Light at the end of the tunnel

In announcing that the Thames Tideway Tunnel (TTT) project had been awarded a licence by water regulator Ofwat, fund manager INPP – a member of the financing consortium – memorably called the tunnel the new “sewer of last resort”. The need for the tunnel to be built could not be more neatly encapsulated than in that description – given that the River Thames was the previous recipient of surplus sewerage discharges.

The big challenge for this vital project was that in order to attract the magnitude of capital that it required (some £4.2 billion; €5.8 billion; $6.6 billion), an eternal mystery would have to be solved: namely, how to match long-term institutional capital with a greenfield project including construction risk. Up to now, the preferred choice of such investors has been coloured brown rather than green, with risk of any kind a major sensitivity.

SECRET SAUCE

It was long rumoured that the TTT project had discovered some kind of secret sauce but details were scant as long as the procurement process was ongoing. The presence of institutional investors in the bidding process – including Allianz, the Pensions Infrastructure Platform and Swiss Life – seemed to provide a strong hint that whatever innovative structuring had taken place must have been sufficient to achieve its goals.

Since the licence award, Infrastructure Investor has been taking soundings from some of those involved in the project – and some key features have been emerging. For example, investors are able to access revenues from day one rather than having to wait until after construction.

In addition there is a “market disruption facility”, which allows investors to continue to access ongoing capital expenditure requirements when the capital markets are closed thanks to a facility provided by government which can be drawn down and then subsequently refinanced when the capital markets re-open.

There is also a financing cost adjustment mechanism, which adjusts revenues in line with changes in the market cost of debt. This allows protection against changes in the interest rate environment, and subsequent impact on financing costs. The mechanism is borrowed from the RIIO regulatory regime as applied to the electricity industry, and effectively provides the safety net that investors in regulated assets have become accustomed to through periodic settlements.

In the vital area of risk, it appears that the architects of the deal have done their utmost to provide investor comfort. The risk that the project will not complete (‘stranded asset’ risk) has been covered by the government agreeing to ‘discontinuation compensation’.

In a similar vein, ‘catastrophic risk’ – for example, that tunnelling under some of London’s prime real estate might do extensive damage that can’t be completely covered by insurance – has also been dealt with by government agreeing to supplemental compensation.

Meanwhile, regulatory risk has been significantly mitigated with the possibility of future changes to the regulatory settlement having been headed off by the inclusion of all the structuring features mentioned above (and more besides) being included in the licence. This gives investors certainty as it means the regulator is not allowed to indulge in the kind of retroactive adjustments to agreements that have been seen elsewhere.

So does all this add up to the much sought-after match-up between long-term sources of capital and large greenfield infrastructure projects? One of the architects of the TTT transaction, Charlotte Morgan of law firm Linklaters, certainly thinks so. She told us:

“Using a regulatory funding structure with targeted adaptations is highly replicable for infrastructure projects. There has been a significant problem with accessibility to regulated assets (which have attractive investment returns) leading to some very hot auction processes.

“What we demonstrated with Thames Tideway is that, with appropriate structuring, infrastructure projects could become a new asset class attracting sources of capital which traditionally would not have entertained greenfield development.”

There is indeed light at the end of the tunnel.