As well as its profound human impact, COVID-19 is having a marked effect on asset prices and transaction activity in all areas of financial markets. But beyond the short-term uncertainty, UK infrastructure stakeholders are looking for clues as to how the crisis could influence the market’s longer-term prospects.
7 minute read
During a major crisis, policy announcements can very quickly be superseded by other events; requiring a raft of supplementary measures to tackle the issue. So, it is proving with COVID-19. The sheer complexity of the health risk, while simultaneously trying to figure out the scope and scale of the economic and market response that will ultimately be needed, is a major ask for even the most seasoned of policymakers to wrap their heads around. Both tasks are made more problematic by the lack of certainty over how long the crisis will last.
Just a few weeks ago, on 11 March, UK chancellor Rishi Sunak stood up to announce what most commentators agreed was a wide-ranging budget, including more than £600 billion of investment into UK infrastructure over the next five years. The budget also included £30 billion of measures to target the impact of the coronavirus on UK businesses and the economy.
The Bank of England has slashed interest rates to a new historic low of 0.1 per cent
However, as it has become apparent that things are set to get worse before they get better in terms of the human and economic costs, an additional £320 billion of measures have been announced to support the economy. Meanwhile, the Bank of England has turned to its tried and tested approach; slashing interest rates, to a new historic low of 0.1 per cent, and committing to purchasing an additional £200 billion of UK gilts and corporate bonds. It seems unlikely the policy response will stop there.
Frozen in time
With concerns over Brexit pushed to the side for the time being, the UK faces a very different outlook. Like its counterparts across the globe, the government is effectively attempting to ‘freeze’ economic activity for as long as it takes to overcome the health crisis, with the hope the economy will quickly recover once that battle is won.
The impact is being felt by every individual first and foremost
Few who witnessed first-hand the global financial crisis (GFC) would have thought they would experience another event that could have such a devastating impact to people, the economy and financial markets. The key difference with COVID-19, however, is that the impact is being felt by every individual first and foremost, before subsequently filtering through to impact the economy and markets. In contrast, the GFC hit financial institutions first, then propagated to government finances, and ultimately the public as countries moved to a prolonged period of austerity.
The post-GFC austerity measures significantly reduced investment into UK infrastructure, but as the recent budget highlighted, that trend was finally being reversed by the current government. The question is whether the UK’s precarious economic position will give further impetus to a more Keynesian approach to infrastructure investment, or whether the scale of financial support needed elsewhere in the economy will cause the government to rethink its infrastructure commitments.
A true test of infrastructure’s resilience
But before we speculate on the future, it is worth assessing the immediate impact of COVID-19 on infrastructure assets. While the attention of many people is on the massive price swings in public markets, the defensive nature of infrastructure is being tested as never before: some assets are experiencing stress beyond what we saw during the GFC, especially those tied to the transport sector.
The main short-term issues facing infrastructure investors are listed below.
An immediate impact is being felt at airports, where the dramatic decline in passenger numbers is leading to financial stress on major airlines. While government support could be implemented, especially for national airlines, airport owners are having to manage the current loss in activity and are already cutting costs.
Toll roads will face a sizeable short-term hit, along with ferry companies and motorway service stations
The early indications from European operators suggest toll roads will also face a sizeable short-term hit, along with ferry companies and motorway service stations, many of which are owned by institutional investors. Ports tend to lag any global GDP shock: on the one hand they will be adversely affected by the decline in global trade; but this may be partially offset by the recovery in economic activity in China.
At the moment, however, it is simply too early to assess the full impact to GDP/demand-based assets – or whether we will see a U, V or L-shaped impact to the economy – when there is so much uncertainty over how long the health crisis will last. Nevertheless, as with any restructuring situation, investors need to assess whether liquidity exists for any given asset and the extent to which sponsors may have to support a sharp loss of income.
Liquidity will be key to prevent any payment defaults or debt restructurings
The robustness of debt structures will also be tested. While a sudden and steep reduction in revenue may result in technical defaults, liquidity will be key to prevent any payment defaults or debt restructurings. A few sponsors are being proactive and engaging with lenders early and acting quickly to assess how to manage any income shortfall. However, this approach is not widespread. Given the delicate nature, lenders need to act reasonably and work with borrowers to ride through the current situation.
COVID-19 is a human crisis, which brings a dimension the infrastructure sector has little experience of. The disruption to overseas supply chains is already evident, along with a more direct impact on the availability of labour for assets in construction or that are already operational. Contractors are trying to manage through this but at some stage, activity – already slowing down – could cease completely.
As delays to construction contracts become more common, the market will pay even closer attention than usual to the issue of force majeure
This could lead to construction delays and, for assets already in operation, to reduced performance if plants cannot be managed. There is limited evidence of this currently, but it could become a critical issue if the infection rate continues to increase or if the government is forced to take even stronger measures. As delays to construction contracts become more common, the market will pay even closer attention than usual to the issue of force majeure.
