November 20, 2012 8:50 pm

Big schemes need big money

As Britain tries to lift itself out of economic gloom, one area is attracting particular attention: investment in infrastructure. Not only do its effects percolate deep into the economy, say enthusiasts, but the UK also faces pressing decisions on energy, roads, rail, water and airport expansion that will shape its productive capacity for the 21st century.

The government has announced many initiatives, including a national infrastructure plan, planning reforms, a Green Investment Bank, an effort to unlock £20bn of institutional investment over a decade, a £40bn guarantee scheme to underwrite private sector projects, and an overhaul of the private finance initiative to fund schools, hospitals and other schemes.

As yet, few of these ideas have resulted in projects on the ground. Potentially, billions of pounds could be available from new sources of finance such as pension funds, insurance companies, asset managers, private wealth management groups, private equity houses and sovereign wealth funds. About two-thirds of infrastructure finance comes from the private sector.

But there are barriers to overcome, not least the need for clear strategic priorities and certainty about policies on energy and airports. Ways also need to be found to overcome the fears of investors who like the long-term income streams from infrastructure but are nervous of construction risks such as cost overruns.

“The real issue is not about government spending more, it’s about taking the steps necessary to give confidence to private businesses,” says Richard Threlfall, head of infrastructure at KPMG, the advisory firm.

All this comes at a time when, as Mr Threlfall puts it, the construction industry is “close to [being] on its knees”. Gross domestic product figures for the third quarter suggest that construction output fell 2.5 per cent in the three-month period and is down 10 per cent in a year. While there are stirrings of activity in housebuilding, a wider recovery of the construction industry remains elusive.

Some parts of infrastructure remain relatively healthy – notably rail, where work is continuing on London’s Crossrail and Thameslink lines. There is a reasonable amount of work in other regulated areas such as water, gas and telecommunications. But road construction, dependent on government and local authority spending, has been in freefall. The Construction Products Association projects a 40 per cent decline in roads investment this year and 5 per cent in 2013.

Against this backdrop, companies that adapt to the structural changes reshaping the industry can still succeed. Costain, the civil engineering company, has focused on winning bigger projects from blue-chip clients in areas such as transport, energy, water and waste – a strategy that is paying off. Its first-half operating profit was up 16 per cent and its order book rose to £2.4bn.

“Big customers are looking to work with a smaller number of tier-one service providers, but on a much longer-term basis, with a broader range of services and bigger contracts,” says Andrew Wyllie, chief executive. “They are all looking to consolidate their supply chains.”

Clients are looking to construction groups that can provide a service starting from the concept of a scheme, through planning and design to delivery, as Costain is doing with its £400m contract to redevelop London Bridge station for Network Rail. This approach has repercussions down the chain. Where Costain five years ago had 18,000 suppliers on its database, today it works with only 3,000 or 4,000. Mr Wyllie still sees a role, though, for working with specialist organisations such as the UK’s strong core of engineering design consultants.

The industry’s overall prospects, however, depend on finding the finance to get projects moving. George Osborne, the chancellor, faces a challenge to attract tens of billions of pounds of pension money into infrastructure – underlined by the fact that the industry has found commitments of just £700m after a year of talks.

The National Association of Pension Funds believes that it has achieved a “critical mass” of investors for its Pensions Infrastructure Platform, which will channel money to big projects such as energy and transport. However, this is only a third of the £2bn that the new group had been hoping to raise in its first year.

Gershon Cohen, chief executive and fund principal of infrastructure funds at Lloyds Bank, believes money will be found for important projects. “If we can arrive at a point where the public sector can bring forward a visible pipeline of high-quality investment opportunities, I believe there would be few problems raising the finance,” he says.

Decisions also need to be made, he argues, on the procurement methodology to be used – whether it is traditional build and design, financed through taxes; or done through utilities with a regulated asset base and charging of users; or through the private finance initiative.

Since the credit crisis, bank finance has become concentrated at the shorter-term end of the market. But institutional investors and insurance companies have been increasing the proportion of investment allocated to infrastructure because it provides a good match for their long-term liabilities.

One problem is that British pension funds tend to be small compared, for example, with the large Canadian funds, and lack in-house expertise to make judgments on greenfield projects. There is also only a small number of fund managers they can turn to with experience of investing in the construction phase.

Mr Cohen says: “The more projects that need funding, the more experienced fund management platforms like mine will emerge.”

Aside from financial constraints, infrastructure companies in some sectors, notably energy, face frustrations over policy uncertainty and political conflict. Phil McVan, managing director of Myriad CEG Wind, a supplier of small wind turbines to farmers, says expansion has been held back this year by resistance from local councils.

Mr McVan says decisions are taken by people who do not understand the technology or the commercial pressures they inflict on dairy farmers, who are seeking to cut energy bills in the face of rising costs and fixed milk prices. He sees it as symptomatic of a wider problem: “The lack of central direction and leadership and consistent policy is allowing people to use their own personal prejudices.”

At the larger end of the energy market, the decision by the Japanese technology group Hitachi to buy Horizon Nuclear Power, a joint venture that has plans to build as many as six nuclear reactors, for £696m, has helped boost confidence in Britain’s nuclear plans. By 2023, the UK will have shut down all but one of its existing nuclear power plants and badly needs new generating capacity.

Alasdair Reisner, director of external affairs at the Civil Engineering Contractors Association, says attention needs to be paid not just to the financing of infrastructure projects, but to who ultimately will pay the bill. One solution is user charging: ministers plan, for example, to introduce road tolling on an expanded section of the A14 in Cambridgeshire, the first time tolling has been introduced on an existing stretch of road.

Another is to ask other beneficiaries to contribute, as in Crossrail, where a special levy on London businesses is funding a quarter of the £16bn cost. Mr Reisner suggests insurers might be persuaded to help fund flood defences if these would cut claims.

He does not, however, hold out much hope of short-term improvement in the construction industry’s prospects. His organisation’s surveys suggest there is less work around than before and the outlook is less than positive.

“The middle market, companies with £50m-£300m turnover, is a fairly nasty place to be at the moment,” Mr Reisner says. “You’ve probably got a big overhead and you’re being squeezed from below and above.”

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Case study: VolkerWessels

By “luck and judgment”, the Dutch-owned infrastructure contractor VolkerWessels UK is doing better than many in the construction industry, says Alan Robertson, its chief executive.The luck is that its business is focused mainly on areas where there is still work, notably rail, ports and airports. The judgment is that is concentrating on areas where it sees a commitment to investment.

VolkerWessels UK saw its turnover grow by 20 per cent last year to £666m and it made a £12.2m pre-tax profit, after a £1.5m loss the previous year. That is still below the £17.5m it made in 2008. “It’s not where we want it to be and we have various plans to grow the profit margin,” Mr Robertson says.

The company has just finished a £32m contract to resurface the runway at Gatwick airport and it is starting a £35m scheme to build a new quay at Southampton docks for ABP. It is also in the middle of a £334m project to extend Manchester’s Metrolink tramway, jointly with Laing O’Rourke.

Mr Robertson says there are pockets of privately funded investment, but the market needs “government commitment and certainty” if infrastructure is to be developed. “Periodically we see government take steps forward and sometimes things go backwards.”

As an example of the latter, he cites the slashing of subsidies for solar projects last year. He also says deferring a decision on south-east airport expansion until after the next election means “we are going to suffer a three or four-year delay in terms of whether Heathrow gets expanded, or Stansted or Luton or Boris island”.

But he praises the government for accelerating the release of 4G radio spectrum, which will lead to high-speed mobile services becoming widespread, and for supporting the HS2 high-speed rail link between London, Birmingham and northern England.

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