The UK government has stated its desire to see more institutional cash going into UK infrastructure. What are the opportunities, and are there enough of them? Jason Holland seeks the case for and against investing at home.
Investing in the UK has historically been relatively secure given the country’s legal framework and the systems that are in place – along with the fact that the government rarely intervenes substantially. So it is perhaps surprising to hear talk of possible government intervention as it aggressively promotes pension fund investment in UK infrastructure.
The reality of the situation is rather different, according to consultant John Ralfe. “It is difficult for the government to force pension schemes to do anything,” he says, noting that it is a matter of law whether “200 years of trust laws” could be overridden. “There would be legal cases for at least five years,” he expects, making intervention “unthinkable”.
Instead, the government must take a “softly, softly” approach, he says, with local government pension schemes ultimately taking the lead.
Ralfe has argued for local government pension funds to consider reducing their overseas investments and instead look for opportunities closer to home, expressing his “genuine surprise” that so much is invested in the US. However, looking at infrastructure specifically, he questions whether there are enough “genuine projects that are sufficiently advanced, where the government has taken on the early risk”.
Although there will be some, he says, and especially small-scale local projects, he is wary of infrastructure “start-up” projects, with HS2 an example. “Pension schemes shouldn’t be interested in holes in the ground,” he says. “What are the mature infrastructure projects?”
Attracting investment
The UK Infrastructure Bank (UKIB), a government-owned policy bank focused on increasing infrastructure investment across the UK, represents one means of possible progress. Seeded with £22bn of financing capacity, UKIB aims to partner with the private sector and local government to increase infrastructure investment in the UK, with objectives of tackling climate change and supporting regional and local economic growth.
“We have a role to play in attracting investment into UK infrastructure projects,” says Ian Brown, UKIB’s head of banking and investments. “Our presence in a deal can help instil confidence with potential investors and we can act as a cornerstone investor in more challenging markets. Through appropriate structuring or the use of our guarantee, we are also able to improve the credit rating of transactions to make them eligible for institutional investment.”
Brown says UKIB’s risk appetite is different to that of commercial institutions “because we are focused on achieving strategic policy objectives as well as delivering a positive financial return”. This enables UKIB “to support sectors to move away from subsidy, scale up existing sectors and support emerging financing markets and nascent technology, whilst continuing to crowd in private finance”.
He adds: “Through our local authority lending and advisory service, we are supporting local authorities, who are at the forefront of driving regional and local economic growth and tackling climate change, through their ambitious infrastructure projects.”
As well as “exciting opportunities” in the transport, digital, water and waste sectors, Brown points to the clean energy sector as a major area of opportunity. “Recently, for example, the bank announced it has committed £50m to the Port of Tyne’s regeneration and expansion plans,” he says. “The bank’s financing will enable regeneration and redevelopment of the land that will provide a base for the growing number of green industries in the area, including offshore wind, which supports the UK’s transition to net zero and long-term energy security ambitions.”
Capital Dynamics, as a renewable energy infrastructure specialist, sees plenty of opportunity in this area, too. “To meet its net zero targets, the UK will need to almost double its renewable energy capacity by the end of this decade, and attract £70bn of funding to do that. That has led the government to commit to a more supportive policy agenda,” says Barney Coles, co-head of clean energy. Renewables Contract for Differences auctions add further positive momentum, he notes.
“These initiatives provide investors with cashflow stability, and there are commitments to upgrades in grid infrastructure that will facilitate a more timely delivery of green generation capacity,” says Coles. While he acknowledges that today there is a relative scarcity of projects, he thinks the future looks positive.
“After the next general election, we expect a relaxing of planning rules to enable renewables projects, given all political parties have signalled their commitment to this,” he explains. “New policies will result in a lot more opportunities.
The UK Infrastructure Bank recently announced it has committed £50m to the Port of Tyne’s regeneration and expansion plans
In addition, many of the world’s largest corporations have operational presence in the UK, and they all want to decarbonise, and therefore are going out and seeking long-term arrangements to buy renewable power directly from renewable energy projects. That depth in the UK is unparalleled. And while there is asset scarcity, those investors with proprietary access to projects are in a very strong position.”
Long-term cashflows
Investment manager Quinbrook expects higher capital allocations from LGPS to UK-focused strategies as a result of the government’s levelling up agenda and post-Brexit inspired focus on ‘home grown’ investments, especially in new infrastructure.
Rosalind Smith-Maxwell, Quinbrook’s senior vice president, comments: “Quinbrook considers that the UK ‘net zero’ transformation offers unprecedented investment opportunities, especially in new infrastructure assets.
“Achieving ‘net zero’ is expected to require substantial investment (£2.7tn of investment to 2035, and £375bn to decarbonise power and grid alone) in the planning, development, construction and commissioning of new infrastructure solutions which in turn have the potential to create and support fair and sustainable jobs, directly benefit local communities, in particular regional communities, drive business stimulus and rapidly decarbonise the UK economy and society. Many of these new investments offer long term cashflows and Quinbrook considers these to be attractive opportunities.”
Smith-Maxwell cites diverse initiatives such as National Grid’s Pathfinder programme, the Contract for Differences programme, and the Capacity Market. “Many new build projects in the UK are able to secure long term revenues with uncapped indexation to CPI from availability and generation services,” she says. “Further, UK power infrastructure assets have diversifier benefits to assets which are strongly correlated to GDP. Together this makes select types of UK infrastructure highly attractive investments even when evaluated in a global context.”
Indeed, Coles thinks that the UK compares extremely favourably with certain established parts of continental Europe. “We consider the Eurozone, the UK and potentially the US as the most mature markets globally for renewables infrastructure. The UK ticks a number of boxes – returns on offer are typically higher than in markets such as Germany and France where there is excessive competition from local institutional capital looking for local investments, and where European base interest rates have historically been a lot lower than in the UK.
