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Infrastructure blocking businesses’ pipeline to growth

HS2, the government’s flagship high-speed rail project, is fast becoming the government’s white elephant. Costs have ballooned, doubts linger about its economic benefits, and pressure groups want to stop the whole thing altogether.

From its original price tag of £30bn, the cost of the rail link between London and Birmingham is now estimated at anywhere between £50bn and £70bn, depending on who you ask. Simon Walker, director-general of the Institute of Directors, has branded the project a “grand folly” while Lord Mandelson, the Labour panjandrum who signed off on it, has labelled it an “expensive mistake”.

The problems with HS2 began in 2010, when the then Labour government decided to back the project for reasons that were “partly politically driven”. Writing in the Financial Times earlier this year, Lord Mandelson, Labour’s former business secretary, admitted the project was based on cost estimates that were “almost entirely speculative” and economic benefits that were “neither quantified nor proved”.

“We were on the eve of a general election and keen to paint an upbeat of view of the future,” he wrote. “We were focusing on the coming electoral battle, not on the facts and figures of an investment that did not present us with any immediate spending choices.”

Mandelson’s admission is startling on a number of levels, but it nevertheless sheds light on why government struggles with long-term large-scale infrastructure projects. No wonder, then, that British business has such a jaded view of the ability to complete these initiatives. The government’s pipeline of projects is impressive, yet sceptics tend to view it as little more than a wish-list, rather than a coherent, deliverable strategic vision.

Infrastructure confidence graphIndeed, businesses sense the government is better at rhetoric than action despite its commitment to publicly fund a pipeline of projects worth more than £100bn over the next parliament. A joint survey of 526 businesses across the UK by KPMG and the CBI found that only a third of companies believe government policies will have a positive impact over the next five years.

“The disappointing thing is the lack of confidence that the government will move quickly enough to put in place the infrastructure to encourage growth,” says report author Richard Threlfall, partner and head of UK infrastructure at KPMG.

Across the five major infrastructure asset categories – energy, transport, water, waste and digital – only the UK’s digital infrastructure is expected to improve in the coming five years. The greatest concerns were reserved for transport and energy.

Such scepticism is derived from a number of areas: chiefly, the lack of long-term strategic planning, a lack of transparency concerning funding, uncertainty about government policy, regulatory limitations and an interminable planning process. In his report on long-term infrastructure planning, Sir John Armitt, who chaired the Olympic Delivery Authority, suggested successive governments had failed to “set strategic priorities around infrastructure investment”.

The success of the London Olympics – delivered on time and on budget – suggests Britain can deliver big infrastructure projects when the will is there. However, even a success such as the shiny new Terminal Five building at Heathrow was beset by a planning process that took eight years.

The problem, highlighted by Armitt and supported by Threlfall, is that politicians are rarely in office long enough to see the electoral and economic dividends of long-term investments that are a tough sell to the public. Difficult decisions, such as what to do about airport capacity in the south-east of England, are put off, leading to “stop-start approach” in the political system.

“Government needs to look at infrastructure as an investment rather than a capital spend,” Threlfall explains. “We went through a period where government used infrastructure investment as economic stimulus but investments will take ten years to come to fruition. We need consistency.”

Behind the investment curve

Public investment graphWhile the jury is out on whether the chancellor’s package of austerity measures have helped or hindered the economic recovery, it is now recognised that government cut capital spending too sharply upon coming into office in 2010. But the underinvestment goes back much further. Since the turn of the century, investment has been well below the majority of OECD countries. Indeed, in 2013 the World Economic Forum ranked the UK 28th for the overall quality of its infrastructure, below Germany, France and the US, and also countries such as Saudi Arabia and Barbados.

“We are behind the curve,” says Nicola Walker, head of group infrastructure at the CBI. “We can’t ignore the fact that these are incredibly tough decisions … getting cross-party support is not easy.”

However, there is a “mismatch” between moves to boost capital spending and investment and shovels actually going into the ground. “There is a lot of talk about infrastructure getting funding, but not much is being built,” says Walker.

