EMEA: In-depth: UK rail sector signals to investors

12 September 2018 - 12:00 am UTC

A pipeline of privately financed rail projects in the UK may be coming down the tracks, starting with the first rail PF2. But doubts around a multi-stage procurement and contractor appetite are growing, as René Lavanchy reports

In today’s infrastructure investment market, the appearance of a genuinely new core infrastructure pipeline in a mature market is a momentous event. Yet that is what the UK Department for Transport (DfT) signalled earlier this year, when it announced market sounding events for the delivery of two new privately financed rail links to London’s Heathrow airport.

As it explained in procurement notices back in March, the DfT proposes to launch next year a PPP project for a western rail link to Heathrow, a long-planned scheme currently going through the final stage of the planning and environmental consents process. It is also inviting so-called ‘market-led proposals’ (MLP), effectively unsolicited bids, for a southern rail link to the airport, for which no government studies or routes exist.

The ambitions of the department and its political leader, Transport Secretary Chris Grayling, extend beyond these projects and towards a reinvention of infrastructure delivery on Britain’s national rail network, which for nearly 20 years has been almost exclusively managed by state-owned Network Rail (NR), funded by charges on train operators and government grants.

A strategy document published earlier this year explained that “Government wants to relieve the burden on taxpayers and farepayers by identifying and leveraging new funding sources in order to increase overall investment”.

In addition to airport links, one potential opportunity for investors is NR’s digital railway initiative, which aims to cut costs and increase capacity across the rail network by installing in-cab signalling (replacing the conventional coloured light signals) and traffic management software.

As a result there is scope, in rail, for a pipeline of both government-led PPP-type projects and unsolicited proposals structured by developers.

Going west
For now, investors sound upbeat about the most market-ready opportunity: the western rail link to Heathrow.

Earlier this year, with help from consultancies Nichols Group and Agilia, the government sounded out the market on its appetite for a PPP which is to be procured along the lines of the Private Finance 2 (PF2) model. It would be the first rail project to use PF2 and most likely the third PF2 transport project, if two long-anticipated DfT road projects commence soon.

“From a financing point of view, bearing in mind there’s a lot of capital out there chasing few opportunities, the market will be very keen to look at this,” says Darryl Murphy, head of infrastructure debt at fund manager Aviva Investors, adding that he views the project as fully capable of being structured as a PPP. “The more challenging issue is whether there is a contractor market that can take the risk.” [extra:pullquoteleft:boxoutcopy=1]

The UK railway is notorious for interface risks, both physical and operational: connecting a new rail line into an existing one is fraught with difficulties. The DfT’s unusually detailed prior information notice suggests government is keen to mitigate this risk.

The western rail link is to be divided into two contractual packages: Package A, an estimated GBP 700-900m rail tunnel connecting into existing tunnels under Heathrow used by the Heathrow Express train service, which is the potential PPP project; and Package B, a rail junction that will connect the tunnel with the main line railway west of London, earmarked for conventional delivery by Network Rail.

This is due, the notice says, to “the complexities of the interface and the constraints in connecting to the operational railway”. Murphy approves of this, noting that a PPP approach works best on projects that can be separated from the existing rail network. However, an access agreement will need to be negotiated with Heathrow Airport Ltd, which owns the Heathrow Express tunnels.

Danger on the tracks
​​​​​Others agree there is increasing reluctance among UK-based contractors to take on risks under fixed-price PPP contracts, particularly after the collapse of construction and outsourcing firm Carillion earlier this year.

“Some of the recent infrastructure projects we’ve seen, the risk has been too heavily on the private sector side,” says Mark Baxter, private finance head at Galliford Try. Baxter is not interested in the Heathrow western link, but if he were, he says he’d be looking at the risk profile and saying: ‘If this is fixed price, lump sum, turnkey under a private finance structure, sorry I’m not interested’. 

Instead, Baxter proposes a risk sharing approach, such as target-price contracting, if a PPP model is to work.

UK players aside, many large contractor-investors active in the British rail sector have sufficient liquidity to invest equity in rail PPPs. Six of the best-known firms – Alstom, Bouygues, Ferrovial, MTR Corporation, Siemens and Vinci – would be able to raise over GBP 100m in debt without affecting their credit rating, according to research by Moody’s and S&P.

But investors used to dealing with UK road or social infrastructure will need to get used to a somewhat different risk profile.

“The technical risks associated with a railway are probably more difficult than, for example, a road,” Mark Elsey, head of infrastructure at law firm Ashurst, says. “Railways are dynamic systems that rely on all the different elements functioning successfully together.”

Upcoming Rail and LRT Projects
Project Transaction Value  Status Status Date
Heathrow Southern Railway Link GBP 1500m Transaction Launch May-18
Western Rail Link Heathrow GBP 900m Pre-Launch May-18
Cambridge Oxford East-West Rail Link GBP 1000m Pre-Launch Dec-17
Southern Rail Access Scheme GBP 1400m Pre-Launch Dec-17
Crossrail 2 Station Infrastructure GBP 10800m Pre-Launch Mar-16
High Speed Three (HS3) GBP 7000m Pre-Launch Dec-14
HS2 (London to Birmingham) n/a Pre-Launch Dec-10
Source: Inframation

Nonetheless, some contractors are willing to take on rail-related risks. “There is evidence that a contractor is willing to take significant amounts of infrastructure risk if the conditions are right,” says Mark Brown, business development director at infrastructure group Amey. He points to Amey’s participation in the forthcoming Wales and Borders rail franchise, due to begin in October – as well as running trains, the franchisee is responsible for planning and managing infrastructure works to be carried out by a separate contractor. Amey is taking the risk on the infrastructure concept and design and on contract management.

