Sending mixed signals

In a recent roundtable discussion on European infrastructure finance, which featured in the September 2010 issue of Infrastructure Investor, regulation was a major talking point. At the time, the Spanish government had only recently announced substantial cuts to renewable energy subsidies – therefore, it was not surprising that most of the talk was of a downbeat nature.

However, the relationship between infrastructure investors and regulators is nuanced. The infrastructure asset class, as with private equity for example, can occasionally be sacrificed on the altar of regulation inspired by political populism. Equally, there are sectors within infrastructure that are attractive to investors precisely because they are tightly regulated and hence provide a predictable investing environment.

Below, we have identified six key regulatory issues that impact infrastructure investors today. Using a traffic light analogy, we’ve divided the issues into those that may stop investors in their tracks (red); those that should allow serene progress (green); and those that could go either way (amber).

AIFM Directive: fundraising fiasco
Poorly constructed, knee-jerk legislation? Here’s example A

As recently highlighted by David Snow in an article for sister magazine Private Equity International, the EU’s Alternative Investment Fund Managers (AIFM) Directive would, if passed as currently drafted, result in a situation where European managers could raise funds in the European Union while non-European managers couldn’t; and where non-European managers could do leveraged buyouts in the EU and European managers couldn’t.     

This apparent absence of logic is the result of the draft Directive – which applies to infrastructure funds as well as private equity, real estate and hedge funds – being drawn up hastily in the wake of the financial crisis. It was the result of EU bureacrats concluding that alternative investment fund managers probably had something to do with the crisis – and if it’s not clear exactly how they were culpable, no matter; better clamp down on them anyway. This has resulted in other iniquities to those mentioned above, such as more rigorous transparency required of GP-owned portfolio companies than non-GP-owned competitors – an unlevel playing field, in other words.   

The good news is that the Directive is still at the drafting stage – and has predictably been delayed as various EU bodies examining the proposals fail to agree on the details. The bad news, according to legal experts, is that substantial revisions to the draft version should not be expected.   
Verdict: This ill-advised Directive will make it harder to raise funds and more expensive to run alternative asset businesses [RED LIGHT] 

EU accounting rules: mind the deficit
Changes to EU accounting rules may put PPPs on balance sheet from 2015

“Remember when European governments could record PPPs off balance sheet? Yeah, there used to be so many of them back then.” This piece of fictional dialogue may become a reality sometime after 2015 if plans to change the way PPPs are accounted for go ahead as part of a wider review of European Union (EU) accounting rules.

Presently, EU states are allowed to record PPPs off balance sheet as long as they effectively transfer certain risks (such as construction and financing risk) to the private sector. But that may not be how it works in the future.

A faction at EUROSTAT, the EU’s statistics arm, reportedly wants to replace risk transferral with “control” as the main criterion determining how PPP contracts are recorded. This means that unless governments cede control of many of the contractual variables within their power today (such as setting tariffs, the scope and services of a contract, and its residual value) to the private sector, they will have to record PPPs on their balance sheets.

The possibility of European governments having to start recording billions in PPP liabilities on their balance sheets would place the vast majority in breach of EU deficit restrictions – in which case, watch out for the impact on financial markets.  

Verdict: If implemented, these changes would probably reduce deal flow significantly [RED LIGHT]

Government subsidies: slashing the cash  
Renewable energy investors have seen the goalposts moved

Tough European Union targets for the production of energy from renewable sources have led to some radical action being taken in certain European countries. In Spain, government subsidies for solar plant operators were so generous that the country accounted for more than 45 percent of global solar installations in 2008. Unsurprisingly, investors swarmed to the country to fill their boots.

Post-financial crisis, with governments looking to make all the savings they can, things are very different. Jaws dropped when, earlier this year, the Spanish government announced it would be slashing subsidies for ground-based solar parks by no less than 45 percent.  Aside from citing the austerity agenda, apologists pointed to the increased efficiency of solar technology – meaning that costs for operators had been lowered. Critics of the cuts said the sector’s competitiveness had been overestimated.  

While arguments rage over the appropriate level of subsidies, the bigger worry for long-term investors in infrastructure is the unpredictability implied when cash flow assumptions made at the outset of a project no longer apply part-way through. Some investors, however are taking a pragmatic view. “There’s uncertainty for the coming months and it will have to be priced in,” says Raj Rao of fund manager Global Infrastructure Partners. “But the opportunity in European renewables will exist for a long time.”

Verdict: Subsidy cuts are unwelcome, but claims that they destroy the investment opportunity are overstated [AMBER LIGHT]
Industry reviews: investors versus shareholders
Don’t end up on the wrong side of a determination

When UK water regulator Ofwat issued its latest “determination” – the process used to determine how much UK water companies can charge their customers over the following five years – in November 2009, opinion was divided. 

Neil Woodford, head of investment at UK fund management group Invesco Perpetual, accused Ofwat of acting like Robin Hood in seeking to take away from shareholders and give to consumers. He predicted a mass exodus of equity investors from the sector as a result.

Woodford’s views were not universally shared, however – including in the infrastructure investment community. Niall Mills, a senior asset manager at fund manager First State Investments and a board member at UK utility Anglian Water, said the determination was “tough and demanding” but also “very well structured”. He believed that the vital distinction was whether assets were out-performing or under-performing. The former had nothing to worry about; the latter, plenty.

Verdict: A well-run asset should have little to fear [AMBER LIGHT]      

Regulated asset base: a sense of security
Granting the RAB concept wider application should lower the cost of capital

In the quest to channel more private funds into infrastructure, one thing is certain: the more regulatory security governments provide, the larger the amount of private money they will be able to attract.

Enter the regulated asset base (RAB). The RAB is a mechanism that commits governments to the costs the private sector has “sunk” to develop an asset by guaranteeing (and capping) shareholder returns via the asset’s customer/taxpayer base. So far, the RAB is only applied to UK utilities but Oxford University economist Dieter Helm thinks it can be applied to PPPs as well.

PPPs have a very high cost of capital, Helm argues. And that’s partly because governments’ commitment to these assets isn’t as strong as it is to regulated utilities, where repayment of the value of the asset (and associated debt) is guaranteed by the authorities.

Part of Helm’s suggested remedy lies in separating the RAB (including ownership) from the capex and opex parts of the business. The former is practically risk-free for equity (and thus ideal for institutional investors) while the latter two involve considerable delivery risks and should be tendered to those best able to manage them.

Verdict: Could be a solution to unlocking more pension investment in infrastructure [GREEN LIGHT]

Unbundling: get ready to feast  
Vattenfall and RWE attest to the benefits of deregulation

July 1 2007 was a happy day for private parties looking to invest in Europe’s energy infrastructure as it marked the date when the European Commission (EC) deregulated the continent’s electricity and gas sectors, opening them up to market competition.

The implementation of the EC’s 2007 energy directive hasn’t been perfect, and many European countries have been slow to adopt it, but the unbundling (the separation of gas and electricity providers from the transportation and transmission grids) of European utilities has already yielded some high-profile infrastructure deals.

One of the most recent examples was the sale of Swedish firm Vattenfall’s German electricity grid to infrastructure investor Industry Funds Management. The current sale of RWE’s German natural gas network provides continuing evidence of the EC’s demand for greater competition in the European energy sector – and the benefits it could bring to funds. 

Verdict: Unbundling equals increased deal flow for the private sector [GREEN LIGHT]