The UK is increasingly seen as an attractive location for investment in infrastructure. More than a third of business leaders now think the UK has a more favourable environment than other EU member states, and believe the UK is more attractive than Russia, India, Brazil and China. However, capital investment is still dis-incentivised by a tax system that is “one of the least generous” in the G20, according to Walker.

In 2009, the government abolished the industrial buildings allowance and Britain is now the only country in the G20 without an allowance in the tax system for infrastructure investment. “We are keen for the government to reinstate tax incentives for infrastructure investments,” says Threlfall.

Road, rail and energy infrastructure are all gasping for private investment. The UK needs huge amounts of private capital to flow into its energy infrastructure to keep the lights on – the Royal Academy of Engineering recently warned that the UK is at increased risk of blackouts over the next two years unless electricity generators are given incentives – while the role of private sector investment in road and rail networks is still to be debated.

For instance, the much-needed upgrade to the A14 has been blighted by funding uncertainties. The scheme was scrapped in 2010, then  restarted in 2011, with the intention of garnering private investment. Construction was later pushed back to 2018. Finance directors from businesses in the area have understandably been left frustrated.

Tony Tatlow, FD at logistics business Norbert Dentressangle, says a major “pinch point” for the firm is the A14. Government dithering has affected the company’s plans to build a “new hub facility” in the area.

“Maintenance of the roads and motorways is a major concern … a high percentage have got potholes,” Tatlow says in a common enough complaint. The greatest concern for respondents to the KPMG/CBI survey is the road network, with businesses growing ever more vocal for a step change in investment.

Victorian legacy
Rail journeys graphAs the need for greater capacity increases, the problems become more acute. Tackling congestion is a primary concern – along with maintenance – while the number of annual rail passenger journeys has increased by about two billion in the past four years; freight tonnage has also seen an uptick.

In January, Network Rail unveiled £37.5bn of planned investment over the next five years intended to improve journey times, increase peak time capacity and reliability. Yet this comes at a time when subsidies continue to fall. Government support reached a peak of £7bn in 2008/9 but has since fallen to under £4bn, much of which is increasingly being used to pay off past investments.

Since the collapse of Railtrack, the new operator has been “grappling with an investment backlog”, explains its CFO Patrick Butcher. In many areas, the nation’s railways are still using the infrastructure bequeathed by the Victorians. So much so that some signal boxes still rely on a human to pull the lever. “It’s not a model fit for industry in the twenty-first century,” Butcher said at the recent TalkPower energy conference. “A lot of assets put in by the Victorians are being used today in the same form.”

This goes some way to explaining current business sentiment towards the rail network. For commuter rail, just 20% of businesses think they have seen an improvement in the infrastructure over the past five years, while 45% think the network has actually deteriorated over the same period.

Much of the investment made by Network Rail is aimed at network enhancements – such as extending platform lengths – but the rate of improvement is being stymied by the size of the operator’s debt position. The cost of servicing Network Rail’s debt has grown to £1.5bn a year; it has a regulated asset base of £40bn and is one of the most capitalised industries in the UK and has a larger debt portfolio than all the water utilities combined.

“As you look longer-term, our debt is getting bigger and bigger,” says Butcher, which has created “distorted incentives” for the business. “Over the next five years, we will need to look at fixing our interest costs.”

In assessing the long-term financial sustainability of the UK’s railways, Butcher says it is important to consider whether Network Rail’s debt level can be re-financed and serviced effectively. But he thinks there is an opportunity to introduce risk capital – or private investment – into the railways.

According to Network Rail’s finance chief, the UK should behave more like Hong Kong, where the network would develop large pieces of real estate and hold the assets. A global leader in the integration of rail investments and urban development, Hong Kong’s MTR Corporation, operates the rail system and develops real estate around the station, which contributes to a significant portion of its revenues.

“In Hong Kong, the tenants would pay rent to the operator,” he says. “There’s lots of opportunity at that commercial intersection. Financing requires a funding model that provides a return on investment.”

Fantasy island
Butcher is not alone in admiring the Chinese way of doing things. Like Butcher, Boris Johnson is an advocate of doing things Hong-Kong style. On a recent stop-over in Hong Kong as part of a trip to China, London’s mayor reiterated his claim that a hub airport should be built on reclaimed land in the Thames Estuary to ease the capital’s airport capacity problems.

