Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Project Finance volume discussing various topics including trends in deal activity, challenges to implenting projects, key regulatory developments and more within key jurisdictions worldwide.
1 What have been the trends over the past year or so in terms of deal activity in the project finance sector in your jurisdiction?
Andrew Petry: Many infrastructure investment decisions were put on hold last year pending the resolution of Brexit and the outcome of December’s election. The threat of a nationalising Corbyn government hung over the whole market and over a number of sectors such as water and rail, in particular. This suppressed deal activity and prices. The election definitively put paid to the Labour nationalisation threat and finally settled the direction of travel on the Brexit issue. The United Kingdom has now left the EU but the final shape of what a post-Brexit UK will look like has yet to become sufficiently clear for many businesses to forge ahead without continued heightened levels of caution. This is true of most energy and infrastructure sectors with perhaps some notable exceptions such as the offshore wind.
Simon Kenolty: The government’s almost total focus on Brexit since the 2016 referendum has meant that infrastructure has not received as much attention as it might otherwise have done. During this time, the feed-in tariff regime for renewables finally closed to new applicants (with limited exceptions) on 1 April 2019 and the renewables obligation certificate regime is now in run-off. The capacity market was suspended for a period due to a legal challenge based on a claim that it constituted illegal state aid. The EU Commission approval was reinstated in October 2019 with further auctions scheduled for 2020. Public private partnerships (PPPs) and private finance initiatives (PFIs) have been formally declared dead and the utility regulators have increased pressure on asset owner returns. All of these factors, rightly or wrongly, have contributed to a dampening of activity.
AP: Interestingly infrastructure investing was a recurring theme in the Conservative Party election manifesto. It promised thoughtful and responsible investment in infrastructure with prioritisation of the environment, while delivering a £100 bllion infrastructure revolution for the UK. This is to be achieved through investing in Northern Powerhouse Rail, the midlands Rail Hub and regional train networks (with a promise to reopen some that have been shut for well over 50 years). Meanwhile, the government has at last given its approval for High Speed Two (HS2) to proceed. This is to be tied into a wider integrated transport programme in the North of England and the Government is to consult on the best way to achieve this integration. This is welcome news for the construction industry as well as new businesses and local politicians who have lobbied extensively for the project, however it comes with requirements for substantial cost savings that may be challenging to achieve.
SK: The manifesto also included promises of road improvements, a gigabit broadband for every home and business, £250 million for new civic infrastructure (claimed to be the largest cultural capital spending programme to be implemented within the last century), £4 billion of new funding for flood defences, £28.8 billion for strategic and local roads, £1 billion for fast-charging networks and the phase-out of the sale of new conventional petrol and diesel cars.
AP: The manifesto is very clear that infrastructure will be a priority for this new Conservative government but the manner in which it will go about deploying the sums promised is not disclosed. It seems unlikely that PFI, PPP, private finance 2 (PF2) or equivalent structures will be used for future UK projects. This leaves open the question of how the United Kingdom’s multibillion investments will be funded. We assume there will be increasing emphasis on direct public sector funding as well as consideration given to possible adaptation of regulated asset base models.
SK: One noteworthy feature of the manifesto is that it makes clear link between achieving the 2050 decarbonisation target and boosting economic growth through domestic clean-tech innovation, particularly in battery storage and turbines. It remains to be seen what concrete steps that government will take to support innovative clean-tech and its commercialisation and export.
Although we noticed a dip in the level of focus on the United Kingdom by energy and infrastructure investors as the Eurozone picked up and UK growth continued to languish at disappointing levels, as far as investment activity in the United Kingdom over the past year or so is concerned, the picture seems to be consistent with recent UK trends. The country continues to deliver a significant number of energy and infrastructure finance opportunities no matter what the government is doing. The International Monetary Fund’s projections of UK growth outstripping that of the EU and most other leading economies should boost investor sentiment.
2 In terms of project finance transactions, which industry sectors have been the most active and what have been the most significant deals to close in your jurisdiction?
AP: Refinancings across all asset sub-classes continue to be one of the most significant areas of activity in the sector. Interest rates remain at very low historic levels and following the economy cooling further in the last months of 2019 there is speculation that there will be a further Bank of England interest rate reduction in the near future. According to our research, refinancings and secondary market sales during 2019 continued to significantly outnumber primary transactions by approximately two-to-one. New project finance transactions tend to be in the renewables sector. On the other hand, the same old large transactions are still making headlines on the public sector side with most of the political attention and debate continuing to focus on the ‘3H’ large trophy projects – Hinckley Point C, Heathrow third runway and HS2. HS2 continues to attract controversy with the latest cost estimates well over £100 billion and a government commitment to re-evaluate. The 27 February Court of Appeal decision that the outline planning permission for the Heathrow third runway has dealt a heavy, and perhaps fatal blow, to this project as the government has said it will not appeal. Alternative capacity expansion plans, including at Gatwick, Stansted and Birmingham, are now being put forward with the government keen to encourage more intensive use of existing infrastructure.
