Darryl Murphy assesses the current state of the UK infrastructure market and the likely drivers of activity in 2021.
We will not forget 2020 in a hurry. In time, it may be looked back on as a pivotal period when profound changes in society took hold; affecting the kinds of infrastructure required to deliver public services. The way we work, live and travel for business or pleasure – as well as our use of technology – could be radically altered.
Infrastructure investment to stimulate the recovery and the pathway to a lower-carbon future are likely to impact the UK market over the next 12 months
It is too early to predict how these trends will shape the infrastructure sector in the long term. But two significant drivers are likely to have a more immediate impact on the UK market over the next 12 months. The first is infrastructure investment as a means to stimulate the post-COVID economy. The second is the pathway to a lower-carbon future, after the UK became the first country to legislate to reduce carbon emissions to net zero by 20501.
Infrastructure in 2020
Before we look ahead, it is worth reflecting on the performance of the sector in 2020. It seemed the year had only just got going when the full impact of COVID-19 was felt. Overall, infrastructure fared reasonably well, demonstrating the resilient characteristics investors expected. But there was also divergence. Demand-based transport projects were acutely affected; airports, toll roads and ferries are still trying to navigate through what is likely to be a long, slow recovery.
The low interest-rate environment helped underpin refinancing activity
Although most investors focused on portfolio management through the initial lockdown period, market activity persisted. Some deals already in process pre-lockdown continued and a few new processes started during the summer. Macro fundamentals were still supportive of activity, with renewables and fibre broadband remaining active. The low interest-rate environment helped underpin refinancing activity; even primary financings occurred for some new assets.
However, the post-summer period did not quite deliver the expected increase in deal flow and some processes moved slower than anticipated, most likely because of the challenges presented by the virtual work environment. Many sponsors decided to push deals into the 2021.
Nevertheless, activity in 2020 was surprisingly strong, with over £18 billion2 of debt transactions closed, although this was down from £30 billion in 2019. Four mega deals accounted for £10.5 billion of the total: the financing of the offshore windfarm Dogger Bank, the acquisition of waste company Viridor by KKR, the financing of the Seagreen Offshore Windfarm and the refinancing of Calisen in the smart meter sector.
While the number of deals was significantly down year-on-year, we still saw a broad range of projects, with large transactions in fibre, greenfield waste-to-energy, renewable assets, smart meters, datacentres and social housing, along with two offshore transmission owner (OFTO) transactions. Also of note was the close of the A465 road deal, the first Welsh mutual investment model (MIM) public-private partnership (PPP) transaction, although it could be many years before we see a similar transport deal of this nature again in the UK given the government’s decision to retire the PPP model.
Infrastructure investors need to react to a continuously changing market
The year also highlighted that infrastructure investors need to react to a continuously changing market, where repeatable pipeline transactions are no longer available outside of OFTOs. Liquidity remains strong; the bigger question is whether supply can match demand.
Some large transactions have carried their way through 2020 and may complete in early 2021. The sales process of Wheelabrator in the waste sector has been known to the market since late 2019 but the deal should close in 2021, with the possibility of a relatively large-scale debt refinancing of its assets. The proposed refinancing of other assets, such as Thameslink and a few other PPP deals, may also re-emerge, especially given interest rates look set to remain at historically low levels and with credit spreads generally tightening back to where they were pre-COVID.
Beyond legacy deals from 2020, we see five key themes that are likely to shape the infrastructure market in 2021.
1. Recovery from COVID-19
The government has been clear it sees infrastructure as a key part of the post-COVID economic recovery plan. The Prime Minister made several speeches in 2020 supporting infrastructure investment, along with the announcement of a ten-point plan for a green industrial revolution3.
At the end of the year, the long-awaited National Infrastructure Strategy (NIS) was unveiled4. The NIS was well-received and sets out an ambitious vision, but the devil will be in the detail on how the strategy is delivered. As many businesses and sports teams have learned, a strategy is worthless unless it can be executed.
The National Infrastructure Strategy signposts a long list of sector strategies that will be issued throughout 2021
The NIS signposts a long list of sector strategies that will be issued throughout 2021, as well as the release of the Energy White Paper in December, which sets out the government’s energy policy. One theme that is very clear from the NIS is the overt support for private capital to meet the vision; this is a welcome message after the negative feeling towards private infrastructure investment that was apparent among some politicians prior to the 2019 election.
For investors, a number of portfolio assets in the transport sector will continue to present challenges, although the rollout of a vaccine will hopefully lead to a resumption of business and leisure travel in the UK and overseas. The forecast for airports suggests a long, slow path to recovery.
