Can the UK Infrastructure Bank unleash the power of private capital?

Now that the details have emerged on the remit and tools available to the UK Infrastructure Bank, meaningful engagement with industry should be the priority, argues Darryl Murphy.

Can the UK Infrastructure Bank unleash the power of private capital?

The long-awaited details of how the UK Infrastructure Bank (UKIB) will work in practice were finally revealed in Chancellor Rishi Sunak’s Budget on March 3.1 Beyond announcing the location of the bank will be in Leeds (not Darlington, alongside the proposed Treasury campus), there was clear intent for the UKIB to “crowd in capital”, provide “additionality” and “bridge the gap in the market”.

The positive tone will be welcomed by the industry, including institutional investors; but we must quickly move beyond rhetoric toward meaningful engagement on how the UKIB can help unblock latent private capital to deliver the government’s objectives for infrastructure investment.  

UKIB: Levelling the playing field?

The UKIB is expected to play a key part in meeting two critical objectives for the government; achieving net zero emissions by 2050 and levelling-up growth and opportunities across the country through regional investment.

It will support private infrastructure projects in sectors such as clean energy, transport, digital, water and waste. Carbon capture usage and storage (CCUS) is explicitly mentioned, which aligns with the current work within the Department for Business, Energy & Industrial Strategy (BEIS) to develop commercial models for the sector. This provides a clear message of political support.

The UKIB will develop a mix of financial tools to achieve its objectives, including equity, loans and state guarantees. It will also provide advisory support to sponsors and local authorities, although it is not clear whether this service will be provided on commercial terms.

The bank will launch in the spring with a financial capacity of £22 billion, comprising £12 billion in capital (£5 billion of equity from the government and up to £7 billion of debt from the market, which will count towards public sector borrowing) and £10 billion in government guarantees.

The Treasury has already stated £8 billion will be allocated to private sector projects

Of the £12 billion in capital, the Treasury has already stated £4 billion should be set aside for local authority lending, with the remaining £8 billion allocated to private sector projects. Public sector lending will be available from the summer at a pre-defined rate of Gilts + 60 basis points. At these rates, one would assume the bank is not seeking to crowd in private investment on similar terms; in effect, the UKIB will take the role of the current Public Works Loan Board.

The creation of the UKIB stems from concerns initially raised by the National Infrastructure Commission concerning the loss of the European Investment Bank from the UK infrastructure investment market. It is critical to note that the power of the EIB was not primarily as a source of liquidity, but it provided below-market pricing for deals given its unique position of being to act outside of State Aid constraints.

One of the key statements in the Policy Design document relates to project pricing and the need to “reflect the level of risk involved in the investment and ensure compliance with the domestic subsidy control rules and the UK’s international obligations”. More detail will be eagerly awaited; experience from the Green Investment Bank showed European State Aid rules were a constraint on activity for a national state bank. It is also worth noting the previous experience of incubating a Green Investment Bank for the private sector to subsequently acquire will not be repeated. The document states a policy to create a bank that will be a “enduring feature of our institutional landscape”.

Will the UKIB replace or supplement existing tools?

Other details need to emerge in the coming months, not least on how the finance function in the Infrastructure and Projects Authority (IPA) fits into the UKIB. Currently, the IPA is responsible for the administration of the UK Guarantee Scheme (UKGS) and the privately managed co-investments into digital and electric vehicle-charging equity funds. Since the global financial crisis, the government has developed a series of financial tools to supplement the capital available in the infrastructure sector.

The UKGS can issue up to £40 billion of guarantees and is open until at least 2026

The UKGS offers government-backed guarantees to help infrastructure projects access debt finance where they have been unable to access it in the capital markets. Set up in 2012, the UKGS can issue up to £40 billion of guarantees and is open until at least 2026. There is no clarity in the current policy document whether this will cease and be replaced by the £10 billion of government guarantees available to the UKIB. For the reporting period to March 2020, the UKGS had issued around £1.4 billion of outstanding guarantees. This is not seen as a failure of the scheme but more a recognition of the liquidity in the debt market, which is arguably greater than ever.

