In July 2012 chancellor George Osborne launched the £40 billion ($67 billion) UK Infrastructure Guarantees programme. The chancellor hoped to use the guarantees to mobilise funding for stalled strategic infrastructure projects. The scheme was designed to address a liquidity shortfall in the project finance market, at a time when banks’ ability to lend long-term was very constrained.

The guarantee is available on both bank and bond financings, and covers a variety of projects, but it is designed to encourage long-term institutional lenders to participate in the sector. But at the start of 2014, market participants are starting to ask whether the guarantees were designed to solve a problem that that no longer exists.

The background and candidates

Infrastructure UK (IUK) is a unit of the UK’s Treasury, and its 20-member staff focusing on project finance include veteran bankers with private sector experience. The Treasury set up a panel of three law firms – Ashurst, Freshfields Bruckhaus Deringer and Pinsent Masons – to advise it on each guarantee transaction.

The Treasury has since prequalified 40 infrastructure projects for guarantees, over half of which are energy projects. The complete list includes gas storage, waste, nuclear, marine energy, offshore wind, biomass, university accommodation, community campus development, rail and a road bridge.

Projects had to meet five eligibility criteria: be nationally significant, as identified in the National Infrastructure Plan 2011; be ready to start construction within 12 months of a guarantee award; have equity finance committed and be financially viable; depend upon a guarantee in order to be financed within a reasonable timeframe; present good value; and to not expose the taxpayer to unreasonable risks.

So far only one project has closed a Treasury-guaranteed loan: Drax Group’s biomass conversion project in North Yorkshire.

Drax is the largest coal-fired generator in the UK, with a capacity of 3,960MW. The £700 million project will convert three of its six boilers to run on biomass. In April 2013 Drax closed on a £75 million 5-year institutional loan with Friends Life, with the Treasury fully guaranteeing repayments. It complements loans from the UK government’s Green Investment Bank and the M&G UK Companies Financing Fund, which provides loans to UK-listed corporates.

The Drax guarantee backed institutional investment in construction-phase projects, though lenders benefited from an existing asset and cashflows. Next up is the Mersey Gateway PPP, which will require a much larger guarantee, and involves much greater levels of construction risk.

The Mersey Gateway bridge will help relieve congestion in the Merseyside region in the north-west of England. The £600 million greenfield project qualified for a guarantee of up to £500 million in June 2013. All consortiums were able to bid for the project with the assumption that up to 50% of the senior debt would be guaranteed.

The financing package is not due to close until March, but a source close to the deal confirms that the guarantee remains in place. The Treasury will provide a full wrap on £250 million of bonds with a 29-year maturity. This would complement commercial senior debt, shareholder mezzanine debt, construction bridge facilities from Korea Finance Corporation and equity from sponsors Macquarie, Bilfinger and FCC.

The guarantee at work

The guarantee does not exist as a particularly well-defined template, and the Treasury has not been prescriptive about how it might work. According to Andrew Briggs, a partner at Hogan Lovells, “Although there are standard form documents, different applications will probably require the parties to negotiate on a free-form basis.”

The Treasury guarantee promised unconditional and irrevocable payment of scheduled principal and interest. Therefore lenders, whether banks or bond-buyers, are effectively only exposed to sovereign risk.

The Treasury and a borrower sign a guarantee and reimbursement agreement, just as a borrower and monoline bond insurer would. In an event of a project company payment default or insolvency that triggers a claim on the guarantee, IUK’s pro forma term sheet says that: “All amounts paid and liabilities incurred by HM Treasury under or in connection with the Guarantee will be counter indemnified by the company.”

As security, “Guaranteed debt and related claims including sums paid pursuant to the Guarantee ... are to rank at least pari passu with other senior lenders over all security assets.” Furthermore, the borrower is liable for all fees and expenses that the Treasury accrues, whether a project reaches financial close or not.

To satisfy EU state aid rules, the Treasury charges a fee for the guarantee at market rates, according to IUK. “In acting as controlling creditor, the Treasury effectively acts as a monoline insurer to carry out credit risk analysis and assign a fee accordingly,” says a lawyer close to the programme.

How IUK’s fee actually compares with the market rate is difficult to tell, because there are no deals that the Treasury can use as a benchmark. A banker close to the Mersey Gateway financing says, “It is hard to compare, as the monolines were operating at a time when the market was hugely liquid. They were wrapping with AAA but they were mispricing risk, so as soon as the credit crisis hit their business model fell apart.” The monolines’ mispricing most affected their securitisation activities, and all but one of them collapsed.

But the monoline wrap re-emerged in the UK last year, when three deals closed. The most recent, the Brunswick Housing PFI, closed in December. Brunswick’s £73.5million of listed bonds priced at 190bp over the equivalent Gilt, with a wrap from the last remaining monoline insurer active in the market, Assured Guaranty. The Leeds Housing bonds come in at 235bp and Edinburgh Student Homes at 215bp also thanks to Assured Guaranty wraps.

Monoline insurance has re-emerged as a viable option for straightforward accommodation and housing deals with low-rated construction contractors. But with energy and transport assets dominating the queue for the IUK guarantees, even the more recent crop of wraps will not serve as meaningful benchmarks.

Crowding out competitors?

As Project Finance went to press, the European Commission launched a preliminary investigation into whether the UK had breached state aid rules on the £75 million Drax biomass loan guarantee. The commission had already launched an investigation into the UK government’s hefty support for the support for the £16 billion Hinkley Point C nuclear project.

The guarantees are meant to serve as a last-resort financing option for projects. But bank and bond arrangers now argue that the Treasury is intervening in a market that is substantially changed from when it launched the product.

