“The only two things that businesses are really interested in at a macro level, as far as the UK is concerned, are Brexit and a Labour government. There are different people asking different questions about those two issues, but we’re spending a lot of time on both of them.”
That conversation with Phillip Souta, head of UK public policy at Clifford Chance, took place shortly before Christmas, and since then no progress has been made in terms of achieving any clarity around either issue.
As we go to press, UK Prime Minister Theresa May had suffered a crushing defeat – the biggest in the country’s modern history – with 230 MPs voting down her Brexit deal. While she managed to survive a vote of no confidence a day later, a snap election still cannot be ruled out. Her ‘Plan B’ is derided as being the same as ‘Plan A’, with dozens of ministers threatening to resign if a no-deal Brexit is not taken off the table, according to The Times.
The next test for May’s government – again, at time of writing – will come in the following days: on 29 January when Parliament will either approve it or shoot it down a second time.
“It’s the prospect of receiving less than market value that has people really nervous” Neidle
“The combination of the political uncertainty around Brexit and comments being made by politicians about nationalisation and the role of private finance in projects at the moment, is causing people – especially when they don’t know the market – to ask us about what could happen, how could it happen and what would it means if these things occur,” Colin Wilson, a partner and UK head of energy and infrastructure projects at DLA Piper, explains.
Aside from seeking information, some investors are also looking for contractual protections. Many existing deals have contracts in place with provisions that address voluntary termination by government, expropriation and various protections for investors, according to Wilson.
“The assumption is that regardless which party gets into power it would still abide by their contractual and legal commitments and therefore investors would get appropriate recovery should [nationalisation] happen,” Wilson explains.
But the key word there is ‘assumption’.
According to Dan Neidle, a partner at Clifford Chance: “Parliament can do what it likes. We don’t have a codified constitution that can over-ride an act of Parliament. It’s the prospect of receiving less than market value that has people really nervous.”
While a future UK government can, theoretically, legally expropriate assets without paying fair-market value, that scenario “takes you into the territory of countries that are flawed in many respects by not fulfilling their obligations to not expropriate assets unfairly and without fair compensation”, Souta remarks.
“It’s all a bit Venezuela,” Neidle adds. “But investors do have a powerful tool, which is the bilateral investment treaties the UK signed over the last 30 years or so.”
Initially designed to allow British businesses to invest in developing economies, the treaties can now help protect foreign investors’ holdings in the UK, “because these treaties provide a guaranteed and prompt right to market value compensation”, Neidle explains.
In addition, any disputes that arise between two parties where such a treaty is in effect will be settled in an international tribunal that cannot be over-ruled by a government.
According to Neidle, “there are a number of investors thinking about that very seriously and considering whether there are steps they can take now to improve their position”.
One foreign fund manager who invests in the UK is sceptical about the effectiveness of such an option. “I think the government would find a way to cut through any sort of structural ways of moving stakes overseas,” this person says.
Asked whether political risk insurance was a viable alternative to protect investors’ stakes, the fund manager concluded it was not: “We did explore ways to mitigate that risk, but the reality we got to – when you look at the premium that’s required and what is actually covered – was that the policy just didn’t make commercial sense.”
“Changing regulation so that existing owners make a zero return on equity, would effectively nationalise [assets]” Claerhout
Andrew Claerhout, who left Ontario Teachers’ Pension Plan last February as head of its infrastructure and natural resources group and is now looking to raise an independent fund, also expresses doubts about the idea of moving stakes offshore as a protective measure.
“At the end of the day, infrastructure assets are local. They are physical assets literally in the ground,” he says. “So, you can move holdings around, you can say the shares of a given company are going to be held in Hong Kong, but if [Labour leader Jeremy] Corbyn gets into power and makes the regulatory environment less independent, the fact that you’re holding your shares in Hong Kong doesn’t help you.”
Semi or outright nationalisation?
Changing the regulatory regime is what Claerhout refers to as ‘semi-nationalisation’, a potentially worse scenario than outright expropriation.
“The UK government doesn’t have the capital to re-acquire all these infrastructure assets, so changing the regulation so that existing owners make a zero return on equity would effectively nationalise them. That would be the worst outcome,” Claerhout argues.
So, what is an investor to do?
One way to mitigate this risk, according to Claerhout, is to partner with local capital, as investors have long been doing when investing in emerging markets.
“If you partner with local capital – let’s say 50 percent of the assets were held by local UK pension funds – all of a sudden, if the UK starts to threaten re-nationalisation or change in regulation, they end up hurting local institutions that have a voice and political sway in the UK. That’s one way to mitigate the risk,” Claerhout explains.
