There’s been a lot of discussion over the past month about the first-ever deployment of the UK treasury’s state guarantee instrument for privately financed infrastructure projects: a £75 million guarantee covering a portion of the roughly £800 million financing for the Drax coal-fire power station in North Yorkshire. The financing, which is expected to be more than needed to cover the initial investment cost, will pay for converting three of the plant’s six coal-fired units to run on biomass (wood). The guarantee was signed late last month.
The idea behind UK Guarantees is fairly simple, and the thinking goes like this: the UK needs more infrastructure; some of that infrastructure needs private finance; that which needs private finance may have a tough time attracting it at the moment; so to reduce the risks associated with lending to infrastructure, and encourage new types of investor to lend to it, the Treasury guarantees to the lender that they will get their money back. The scheme was launched last July but until now, no private party has agreed to actually use it.
There’s been a lot of criticism of UK Guarantees, including a slew of unflattering references to it in the Financial Times; now that the scheme has finally found one home, does this mean it has proved its worth? Well, er, no.
The trouble is that risk is linked to reward, and the lower the risk you are taking, the less reward (or risk premium) you can expect to get for it. Although using a guarantee does remove the risk for an investor that they won’t get their money back if the project goes wrong, it also reduces the return they will get.
As the government knows, it needs to attract more insurance companies and pension funds to invest in infrastructure to replace the banks which are progressively withdrawing from the market. And it’s true that these types of investor want low-risk investments.
But introducing a state guarantee means that the risk they are taking is that the state won’t pay – they are effectively borrowing from the UK government. Well, they can already do that by buying government bonds. Insurers and pension funds do want low risk, but they also want a diversified portfolio, with some investments slightly riskier than others. They might not want their investments to be covered by this guarantee.
So who is lending to Drax under the guarantee? Step forward insurer Friends Life (formerly Friends Provident), who are lending £75 million which will take up the whole of the £75 million guarantee. But not for much reward.
Market sources are saying that the margin on this loan – i.e. the interest rate over Libor – is insanely low, and one told me that it’s a mere 40 basis points – 0.4 per cent! That compares to a reported 225 basis point margin for another component of the financing, a £400 million revolver. 40 basis points is totally unaffordable for a bank, and I would guess for many insurers and pension funds too. A good deal for Drax, but it won’t attract many people at that rate.
The other reason Drax isn’t likely to set a trend is that the duration of the various loans – which range between four and eight years, according to a report in Infrastructure Journal – is far too short for most infrastructure projects. It’s okay for Drax because a) biomass doesn’t take that long to build and b) it’s a conversion of an existing plant so there is immediate cash generation on tap to service the debt. But most of the projects in the government’s National Infrastructure “Plan” are entirely greenfield, i.e. new builds, and they will require longer-term debt to sutain them while they make a return – in most cases, over ten years. Insurers and pension funds actually quite like such long-term debt, because it closer matches their liabilities. But Drax hasn’t shown them how to access it.
Nor does the guarantee encourage an investor new to the market to learn about infrastructure, as my ex-colleague at Infrastructure Journal Olivia Gagan pointed out to me. If you are taking UK government risk, why bother finding out about the risks inherent in the project? But if you don’t, you won’t develop a taste for investing in infrastructure as such – a taste which must become more popular, because UK Guarantees don’t cover everything, they can’t cover everything, and nobody wants them to anyway.