The dangers of ‘Zhivago Syndrome’

It is arguably the biggest talking point in infrastructure investment today: the capricious acts of regulators. But, as Jeffrey Altman points out, such acts do not necessarily mean afflicted investors will run for the hills

Over the past two years, Infrastructure Investor has reported several instances in which infrastructure regulators have made capricious proposals or imposed decisions with draconian effect on core infrastructure investors. Viewed collectively, these actions appear to point towards a trend, which, if true, has broad implications for both global regulated and non-regulated infrastructure.

What is of interest to note is that a rash of European measures in 2010 and 2011 were centered on renewables. However, in late 2012 and early 2013, a couple of actions were taken with regard to traditional core investments. Many were quick to dismiss the changes in the Southern and Central European countries (except those which invested in these areas) as unsurprising given their fiscal distress, and that such changes were unlikely elsewhere in “stable” and “Northern” regimes.

But with Germany, Norway and the UK appearing poised for action, it would appear that investors should take note of all Western European countries. Although OfWAT, the UK’s water regulator, had been signaling to the market about potential changes to the 2014 final regulatory determination, few expected the recent proposals from Norway and Germany.

With respect to Norway’s Gassled, the regulator took some 8 months to approve the sale. It would be fair to say that it’s unlikely investors would have committed to this transaction were it known that, in 6.5 years, there was the potential for a 90 percent tariff cut. Just as shocking are the German proposals for a retroactive tax on renewables. Depending on the final regulatory decisions of both countries, investors may have the right to seek legal recourse.

Underlying factors contributing to regulatory changes

It is essential to first understand the underlying factors that are contributing to the decision-making of regulators. They include, but are not limited to:

Correction of regulatory regimes that were initially inappropriately structured, gamed by market players or made obsolete by unforeseen market conditions;
Large fiscal deficits of federal and state governments;
Recession and stagflation;
High energy costs or other usage rates negatively impacting already stretched consumers;
Efficiency improvements in renewable technologies reducing the need for subsidised feed-in tariffs;
High premiums being paid by investors for assets that provide the perception to the regulators that they have undervalued the respective assets;
Backlash against financial institutions and foreign investors;
Broad ownership base of foreign investors enabling the ability to “diversify the pain”;
Revival of socialism or nationalism, change of political majorities in general;
“Cognitive intransigence” i.e., pursuing policies contrary to the self-interest of the organisation and its constituents (See Barbara Tuchman’s masterpiece The March of Folly).

Projecting forward

In assessing future political, regulatory and tax risks for infrastructure investments, one needs to analyse the aforementioned factors (and others) and determine whether they will continue over time. If so, one must also determine the probability of further regulatory changes. When assessing the present global infrastructure market, every country has one or more factors listed above that infrastructure investors need to consider.

Historically, countries have gone through their respective cycles of economic performance and regulatory regimes independent of one another. This was particularly evidenced in the development of the global Independent Power Producer (IPP) market during the 1990s to 2000s, whereby various governments imposed appropriations, windfall taxes and other material changes to the returns of the investors in these assets, the majority of which were foreign-owned institutions.

The difference today is that we operate in an interdependent world facing a prolonged global financial crisis whereby governments are working collectively in implementing more regulation across all sectors (banking, insurance, fund management, etc.) in an effort to correct real or perceived improprieties, reduce fiscal deficits and reduce the perceived burden on the consumer.

In this context, as infrastructure is an evolving asset class, various stakeholders are still trying to understand its meaning. Yet there is presently no unified platform representing the infrastructure industry. Therefore, there continues to be a misunderstanding of this business model, which is creating further problems between governments and investors. These implications are now being felt in Europe and could shortly move to other regions.

‘Zhivago Syndrome’

Accordingly, the recent proposed or imposed regulatory decisions appear to imply that the existing social contract between regulators and regulated entities can no longer be taken for granted.

Governments (at least more developed governments) and their respective regulators have always been expected to uphold their prior decisions, many of which are codified in laws, and signal in advance to all parties their intent to change regulation to all interested parties. Concepts of “stranded assets” and “transition charges” ensured recovery of investment made under old regimes as the rules changed, with a view that such treatment was essential to continue to attract long-term capital for essential services.

It is a fact that both developed and developing governments are expected to continue to struggle for some time to shore up their fiscal deficits and minimise the impact of austerity on their citizens. In such an environment, it is no longer unreasonable or unthinkable to assume that the regulatory changes described above will continue, and in fact could provide impetus for further contagion in other sectors in these and other countries.