Looking further into 2021, the start of an economic recovery should provide a level of confidence across the transport sector. At that point, companies may start to look closely at their assets’ balance sheets, which may result in some refinancing opportunities and even opportunistic sales processes for investors willing to take a longer-term view on the value of these assets.
2. Birth of the NIB
The NIS included the long-awaited formal announcement of the National Infrastructure Bank (NIB). More detail on the project is expected in the spring, including the precise location of the Bank and how it will be resourced. Private infrastructure investors eagerly await more information on the mandate of an institution that may have a wide array of products at its disposal; from loans to guarantees to equity stakes. It will be important for the government to demonstrate the NIB is truly aligned to the crowding-in of private sector capital.
The National Infrastructure Bank will be focused on rallying the investment required to meet the government’s net zero target
It is clear the NIB will be focused on rallying the investment required to meet the government’s net zero target. It may serve an important role in opening up new technologies by providing much-needed early stage development capital. Post-Brexit, the most important challenge for the NIB will be to navigate the state aid rules that historically stifled similar investments from the Green Investment Bank and the wider use of the UK Guarantee Scheme.
3. Net zero gets real
In some ways, 2021 will feel like a rewind to the start of 2020. The vast investment required to meet the UK’s legally binding target of net zero carbon emissions by 2050 begins in earnest in 2021. The recent Energy White Paper will be accompanied by a raft of strategies through the year, including initiatives focused on hydrogen, heat and buildings strategy, electric vehicle (EV) charging strategy and many more. These will be important milestones as we head towards COP 26 in Glasgow, which will be staged one year later than scheduled in November 20215.
Nascent technologies will generate interest, but investment opportunities will remain limited
For investors, many nascent technologies will continue to generate interest, but actual investment opportunities will remain limited in a number of new sectors such as: EV charging, hydrogen, carbon capture, utilisation and storage, and battery storage. We may also see nuclear re-emerge with a regulatory asset base (RAB) model, which will require private investment. The key to the success of many of these projects will be how the NIB combines with government policy to encourage private capital.
Mainstream renewables will also return to the spotlight through the fourth Contracts for Difference (CfD) auction, which promises to trigger a renaissance in the solar and onshore wind sectors, along with more capacity in offshore wind6. The target of 12 gigawatts of generation could lead to a large amount of investment opportunities, albeit in 2022 (as the CfD auction will happen late in 2021).
4. Fibre 2.0
The hottest sector of 2020 was fibre-to-the-home, with several corporate sale processes taking place throughout the year, along with debt raising. Appetite for the sector among infrastructure funds remains high.
Appetite for the fibre sector among infrastructure funds remains high
Many fibre infrastructure providers continue the rollout of their business plans, but substantive activity could emerge in the form of consolidation and larger-scale financings for more mature businesses. The government target of 85 per cent gigabit-capable coverage across the UK by 2025 – as set out in the NIS – should help to stimulate greater investment. The sector shows no sign of slowing down in 2021.
5. Regulation to competition
The NIS promises an overarching policy paper on economic regulation in 2021, which will look at whether regulatory models need some adjustment to adapt to the changing needs in the regulated utility sector – not least their role in the pathway to net zero.
We are also beginning to see the emergence of the first Direct Procurement for Customers regime in the water sector, with the first scheme, Haweswater Aqueduct for United Utilities, entering the bidding phase in 2021. It will be interesting to see how this model develops as a hybrid between a corporate PPP with a water company and an extension of financing for a water company outside of the RAB model.
The NIS will look at whether regulatory models need to adapt to the changing needs in the regulated utility sector
The Early Stage Competition plan for onshore transmission (previously known as CATOs) has now entered its Phase 3 consultation. The model proposes a move to competitively procured models for discrete parts of the network, although the first transactions may not emerge into live competition until 2023. These examples illustrate regulators’ ongoing desire for greater contestability within existing regulatory models.
The more mature OFTO process will continue into 2021, with the expected financial close of Hornsea, the selection of preferred bidder on East Anglia and the commencement of the next round of bidding for two more assets.
We are also likely to see the first project-financed interconnector project in 2021, supported by the Ofgem Cap and Floor mechanism.
As society emerges from the pandemic in 2021, investment into infrastructure will play a key role in the economic recovery. The sector enjoys the strong support of government; but while that is positive, private infrastructure investors will need to remain agile and selective if they are to find the right opportunities to meet their risk and return profiles.