A game of risk

Demand for regulated assets shows no signs of abating, but neither does regulatory risk as a major investor concern. We delve into the apparent cognitive dissonance.

This is the second of three installments on Risk. Read our analysis of the changed nature of reputational risk here.

Infrastructure investment and regulation have always been odd bedfellows. The latter has always had the potential – and indeed has realised it – to seriously damage existing investments. And yet, regulated assets are consistently (some would argue increasingly) in demand by infrastructure investors, as the proliferation of ‘super core’ funds readily attests.

For all that car parks, service stations and crematoria have entered the infrastructure lexicon, managers – driven by LPs’ unquenchable thirst for core infrastructure – remain wedded to the energy, water and airport sectors, among others, which are subject to individual countries’ regulatory regimes.

This comes despite surveys in recent years by the likes of Deloitte and Freshfields finding regulatory risk consistently topping investors’ risk concerns. Such risks are clear and present, although there is a lingering suspicion amongst some that the perception of regulatory risk is too often conflated with political risk.

The UK, for example, is currently going through pricing reviews in the water and energy sectors from respective regulators Ofwat and Ofgem. The two watchdogs – historically considered at worst a necessary evil by the industry – periodically respond to fluctuations in the market, macroeconomic trends and consumer sentiment by adjusting investors’ allowed returns in their respective sectors.

This time, their tone seems different, though. Ofwat has demanded “profound change” in the water sector, while Ofgem has told investors to expect a “significantly lower range of return” amid rising consumer anger at ballooning bills. The current proposals by the latter have been criticised recently by National Grid as “too low for the risks faced” by transmission companies and “will not offer adequate return for investors”.

Meanwhile, the political backdrop is providing investors with further sobering thoughts – including an opposition party leader who wants to renationalise such assets, which, in turn, is putting pressure on the current government to be seen to be more visibly defending consumer interests.

Blurred lines?

The question on everyone’s mind, then, is whether political risk has increased regulatory risk in what has long been Europe’s bastion of private infrastructure investment? Ian Andrews, infrastructure sector leader and partner at Linklaters, contends there aren’t concerns about the regulator’s independence, but there is a careful balancing act to be performed by the regulatory bodies.

“What is most important to the private sector is the regulator is someone they can talk to and is reasonable,” he explains. “Britain has historically been seen to be a common sense and pragmatic place [to invest in]. Ofwat and Ofgem have been around for a long time so they’ve got a real history. I think clients understand the pressure regulators are under and the need to justify themselves in the public eye.”

The reputations of the regulators go some way to mitigating regulatory risk, regardless of the political environment. But they are not to be taken for granted, according to James Wardlaw, head of infrastructure at Campbell Lutyens and an advisor to UK Regulators Network.

“I think that people generally still regard the UK as the sort of ‘gold standard’ from a regulation point of view. That’s something I don’t think we should rest on our laurels about and I think that the way we do things is something that does need to be reviewed regularly and improved upon. However, the perception that the system of regulation in the UK has become more overtly political has been challenging for investors.”

Instances of those challenges have cropped up more regularly  in Continental Europe, with infrastructure investors unlikely to look too fondly on Norway or Spain when they review this past decade.

UBS, Allianz, Canada Pension Plan Investment Board and the Abu Dhabi Investment Authority were all hit when Norway’s government in 2011 and 2012 pushed through 90 percent gas tariff cuts, prompting a legal battle still being heard in Norway’s Supreme Court, after lower courts ruled in favour of the regulation.

So, too, in Spain, where the government enacted retroactive subsidy cuts on renewable energy assets between 2010 and 2013 and has won several court cases since, fending off challenges from bitter investors. In both cases, the embattled stakeholders were left unsuccessfully arguing they were the victims of unfair laws, rather than having entered into weak contracts.

“There will be mechanisms within all regulatory regimes for allocation of risk, for understanding where risk best sits between effectively the party delivering the infrastructure, the regulator and any other counterparty,” says Martin Bennett, managing director of infrastructure at insurance and risk management firm Marsh. “Often the way in which regulation is drafted can leave elements of uncertainty over the final allocation of risk. And in some situations, the determination of a risk situation may require a specific before the regulator can provide certainty of outcome.”

And yet, particularly in the case of Spain, the regulatory debacle did not prove to be a lasting deterrent to the country. While investors steered clear of Spain for several years after the retroactive cuts, many are slowly returning, lured by the country’s reformed renewable energy programme.

“Spanish regulation was perceived at one point to have changed in a way that unfairly disadvantaged investors,” says Andrews. “Now Spain is back because the Spanish authorities had been at pains to change that perception and they do want foreign investment. Spain learnt a lesson in that.”

Nevertheless, a degree of risk remains, and some investors might have felt uneasy at being beholden to what was, until last month, the same government which enacted the retroactive cuts in the first place. For turnkey renewable energy developers, Spain might well sit in the sunshine again. For deep-pocketed, infrastructure investors looking for stable, long-term cashflows, the reality might be slightly different.

Passport, please

A recent regulatory issue rearing its head across the infrastructure world is the debate around foreign ownership of assets. The most high-profile of these decisions came in Australia in 2016, when Hong Kong’s Cheung Kong Infrastructure and China’s State Grid were prevented from buying transmission network Ausgrid on grounds of national security.

Since then, similar decisions have been pondered in Britain and Belgium, while a recent furore around IFM Investors’ potential sale of its stake in Germany’s 50Hertz to China State Grid resulted in fellow shareholder Elia using its pre-emption rights to secure 20 percent of IFM’s 40 percent share.

The German government was powerless – and remains powerless – as IFM seeks to sell a further 20 percent, given a minimum 25 percent share sale threshold must be crossed for the authorities to be able to investigate a foreign investment case. However, Germany and France have been leading calls for change at EU level, and the bloc is now in the process of implementing regulation for tougher screening of foreign investment in critical infrastructure assets.

“I’ve never seen that stopping a deal being done, but it is something that people are aware of,” Andrews comments. “Inevitably any seller and purchaser will take this into account when dealing with the sale of more sensitive industries or assets.”

With the EU rules set to come in later this year, they will act as a further regulatory consideration when realising portfolios or considering privatisations. In a twist, at the end of May, China eased foreign investment restrictions on the energy, transport and wider infrastructure sectors. That’s the point with regulatory risk: as one door closes…