Many argue that investors will cease their investments in those countries that have breached this social contract and regulators across the world will take note and cease such actions in the future (the concept of checks and balances). Historically, however, this has not been the case. In May 1997, the newly elected UK Labour party imposed a windfall profit tax on all privatised utilities to support a welfare-to-work programme and capital investment for schools. This tax raised some £5 billion. Interestingly enough, other investors started to invest back into this sector circa a year after this decision.

A more current example is Spain, whereby a year after the country made its first retroactive change to solar photovoltaic (PV), several investment funds and direct investors made investments in 2011 into offshore wind, thermal solar and even PV. With further regulatory changes in Spain during 2012 and 2013, it remains to be seen when the next round of investments will begin.

Given this predilection of the investment community to reinvest after a regulatory shakeout, regulators may remain undeterred in imposing such sanctions as necessary. Moreover, as the public continues to feel squeezed, they too will have no issue in seeing those service providers being heavily taxed for services that many consider they should not be paying for.

Hopefully, investors will not be overwhelmed by this potential crisis which, for the lack of any appropriate terminology, we shall define as the “Zhivago Syndrome” (in honour of Boris Pasternak’s classic novel Dr. Zhivago) – whereby regulators act capriciously and without any compunction in materially altering existing regulation, which may incorporate windfall or retroactive taxes; and, with respect to new regulatory regimes, restructuring models in a way that creates significant value-destruction for existing investors.

One should also highlight that the infrastructure industry consists of financial institutions, often owned by foreign investors. Similar to the history of the IPP industry, these institutions are now becoming targets for governments, which enable them to diversify the pain. One need not look any further than the UK and the November 2012 article in The Observer on Simon Hughes, Deputy Leader of the Liberal Democratic party, whereby it said: “What he discovered was a system that he believes is letting down customers and the taxman and one that appears to be repeated across the UK, where 76 percent of water companies are owned by private equity firms.”

Looking in retrospect, the UK’s Office of Fair Trading December 2010 study on Infrastructure Ownership and Control Stock Take is starting to take on some sinister connotations. Similar comments relating to various infrastructure sectors are being held in other countries as well.

The most effective way to stave off these material regulatory changes is to work collectively as an infrastructure industry association (which has yet to be formalised) to define its important role in building, maintaining and upgrading global infrastructure. It also needs to clearly communicate to all stakeholders the pitfalls of regulatory uncertainty including delayed capital investment during times of need as well as value destruction to pensioners and other citizens’ retirement funds.

Moreover, the infrastructure industry needs to develop and/or strengthen existing bi-lateral agreements (such as the Energy Charter) with governments for the establishment of a legally binding multilateral instrument that ensures investment in infrastructure while protecting those respective investors. Finally, the infrastructure industry needs to work with respective industry associations (e.g., electric, gas and water) to present coherent arguments against such proposals to politicians, regulators and the public.


The recent proposed and imposed regulatory changes in Europe suggest a trend of ongoing changes in Europe – and perhaps other regions and other sectors as well. Underpinning this is the financial crisis, concerns over the consumer and a new relationship between investors and regulators. All of which point to a more uncertain market with lower returns that are presently affecting both investor appetite and the method by which institutional investors commit capital. Investors and fund managers need to carefully assess their existing portfolio of core assets and examine the potential long-term implications to this sector.

In parallel, infrastructure investors are also well advised to engage as an industry, not individually, to protect their investments and to communicate to the public and politicians the pitfalls of regulatory uncertainty. The infrastructure industry needs to develop and/or strengthen existing bi-lateral agreements with governments for the establishment of legally binding multilateral instruments that ensures investment in infrastructure while protecting investors. If not, infrastructure investors could be repeatedly plagued with ‘Zhivago Syndrome’ over time.

*Jeffrey Altman is a senior international infrastructure executive with 20+ years’ experience of the energy and infrastructure sectors

Recent examples of regulatory change

The Spanish government has made several energy-related regulatory changes. In September 2010, it limited the solar PV tariff to 25 years from the full project life of the original. This was followed in December 2010 by both a permanent limit on hours that PV projects could claim the tariff, and another even lower limit for 2012 to 2013, the equivalent of a 22 percent cut for existing projects.

Next, in December 2012, the Spanish government imposed a 7 percent tax on gross revenues on all electricity producers and imposed extra technical requirements on Concentrating Solar Power (CSP) projects.

