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After a year in which infra debt issuance remained strong despite a challenging backdrop, Darryl Murphy identifies the themes that could drive the market in 2018.
While some investors may decry a perceived lack of opportunities in UK infrastructure debt, 2017 should be viewed as a year when the market exceeded expectations; particularly given the uncertain economic outlook.
The volume of debt issued in the UK had reached around £20bn in the year to December 1, maintaining its historical level, and representing around a third of the value of the overall European infra debt issuance. The number of infrastructure assets in private sector hands is both significant and encouraging, with 2017 seeing a series of large acquisitions and refinancings; including National Grid Gas Distribution, a range of airports, HS1, Moto Services and the M6 toll road.
Less positively, a lack of large scale greenfield investment was evident, other than the institutional financings of the mega-offshore wind Walney Extension project in the Irish Sea and South Western Railway rolling stock.
So what can we expect to see in 2018? Here we pick out emerging trends we believe will characterise the infra debt market over the coming year.
Falling back in love with public-private partnerships
The market continues to hope the UK government will give Private Finance 2 another chance. However, after a year waiting for a promised pipeline, the likelihood is that we will not see any immediate transactions but a much slower renaissance.
While the government has decided to progress the widening of the A303 road in the south west of England and new Lower Thames Crossing through Thurrock as private finance projects, the forecast financial close timings of 2021/22 are sobering. Alongside these transport schemes, other possible projects include prisons, primary health care (in the aptly named Project Phoenix), acute hospitals, defence estate rationalisation and schools. However, it seems reasonable to assume none of these transactions will close until 2019 or 2020.
The one project in procurement, Silvertown Tunnel - a new road tunnel planned for East London underneath the Thames - looks set to be delayed into 2019, although it will provide some evidence of how robust appetite is for greenfield construction risk. We should also see the Welsh Government progress Velindre Hospital and the widening of the A465, although the main concern in Wales seems to be the lack of contractor interest given the weak appetite of the UK construction industry for PPP projects.
All aboard for the rail sector
One area that continues to promise much is the rail sector. Aside from further rolling stock deals associated with the Wales & Borders and South East franchises, Network Rail seems set to return to the market with its divestment programme and a willingness to embrace potential PPP-type models for capital investment. Recent announcements regarding infrastructure being included in operator franchises possibly opens the door to future private finance opportunities.
Despite the elevated level of UK public sector debt, the concept of using private finance in the form of PPP remains far from supported across government. Therefore, industry needs to win both the public hearts and minds and government ministerial support through showing the positive features and analytical data associated with the past PPP programme.
The price is right for refinancing
In the absence of a greenfield PPP market, much focus will remain on green energy and refinancings. A number of PPP projects that closed between 2010 and 2012 still exist, which provides material refinancing gains to the public sector and sponsors. 2018 may see the largest of these refinancing opportunities come to market, the M25 PPP, along with other acute hospitals. With all-in debt pricing at an historical low, many have started to call the bottom of the market, so now may be a good opportunity to source attractive debt terms.
Energy remains switched on
In the energy space, the lack of greenfield wind and solar projects will mean a focus on a small number of new waste/biomass schemes and the continued growth of offshore wind.
The offshore wind sector is set to remain busy with new financings possible for the jumbo Hornsea project, the world’s largest offshore windfarm in the North Sea, the return of NnG in Scotland after various legal challenges, and the continued equity sale processes that may bring more HoldCo type financings. The possibility of refinancings may also appear with large wind farms set to become operational.
Ofgem remains the only public body with an actual programme of projects through the Offshore Transmission Regime (OFTO). The recent announcement of Transmission Capital as preferred bidder to own and operate the high-voltage transmission link from the UK mainland to the Dudgeon wind farm off the Norfolk coast for the next 20 years may see the public project bond market tested for the first time in many years. It is set to be followed by the larger Race Bank scheme, also located in the North Sea. This may bring some interesting features in what has become an established private debt market.