SK: In terms of PPP and PFIs, deal flow continued was very limited. The use of PFI and PPP or, indeed, PF2 and its regional variants was ruled out in 2018 by Chancellor Hammond and the Conservative party election manifesto of 2019 makes no mention of them. Some limited run-off projects continue including the A465 road MIM in Wales, the Lower Thames Crossing tunnel between Essex and Kent continues to be expected to be procured as a PPP. However, the A303 road and tunnel DBFM is now in doubt due to HM Treasury opposition and value for money concerns given alternative routes.
AP: Last year saw further announcements that the multibillion-pound Crossrail project (originally around £15 billion but now very significantly more), linking central London on a fast west–east axis with Reading, Heathrow, Essex, Kent and the wider South East, would suffer more delay with a phased start-up and a final completion date of mid-2022. This would make the project two and a half years’ delayed. Delays are primarily due to problems integrating the three separate signalling systems and knock-on delays in live testing, plus station works, but no doubt by a wide range of other reasons too. Despite this, talk of a Crossrail 2 project continues. This would serve stations throughout the South East, linking southwest and northeast London, as well as destinations in Surrey and Hertfordshire. The project is mooted to have a price tag of over £40 billion and is causing political controversy, with calls for northern rail projects such as wider electrification and east–west links to be given preference. Controversy about the role of private train operators continues, with the government considering nationalisation of struggling train operating companies. The procurement challenges from Stagecoach, Virgin Trains and Arriva following their disqualification from the competition for the West Coast Main Line and East Midlands franchises over legacy pension liabilities has cast a further shadow over the franchise system.
SK: As mentioned earlier, outside directly government-procured sectors, the most active sector continues to be renewables such as the £1.4 billion financing of the East Anglia ONE offshore wind farm. One of the big discussion points in 2019 continued to be the scope for subsidy-free or even ‘negative subsidy’ renewable projects, following the sharp drop in the cost of offshore wind projects in contract for difference auctions and sharp drops elsewhere in Europe. This reflects increasing economies of scale in offshore wind, particularly driven by increasing turbine size and increased investor confidence and appetite. However, there are still big questions over the extent to which low bid costs in offshore wind are becoming decoupled from actual project costs, reflecting other factors such as political issues, the importance of maintaining deal flow and differing treatments of grid connection costs. The latter are still a big factor in UK renewables costs. At the same time, other technologies such as solar power are being developed on a subsidy-free basis, especially with corporate power purchase agreement backing. Examples include the 50MW Llanwern solar and storage project, on which we advise the developer, which is the first renewable energy project to receive planning permission as a Development of National Significance under the Planning (Wales) Act 2015.
AP: The United Kingdom is also still relying on the development of substantial new nuclear capacity. EDF and CGN’s Hinkley Point C, which benefits from an above-market tariff of £92.5 per MWh, continues to progress albeit behind its original schedule. However, elsewhere the sector is beset by delays and difficulties, notwithstanding the fact that the sector continues to receive support. The financial difficulties at Westinghouse and Toshiba, and their subsequent failure to find a buyer for the Moorside project after KEPCO withdrew, led to that project being cancelled. Meanwhile, Hitachi’s Wylfa project has been indefinitely suspended due to substantial funding difficulties, despite negotiations with the Japanese and UK governments for direct financial backing. Government financial support had been expected, if provided, to be a mixture of debt and equity and would have been a significant departure from the UK government’s current approach of only providing price support. These funding difficulties have led to the Department for Business, Energy and Industrial Strategy confirming that it is reviewing possible use of a regulated asset-based approach for future nuclear power projects, where the developers would earn a regulated return based on the value of the assets, although the model has not been used for anything with such technically complex and lengthy construction as nuclear.
SK: Meanwhile, the government has announced £18 million of matching funding with a Rolls-Royce consortium for the development of 440MW small modular nuclear reactors. These are expected to be constructed in a more standardised manner to facilitate significant cost reductions.
3 Which project sponsors have been most active in driving activity? Which banks have been most active in providing debt finance?
SK: Notwithstanding continuing Brexit concerns, the United Kingdom remains one of the most open economies to foreign investors and the government is keen to encourage this in the post-Brexit world. The UK continues to attract the attention of investors from all around the world. Institutional investors have increasingly been taking part in greenfield and brownfield financings as well as refinancings of operational assets. We have seen numerous transactions where overseas buyers have funded or acquired infrastructure in the UK and expect this to continue, and most likely increase, in the next 12 months so long as the final form of Brexit does not end up destabilising the market too badly.
