Why investors and consumers have a common interest

Those of us old enough to remember the wave of UK privatisation in the mid- to late-1980s will remember the strongly-held belief that the private sector could manage more efficiently and improve quality of service. Furthermore, significant investment would be required to increase the capacity of UK infrastructure assets to meet the needs of a growing and more demanding population.

Economic regulation was put in place to protect the interests of the consumer, in the long and short term, while at the same time providing incentives for these industries to invest, along with a stable and objective environment for those affected to anticipate future decisions and make long-term investment decisions with confidence.

While there is no doubt that, at times, this will come into conflict with the government’s accountability to protect the cost to the consumer, in recent years this pendulum has swung too much towards short-term political interests, to the point where we could seriously question if the long-term interests of consumers are also at risk.

However, what is clear is that the UK needs to address this balance when you look at the precipice we are facing.

NEW DEMANDS

This lack of long-term focus has now put basic consumer needs such as electricity
supply at risk. Climate change and ageing infrastructure are placing new demands on our water supply, and political indecision over where and how to invest in our transport network is placing both London and the UK at a competitive disadvantage internationally.

The EC Harris Global Wealth Index illustrates the impact of a lack of government policy and investment on the prosperity of a nation. We can see the UK currently sits at number 13, but, more alarmingly, in less than 10 years we could have infrastructure that is barely capable of meeting consumer demands. Reversing this will come at a cost and, in future, consumers will be paying significantly more than they do today.

For example, our dependency on oil, and inability to become more self-sufficient by using natural gas reserves, means that cost to the consumer will only go in one direction. Climate change means we need to consider more water storage facilities, i.e. reservoirs, or find a solution that re-distributes supply around the UK, rather than just within regions. This basic human need will require significant investment.

This applies to electricity too. Although the recent announcement on a nuclear “strike price” with French power company EDF is welcome, it will come at significant additional cost to the taxpayer.

‘STICKING PLASTER’

There are numerous examples of complex challenges around our ageing infrastructure which regulation is not adequately addressing. One such is the water and sewerage network under London. Current regulation means UK water utility Thames Water only
addresses leakage, and while these challenges exist, the reality is that the regulation is only producing a sticking plaster solution to a crumbling network that requires systematic replacement over the next 20 years.

Moreover, whatever the outcome of the Davies Commission, one thing is certain: we
need more airport runway capacity in the South East. This would get funded through
a RAB (regulated asset base) model, which in turn is passed onto the consumer. And while, encouragingly, we are seeing record levels of investment in our rail infrastructure through Control Period 5 [the latest Network Rail five-year planning period], nobody has declared what this will mean in terms of cost to the consumer.

The reality is that, for an island nation with inadequate infrastructure, we have stored up a problem that has only one outcome for the consumer – the collective
cost dramatically increasing over the next decade for what are now essential services in modern society.

There is one other component only just beginning to show itself, and that is the private ownership structure of our infrastructure assets and the controlling interests that now exist in these sectors. For the last 25 years, economic regulation has played a significant role in establishing the terms under which investment is made. The rate of return the regulator allows investors has always been a hot topic, but two factors have changed the game for industry:

• We are in an unprecedented financial climate where the cost of capital has been historically low and;
• The next wave of infrastructure requirements for our assets are increasingly
complex and higher risk, yet policy is not creating conditions for investors to tackle these challenges.

Our regulatory framework has not recognised this shift, and more importantly, the commercial leverage now sits strongly with investors, not the regulator. Unless the framework redresses this balance with more appropriate conditions for the investor, we will see a number of companies challenge their regulator’s financial determination. The effect of this will be either no new investment or a more favourable pricing model agreed on appeal – again, at the expense of the consumer.

So what changes need to be made?

• While the model itself still provides a suitable framework, it is the application of the model that needs to change. With predictability comes an acceptable level of return relative to other investment vehicles. If the nature of our infrastructure plan is seen as higher risk than previously, this will understandably command a higher return. Policy and regulation can help de-risk the environment, leaving companies to focus on managing delivery risk, which will benefit the consumer.
• For the last 25 years, regulation has incentivised investment to meet rising demand. The cost to consumers is now such a material part of daily life that regulation should start to incentivise controlling consumption to manage demand. Placing greater emphasis on the use of technology in homes, and the benefits that would bring to consumers, is an obvious example.
• Given much of our infrastructure is about replacement, or doing things differently, investors should be incentivised to reduce the wholelife costs. Current regulation has become increasingly prescriptive with the focus on short-term operational costs and pricing, and perversely placing a greater management
burden on industry in the process. The consumer does not benefit from this approach as all it does is discourage investment.
• Let wider industry get involved and pool its talent. There is plenty of evidence that investors will get support to manage the delivery risk if the right conditions for investment are made. The Armitt Review is the latest in a line of industry expert assessments that provides solutions to support a wider regulatory framework.

For all of the above, the consumer wins and so do investors. Whether we like it or not, the UK is now dependent on foreign investment for the next generation of infrastructure investment. The Prime Minister reiterates that the UK is open for business, yet when that business arrives, it discovers an environment where, at best, investors are distrusted and penalised and publicly ridiculed by the media.

With industries ready, willing and wanting to do right by infrastructure and the consumer, all we need are the right conditions to invest.

Mat Riley is head of infrastructure, industry and utilities at EC Harris, the London-based built asset consultancy.