Ways in which the HM Treasury could back project bonds for new infrastructure to help the UK's post-Brexit economic revival

In brief...

While the EIB has confirmed that Brexit will not affect its existing loans to UK infrastructure projects, any post-Brexit EIB funding seems questionable. This article reviews the UK government's commitment to the infrastructure sector, the capacity of its Guarantee Scheme and ways in which backing could come in future, e.g. through senior-tranche guarantees, junior-tranche investment and hedging arrangements.

This article was written and updated as at 15 November 2016.

Theresa May, the UK Prime Minister, has pledged that she will boost infrastructure investments and projects in the UK, which are to be funded with the help of "more Treasury-backed project bonds for new infrastructure". This is consistent with her belief in building "a country that works for everyone, not just for the privileged few".

Although at the time of writing no project bonds backed by the HM Treasury (Treasury) have been issued to support infrastructure projects, it is worth considering how the Treasury might choose to give such support.

The UK project pipeline

According to the government's National Infrastructure Delivery Plan 2016 to 2021, published before the Brexit vote, the UK is expecting a project pipeline of 483 billion, with over 100 billion to come from public capital investments.

It is as yet unclear whether (and how) Brexit will affect the infrastructure projects pipeline. Projects in their early planning stages may lose some momentum as the government focuses its efforts on the unavoidable Brexit negotiations, but there are still some positive signs - most notably the (delayed) green light given to the Hinkley Point C nuclear power project (estimated cost of 18 billion), the government's endorsement to expand Heathrow Airport (estimated cost of 17.6 billion) as well as the go-ahead of the Silvertown tunnel (estimated cost of 1 billion) signalled by the Mayor of London Sadiq Khan.

The UK government's commitment

In recent years the government has been consistent in its determination to deliver better infrastructure. A financial guarantee scheme (Guarantee Scheme) was introduced through the passing of the Infrastructure (Finance Assistance) Act 2012, under which up to 40 billion of financial guarantees would be issued for qualifying projects up to the end of 2016. The capacity of the Guarantee Scheme has recently been expanded to 60 billion, with its closing date extended from December 2016 to March 2021.The most recently reported figures available on the uptake of the Guarantee Scheme show that the total value of commitments entered into by the Treasury stands at 3.7 billion (as of November 2015), 2 billion of which is earmarked for the Hinkley Point C project. There is certainly room for further use of the Guarantee Scheme.

According to George Freeman, head of Theresa May's Policy Board, the UK government is ready to borrow cheaply to fund infrastructure. The form of borrowing however remains uncertain - it appears that sceptics in the government may not overly welcome the idea of project bonds, given that they normally come with higher coupon than ordinary UK government gilts.

Although the Autumn Statement, one of the two statements made annually by the Treasury to the Parliament, has not yet been published at the time of writing, infrastructure is expected to be its main theme, with a possible indication of a spending programme for new infrastructure. It is also rumoured that the UK government could be planning to set up a new infrastructure bank, which will aim at increasing finance available for infrastructure projects.

Forms of Treasury backing

At the time of writing, it is unclear how the Treasury is expecting to back project bonds - possibly it would come in one (or a combination) of the following forms. The intended outcome is to enhance the credit rating of project bonds, which would result in such bonds becoming a more attractive investment to investors, and therefore reduce project financing costs.

Treasury to provide financial guarantee

The Treasury could provide a guarantee for the whole or a part of the payment obligations of the issuer project company under the senior tranche(s) of the project bonds. This would have the effect of enhancing the credit rating of the project bonds by taking into account the creditworthiness of the UK government rather than relying solely on that of the project company.

It is, however, hard to see how different this would be from the ongoing Guarantee Scheme. While Theresa May's new initiative targets project bonds specifically, the Guarantee Scheme offers a high degree of flexibility and project bonds were by no means excluded.

Treasury as junior debt investor

The Treasury may be an investor in the junior tranches of the project bonds to be issued. This would enhance the credit rating of the senior tranche(s) of the bonds as this provides a subordinated buffer before the investors in the senior tranche(s) have to suffer any losses in their investments.

One concern the Treasury may have with being a junior debt investor would be the requirement to inject liquidity into the project from day one, as opposed to only getting involved as a primary debt obligor under a financial guarantee when the project company fails to meet its payment obligations to the senior project bondholders (which would be unlikely to happen until a later stage if the project becomes unsustainable).

Treasury to provide hedging/swap arrangements

One other way which the Treasury may back the project bonds is to act as a swap counterparty under the project bond structure. This may be effected through structuring a liability swap with the issuer project company, such that the Treasury would pay a fixed amount reflecting the periodic interest payments throughout the life of (or part of the life of) the project bonds in exchange for a fee and a floating payment from the project company. This could ensure that if the project company could not meet its ongoing payment obligations under the project bonds, such obligations could be met by the payments from the Treasury as swap counterparty.

EIB funding and Brexit

Post-Brexit, the infrastructure industry may be concerned whether it could continue to obtain low-cost funding from the European Investment Bank (EIB), of which the UK is a 16% shareholder. EIB investments in the UK economy came to about 7.8 billion in 2015. This was approximately 10% of the total lending made by the EIB in 2015 - the EIB's largest-ever engagement in the UK. While the EIB has confirmed that the existing loans provided to UK infrastructure projects will not be affected by Brexit, it is doubtful if the same level of support will be afforded to UK projects postBrexit, which could happen as soon as 2019.

With the likely reduced support from the EIB, Treasury-backed lower-cost funding options, in whatever form, will become essential. Given the government's support, and the generally low interest rates in the lending market, infrastructure development may become a leading force for the UK's post-Brexit economic revival.