AP: On the debt side, the more restricted availability of long-dated bank debt, coupled with low returns on government bonds and other investments, and a concerted push by governments to stimulate institutional infrastructure lending, has continued to stimulate new money coming into the market from institutional funders and specialist infrastructure debt funds. Some funders are increasingly buying up the debt of operational projects either by deploying their own funds or investing on a managed account basis. Many of these funders are also moving into funding greenfield projects, with some institutional funders overcoming, in large part, the issues of inflexibility that have traditionally put them at a disadvantage when compared with banks. A number of banks such as BNP Paribas and Credit Agricole from France, MUFG and SMBC from Japan, KfW Ipex and Bayern LB from Germany and Santander remain active, while other banks are looking to increase their project finance activity again. However, bank lenders face increasing competition from sophisticated institutional investors such as Aviva, M&G, LGIM and BlackRock and bank tenors are constrained by Basel III and Basel IV considerations to around the 20-year mark (and often considerably less) with longer-dated money almost invariably being securitised, as in a number of other countries.
4 What are the biggest challenges that your clients face when implementing projects in your jurisdiction?
AP: One of the biggest challenges for our clients continues to be finding investible transactions. The majority of secondary investors wish to buy off-market and sell in competitive auctions, but if everyone seeks to do this, the market becomes unsustainable. For some institutions or funds, investors need to find very large transactions to make their involvement worthwhile and therefore good opportunities for them can be few and far between. This has been the case for some time now, but debt remains comparably very cheap and there has, in recent years, been record levels of fundraising in the sector, which means even greater resources competing for the assets that do come into play – both on the debt and the equity sides. Many of the newer opportunities and sectors such as smart metering, opportunities related to the electric vehicle revolution, onshore renewables, district heating, fibre, data centres and energy efficiency projects consist of many smaller opportunities that need to be rolled out in volume as opposed to providing the opportunity to acquire or fund a large trophy green or brownfield asset.
SK: The restoration of the UK’s Capacity Market scheme, following the European Court of Justice’s surprise November 2018 ruling that it was unlawful state aid, alleviated the serious concerns that had arisen with energy policy. However, Tempus Energy continues to challenge the current Capacity Market structure in favour of giving greater prominence to demand-side response.
The increased political risk concerns engendered by the Labour Party’s proposals for nationalising water, rail, PPP, PFI, mail and other infrastructure assets has been substantially mitigated by the Conservative Party’s emphatic victory in the December general election. Although we expect that investors will take comfort from this, the continuing uncertainty over the post-Brexit relationship with the EU is likely to continue weighing on investors. A key part of this is the government’s attitude to state aid and support of domestic businesses. The EU is pushing for strong level playing field protections, including state aid restrictions, which the UK government has stated it rejects. Its support for the Flybe rescue demonstrated its willingness to actively intervene in markets. The justification in this case was Flybe’s importance to regional connectivity. Given the government’s oft-stated commitment to ‘levelling up’ the UK by boosting regions, it is easy to see the government intervening in other circumstances. One of the domestic policy challenges is to formulate a coherent set of principles and procedures governing such interventions and we will be watching this with keen interest and contributing appropriately to consultations.
5 Are there any proposed legal or regulatory changes that may give rise to new opportunities in project development and finance? Do you believe these changes will open the market up to a broader range of participants?
AP: It is safe to say there is a general consensus that infrastructure investment is good for the economy: witness the way Boris Johnson’s manifesto made it one of its most important themes for post Brexit Britain. There is a continuing crisis among NHS trusts and the NHS more generally, the education sector and other areas of the state where PPPs have in the past extensively been used to fund infrastructure. The new infrastructure was typically warmly welcomed when it was procured but now, as budgets are either cut or need to stretch further, the procuring entities find that they are not able to raid maintenance budgets or mothball their infrastructure without incurring politically and financially painful costs. Various solutions are being developed to alleviate the pressures put on the public entities caught in this situation. Given the need to fund ambitious infrastructure plans and continuing government balance sheet constraints, we expect intensifying consideration of non-PFI private funding models such as the regulated asset base model already used in, for example, the water sector (barring of course a Labour government being elected in an early election) and as and when the political classes find time away from dealing with Brexit to focus on infrastructure.
SK: Given the well-publicised difficulties in developing new nuclear power, the risk that the United Kingdom will have insufficient power generating capacity in the coming years remains a material one and the question of how to support UK nuclear power remains unanswered. No new nuclear reactor has started generating power since Sizewell B in 1995 and the likelihood that the new nuclear generation capacity will be ready later than hoped for is very high. Filling the potential future generation gap is therefore becoming an increasingly critical issue. Solutions may involve further extending the life of existing nuclear plants, the government buying minority stakes in proposed UK nuclear projects or providing credit guarantees, more international interconnectors and a resurgence in the use of gas-fired plant as the price of LNG and gas comes down.
