How watertight is the Thames Tideway Tunnel?

Three months after the UK voted to leave the EU, infrastructure investors could be forgiven for feeling a bit puzzled by Westminster’s attitude to the sector. Theresa May and her government, in keeping with the political times, have spoken highly of infrastructure’s role in boosting the economy. Importantly, the new Prime Minister’s loosening of budgetary constraints and greater enthusiasm for fiscal intervention lays the right foundations for a boost in infrastructure funding.

But a few mixed signals have left investors scratching their heads. First came the Hinkley Point procurement snafus, which left China’s CGN and France’s EDF stranded after May deemed more time was needed to assess the £18 billion ($23.5 billion; €21 billion) nuclear plant project (it was approved six weeks later). Then the UK’s National Infrastructure Commission, a body tasked with making sure the country addresses its long-term infrastructure needs, suffered a blow after it was omitted from a bill designed to establish the body on a statutory basis.

It is therefore only natural that when the National Audit Office announced it would investigate the financing package provided to the Thames Tideway Tunnel, some saw it as a signal that infrastructure’s road to policy prominence was bumpier than it seemed. London’s £4.2 billion ‘super-sewer’ project, backed by hefty government guarantees, had been seen as a much-needed solution to the greenfield infrastructure institutional funding problem.

But does this promising financing innovation have a catch so big that it does not genuinely offer good value for money?

NOT-SO-RISKY BUSINESS

Proponents of the deal think not. “The infrastructure provider structure delivers a lower cost of capital for large infrastructure projects than other project structures,” says Charlotte Morgan, a partner at Linklaters, which advised UK utility Thames Water on the project. “The original forecasts for the cost to customers of the TTT project were in the region of £70-80 per customer. With the IP structure and effective procurement Thames Water have been able to deliver a project cost of nearer £20-25.”

Achieving this required the introduction of a number of novel features that it is useful to recall. This secret sauce allows investors to access revenues from day one rather than having to wait until after construction completes. The ability to mitigate greenfield’s ‘J-curve effect’ has played a crucial role in attracting the likes of Allianz and the Pensions Infrastructure Platform, notably because it eliminates the main inconvenience associated with construction delays – postponed cashflows.

But the structure has other strengths. It is equipped with a ‘market disruption facility’, which enables investors to retain access to ongoing capital expenditure requirements when the capital markets are closed, thanks to a facility provided by the government. The latter can be drawn down and then subsequently refinanced when capital markets re-open. There is also a financing cost-adjustment mechanism, which fine-tunes revenues in line with fluctuations in the market cost of debt, an attractive feature in today’s interest rate environment.

There is also much to make investors comfortable with regarding other black swans, starting with the risk that the project simply doesn’t complete (‘stranded asset risk’). That is being covered by the government agreeing to ‘discontinuation compensation’. The same goes for ‘catastrophic risk’: should prime buildings sitting atop the digging sites suffer damage of a magnitude that insurance policies cannot cover, additional compensation will be provided. All these guarantees are enshrined in the licence that was awarded to the winning consortium last year, protecting investors from retroactive changes.

If this all sounds rather innovative, says Michael Watson, a partner at Pinsent Masons, it’s worth remembering that the structure draws its inspiration from a variety of sources, from schemes put in place by Ireland’s Mutual Energy to the Welsh water securitisation and offshore wind transmission projects. “The structure is very attractive because it’s very transparent, in common with many aspects of privately financed/PPP models. There’s visibility on the returns, the weighted average cost of capital, and on the cost of maintaining and operating the assets.”

STORM IN A THAMES CUP

With so much to credit the TTT’s financing structure, how to understand the rationale behind the NAO’s investigation? In its urge to attract private capital, has the government simply been too generous with its private partners?

First, it helps to underscore that such probes are in fact fairly routine. The audit office investigates pretty much everything that has to do with taxpayer and consumer money, which leads it to zoom in on about 200 projects a year. It is important to note that the focus here is on the government’s actions, not on the project itself or its private backers, which in addition to Allianz and PIP also include International Public Partnerships and DIF. “The NAO holds the government to account. It’s doing what it’s supposed to do, which is to look at things,” says a source close to the project.

DIF and INPP declined to comment, as did Thames Tideway. Allianz did not respond to a request for comment. PIP could not be reached.

The size of TTT – and its “unusual” funding structure, as the NAO itself puts it – also makes it an ideal candidate for an auditing probe. “The NAO will look at whether it would have been cheaper to have publicly funded the whole thing,” says Watson, who has his own views on the matter. “But one should take into account that it’s not normal for a project of this size to be publicly funded and the opportunity cost of doing so. Think about the overall impact this would have on the government’s balance sheet. And if it had been publicly funded, would the right incentives and skills from the private sector be deployed to the project in the way they have been?”

Importantly, the probe has some history, Morgan points out. In June 2014, the NAO took the initiative to look at the project before it was completed and funded – a near-first for the industry. This preliminary review highlighted three potential areas that could become the focus of a full audit: the role of different parties in leading it through; potential risks to taxpayer and consumers in terms of value for money; and what the public-sector management of a project like this would look like.

The NAO’s report did not reach any conclusions. Instead, it set out a series of expectations as to how things would happen. What the NAO is doing now is checking in on these three subjects, Morgan and Watson both suggest. With the audit office’s expectations highlighted before the structure was finalised, argues Morgan, the structure is probably on a good footing to withstand scrutiny.

The watchdog’s verdict will be known later this autumn. But strong international interest for the structure suggest investors and sponsors are not too worried: delegations involved with projects ranging from Australian urban rail to US water are said to have visited the UK this year to understand its magic. Unless the NAO really pours cold water on the project, their appetite for finding structures that will encourage institutional investment in greenfield projects is unlikely to be dampened.