“In addition, we believe the risk-return profile for UK renewable investments is more attractive, particularly given the wide availability of ‘pay-as-produced’ power offtake contracts being offered by global organisations operating locally, rather than the inherently more risky ‘baseload volume obligation’ contracts on offer in areas such as the Nordic region.”
Smith-Maxwell adds: “The UK recently reaffirmed its position as fourth in EY’s renewable energy country attractive index which rates all countries on their relative investment attraction. Whilst the UK is a smaller market than Europe or the US for example, it does have aggressive decarbonisation targets.”
Institutional investors such as the LGPS typically have exposure to both global and UK focused investment strategies, and the various opportunities are not mutually exclusive, points out SmithMaxwell. “There is ample opportunity to allocate more capital to UK investments yet still retain geographic diversification in overall portfolios,” she says. “The UK is able to offer investors access to a holistic approach to the energy transition, with opportunities in grid support, storage and generation all capable of being supported by long term inflation linked contracts.”
Looking to the future
On the outlook for the case for investing at home, Smith-Maxwell thinks that while the overall opportunity will be “enduring”, the next 3-5 years “will be a critical phase and should reward investors who address the UK’s urgent supply need for low cost and carbon free renewable power”.
She adds: “The outcomes are expected to be improved power grid reliability, efficiency, and stability, driving innovation and growth in much needed technological advances in energy asset management, and building longterm, sustainable solutions focused on creating positive impacts to stakeholders across the full asset and business lives.”
Ralfe thinks that while there are opportunities for the LGPS, limitations remain. Pools are all trying to find the right opportunities, and it is “the same clever people trying to get the same clever deal, and there are not too many deals around”.
Ben Crawfurd-Porter, LGPS investment manager at Ruffer, also strikes a cautious tone. He notes that while valuations of long-term UK infrastructure assets have been supported by “relatively stable long-term discount rates, despite rising inflation”, should inflation begin to “look entrenched and central banks lose credibility, there is a risk that longer term inflation expectations rise, and interest rates remain higher for longer. This would increase the discount rate and weigh on previously robust UK infrastructure valuations.”
Nevertheless, one of the longer-term consequences of the LDI crisis last year “is likely to be an increased supply of private market – including UK infrastructure – investment opportunities available in the secondary market as corporate DB pension schemes de-risk and reduce their illiquid positions”. The LGPS “should be well positioned to capitalise on this opportunity, if they can be nimble enough to take advantage”, he notes.
But LGPS funds should be “mindful” of liquidity risks when committing to long-term infrastructure projects, he adds. “Capital calls can be lumpy, irregular and delayed. Thought should be given on appropriate places to hold funds being transferred from equities to private markets.”
There are prominent examples of infrastructure investments gone wrong, as the negative media headlines for UK water companies highlight. In this case, private equity’s tendency to accelerate the pace of gearing at the expense of sustainable long-term investments has generated scandals around sewage spills and environmental pollution. It has also left investors exposed to potentially hefty fines. This is likely to be a real concern for investors such as GLIL, which owns a 7.5% stake in Anglian Water. For private equity investors in UK infrastructure, significant engagement and stewardship efforts will be required in order to avoid scheme members being exposed to regulatory risks.
Another risk is rising interest rates, particularly for infrastructure firms that are heavily geared and are now struggling to refinance, as the case of Thames Water illustrates. The true scale of this problem will only be revealed over time when current credit agreements expire. But there is a flipside to that. For investors with a long-term investment horizon and sufficient cash reserves, struggles to refinance might mean that infrastructure assets become more affordable, if investors are willing to stomach the risks.
Keen appetite
Despite these potential risks, UKIB’s Brown says UK investors are continuing to show a “keen appetite” for domestic infrastructure, “as demonstrated by the NextPower UK ESG Solar Fund that UKIB cornerstoned and which has, so far, won the support of four LGPS pools”.
He adds: “It is also encouraging to see LGPS-owned GLIL Infrastructure continue to grow to £3.6bn of commitments, with a UK-focused mandate and investors such as Railpen transition to more direct strategies.
“Those that have invested in infrastructure that delivers explicit inflation protection will have been vindicated in current market conditions. After well over a decade of benign inflation, the recent spike will have been beneficial to revenues at a time when costs and borrowing costs are rising, cushioning the valuation of portfolios.”
Coles says Capital Dynamics, too, has been “pleasantly surprised” by the level of appetite from the LGPS community investing in its UK funds. “There appears to be a big push for the LGPS to invest in the UK. Given its net zero commitments, the UK government is doing its best to incentivise and encourage funding from the LGPS in these areas. We have positioned ourselves as a manager to facilitate that in UK renewables in particular, given our access to high quality proprietary projects across the country.
“Clearly renewable energy infrastructure is very much decentralised given its link to underlying solar or wind resource – often physically located in more remote places in the UK – and with this it brings significant investment in local communities and local skilled jobs; benefits which wouldn’t otherwise be there.
“Renewables is a good way for LGPS investors to tick those boxes. Returns on offer are still extremely attractive if deployed smartly, using the right investment structure, and with a clear and visible deal pipeline that will be delivered quickly and efficiently whilst supported by the highest quality contracts. It’s all about the package.”
Perhaps the strongest appeal of UK infrastructure, beyond returns and diversification benefits, remains the fact that investing in local assets is a strong story to take back to scheme members. “Our scheme members are very connected to our places and therefore, doing good things in these places is important to us, says George Graham, investment director at South Yorkshire Pension fund.
So with government encouragement rather than intervention, UK infrastructure presents opportunities for institutional investors to seriously consider – now and in the near future.
