Francisco Sebastian explains the possible impact of Brexit on infrastructure investment in the UK
Domestic investors, notably pension funds and insurers, have been adding UK infrastructure to their portfolios in the past few years, as the asset class provides longer duration cashflows to match liabilities and its liquidity premium enhances yield. Infrastructure is a pillar of economic development, and therefore will be subject to the changes in the economic, political and investment landscape that are expected to materialise following the result of the Brexit referendum. Moreover, as infrastructure represents a large fraction of total fixed capital formation and is a primary vehicle for public expenditure, it will play a crucial role in shaping the UK's economy during and after Brexit implementation. This complex, dynamic environment provides an intellectual challenge that makes some actuaries feel like a child in a sweetshop.
Brexit will most likely entail an unprecedented change in the UK's regulatory and institutional environment, which affects internal economic growth and the relationships with the EU - the UK's main trade partner (accounting for 43.8% of exports of goods and services in 2015) - and with the rest of the world. The growing political and social tension in Scotland and Northern Ireland has also boosted the (already high) level of uncertainty, as the economic policy uncertainty index shows.
In the aftermath of the Brexit referendum, gilt yields reached historical lows. This is the combination of increased perception of risk with the Bank of England's subsequent expansionary reaction and additional measures, which are intended to pre-empt potential disruption in lending markets. Along with interest rates, and with the increased uncertainty, the British pound has declined around 10% and 14% versus the US dollar and the euro respectively, reaching multi-decade lows.
With policy uncertainty soaring, real investment is likely to be subdued, which would dent economic growth in the short term. Furthermore, the erosion in purchasing power from the decline in the currency is expected to bolster inflation in the coming months. The combination of policy and institutional uncertainty, lower economic growth, higher inflation expectations, lower yields and weaker currency affects valuations of both existing and planned infrastructure assets.
Implications on valuations
In the base case scenario of short-term economic slowdown and lower yields, most infrastructure assets are likely to preserve or increase value relative to other investments, for several reasons:
- In most cases, infrastructure services are oligopolistic, with high-entry barriers, and cover basic household and business needs. These features make demand for infrastructure services, such as energy, communications, lodging or transportation, partially stable during periods of general economic slowdown.
- The overall inflationary environment may strengthen the case for infrastructure operators competing in domestic markets to increase fees.
- Furthermore, for ports, airports and certain energy operations competing at international level, the currency depreciation boosts their competitiveness.
Lower funding cost:
- As most infrastructure projects are heavily reliant on borrowed funds for long periods of time, the lower interest rate environment is also positive.
- Although it is reasonable to expect that uncertainty increases risk premia, funding is likely to continue to be widely available, because mature projects' revenue stability underpins their credit quality; and monetary policy will most likely continue to be supportive.
In summary, existing infrastructure projects should be able to withstand the economic slowdown and uncertainty spike scenarios. Valuations may be positively affected, owing to the combination of steady cashflows and lower interest rates, with contained risk premia.
However, some sub-sectors that bank on the UK economy's openness may be an exception to the aforementioned positive effects; commercial real estate valuation growth started gaining momentum in 2013 and peaked at the end of 2015. International demand was a catalyst for transaction price growth, especially in London. These investors did not always seek to capture the economics of the property, but rather used the assets as means to preserve value and for their relatively high liquidity. The downturn in valuations started in early 2016, triggered by the changes to Stamp Duty in the March 2016 budget, which introduced an extra transaction cost that made these assets less competitive internationally. Legal uncertainty from Brexit is amplifying this effect, as London's status as a global financial hub is questioned, which could eventually lead to weaker demand, lower rents and more scarce liquidity.
Furthermore, Brexit may also have negative consequences on valuations of future infrastructure projects:
Less competitive funding cost:
Although the lower interest rate environment contributes to the decrease of the overall funding cost, the combination of systemic policy uncertainty from Brexit and project-specific cashflow uncertainty may increase risk premia for projects in greenfield stage.
Higher construction cost:
- Infrastructure often requires importing materials and specialised technology. The UK's longstanding goods trade deficit is a sign of dependence, especially on imports of basic materials, semi-manufactured, intermediate and capital goods. In most cases, these inputs cannot be replaced with domestic ones swiftly, because either they physically do not exist in the country, or developing the expertise to manufacture them would take years. Therefore, the UK will continue to depend on the rest of the world to develop infrastructure, and the currency depreciation will increase the cost.
