22 Oct 2024
Jonathan Platt, Head of Fixed Income
It has not been a good week for UK infrastructure. EDF’s Hinkley Point nuclear plant needs more money, a middle eastern investor has written off its equity stake in Thames Water and the HS2 saga continues to astound.
It is now revealed that the cancellation of the northern leg from Birmingham to Manchester will mean less capacity and slower running speeds on this route. How is this possible? Well, the new trains, running on old lines, will be shorter and are not designed to tilt, thereby reducing speed. Faster to Birmingham, but slower on the next leg. This seems a terrible return for the billions already spent. Where did it all go wrong? Poor planning, constant mind changing, over specification, extensive tunnelling, cost inflation, labour shortages, habitat protection, archaeological finds, bureaucracy – take your pick.
It is clear that the UK has a big problem with infrastructure development. The new government is keen to attract private money to support capital investment. But the numbers do not look attractive. When the last government held up consent for the final section of HS2 to Euston, it was on the premise that private investment would be required for this project to move ahead. Given the abysmal record it is doubtful whether any investor would contemplate participation on terms that the government would be prepared to countenance. Basically, the risk would be so high as to require a large potential return.
This presents a looming problem for the government as our infrastructure needs dramatic improvement. From a financing viewpoint, government debt is the cheapest option. But as HS2 demonstrates, public sector implementation is far from perfect and there is a limit on the amount of public debt investors will stomach. A blend of public and private solutions looks the best outcome but, from a private sector viewpoint, confidence in regulatory frameworks is essential.
Unfortunately, the situation in the water sector is a good example of how confidence in regulation can be sapped. There is little public sympathy for water companies with sewage spills, sea pollution and ‘Fat Cat’ bonuses regularly cited as examples of uncaring companies. What is rarely acknowledged is the vast capital expenditure that has been undertaken and will be required in the future. It is assumed that the required financing will somehow miraculously appear and that customer bills will be protected. This is just unrealistic. In the case of the water sector, we are moving into a scenario where the cost of debt is undermining accepted business models. Basically, a stable utility business can support high debt levels when the cost of financing that debt is relatively low. This allows debt to be raised, customer bills to be maintained at affordable levels and capital investment to be undertaken. The premise is that the companies are allowed to earn an economic return on their asset base. When that premise is challenged, the model begins to fall apart as investors seek higher returns on their riskier debts. If that is not forthcoming the capital is diverted elsewhere. This is beginning to happen in the UK water sector.
In the case of Thames there is no public sympathy. But it is forgotten that equity investors have not taken a dividend for years. Few would be happy with such a return on risk capital. With operating company debt trading at distressed levels there is an expectation of a ‘haircut’ on this debt – to provide a more attractive environment for new equity. We are now into dangerous territory. In my view, it is imperative that unnecessarily large debt haircuts are not manufactured as part of an equity recap solution, thereby handing short-term equity providers super-normal returns from the current uncertainty at the expense of long-term lenders. The ultimate health of the water sector and, indeed all infrastructure investment, depends upon the functioning of debt markets. At the present time, the messaging to both domestic and international debt investors in UK infrastructure is not encouraging and may ultimately derail attempts to get more investment into vital projects. If this were to happen, the long-term economic consequences will be severe. Even more debt will have to be assumed by government and taxes will need to be raised. Bad economically, bad politically.
From a market perspective, government bond yields continued moving higher as US data remained broadly supportive of a benign economic outlook. Treasury 10-year rates hardened, ending the week at 4.1%, a rise of 13bps. In the UK, GDP rose 0.2% on the month in August after a flat couple of months. Both services and manufacturing saw a bounce back in output. Overall, the UK looks like an economy that is seeing modestly positive growth. Whether this is sustained in the next release, given Budget related uncertainty, has yet to be seen. Following the lead from the US, UK 10-year yields rose 7bps to 4.2%. At the 20-year point, rates closed at 4.7%, just 30bps below the spike during the 2022 LDI crisis. In credit markets spreads were tighter; in sterling, non-gilt indices saw spreads head towards 12-month lows.
To conclude on infrastructure. Getting things built is not easy. Keeping investors onside is tricky and navigating regulatory and legal requirements is hard – for example, the proposed Lower Thames crossing has a report of nearly 360,000 pages. Sometimes we perhaps do not appreciate what past generations bequeathed us. The observation that the daily cost of around-the-clock water and sewerage services in the UK is lower than a first class stamp is amazing.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.