AP: One of the most important changes in the power sector is the decline in price support for renewables. Another related factor is the move away from, primarily diesel, but also petrol, for use in the transport sector. The government launched a £400 million Charging Infrastructure Investment Fund (CIIF), to fund the roll-out of charging infrastructure. £200 million is to come from the government, with the rest to come from private investment.
SK: Also, on a negative note, one of the implications of Brexit is that the United Kingdom will leave the European Union’s Internal Energy Market with possibly consequent restrictions on its ability to trade energy with the EU through interconnectors. Proposals to address this are urgently needed.
6 What trends have you been seeing in terms of range of project participants? What factors have influenced negotiations on commercial terms and risk allocation? Are there any particularly innovative features?
SK: Contract terms are looser, and we are frequently seeing features such as equity bridge loans, debt service reserve facilities and other financial enhancements that reduce the cost of funding at the expense of a degree of lender comfort and security. Another issue that has been highlighted recently is the fragility of the balance sheet of some of the developers and the engineering, procurement and construction and facilities management providers’, which can be an inhibiting factor for the sector. This poses risks for joint venture partners and off-takers as well as lenders.
AP: The need for funding is one that has become a global issue and the increasing involvement of institutional money on the equity and the debt side is having an impact on how transactions are being structured with fixed interest debt funding and modified make-whole provisions now common. Some of the assets that were bought by closed-ended funds in the mid-2000s have been coming to market as the funds need to realise their investments with other funds seeking to develop strategies to hold on to their assets through extension and continuation fund strategies. What we are not seeing, perhaps as much as we had anticipated, is reliance on the capital markets for infrastructure financings.
SK: The other feature seen increasingly in the renewables market, in large part because of the ongoing reduction in government price support, is the use of corporate power purchase agreements to provide long-term price certainty for projects. We expect this to accelerate.
7 What are the major changes in activity levels or new trends you anticipate over the next year or so?
SK: The biggest threats to infrastructure investment undoubtedly remain Brexit risks, given the uncertainty over the final relations with the EU, the US and other major economies; government intervention in markets, whether through price regulation compressing returns; nationalisation or direct intervention; and a lack of a deal pipeline. The unprecedented period of historically low interest rates needs to come to an end at some point. Although there is a pressing need for new economic infrastructure, and the Conservative manifesto indicates a promising direction of travel, there remain concerns over how quickly and effectively the government will actually be able to develop and implement projects and the exact funding models to be used.
AP: The North Sea oil industry is coming under sustained pressure from investors about decarbonisation. Oil & Gas UK, an industry body, has in response set out a series of proposals for how the industry can use its resources and expertise to contribute to achieving net zero carbon. This includes carbon capture and storage (CCS) in North Sea oil and gas fields offshore and hydrogen for heating in buildings. If this can be commercialised, it would help to achieve the government’s aim of developing exportable clean-tech. However, we note the limited success of CCS so far and the cancellation of previous government financial support for test projects. It remains to be seen how and when the new government will support these initiatives.
SK: As predicted last year, the integration of renewable generation and storage has continued to accelerate in 2019, although for storage to achieve its full potential, its unique characteristics compared to generation needs to be properly recognised by electricity market regulation. We remain confident this trend will continue in 2020 and beyond.
The Inside Track
What three things should a client consider when choosing counsel for a complex project financing?
A client needs to look behind the numbers to ensure they are getting the lawyers they need. Often those lawyers whom the client meets at the pitch meeting and on whose reputation and presentation the client bases their choice of adviser will be much less evident during the day-to-day delivery of advice. The lawyer a client hires should have a broad experience base to draw upon but also be part of a wider team that is able to support the chosen counsel in the whole range of potentially relevant non-core skills. Finally, a client should think carefully about the kind of lawyer who will complement the client’s team the best. A good lawyer should be able to fit seamlessly into the wider client team, whatever the dynamic that team may have. The importance of personality fit should not be underestimated given the long hours and stressful situations that are inevitable on a project.
What are the most important factors for a client to consider and address to successfully implement a project in your country?
Investors should not underestimate how UK regulatory regimes and the politics of infrastructure investment can unexpectedly evolve and have an impact on deal flow and how transactions are structured. This has been true recently in the renewables space but is true of other sectors too, particularly given the potential stress of implementing Brexit and the uncertainty regarding private infrastructure funding models.
What was the most noteworthy deal that you have worked on recently and what features were of key interest?
We are currently advising the UK government on some strategic nuclear decommissioning issues and the Ministry of Defence on several of their highest profile PPP and outsourcing transactions. We continue to advise investors and contractors on a range of renewables transactions, predominantly in the solar and wind sectors including a number of entrant bidders for stakes in offshore windfarms. We also continue to advise Next Energy, which are currently developing one of the UK’s largest subsidy free photovoltaic solar plants at Llanwern.