The scheme guarantees the principal and interest payments on infrastructure debt issued by the borrower to banks or investors, representing “credit substitution”. All guarantees are issued on a commercial basis with all-in pricing required to be at the equivalent market price. While a guarantee is an effective product for the government as it represents a contingent liability, it attracts very different institutional investors who, in effect, achieve a small premium over Gilt yields compared to equivalent market rates for the underlying credit risk.

Will the UKIB be the solution for early-stage development capital?

The UKIB will offer four financial products alongside advice; senior debt, hybrid products such as mezzanine loans or first-loss credit products, guarantees and equity. We know little about the potential balance of commitments across these products; the only detail on equity, for example, is for it to address “construction risk or to assist in crowding in other investors”.

The main area of market failure is in early-stage development of new technologies or business models

One message we have consistently delivered to the government is that the main area of market failure is in early-stage development of new technologies or business models. The policy document does not provide direct comfort whether early-stage equity capital that is explicitly designed to be recycled is within its remit.

Hopefully, assurances on this will follow soon. The UKIB should look to provide additional support using early-stage development capital to ‘pump prime’ key policy priorities in new technologies. The objective would be to use this capital to develop new technologies or assets, which can be recycled at an early stage when the project can ‘crowd in’ capital from private sources.

The UKIB is being positioned as a public sector bank, not an infrastructure fund. This implies the government sees a greater gap in debt than equity, which is not a feature readily observed in the UK market today. The focus of the bank will ultimately be heavily influenced by the leadership and staffing in terms of the level of debt or equity investment experience.

Can the UKIB address the market failure?

The UK infrastructure debt market is awash with liquidity. Commercial banks, insurers and pension schemes all have strong appetite for infrastructure debt. Liquidity would appear to be even greater than pre-COVID-19, making the market very attractive for equity sponsors.

Analysis of data from Infrastructure Journal suggests there were around £20 billion of infrastructure debt transactions in the UK last year. While this seems relatively healthy taken at face value, a small number of large deals represented the bulk of the total, including KKR raising around £2.5 billion for the acquisition of Viridor and the sponsors on the Dogger Bank Offshore Wind Farm raising around £5 billion.

Many investors, including Aviva Investors, are concerned about the lack of investment opportunities. This is especially acute for institutional insurance investors subject to Solvency II requirements. In the absence of significant changes to Matching Adjustment requirements, a large volume of potential capital well aligned to the long-term nature of net zero-related infrastructure will not be available. It is, therefore, critical to understand whether and how the UKIB can help to mobilise this capital.

There are few examples of commercially viable new assets that are unable to attract private sector capital

Right now, there are few examples of commercially viable new assets that are unable to attract private sector capital. Assets only struggle to raise capital for clear reasons associated with the underlying commercial risk, although this position may change over time as the UK accelerates new technologies and policies to support the pathway to net zero.

The bank will need to work carefully through each sub-sector to understand the precise financing challenges and determine its risk appetite for new technologies or commercial models. There are many examples of the challenges ahead; the appetite for long-term subsidy-free renewable projects, early-stage technologies in the waste-to-sustainable-aviation-fuel sector, early-stage projects relating to the hydrogen economy and the development of small modular nuclear reactors.

Crowding-in private capital for such projects will not be straightforward and require carefully designed financial structuring. The government will also need to determine how it seeks to balance the use of the UKIB with other policy levers to make new sectors financeable. A good example is in CCUS. BEIS is currently designing a commercial framework involving the adaptation of the successful contract-for-difference and regulated asset base models, which can help transform a new sector into one that is readily investable by the private sector.

Working together

In the meantime, the bank will commence operations in an interim form this spring, followed by finalisation of its organisational design. In the policy design report, there was a noticeable emphasis on the bank building relationships and the development of business tools and mechanisms to support market engagement.

Emphasis on the bank developing business tools and mechanisms to support market engagement

Again, such an approach would be welcomed by the industry. Only by providing an effective, open and transparent conduit to the financing and investment market will the UKIB be able to deliver on its stated objectives to work alongside the private sector and unleash the billions of capital waiting to be deployed.

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