In recent times, the UK has seen significant capital committed to infrastructure at a scale reflective of the Victorian era. The National Infrastructure Delivery Plan (see p. 44) sets out £400 billion ($523 billion; €462 billion) of investments; the National Infrastructure Commission has endorsed the Crossrail 2 and Transport for the North projects as national priorities; and money continues to be put towards High Speed 2, tube modernisation, highways, airports, and ports. Furthermore, the UK has historically benefited from significant availability of capital for infrastructure.
However, according to McKinsey, the UK has nevertheless historically underspent. Between 2008 and 2013, approximately 0.4 percent of UK GDP was spent on infrastructure projects, which is less than Australia, Japan and China. With London delivering around 25 percent of UK GDP (in comparison, Berlin contributes 5 percent to German GDP), the role of the regions in executing the UK’s industrial strategy and related investment in infrastructure is critical to sustaining economic growth, especially following the EU referendum. Arguably, the Leave vote has amplified the need to continue investing in the regions.
Yet there continues to be some nervousness in the infrastructure investor community following Brexit, which is largely down to uncertainty related to three questions:
What will the government’s policy be on infrastructure?
What might the economic impact of Brexit be on the UK and how do investors deal with the uncertainty?
What are the implications for specialised skills and sector capability in the UK?
Considering these issues in further detail, the government seems to have shown some early signs of treating infrastructure as a priority sector. There have been positive statements from the Prime Minister, Chancellor and several other ministers, which suggests the government may potentially be open to borrowing to finance long-term investments in infrastructure.
The government has also cleared the expansion of London City Airport and, while this is a small development, it is a positive sign. However, at the same time, the government has initiated reviews of Hinkley Point and the Mayor of London has, independently, initiated a review of Silvertown Tunnel – both of these creating political uncertainty in the minds of some investors. Overall, it seems that the weeks since Brexit might be considered neutral from an infrastructure perspective. However, there perhaps aren’t yet enough signs that would allay investor nervousness. It’s a ‘wait and see’ scenario in which the investor community requires affirmative statements from the government around infrastructure.
Which brings us to the question of what the government could do to convince investors of its commitment to the infrastructure agenda? In our view, investors would like a number of positive signals from the government, including:
A decision on the London airport capacity debate. This has been deferred a number of times and a favourable decision could be seen as the most positive sign of government intent.
Continuing to show progress on HS2 and other projects already underway.
A decision on Hinkley Point, which would also effectively be seen as a sign of government policy on nuclear.
Consideration of other ideas on how government could promote infrastructure development. For example, the idea of Treasury-backed bonds has been in circulation.
Developing a pipeline of investible projects for investors.
An early thought process for dealing with the European Investment Bank issue, post-Brexit. The EIB has been one of the largest lenders to UK infrastructure projects and while the EIB can continue to finance UK projects post-Brexit, in the same manner as it finances other non-EU countries, it would seem that an amendment to the purpose and application of the UK Treasury Guarantee Scheme might offer the most efficient way to address this issue.
On the second issue of what the economic impact of Brexit might be, there seems to be a general consensus that economic growth will slow. In the short term, the non-governmental forecasting group EY ITEM Club is predicting GDP growth of 1.9 percent this year and 0.4 percent in 2017. The longer term impact on the economy is likely to be influenced by when the government triggers Article 50, the baseline position in EU negotiations, and the nature of the trade arrangements post-Brexit. The key question, therefore, is what strategies are infrastructure investors deploying during these uncertain times?
Unlike the 2008 financial crisis, which led to a significant loss of market liquidity for funding projects, there is no dearth of liquidity in the current market for well-structured projects. Both the banking and the institutional sectors have funds available to deploy in infrastructure. We have seen some tightening of credit margins – and we cannot rule out shortening of debt tenors to some extent – but we are not expecting the availability of funding to be a constraint. At the same time, the cost of capital being applied by investors to UK deals (pre-Brexit) had reached an all-time low, with PFI secondary trades yielding just around 6-7 percent return to equity investors. Even trophy assets with real economic risk have transacted at single digit returns. These rates of return were reflective of a paucity of dealflow, an expectation of a low long-term interest rate environment, and an increasing shift of long-term capital into infrastructure.
Given this context, investors will now need to work though the implications of a number of years of uncertainty that could result from Brexit. While there cannot be a unified view on how investors are reacting to the new environment, here are our expectations on investor behaviour:
Brexit has highlighted the currency mismatch risk, since funding was raised largely from non-UK investors to buy UK assets. With a sharp currency depreciation of the pound, the effective rate of return (in Euro or US dollars) on UK investments has dropped by approximately 15 percent from pre-Brexit levels. This is highlighting the need for some investors to maintain diversified portfolios.
Some investors are actively diversifying into asset classes that are traditionally not seen as appropriate for financial investors or seen as infrastructure. This move was largely to counter the low volume of deals and also to seek higher returns. While this trend was already evident pre-Brexit, investors may need to be bolder in their hunt for investment opportunities post-Brexit, as the deal pipeline might be further impacted by owners seeking to defer decisions to sell assets until there is a greater certainty in the market. As an example, some investors are actively considering greenfield investments or more complex brownfield investments. Investors are also seeking out new investment ideas such as smart meters and broadband, so we expect the definition of infrastructure to be expanded. The competition for the disposal of Grandi Stazioni is another example of this trend, with the asset successfully acquired by Antin, an infrastructure fund.
We expect some increase in the cost of capital being used by investors, largely to adjust for the uncertain economic and political environment. However, this might be partially offset by the expectation of a very benign interest rate environment for an extended period.
Skills and capability is another area that many employers are looking at closely in light of Brexit. The UK is seen as a global centre of excellence in infrastructure, with a huge concentration of capability across the entire value chain – consulting, banking, investment, technical and legal, to name but a few. A key challenge for the sector will be its ability to retain this capability post-Brexit. A stronger pipeline of projects in the UK market, coupled with a push to serve the global market, would be critical in retention of talent.
In summary, in this new environment, the need to invest in infrastructure does not diminish. The sector requires sustained funding from government to be balanced against the fiscal challenge, deficit reduction plan and the wider impact of any downturn on government revenues. There may be significant challenges ahead and uncertainty over how this situation unfolds. However, the UK is the global leader in this sector and the community needs to work together to maintain its leading position.