Finally, in February 2013, Spain changed both the inflation index and computation methodology for renewables, decreeing no inflation increase for 2013 and a 50 percent reduction thereafter. It also eliminated the “market price plus premium option”, leaving renewables only a lower, fixed tariff.

The 2010 changes were upheld by Spanish courts, but foreign investors are challenging them in arbitration under the Energy Charter Treaty. Investors are reviewing grounds for legal challenge for the most recent changes.

Czech Republic
In November 2010, the Czech Parliament approved a 26 percent to 28 percent retroactive tax on gross revenues (depending on the type of project) on solar PV assets that were commissioned from 2009. In May 2012 The Constitutional Court upheld the tax.

Italy converted into law in September 2011 an additional 6.5 percent corporate tax on all energy producers, including renewables.

In September 2012, Bulgaria implemented a retroactive gross revenues tax up to 39 percent for solar PV operators. Investors are currently challenging the tax.

Ofwat’s October 2012 consultation proposed regulatory changes that would have included removing approximately 40 percent of water companies’ total revenues from the regulated established price control framework.

Industry negotiations with Ofwat succeeded in blocking this change; however uncertainty remains as to what will be decided in the 2014 regulatory determination and thereafter. One should also not forget the verbal tirade about the UK water industry by Simon Hughes, Deputy Leader of the Liberal Democratic party, in The Observer in November 2012 in which he referred to “one of the worst cases of widespread corporate misbehaviour that has been exposed so far.”

Hughes accused the UK water sector of questionable tax practices, arguing that “as a result of massive borrowing, we have seen taxable profits drop dramatically in companies that have been taken over by private equity funds. Often these loans have been used to pay off investors through complex debt arrangements routed through one or more offshore jurisdictions”.

In November 2012, as part of its austerity measures, Greece imposed a 30 percent retroactive tax on solar PV in November 2012. Investors are currently challenging the tax.

The Norwegian Minister of Petroleum and Energy came out in January 2013 with a proposal to reduce the tariff rate for Gassled’s transportation contracts up to 90 percent and starting no earlier than 2017. This proposal comes approximately 1.5 years after a consortium of infrastructure investors acquired a 24.1 percent stake in the Gassled network asset for $3.25 billion.

At the federal level, in January 2013, German Environmental Minister Peter Altmaier proposed freezing the cost of renewable energy subsidies until the end of 2014 by limiting or reducing the subsidies for new plants, and by retroactively reducing feed-in tariffs for existing projects by 1.5 percent for the year 2014.

Another political party, the FDP, is proposing even more stringent measures. In February 2013, the elimination of a feed-in-tariff element (liquid manure bonus) was suggested with regards to existing and future biogas projects, a sector which has already gone through various material regulatory changes. Conversely, the situation with regard to offshore wind projects was significantly improved. However, consumers have to take most of the risk of delays in grid connection.

At state level, The Land of Berlin has been in discussions with Veolia Wasser with respect to their share of Berliner Wasser Betriebe (BWB), which they have held jointly with RWE since partial privatization in 1998 (Veolia and RWE held 49.9 percent plus an additional vote at board level for a controlling stake and certain investor protections). Recently, The Land of Berlin has acquired RWE’s shares and in parallel has gone to the Federal Cartel Office to reduce BWB’s tariff rates. Veolia now holds a minority ownership and the future relationship between The Land of Berlin and Veolia Water is under discussion.

Regarding gas and power distribution grids, there have been various regulatory changes over recent years such as the introduction of tariff benchmarking, the redefinition of terminal values at the end of concession agreements and changes to regulatory returns.

Although the above examples relate to Europe, one should not assume that similar situations have not, or will not, occur elsewhere. Asia, Africa and Latin America have had numerous examples of windfall profit taxes, massively reduced tariff rates or even the unthinkable – expropriation.

In December 2012, Marsh & McLennan issued a report highlighting emerging market risk for infrastructure.

It would be remiss not to mention that although North America, particularly the US, has not materially altered regulations (other than nuclear and the Californian wholesale and retail markets), it has nonetheless identified national security issues whereby investors have had to sell their investments.

The most notable cases were Dubai Ports World, which had to sell port investments in 2005 to 2006; and Rolls Corporation, a Chinese wind park developer which was forced to divest certain assets in Oregon in September 2012 because they were too near a US naval facility.