- Since 1997, the number of non-UK nationals working in the UK has increased from 928,000 to 3.34 million, with about two-thirds being EU nationals. Immigration from the EU has been crucial to sustain the high levels of activity in the construction sector, which is structurally understaffed. As the construction sector is crucial for future infrastructure development, any demographic changes from restricted immigration as a consequence of Brexit could further increase the labour shortage in the construction sector, increase the cost of new investments and the time required for completion.
Implications on capital supply
Although the post-Brexit policy, institutional and economic framework is yet to emerge, the reaction from some investors is to postpone upcoming investment projects and to re-evaluate ongoing ones. This is particularly critical for foreign investors, which are generally more sensitive to regulatory changes that may affect their fixed investments in the UK. The UK has historically developed strong ties in investment with EU countries, which represent a large fraction of both direct and portfolio investments.
The most evident implication on capital availability of Brexit is the potential discontinuation of the European Investment Bank's funding programmes. The EU has developed a number of budget and finance programmes for infrastructure development.
The European Investment Bank (EIB) and the European Fund for Strategic Investments (EFSI, aka Juncker Plan) are worth noting for the large size of resources available and their focus on infrastructure:
- The EIB is a financial institution funded by the EU member states, with a mandate to invest in infrastructure and sustainable projects that contribute towards EU policy goals, notably environmental and climate change. The UK is one of the largest shareholders of the EIB, with a 16.11% stake, along with France, Germany and Italy, which have identical stakes. In 2015, the EIB lent EUR 7.7 billion to UK projects and businesses, which represents about 11% of total annual UK infrastructure investment from 2010/11 to 2014/15. Although the EIB provides capital for projects outside the EU, its primary business is within the EU. Therefore, funding from the EIB for UK projects would be subject to the terms of the relationship between the UK and the EU resulting from the negotiations.
- The EFSI is an initiative approved in 2015, under which a portion of the EU budget is used to guarantee financing provided by the EIB. The plan targets projects in different sub-sectors, with energy and transportation attracting about half of the funds. Prior to the Brexit referendum, the UK was the second largest recipient of funds approved for projects under the EFSI, with around EUR 1.4 billion. The Brexit negotiations will also affect financing available for the UK under the EFSI.
In a Brexit scenario in which the UK no longer has access to the schemes above, the UK government could set up comparable ones domestically. However, in the meantime, funding available for new infrastructure projects will most likely be reduced. Furthermore, as those new schemes would be subject to the UK's fiscal constraints (as opposed to the broader EU ones), availability of funding in the long term would most likely be less stable and more correlated with the dynamics of the domestic economy.
Domestic investors, notably pension funds and insurers, have been adding UK infrastructure to their portfolios in the past few years, as the asset class provides longer duration cashflows to match liabilities and its liquidity premium enhances yield. The outcome of the Brexit referendum, with lower yields, has made liabilities of defined benefit pension funds grow in excess of their assets, enlarging the size of the historical funding gap. Furthermore, the lower yields also trigger second-round effects on the pension funds' and insurers' asset-liability management programmes, as duration from liabilities increases and these investors often struggle to find non-government investments that can meet their long-duration requirements. As a consequence, the lower-yield environment has increased long-term investors' need to search for yield, which is increasing demand for infrastructure investments.
Capital supply for infrastructure from the public sector is also likely to become increasingly available as the UK government may continue with the infrastructure investment plans that the former leadership had defined. Prior to the referendum, the UK government had made infrastructure investment one of its priorities. In March 2016, the government released the National Infrastructure Delivery Plan (NIDP), which identifies projects currently being developed and planned for the 2016-21 period. The total size of the investment is around £300 billion over the period, with nearly 50% of it coming from private sources. Although the NIDP stretches over different sub-sectors, it is worth noting that the bulk of the investment focuses on transportation (rail, roads, airports and ports) and energy projects.
From the public side, a major obstacle to the execution of the NDIP could be funding. Although the chancellor of the exchequer announced after the referendum that the deficit reduction goals are likely to be relaxed, the slower economic growth and potential tax cuts may absorb part of the resources that could be allocated to infrastructure development.
The Brexit referendum has made the growing discomfort with the EU re-emerge, which may also threaten new infrastructure development. Although the NDIP focuses on England and acknowledged devolution plans for Scotland, Northern Ireland and Wales, the risk of Scottish secession could jeopardise certain large-scale, country-wide projects.
The high degree of uncertainty that Brexit has created has had a positive effect on valuations of existing infrastructure. However, it will most likely have a negative effect on the expected returns of future projects, as well as investment dynamics. This creates a more challenging environment for investors (including insurance and pension funds), which have additional pressure to get returns from an asset class that is expected to be fundamentally less yielding.
As international investors retrench, the UK government and domestic investors may find it easier to get access to the asset class and continue to support infrastructure development.