European institutional investors have begun to step up to provide long-term debt to UK infrastructure projects without any government support. In December 2013 British insurers Legal & General, Prudential, Aviva, Standard Life, Friends Life and Scottish Widows said that they plan to invest £25 billion in UK infrastructure and energy over the next five years.

In February 2014, Allianz Global Investors provided £174.8 million of unwrapped institutional debt for Scotland’s greenfield M8, M73, M74 road PPP. Allianz has already closed at least two French PPP financings without any external enhancement at all.

Banks now complain that too much debt capital is now chasing too few infrastructure projects. The banking source comments: “The issue is that the banks are doing long-term financing now. I‘m not sure some of the projects do need the guarantee but councils probably won’t turn it down, and the borrowers probably won’t turn it down. It is much like EIB [European Investment Bank] funding – you use it because it’s there and it’s cheap.”

Briggs of Hogan Lovells comments, “The real area of application is going to be in the energy space, where the guarantee might provide support to an offtaker’s credit or a developer. IUK has publicly stated there have been many applications but the market doesn’t have visibility on how those are developing.” Prequalified guarantee candidates tended to use newer energy technologies, including nuclear, marine energy, offshore wind and biomass.

The banker echoes Briggs’ verdict: “For availability projects, such as in the healthcare sector, that is the most competitive end of the market and they’re not getting involved there. For energy, although there are contracts for difference subsidies in place, the projects are market-facing and that is where IUK is looking.”

Déjà vu from TIFU

The UK Guarantee scheme is not the first time the UK government has tried to prop up the infrastructure and energy lending. While the latest round of guarantees is meant to help foster the growth of an institutional debt market, in the aftermath of the 2008 crisis, government contemplated taking over from bank lenders.

In 2009 the government established the UK Treasury Infrastructure Finance Unit (TIFU), which provided a direct £120 million loan to the Greater Manchester Waste scheme. The TIFU loan was floating rate and commercial banks hedged its interest rate risk.

“TIFU was like a bank within the Treasury, set up effectively to lend for Greater Manchester. It was meant to be available for as long as it was needed and would have liked to do more projects, but there weren’t further projects closing at that point in time. It lasted for 18 months or so, but some of the thinking behind TIFU and some of the people are now morphed into the team for IUK; so a kind of evolution has happened,” says Briggs.

TIFU lives on more explicitly in the renewables sector. The UK has already established the Green Investment Bank, which has been operational since October 2012. The government allocated it £3.8 billion to lend directly on a for-profit basis to renewable projects and by November 2013 it had committed £700 million.

u The US and Canada in practice

Marquee energy projects have been the best candidates for government-guaranteed debt financing, particularly when a project’s size or technology makes it difficult for the commercial debt markets to absorb deals.

The Canadian government, for instance, wrapped C$5 billion ($4.5 billion) of bonds for Nalcor Energy’s Muskrat Falls hydroelectric generating plant. The long-term project bonds priced at a competitive rate of less than 75bps over their government of Canada benchmarks, thanks to the guarantee, and closed on 13 December 2013.

The Muskrat guarantee was structured to make the bonds resemble sovereign issues as closely as possible. Xeno Martis, partner at Fasken Martineau, advised on the deal and says “The structure was unique; it was our intention to have the guarantee transfer the AAA rating of the federal sovereign to the project... There is only one default the bondholders could raise: a payment default. It looks and feels like government paper.”

The project was unusual because the sponsor is a provincially owned utility, and Muskrat Falls comprises an 824MW plant and about 1,500km of transmission lines running across several provinces, also with subsea segments. While Canada has become increasingly influential in how government finances essential infrastructure, Martis cautions that the deal is probably a one-off. “Muskrat’s guarantee was for one of the provincial crown corporations on a one-off basis,” he says. “The federal government has no guarantee programme, though some provinces do. At the federal level, there is no apparent political appetite for it.” Most of the Muskrat bonds went to Canadian investors, even though their illiquidity premium over sovereign bonds might have offered attractive trading opportunities to overseas accounts.

The US has hosted a more extensive programme of guarantees for power projects – the 1703 and 1705 Department of Energy (DoE) loan guarantee programmes. The programme started under president George W Bush, when the Energy Policy Act of 2005 passed, but did not really pick up until the 2009 American Recovery and Reinvestment Act (ARRA), which current president Obama pushed through Congress in 2009.

The 2005 act permitted guarantees, but the 1703 programme that the earlier act established required the department to charge borrowers a fee that reflected credit risk, whereas the 2009 act’s 1705 programme set aside tax revenues to cover the fees. Over 20 deals closed with 1705 guarantees before Congress allowed the funding to lapse in 2011.

Since then, the department has in theory been able to offer 1703 guarantees, and has some funding available for new projects, but it has struggled to close new deals. And as Project Finance went to press, the DoE closed a $6.5 billion loan guarantee under the 1703 programme for the 2,200MW expansion of Vogtle nuclear power plant, the first new nuclear construction in the US in nearly three decades.

But the US guarantee programme slowed in the face of congressional scrutiny of a DoE loan to Solyndra, a solar panel maker that later collapsed. It was designed to serve US government priorities rather than travel well. According to Martis, “The guarantees in the US are much more difficult: you can wait a long time to collect because their structure has complicated terms of payment. The US system has benefits but not at the same level as the Muskrat guarantee.”

u Evolution and expansion

The UK infrastructure guarantee programme still has many unknowns, and still needs to evolve. One banker following its progress thinks that there needs to be debate about how the guarantee might be adapted further. Thames Water is tendering the £1.6 billion Thames Tideway Tunnel in three construction lots and even in these smaller batches, government might have to provide support for contractors’ attempts to mitigate construction delay and overrun risk. But Mersey Gateway will provide the most immediate evidence for how the product will evolve.