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Philip Vernon, global practice co-head of corporate projects at Ashurst, sets out his view on the short-term and long-term implications for project finance.
It was natural to expect an initial tightening of credit markets following the Brexit vote. Stock and currency exchange volatility and changes to inflation and interest rate expectations have had a destabilising effect. The majority of economists were clear that Brexit would have negative repercussions—differing only on the predicted degree of severity. It is, therefore, not surprising to see how markets have reacted, especially as they had seemingly priced in a Remain vote. This translated into a falling pound, concerns about the UK commercial real estate sector, and also wider anxiety about the financial health of certain European banks.
Early market evidence, as reflected in the July Bank of England Financial Stability Report, suggests that for many UK borrowers any increase in margin cost has been more than offset by tightening gilts yields or wholesale funding costs. This is encouraging when compared to the funding cost ‘blow-outs’ of the GFC.
Most commentators expect the credit markets to be more resilient than was the case during the GFC. In particular, despite the initial bank downgrades and sell-offs, many banks are thought to be in a stronger position than they were during the GFC in terms of their ability to withstand both short-term shocks and longer-term underperformance of the economy. Even if wholesale funding costs increase, the capital and liquidity positions of most banks have improved materially and are likely to benefit further from the monetary stimulus policies of the central banks. For most banks it seems to be business as usual.
Another significant difference to the position today, as compared to the GFC, is the depth of the alternative credit funds market and an increase in direct lending by institutional investors, with the growth of the private placement market. Disintermediation has been one of the notable developments since the GFC. There will be some regulatory uncertainty and costs, such as considering the implications under the Solvency II Directive 2009/138/EC, but UK and international insurance companies and pension funds will still need to fund liabilities, and now increasingly have the ability to self-originate transactions.
It is not difficult to envisage a trigger event leading to a loss of market confidence generally and a much more constrained funding environment. However, even before the effects of policy responses have been felt (such as rate cuts and quantitative easing, as well as lowering the banks’ countercyclical capital buffer) there are reasons for relative optimism about the general state of the credit markets.
Infrastructure is usually seen as a non-cyclical sector. Commissioning large infrastructure projects often forms an important part of the policy response from government when faced with a recessionary environment. The National Infrastructure Delivery Plan 2016 (NIDP) outlines £483bn of investments in UK infrastructure to 2020–21 and beyond. When combined with the benefits of expenditure in the real economy, pressing on with infrastructure investment in today’s uncertain environment would seem to be an appropriate policy response. The Chancellor’s 2016 Autumn Statement, scheduled to be delivered on 23 November 2016, is therefore awaited with interest.
The NIDP recognises that around 50% of the infrastructure pipeline will be delivered through private finance, with ultimate funding through consumer bills, user charging, public funds from taxation or a combination of these.
Even before the Brexit vote, some banks were struggling with the impact of capital adequacy requirements on the economics of long term lending for infrastructure investments. In addition, the Brexit vote creates uncertainty over access to European Investment Bank (EIB) funding, which has been a major source of low cost finance (€5.5bn in 2015 provided to infrastructure, according to the NIDP). However, for many investors, infrastructure offers an attractive risk-adjusted yield pick-up, particularly when gilts have tightened and interest rates are low. In addition, as noted above, disintermediation has increased the depth of the alternative credit fund and institutional investor market, particularly in direct investment in the infrastructure space.
If credit liquidity does become unduly constrained then the UK government has a range of government guarantee-based funding products at its disposal. Even though the rating agencies have downgraded the sovereign rating, gilt yields have tightened reflecting their status as a safe haven investment. We therefore expect government paper, such as the HM Treasury Guaranteed bonds used to fund infrastructure, to remain attractive and available if needed.
Outlook—reasons for relative optimism
In our view, the infrastructure sector should remain active in the aftermath of the Brexit vote, notwithstanding the buffeting caused by exit negotiations, particularly based on:
We have not seen specific terms built into existing EIB facilities in anticipation of Brexit (whether by way of drawstops, prepayment events or defaults), but illegality is a normal default in any financing, including EIB financing.
The situations in which an illegality clause might technically apply include a change in the law in:
These risks currently seem very remote particularly given that:
On this basis, we do not currently consider the risk of illegality as a result of the UK exiting the EU to be significant.
It is too early to predict the EIB's role in future projects in the UK, given the current uncertainties around the terms of Brexit. The EIB and its shareholders will naturally have to develop a policy position in relation to UK borrower eligibility for future loans. It seems feasible that this might depend on the terms of any EU exit but, as noted above, the EIB already makes some loans in non-EU countries.
Until a formal Brexit has been completed, the UK will be under an obligation to implement the EU’s public procurement directives together with UK national measures implementing those directives (such as the Public Contracts Regulations 2015, SI 2015/102). This means that bodies caught by the public procurement rules must continue advertising and awarding public contracts in accordance with the obligations established through the implementation of EU Directives.
Irrespective of the legal status of the EU-derived public procurement regulations following a formal Brexit, it is expected that procurements commenced prior to a formal Brexit would be subject to the rules in force when the tender was commenced, as a result of transitional arrangements or otherwise.
The position as regards procurements commenced following formal Brexit is less clear. A formal Brexit is not expected to result in the UK’s existing public procurement regulations immediately falling away. Instead, it is expected that the UK’s existing public procurement regulations would continue to apply unless and until repealed by Parliament.
If the UK wishes to maintain full access to the EU’s Single Market, it would remain under an obligation to continue to adopt and apply the EU's public procurement Directives. Therefore, no changes would need to be made to the existing regime.
If the UK wishes to negotiate a bespoke relationship with the EU, it would be free to establish its own public procurement regime and could choose to repeal the EU-derived rules. However, in all likelihood, we would expect the UK to maintain a substantially unchanged public procurement regime following Brexit owing to:
As noted above, there are reasons for relative optimism in the field of project finance of infrastructure—including its role as a monetary stimulus.
There are various areas for consideration by project lenders and/or sponsors (see above). It will be interesting to see whether preferred sectors emerge for debt and/or equity investors during the Brexit negotiation period. Similarly, if and when a timetable for Brexit becomes clear, investors will no doubt focus carefully on projects where completion is expected to fall after the scheduled date for the UK to leave the EU. However, it seems largely a question of waiting until the Brexit terms become clearer—and ‘business as usual’ in the meantime.
Interviewed by Nicola Laver.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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