- Spending boom creates opportunities for contractors
- New funding sources needed to replace 'dead' PFI model
When the UK government announced plans to "build back better" from the pandemic in 2020, newly-installed chancellor Rishi Sunak said it would embark on “the highest levels of investment in real terms since 1995” (infrastructure), pledging more than £600bn by mid-2025.
As with most political pronouncements, there was an element of bluster. An initial pipeline published by the government’s Infrastructure and Projects Authority (IPA) included a series of schemes that were already ongoing or which would have needed funding anyway, such as new cycles of multi-year frameworks covering roads, rail and utilities.
Still, there are signs that the commitments made are feeding their way into the marketplace. Office for National Statistics figures show new infrastructure orders hit £2.26bn in the first quarter – a 34.5 per cent increase on the same period a year earlier. Even as other parts of the industry slow, the Construction Products Association forecasts infrastructure sector growth of 8.8 per cent this year and 4.6 per cent next.
But there are questions over how this pipeline will be funded, given the shift away from the previous private finance model.
A large pipeline
The IPA’s analysis of public and private projects envisages £21bn-£31bn of contracts being brought to the market in the fiscal year that ended in March – part of a 10-year pipeline worth £650bn. More than £200bn of this will be committed over the next three years, it said.
The heads of the contracting companies who will be responsible for delivering much of this are unsurprisingly bullish.
Balfour Beatty (BBY) chief executive Leo Quinn told the Financial Times in April the UK was “entering into an era of 10 years of infrastructure growth”.
Kier (KIE) chief executive Andrew Davies said at its recent capital markets day that its prospects were underpinned by the government’s spending commitments.
“Given our business is counter-cyclical and Kier is a strategic supplier to the UK government, over the medium term we believe there’s significant opportunity to drive growth,” he added.
Investors have yet to be convinced, though, and seem more concerned about the inflation headwinds affecting the sector and their potentially deleterious affect on margins. The FTSE 350 Construction & Materials Index has fallen by 16 per cent since the start of the year, pushing the values of lowly-rated contractors down even further.
Kier, for instance, has a market cap of £345mn – just four times forecast earnings or roughly two-thirds of its net asset value of £509mn as of the end of last year.
“Valuations, in my view, don’t reflect the opportunity out there,” said Peel Hunt analyst Andrew Nussey. He believes investors are somewhat scarred by contractors’ past performance.
Alongside the high-profile failures of industry giants Carillion and Interserve, Kier also had to complete two equity raises within three years and sell off its housebuilding arm to shore up its balance sheet after racking up losses on problem projects.
With contractors typically operating on single-digit margins, it doesn’t take many of these to knock a company off-course.
Yet the industry “has now got itself in a place where it is capable of delivering projects on time, on budget”, Nussey argued.
Attempts to make relationships between clients and contractors less adversarial stretch back around 30 years, but contract terms have improved to encourage more transparency and a more equitable sharing of risk, Nussey said.
“Behaviours – whether that’s the customer, the contractor or supply chain behaviour – are so much different now than five, 10 or 15 years ago,” he said.
Contract blow-ups may be less likely but margin pressure hasn’t been completely removed. Some projects work on target cost mechanisms, where the pain of exceeding budgets is shared between contractor and client. Others are inflation-linked, but when the year-on-year prices of materials like timber and steel soar, these offer scant protection.
Counting the cost
“We are seeing … challenges on project budgets,” said Alasdair Reisner, chief executive of the Civil Engineering Contractors’ Association. “We’re seeing escalation in the pricing of some materials by up to 50 per cent in very short order, which is something we’ve not seen for decades.”
Rising prices could also lead to delays. The £650bn worth of projects identified by the IPA has been budgeted for, but if costs exceed these “we may see the value of activity but not the volume”, said Noble Francis, economics director at the Construction Products Association.
If the Treasury remains committed to its Spending Review commitments “something is likely to give and we are likely to see projects towards the end of five-year spending programmes slip” into following periods, Francis said.