Changes to services
Although social infrastructure PPP/PFI projects are not subject to demand risk, they are exposed to severe pressures on public services. Schools are effectively closed for most pupils, but facilities management services need to continue. More critically, the strain on the health system is being felt from acute hospitals through to primary care centres. It will be critical for sponsors, lenders and the public sector to work together to ensure these facilities continue to fully operate and, where necessary, offer increased services.
Counterparty credit risk
As we saw in the aftermath of the GFC, governments across Europe may experience stress on their credit ratings and possible ratings downgrades due to the costs of dealing with COVID-19. Sub-sovereign institutions may test the assumed implicit support from central government, such as Transport for London as passenger revenues fall. Companies may also become stressed as offtakers to contracts in the transport and energy sectors.
Resilience in challenging times
The risks mentioned above have been focused on transport and social infrastructure. However, some sectors within infrastructure have been relatively unaffected by the immediate impact of COVID-19; including power, utilities and digital. This serves as a reminder of their resilience in times of economic stress, but also to infrastructure’s critical role to the economy and society. While this period of self-isolation is difficult for individuals and businesses, it would be worse without the ready provision of light, heat, water and digital services.
Renewable energy assets will feel the impact of lower power prices caused by the economic contraction and falling oil and gas prices
For investors, although renewable energy assets have not suffered the liquidity issues experienced in transport, they will feel the impact of lower power prices caused by the economic contraction and falling oil and gas prices. We saw evidence of this in late 2019, but that trend is set to continue as analysts produce new – and inevitably lower – short-term estimates. This may reduce the valuation of assets in the short term, but over a much longer time horizon the expectation continues to be one of increasing power prices. This means there should still be value for long-term investors.
Even though investors’ primary focus is on the impact to their portfolios, transaction activity has continued, as highlighted by KKR’s £4.2 billion acquisition of Viridor (a recycling, renewable energy and waste management company) from Pennon. However, deals will become increasingly difficult to execute the longer the crisis goes on. Liquid markets are incredibly volatile, with public bond markets seeing massive spread movements. This will make it extremely difficult to price infrastructure debt transactions where those bond markets are used as a reference.
In the meantime, the commercial bank lending market seems to have been resilient so far. However, as we saw during the GFC, this could change quickly as bank funding costs increase, corporate facilities are fully drawn, and capital becomes scarce. Central banks have already indicated their willingness to increase bond purchase programmes and cut rates as far as possible to prevent a possible credit crunch, but that risk remains real.
For deals in the pipeline, there are three strategies emerging:
- Continue to try and close deals that are approved at pricing agreed prior to the escalation in the crisis. Despite the obvious questions over such an approach, such activity is still observable.
- Continue to work on deals from a credit perspective and leave pricing to one side until the market settles.
- Put deals on pause for the foreseeable future.
Whatever the approach, 2020 deal flow will inevitably decline. In 2008, the UK government launched the UK Guarantee Scheme to support transactions in the pipeline, many of which were publicly procured PFI/PPP deals. Today, the vast majority of deals are private-to-private refinancings or M&A situations. As such, there will be a limited case for government to intervene in the same way.
While too early to assess the longer-term impact of COVID-19 on infrastructure, institutional investors still have capital to deploy. If the past is any guide, infrastructure for the most part should be able to demonstrate its defensive characteristics relative to other asset classes. Infrastructure remains critical to the UK economy as it is to all countries globally, which should be supportive of private investment.
Nevertheless, although the economy will hopefully recover relatively quickly, this may require massive public sector borrowing – the question is where this will be directed and whether previous decisions on its infrastructure commitments need to be reconsidered.
The government will soon need to set out its pathway to net zero by 2050
This crisis has taken hold just as the government was due to provide details on investment within the anticipated National Infrastructure Strategy, the summary of the Infrastructure Finance Review and the Energy White Paper. While the focus is understandably on other matters right now, climate change cannot be forgotten: the government will soon need to set out its pathway to net zero by 2050. Decisions may be deferred until later in the year and may even need to be amended to reflect post COVID-19 conditions, but details need to emerge sooner rather than later. This is likely to make decisions around financial support for new technologies in the transition to low-carbon energy even more critical.
The government will also face demands for investment in roads and railways, especially in northern England, and its previously stated investment plans for the NHS will surely increase as due to the current crisis. Whether private investment previously dismissed for these sectors will be reconsidered as a result of pressure on public finances will be a key policy decision.
The budget provided clear guidance that private finance is needed to support the energy transition and to enhance digital infrastructure
For infrastructure investors, the budget provided clear guidance that private finance is needed to support the energy transition and to enhance digital infrastructure. Nothing that happens over the coming months is likely to change this; indeed, the relationship between the government and private investors needs to become even stronger. Investors remain keen to engage on these areas and help deliver the much-needed investment.
With the efforts to address COVID-19 likely to continue over the coming months, infrastructure investors will need to focus their immediate efforts on managing the risks in their portfolios. As with the GFC, it is likely the current crisis will lead to a reassessment of investment risk, particularly for demand-based assets, along with a greater focus on conservative deal structures, liquidity and probably lower asset pricing. As in the past, lessons will need to be learned quickly in order to support the case for long-term investment by institutional investors.