More disappointingly, the Competitively Appointed Transmission Owner (CATO) concept for onshore transmission seems stuck in the sidings, awaiting legislative capacity from a government that has to prioritise Brexit-related matters. Therefore, a contractual version remains an option; it may look like the Direct Procurement for Customer model being developed by OFWAT – perhaps showing that despite the strengths of the regulated utility model, regulators see the benefit of contestability for large capital projects. Whether any deals emerge and close in the next twelve months is perhaps more debatable.
Interconnectors (transmission cables) to the continent seem set to continue, and we should see the FAB asset come to market. That may be an interesting bellwether of post-Brexit sentiment towards European energy markets. The project, which will consist of high voltage underground cables running between France, the island of Alderney and Great Britain, is intended to meet the need for energy trade between the UK and France with construction due to begin in 2018.
More widely, debate over the impact of electric/autonomous vehicles and energy storage will continue. While it is unlikely to have an impact on the immediate debt financing market, it could give credence to the idea we are slowly transitioning to a new world that will not be driven by financing large capital projects but smaller networks and aggregation of assets.
The next Capacity Market auction early in 2018 may provide some larger opportunities for financing of OCGT/flexible generation opportunities, but the focus is more likely to move to decentralised energy assets. Although the rationale is admirable - it is intended to incentivise investment in more sustainable, low-carbon electricity capacity at least cost - most debt providers will remain interested observers unless there are longer-term revenue mechanisms in place. Without them, the appetite for risk in the merchant energy market will remain limited.
In other energy technologies, a financeable model for nuclear needs to progress, but will continue to look more like a government-government transaction with the involvement of Japan, Korea and China, with little private finance involvement unless under a sovereign guarantee.
The next year may also see a final decision point for tidal energy and the Swansea Bay scheme – potentially the world’s first tidal lagoon power plant. Here, the odds of moving forward have seemingly widened, given the absence of comment on the technology in recent industrial strategy announcements.
Given the challenges to find financeable projects in the energy sector, funders will continue to look at wider opportunities in new asset classes. The move to smart meters needs to pick up pace, which may drive activity. In addition, broadband investment in the telecoms sector may offer opportunities in what has historically been a strong corporate finance market.
High asset prices may continue to drive secondary activity
While large asset sales may have driven activity in 2017, the issue for the debt market is that these deals are typically not foreseeable; hence participants need to react to a shorter horizon.
With the volume of equity capital seeking a home, shareholders are seeking value by trading stakes at the end of life for some closed-end funds. The market will continue to see asset sales that will bring debt opportunities for new investors, many of whom are longer-term investors actively seeking longer term, stable capital structures. This may be combined with debt opportunities at the HoldCo shareholder level or, as we now have learnt, the friendlier sounding MidCo (intermediate holding company) position above the operating company.
In the current market environment, funders will need to remain open to an active and diverse market characterised by small number of greenfield projects, a peak in refinancing opportunities and an active M&A market. In addition, funders will need to scan the full spectrum of infrastructure sectors to find value.
Liquidity remains high and we have seen price tightening in a market that has remained resilient despite heightened political risk. This leads to the conclusion it is a good time to be a borrower, although experience suggests the good times won’t last for ever.
While many practitioners will be confident of finding sufficient opportunities in 2018, one of the biggest items on the wish list is for greater clarity on the government’s infrastructure plans. Investment in infrastructure is not discretionary, especially in a post-Brexit economy. For a market that relies on long-term planning, any political instability is generally negative.
On that note, recent announcements from the Labour Party relating to existing PFI contracts, regulated utilities and rail franchises have certainly grabbed the attention. While wholesale nationalisation may be unlikely, the industry will take an increased interest in Labour policies relating to infrastructure investment and whether a new model could emerge where the public and private sector can work better in partnership.
For the time being, activity will continue to be more focused on the private sector and technological developments that should keep investors active for many years to come.
 Source: Inframation, as at 30 November 2017
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at December 11, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.