those outside of the UK), will be means by which the PF2 proposals seek to address the problem of being able to secure long term funding for future infrastructure projects.
It is apparent that the GFC and the resultant capital adequacy requirements being imposed on commercial banks has and will reduce the ability of commercial banks to lend on a long term basis at levels required to deliver major infrastructure projects. The previous heavy dependence on financing from commercial banks is therefore likely to be replaced by a more diversified system with a greater involvement from alternative financial markets and institutional investors. Indeed, without this shift, it is not clear where funding would come from for the infrastructure projects needed in the near to medium term.
Whilst the PF2 proposals do not provide a solution (if indeed there could ever be a ‘one-stop-shop’ solution in the current financial environment), they recognise the issues and pave the way for and positively encourage alternatives to bank led financing structures that we have become accustomed to in more recent times. Notably, it is a stated requirement that bidders for PF2 projects will be obliged to present a funding solution that is not wholly dependent on bank debt.
So how will PF2 facilitate the use of alternative structure and what are we seeing in the UK market at present?
It would be usual that a PPP project would attract a credit rating of approximately BBB-/BBB range. In order to attract institutional investors in the bond markets it would be necessary to raise this rating to at least BBB+/A-.
It is clear, therefore, that credit enhancement measures will be key if institutional investors are to be encouraged to participate.
The equity stake being taken by central government under the PF2 proposals, outside of the value for money considerations outlined above, can be viewed as a key credit enhancement tool. This increased equity contribution will increase the amount of debt that is subordinated to the most senior debt tranche on a default and will provide additional cover for cost overruns to help mitigate the construction/delivery risk – one of the most significant risks for any project and one of the key areas of concern for institutional investors.
There is evidence in the market that several projects yet to reach preferred bidder stage contain bids which provide for a project bond solution facilitated through credit enhancement of one sort or another.
The UK government has also enacted legislation (the Infrastructure (Financial Assistance) Act 2012) which enables the UK Treasury (or the Secretary of State with the consent of the Treasury) to provide guarantees or other suitable forms of financial assistance in respect of the provision of UK infrastructure (the ‘UK Guarantees Scheme’). The level of the guarantee or assistance is notionally capped at £50m but the Treasury is given an order making power to increase the level of any one commitment.
Certain eligibility criteria must be met to qualify for assistance from the UK Guarantees Scheme. These criteria include that the project must be nationally significant, as identified in the UK government’s National Infrastructure Plan. The government will also consider other exceptional projects of national or economic significance on a case by case basis.
Again the UK Guarantees scheme provides the opportunity for a portion of the debt covered by institutional lenders to be guaranteed with perhaps the uncovered portion being provided by commercial lenders. Again, this can be seen as a key credit enhancement tool which will help to facilitate participation by institutional investors.
It is expected that Thames Water’s £3.6bn Thames Tideway sewer project will be among the projects seeking government backing through the UK Guarantees Scheme.
It is clear, therefore, that the environment is set to encourage a more diverse set of funding arrangements. Outside of the support being provided by the UK government, there may also be a role for other means of credit enhancement. This may include support from the Europe 2020 Project Bond Initiative (EUPBI) or the use of more innovative financing structures such as Pan European Bank to Bond Loan Equitisation (Pebble) structure or Hadrian’s Wall Capital. Whilst further consideration of these structures extends beyond the scope of this article, it is correct to say that significant intellectual capital is being applied to coming up with a solution to plug the funding gap.
The stage is set for significant reforms to the way in which infrastructure is to be delivered in the UK and internationally. The PF2 reforms are designed to reflect an evolving approach to the way in which infrastructure is procured in the UK to generate greater value for money and to reflect a changing financing environment.
By the end of 2013 there will no doubt be several lightly trodden paths to non-bank led financing solutions for infrastructure delivery. It’s not a case of ‘if’ it will happen, it’s more a case of ‘how’ and ‘when’ it will happen.
Mark Berry is a partner, Oliver Carruthers is of counsel and Matthew Hardwick is a senior associate at Norton Rose LLP. Mr Berry can be contacted on +44 (0)20 7444 3531 or by email: firstname.lastname@example.org. Mr Carruthers can be contacted on +44 (0)20 7444 3903 or by email: email@example.com. Mr Hardwick can be contacted on +44 (0)20 7444 5550 or by email: firstname.lastname@example.org.
© Financier Worldwide
Mark Berry, Oliver Carruthers and Matthew Hardwick
Norton Rose LLP