What are investors afraid of?

With this month’s issue focusing on regulation, we took the opportunity to ask several industry experts to discuss which regulatory risk they considered to be the most significant in connection with US infrastructure.

Unsurprisingly, what topped respondents’ ‘worry list’ was political risk – in the form of shifting policy and rule changes. While political risk is often associated with developing markets, as their regulatory frameworks may not yet be clearly defined, it is always a bit more shocking when it occurs in established markets.

Take for instance, Spain’s recent cut in renewable energy subsidies in July. Or, Norway’s decision earlier in the year to cut tariffs for the country’s gas transportation network, Gassled, by 90 percent. These examples as well as those presented here make it clear that political risk keeps investors awake at night, regardless of geography.

Joel Moser, partner, Kaye Scholer:

“The greatest regulatory risk to the infrastructure market in the US is the lack of central planning. Infrastructure is best planned centrally by engineers but in the US planning is now done locally by politicians. This is a result of the federalist system of the US Constitution but the scheme has long outlived its purpose in this instance. Mega-projects are regional and national in scope and, long ago, the Federal government took a major role in planning with the provision of funding as the factor that broke through the niceties of State rights and the local political framework.

With Washington now in the grips of Tea Party nihilism, Federal dollars no longer bring a national viewpoint to infrastructure. Meanwhile, the antiquated muni bond tax-exemption allows local politicians to indirectly spend from the Federal Treasury without Federal oversight.”

Michael Albrecht, associate director, global infrastructure & real assets, Allstate Investments:

“A key risk for investors to be focused on is customer rates; investors should not be myopic on allowed and earned return-on-equity targets. While customer utility bills tend to be a relatively small proportion of a household budget, approximately 5 percent according to the Bureau of Labor Statistics, a large percentage increase in bills can create a high probability of intervener risk. Even if a utility is under-earning, if customer rates are high relative to other comparable systems in the state, regulators will likely question why they should allow rate increases.

The key take-away is that investors should not simply assume they can bridge the gap between earned and allowed return-on-equity (ROE) targets by requesting customer price increases; regulators and customers expect value for their dollar and investors must also seek out alternative ways to increase value for customers. For example, identifying opportunities to reduce costs which do not increase customer rates yet allow equity investors to earn a return in line with their allowed ROE.”    

Vittorio Lacagnina, director, SteelRiver Infrastructure Partners: 

“We believe that the nature of the underlying investment exposes owners of infrastructure assets to a higher level of regulatory risk than that typically imposed on other businesses. Specifically, when investing in “core” infrastructure, there is a risk that governmental agencies may repeal, amend, enact or promulgate laws or regulations, or issue new interpretations of existing regulations, departing from any contractual rights that government counterparties may have with private investors under an existing agreement.

Given the essentiality of the services provided, and the limited-competition environment in which core infrastructure assets operate, there is also a real possibility that regulatory regime changes may be induced and/or influenced by political considerations affecting not only the private investors but, ultimately, end-users and other stakeholders. In this respect, we view the “politicisation” of changes in regulatory regime frameworks as one of the biggest regulatory risks when investing in the asset class.

In order to establish and foster a conducive environment for private investment in infrastructure, it is important for the regulatory framework to play a stabilising role while the public policy process responds to the immediate challenges brought by economic, technical and environmental changes. At the same time, a resilient regulatory framework also implies a willingness to adapt to external stimuli while retaining the fundamental risk-sharing arrangements that were part of the original regulatory bargain, thus evolving into a more “fitting” institutional structure.

In the US for example, the “Regulatory Compact”, also known as “cost-of-service” regulation and the traditional mode of utility industry regulation, has gone through a process of adaptation since it was implemented over 70 years ago. By and large, the Regulatory Compact has preserved the relational contract between utilities and their customers, adopting new pricing tools and mechanisms to address specific issues without compromising the entire architecture and remaining open to innovations to streamline and improve the rate-making process.”

Dana Allen Sands, partner, Energy Infrastructure Partners:

“We worry about different facets of regulatory risks in different sectors.

For example, in solar, the regulatory risks that worry us are the in the weeds interpretation of the 1603 rebates. What if the IRS interprets the reimbursement filing differently? What about tariffs on the importation of Chinese panels? Will that make my project unviable? There are also a myriad of state issues that concern us. For instance, what if Massachusetts does not continue to shore up its Renewable Energy Certificate (REC) market? What if the Renewable Portfolio Standard (RPS) gets rolled back, as is threatened in many states? What happens when the net metering rules are negatively rewritten? What if Vermont doesn’t stand by its extremely rich feed-in tariff? We have seen this happen in other states.

But the biggest regulatory risk is true, out and out political risk, in the form of flawed P3 processes. We have personally been involved with one too many processes that have gone awry: a project that was cancelled in the dead of the night; bids that were shut down because the city decided not to be flexible in its concession negotiations.

The future of the health of infrastructure in this country (other than the regulated industries) relies on a streamlined, more reliable P3 process such as the one in place in Canada.”

Robert Fleishman, partner, Morrison & Foerster:

“Many electric utilities no longer own or build generating resources but nevertheless must procure/satisfy state regulatory requirements that customers receive reliable and reasonably-priced service. As distributed generation (such as rooftop solar installations) and resources that are fueled significantly by regulatory policies (demand response) expand, the possibility of “stranded” utility infrastructure looms on the horizon. And if utilities must maintain infrastructure to serve even those who go off the grid, how should rates for standby-type electric service be designed so investors have an adequate opportunity to recover those and other costs?

A majority of states have adopted regulatory or legislative mandates that utilities and others procure renewable energy resources. Constitutional challenges to some of these mandates have led savvy infrastructure investors to analyse carefully the extent to which such mandates can be relied on when committing to a project.

Regulatory risk also stems from FERC’s Order No. 1000, which requires regional transmission organizations (RTOs) to develop regional transmission infrastructure plans that promote reliability and efficient cost allocations and consider state and federal public policy requirements. Whether investors will be adequately compensated through transmission rates for their investment risk will depend on FERC policies.

Regulatory uncertainties about wholesale electric capacity markets can significantly affect where to build power infrastructure, and how much. These capacity markets are operated by RTOS/ISOs under complex tariffs, market rules, and contracts developed through multiparty stakeholder processes and approved by FERC. Because terms, conditions, and documentation vary in each organised wholesale power market, an infrastructure investor that has invested comfortably in one organised market, such as PJM, cannot simply transfer that knowledge to a potential investment in a different organised market.”