The foreign fund manager we spoke to agrees that nationalising PFI projects, for example, “would lead to serious political blowback”, since many of those projects are owned by UK local authorities and UK public pension funds.
If a future Labour government would go ahead with the nuclear option of outright nationalisation, the greatest source of anxiety for those who have invested in UK infrastructure assets already – echoing Neidle’s earlier comments – is not receiving fair market value for their assets.
As it happens, that’s a real possibility.
According to a May 2017 study conducted by Kate Bayliss and David Hall – a research associate at the University of London and a visiting professor at the University of Greenwich, respectively – “the UK legal framework for compensation for the former private owners has no connection with the stock market rules. It allows Parliament to set its own rules in each specific case, taking account of public interest considerations, as determined by the democratic process.”
The study’s authors go on to cite the case of Northern Rock, a bank that collapsed in 2008 and was nationalised. The bank’s shareholders received zero compensation even though the bank’s shares were trading at £0.90. The UK government’s evaluation process was validated “as entirely legitimate by the High Court, the Court of Appeals and the European Court of Human Rights,” according to Bayliss and Hall.
“The ECHR re-stated the general principle that there was no right to full market value compensation if public interest objectives, including social justice and economic reform, lead to a different conclusion,” the two academics explain.
While bankruptcy is not the criterion Labour has set as a reason behind its nationalisation plan, social justice and economic reform are.
“Look at the scandal of the privatisation of water,” Corbyn said during his speech at the Labour conference in September. “Water bills have risen 40 percent in real terms since privatisation. £18 billion has been paid out in dividends. Water companies receive more in tax credits than they pay in tax,” he said. “Each day enough water to meet the needs of 20 million people is lost due to leakages.”
A month later, Rachel Fletcher, chief executive of regulator Ofwat, slammed the industry, telling attendees at a Moody’s conference on UK water and regulated networks that UK water companies “created [the] perfect conditions for renationalisation”.
“Some companies have focused more on taking money out of the business than delivering for customers,” she said.
According to Bayliss and Hall’s study, three water companies – Anglian, Severn Trent and Yorkshire – “have paid out more in dividends than their total pre-tax profits between 2007 and 2016”.
The water industry’s performance track record hasn’t helped. According to Ofwat’s Fletcher, leakage rates accounted for 22 percent of all water produced in 2017.
While a Labour government could save the £90 or so billion it would cost to re-acquire the country’s water and sewerage companies – which according to the Social Market Foundation, a think tank, would add 5 percent to the national debt – by not paying existing owners fair market value, it would still incur a cost, perhaps higher and more difficult to estimate.
As the foreign fund manager, we spoke to, put it: “From a logical stance, [re-nationalisation] simply doesn’t make sense. For the government to do it in the first place, they would have to take a view that they are happy to disenfranchise overseas investors who invested in the UK, which would basically mean that the UK becomes pretty uninvestable.”
In the end, that might be the strongest protection investors will get.
The multi-billion pound question
How the Labour Party would execute its nationalisation plan should it find itself in office is one question, among several, Infrastructure Investor sought to answer by going straight to the source: Shadow Chancellor of the Exchequer John McDonnell and Shadow Secretary of State for Business, Energy and Industrial Strategy Rebecca Long-Bailey.
While Long-Bailey never responded to our questions, McDonnell’s office did, referring us to the speech he delivered at the 2018 Labour conference in September and media reports that covered the event.
The speech and the related articles make clear that Labour intends to bring back into public ownership water, energy, Royal Mail and rail, but provides no details as to how it will go about doing so.
Asked how much this endeavour will cost, McDonnell’s spokesman referred us to comments the Shadow Chancellor made in a February 2018 interview with Sky News.
“It would be cost-neutral because you would be bringing into public ownership an asset,” McDonnell said. “In addition to that, you would not just have an asset, that asset would give you income. Instead of that income going to shareholders, it would come to the taxpayer,” he said.
Yet, the Social Market Foundation, a UK think tank, estimated last year that nationalising the water sector alone would cost between £87 billion ($112.0 billion; €98.6 billion) and £90 billion.
“The SMF calculation of £87 billion-£90 billion is a ‘takeover price’ based on an assessment of company accounts and following valuation methods used by investment banks and fund managers,” the organisation said in a statement.
As Clifford Chance partner Dan Neidle points out, one possibility is for renationalisation to be funded by issuing gilts.
“One view is that the government can borrow as much as it likes because everyone wants gilts,” Neidle remarks.
“The other, which Labour is fond of, is that the government can behave a bit like a hedge fund and the returns it has to pay on the gilts will be less than the amounts it yields from the businesses, which is kind of crazy given that they intend to be making less profit from these businesses.”