Road to ruin, or road to RAB?

The UK government recently announced it was undertaking a feasibility study to look at ways of utilising private capital to improve the country’s roads network. The Treasury and Department of Transport, which are in charge of the report, will reach conclusions in the autumn. Some aspects of the report  will come as no great surprise.

What seems clear, for example, is that tolling in some form will be a part of the plans – and this, in itself, is a potentially exciting development for infrastructure investors. Traditionally – with one exception being the M6 toll road – UK roads have been packaged by successive governments as 25-year concessions with availability income streams. This has attracted niche public-private partnership (PPP) investors lured to a low risk/return profile where demand risk stays with the government.

But the wider, non-PPP universe of infrastructure fund managers have not been similarly enticed. As James Riddell, head of infrastructure M&A at Deloitte UK, told us: “UK roads have traditionally come with construction risk and minimal demand risk once operational, resulting in low operational returns. Minimising exposure to construction risk will continue to be key for some investors just as shifting realistic demand risk from the government to the private sector, with a resulting increase in returns, will be needed in order to attract significantly more investors.”

Many in the industry, like Riddell himself, are anticipating just such a shift in order to bring in the quantum of investment that the government requires. And, as an Australian national, Riddell thinks the UK government may well be tempted to look at private sector road transactions Down Under for a model.

In Australia, it has become common practice for investors in new roads to be offered contracts to construct and operate the road (again over 25 years) with bids based on the toll bidders want to charge (increasing over the period of ownership in line with inflation). The government likes the model because demand risk is taken on by the private sector; investors like it because it offers higher returns.

However, the Australian experience might reasonably be accompanied by a flashing neon light framing the words “Buyer beware!” The country has seen some ferociously competitive bidding processes with winning bids occasionally based on what might be politely termed “highly optimistic” traffic projections. Some roads – such as Sydney’s Lane Cove Tunnel, backed by Cheung Kong Infrastructure – have ended up plunging into receivership as a result.

For the Australian government and general public, this has not been a disaster. The roads in question have generally ended up being recapitalised to better reflect their traffic profiles and – at the end of the concession – the government/public ends up taking ownership of a quality asset which, without private sector help, would not (should not?) have been built. 

In the event that the same model is adopted in the UK, investors would be well advised to spend a lot of time stress-testing those traffic forecasts.

Avoiding extremes

Maybe, however, the UK government has been giving some thought on how to avoid the kind of extremes that would see private investors either making too much money (and enraging the general public) or making too little (a number of Australian-style disasters could see investors lose faith in the sector). If it has, it would shed light on Prime Minister David Cameron’s reference to the water industry when speaking of the roads plan.

At first glance, the reference was surprising – and controversial. In some quarters, the perception of the UK water industry’s privatisation is of large companies making excessive profits while the cost of services to the consumer rose significantly. However, what Cameron may have had in mind was the regulated asset base (RAB) model of regulation for UK utilities – and the possibility that this model may also be applied to roads.

Because it has not been attempted before, it’s hard to envisage exactly how the RAB would be applied in this new context. But it would likely involve the level of tolls being re-set at the end of set regulatory periods according to whether demand for the road had been higher or lower than anticipated. In other words, invsetors would give something back from over-performance and get something back for under-performance.

And that could be an interesting proposition for investors  interested in toll roads but deterred by demand risk.