While COVID-19 continues to hit the global economy, governments are looking to infrastructure as a way to create future employment and sustain the eventual economic recovery.
This includes the UK, where the government is promising to invest £100bn (€112bn) in new infrastructure by 2025, taking its public investment as a share of GDP from 2% up to 3%, in line with the OECD average. The UK’s National Infrastructure Strategy (NIS) plans for £640bn in capital investment across the economy by 2025. The government is expecting the new National Investment Bank (NIB) to be key in ‘crowding in’ private capital.
This is easier said than done. Globally, private infrastructure investment has been declining for a decade. The G20-affiliated Global Infrastructure Hub calculates that annual private investment in primary infrastructure globally – greenfield projects or asset recycling – has dropped from $155bn (€128bn) a decade ago, to $106bn in 2019, with the greenfield share of private capital falling much faster. Public private partnerships (PPPs) are stagnating at 0.1% of global GDP, totalling about 2-3% of all infrastructure spending.
In the UK, the Private Finance Initiative (PFI) model delivered more than 700 pieces of infrastructure from the mid-1990s to 2018. The debt heavy model, whereby private sector consortia came together to finance, build and operate infrastructure, is now seen as too expensive, too complex and too opaque. Private sector constructors meanwhile had become disillusioned by lengthy procurement processes, upfront costs and balance sheet risks.
IFM Investors (IFM) have been working on a new model for consideration by the NIB, called the Build Britain Model (BBM).
The BBM differs from PFI and other PPP models because it puts pension capital in partnership with government.
Pension capital has a greater capacity to absorb the volatility associated with greenfield developments, as it has the ability to smooth out the investment across a 30-40 year horizon. The returns on pension capital also serve to protect and appreciate the retirement savings of millions of working peopl around the world – often the same people who will use and benefit from new infrastructure in their communities.
And many pension funds globally are at the vanguard of responsible investment, with a conviction that managing environmental, social and governance risks and opportunities are key for long-term value creation and investment performance.
This model has the potential to help unlock billions in pension capital that can be invested in productive, job-creating infrastructure, while delivering long-term returns for pension fund members.
The BBM would see pension capital invested upfront in new projects and make returns through the long-term operating and managing of the assets.
It is IFM’s view that pension funds that invest over decades and have significant global experience in delivering large infrastructure projects are the natural equity partners of governments when it comes to designing, procuring, constructing, and operating new economic infrastructure.
How would the BBM work?
The government would tender for the long-term equity ownership of the asset – based on experience and capabilities and incorporating the bidders’ proposed internal rate of return (using an IRR range, a measure to estimate the profitability of prospective investments).
This would account for the construction risk, the long-term risks associated with the asset and the duty of pension funds to deliver a fair rate of return on members’ savings.
The preferred bidder would then prepare a brief for the design and construction process, in association with government.
A public tender for construction contracts, which will include a fixed price and completion date as well as design requirements.
A procurement process for operation and maintenance (O&M) contracts takes place.
The government and the equity partner proceed to final investment decisions and a ‘go/no go’ decision. Following a ‘go’, the construction and O&M contracts are signed and the project is delivered.
There are several key benefits of the BBM.
• Genuine alignment: Long-term investment provided by pension funds, in partnership with government, has an incentive to maximise the value of an infrastructure asset over its lifetime, increasing the owner’s focus on the long-term environmental and social impacts of the projects, from construction through to operation. Pension capital would make returns through optimal long-term operation performance and asset management rather than high upfront fees, construction costs, and a post-completion sell down of equity.
• Lower residual project risk for government: Pension funds would be required to provide meaningful balance sheet equity upfront. This would enable genuine long-term risk transfer at a capital cost that accounts for risk and balanced returns to investors. The equity sponsor would also accept package interface and programme related risks due to their involvement in the project’s design.
• Reduced construction and ‘whole of life’ costs to taxpayers: The BBM would drive savings and value for money through an upfront partnership with government on design and engineering, reducing problems and variations down the track. More efficient procurement processes would enable project contingency held at an equity level to be applied transparently and used to manage issues in a timely manner.
• Major projects shovel-ready sooner: A collaborative shared equity partnership would enable a project to be ’shovel ready’ earlier, through an ability to begin early works, supporting the economic recovery.
• Greater Transparency: The BBM proposes that the allocation of contingency is applied transparently on an open-book basis, meaning that profits cannot be ‘padded out’. This will help deliver the recommendation by the National Audit Office that commercial arrangements incentivise greater supply chain transparency.
IFM is putting BBM forward as a constructive proposal that may help the government achieve its ambitious infrastructure investment goals.
As we rebuild from the COVID-19 crisis, there is an opportunity for pension funds and governments to work together, helping deliver jobs and the infrastructure that the UK needs.
David Neal, CEO, IFM Investors