Johnson called on the government to follow Hong Kong’s example, where the Chek Lap Kok airport is built on land reclaimed from the sea, and said David Cameron and George Osborne are “kidding themselves” if they think a third runway at Heathrow will be enough to keep Britain competitive.

But Johnson is alone in calling for a new airport. “I don’t see anybody else coming to the barricades. Do you hear them? Do you hear anybody else?” he told the Financial Times in September. Supporters of expanding Heathrow point to the lower price tag of about £18bn, compared to the estimated £98bn a Thames Estuary airport would cost.

Arguments aside, a decision has been repeatedly kicked into the long grass. A white paper sought to address the issue of limited capacity in 2003 by setting out a 30-year strategy that centred on expansions to Heathrow and Stansted. Nothing happened, the government changed, and the proposal was dropped. Ten years on, and the findings of another commission – this one led by Sir Howard Davies – are eagerly awaited.

In the meantime, the country’s airport capacity is diminishing. It has been 60 years since the last major runway was built in the south-east of England, both Heathrow and Gatwick are operating at near full capacity, and some estimates put the south-east’s airports as potentially becoming full by 2025.

Three-quarters of business leaders expect the UK’s airports to stay the same or worsen, which does little to instil confidence in businesses being encouraged to look abroad for growth as part of the government’s target of an export-led recovery.

“It’s crucial we have more capacity,” says Threlfall, who warns trade will start “hubbing through countries outside the UK”. “That can’t do any good in a global market.”

Getting strategic
So where does the UK go from here? On the investment front, the government is edging closer to implementing PF2, its preferred model for public private partnerships, and announced rail, road and energy projects worth £33bn have passed the first hurdle in joining its infrastructure guarantee scheme.

In the past 15 months, the UK Guarantee Scheme, which has the capacity to underwrite up to £40bn of investments up to 2016, has been used just once when £75m of the £700m project to convert the Drax power station was underwritten. At the time of writing, 15 applicants have been named.

In the longer term, experts are calling for the government to adopt some form of independent commission to develop a nation-wide infrastructure strategy. The LSE Growth Commission, a group of economists, has called for the creation of a an ‘infrastructure strategy board’ to provide independent expert advice to parliament to guide strategic priorities. Under this would come an ‘infrastructure planning commission’ to deliver those priorities and an ‘infrastructure bank’ to provide finance.

Their suggestions are not far from the mark laid down in the Labour-commissioned Armitt review, which itself called for a ‘national infrastructure commission’ that would be set up by an Act of Parliament. Its remit would be to identify the UK’s infrastructure needs over the next 25-30 years. Every ten years, the Commission would produce a National Infrastructure Assessment looking at the UK’s needs over a 25-30-year period. The Assessment would focus predominantly on “nationally significant” infrastructure as defined by the 2008 Planning Act and would cover all of the key economic infrastructure sectors (energy, transport, water, waste and telecommunications) in parallel, rather than looking at individual sectors in isolation.

As the debate over the value of HS2, and whether money should be spent on planes, trains or automobiles – not to mention the country’s digital, water, waste and energy capabilities – rages, Threlfall believes it “isn’t about prioritising one over another”.

“Most important is to set out a holistic plan of how it all fits together and how they support each other,” he says.

BOX – Nuclear option

Judging by the policy statements on energy pricing being fired off during the political conference season, the need for affordable energy has become something of a hot potato for politicians. In recent weeks, British Gas and SSE hiked their prices and partly blamed government policies for the increase.

Indeed, more businesses are concerned about future supply. Significant amounts of investment hangs on the passage of the Energy Bill, with business leaders becoming more sceptical about the prospects of improvement in energy infrastructure.

Strides have been made, however, after the government struck a deal with French utility EDF to build the UK’s first new nuclear plant in a generation. The long-awaited agreement paves the way for the construction of a £16bn power station which will provide 7% of the UK’s electricity when it is completed in 2023.

However, critics the government’s guarantee that it will pay a “strike price” of £92.50 per megawatt hour to EDF and its Chinese partners over the next 35 years – whatever the prevailing market price will add to the cost of fuel bills.

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