And a project shelved risks becoming a project abandoned.
“It’s harder to say if things are going to go ahead further out in the pipeline, particularly if they extend beyond a spending review,” said Reisner.
Thus far, funding commitments made by the government are being upheld, he added.
“At the moment, the government is effectively writing the cheque and it has the lowest cost of capital,” Peel Hunt’s Nussey said.
The combined capital and operating spend for infrastructure has worked out at about £7,000 per household for the past two decades, according to the National Infrastructure Commission, an independent body advising government on delivery.
The substantial increases planned will eventually have to be funded either by taxpayers, consumers or a combination of both, but delays in establishing funding models “are now holding up delivering infrastructure”, it said in a review published in March.
The government ended its use of private finance initiatives (PFI, or PF2 later) in 2018. It had been used to fund more than 700 schemes with a capital value of £60bn, but whose annual charges were running at £10.3bn until it was scrapped, with future obligations worth £199bn running into the 2040s .
The National Audit Office found it had not been able to properly quantify how well PFI schemes performed and the inflexibility of contracts made savings difficult. The Office for Budget Responsibility also warned of heightened fiscal risks due to the off-balance sheet nature of the liabilities incurred.
“PFI is dead,” said Duncan Ball, co-chief executive of BBGI Global Infrastructure (BBGI) – a London-listed fund with a market cap of £1.2bn.
Yet with over half of the UK’s existing infrastructure being delivered by the private sector, clarity is required on the models that will be used, said Julia Prescott, one of the NIC’s 10 commissioners and the co-founder of Paris-based asset manager Meridiam.
In nuclear, the government is using the Regulated Asset Base structure, where a commitment of £1.7bn towards the construction of new plants is eventually being paid by energy customers through bill surcharges.
In Wales, a scheme to upgrade the A465 has adopted a Mutual Investment Model, where the Welsh government’s development bank has taken an equity stake in the vehicle delivering it, which should make charging structures more transparent.
“When you look at how much spending is planned … they [the government] are going to need private sector involvement to help deliver on those commitments, especially if they want to do it efficiently and quickly,” Ball said.
Banking on success
A new UK Infrastructure Bank has £22bn to deploy and has already done seven deals, three of which have funded fibre broadband roll-outs. It has also made two co-investments, with the latest being a £100mn injection into an Octopus Investments vehicle providing equity for sustainable infrastructure schemes.
These are not without controversy, though. Lord Aamer Safraz, the prime minister’s trade envoy to Singapore, told the Financial Times that the bank should “do the difficult direct deals, not outsource their responsibilities to third party fund managers”, adding that these would give it little control in where cash is invested.
Demand for infrastructure investment is strong given the fact that it offers inflation protection, predictable yields and only has a low correlation to equity markets, said Edward Hunt, who manages HICL Infrastructure (HICL), an investment company with a market capitalisation of £3.4bn.
He thinks that with government balance sheets stretched after funding Covid-19 relief and cost of living economic packages, “that fully government-funded initiatives around these infrastructure development ideas seems unlikely”.
“But there’s not a clear replacement for PFI” and the regulated asset base model won’t work for all types of investment, he said.
One answer could be for the government to continue funding the building of infrastructure, and then agree sale-and-leaseback structures with infrastructure investors, allowing capital to be recycled, Nussey said.
There is certainly plenty of money available. As of March 2022, there was £8.1bn in UK-domiciled infrastructure funds tracked by the Investment Association. According to Preqin Pro, alternative asset managers held $22.5bn (£18bn) in UK-focused infrastructure funds as of September 2021. Almost $5bn of this was in dry powder, or capital waiting to be deployed.
In theory, the visibility offered by the creation of a multi-year pipeline of projects offers plenty of potential for investment – either into the contractors that will build schemes or the funds that will provide the capital. However, as the last few days have proved, short-term politicking can derail the grandest of long-term plans.