Recent publicly-funded rail upgrades have been dogged by problems. For example, the electrification of the Manchester to Preston line, on which Amey took over as contractor from Carillion, has been pushed back at least seven months due to poor ground conditions. Nonetheless, Brown says he would be happy to fix a price for such work in future, but with the proviso that he would not take the risk on the quality of ground surveys provided to him as contractor. Given that surveys never provide 100% certainty about ground conditions, this would probably require some risks remaining with the public sector.

Another source of anxiety among both contractors and investors is Network Rail, which owns and manages the national rail network. Several people spoke to for this article expressed mistrust in NR and a wish for it to be kept at a distance from project identification and delivery. For its part, NR has acknowledged criticism that it is difficult to work with and has overhauled its structures in the past two years to become more business-friendly.

Twin-track approach
DfT is adopting a twin-track approach to attracting private investment on the railway. A new framework, the Rail Network Enhancements Pipeline, will see the department identify, develop and procure upgrade projects on a rolling basis.

These projects, led by government, will be privately financed where it is deemed appropriate, and they will receive government funding, for example through availability payments (which are envisaged for the western Heathrow link). But DfT is also keen to attract new project ideas from the private sector in the form of MLPs. It is particularly keen to solicit MLPs that are able to recover their costs without public funding, for example through track access charges or third-party contributions.

The DfT held a ‘call for ideas’ for MLPs earlier this year, which closed at the end of July. At least five companies are known to have submitted proposals, two of which have confirmed they have external backing.

Heathrow Southern Railway Ltd is proposing a GBP 1.3-1.6bn link connecting Heathrow to London Waterloo station and the South Western rail network. Aecom has invested in the company for the development stage. Another proponent, Windsor Link Railway, has submitted two MLPs, totalling about GBP 1.37bn, which would connect Heathrow to the town of Windsor and to the Waterloo to Reading railway. According to company founder George Bathurst, Meridiam has been signed up as a prospective 50% equity investor, with a “leading contractor”, reported to be Skanska, taking the other 50%.

DfT has not provided any funds to develop MLPs so proponents need to fund development at their own risk. In addition, any MLP which relies on government support or guarantees, such as a minimum usage guarantee or government grant, needs to go through a procurement process once approved.

Procurement would be tailored for each project but could involve two or three separate contests for option selection, design and construction. Exactly how this would work in practice is unclear.

This concerns Graham Cross, chief executive of Heathrow Southern Railway, which has spent over GBP 1m on development already. “Our clear message to government is, if you want us to invest further… we need to understand what the process is and where it leads to. At the moment, we don’t understand that.”

One step at a time
Cross adds that multi-stage procurement will discourage investors from putting forward MLPs. “No-one will risk the intellectual effort and cost in putting stuff forward if they can’t be sure of winning results in return,” he warns. “We are clear that [one-step procurement] works, and that is our advice.”

The Heathrow South project can pay for itself solely from track access charges on train operators in some of the scenarios developed, Cross notes, although he says a capital contribution from the airport would be “appropriate”. But he is asking for government to guarantee a minimum number of train services along the new infrastructure, to give investors the comfort he says they require.

Indeed, most people spoken to for this article regard revenue risk as problematic, if not outright impossible, for investors to take on a private finance rail project.

“I think it’s unlikely we’ll see any revenue risk-based rail infrastructure projects in the UK,” says Elsey at Ashurst. Mark Brown of Amey says he would be prepared to look at sharing revenue risk with government, though not pure revenue risk exposure. [extra:pullquoteleft:boxoutcopy=2]

Structuring a project financing for a rail infrastructure deal is not straightforward, says Werner von Guionneau, chief executive of fund manager InfraRed Capital Partners, who welcomes the DfT plans.

While some railway assets have a lifespan roughly equivalent to a 30-year concession, railway track lasts considerably longer – leaving significant residual value at concession expiry for an investor who has financed and built new track. “The longer it is, the more difficult it becomes. That requires the government to come up with a different approach, because then the private markets can’t function easily,” he says.

Von Guionneau adds: “Attracting new international capital into the UK is a lot more difficult than it was, which has to do with the perceived level of political stability”. This may be a particular issue for rail deals, owing to the railway’s intrinsically political nature and the possibility of a Labour government wishing to roll back privatisation. As well as UK-focused funds, he reckons British institutional investors could have higher tolerance for the political risk involved.

The digitisation play
Private equity may find a role to play in digitisation projects, which offer the chance to share in Network Rail’s efficiency gains by increasing the capacity and resilience of the railway. From a fund manager perspective, von Guionneau is enthusiastic about the opportunity, but suggests that private equity may hold back until a track record has been established. “I would expect that a lot of the [current] proposals are going to be developer-led,” he says.

Expected equity returns for rail projects, he adds, would range from 6.5-7% for the most “high quality, stable” projects with well-wrapped operating risk and no technology delivery risk, to higher rates for projects with additional risk.

Upcoming Rolling Stock Projects
Project Transaction Value  Status Status Date
InterCity West Coast Rail Rolling Stock n/a RFQ returned Jul-18
South Eastern Rolling Stock GBP 1000m Shortlisted Proponents Oct-17
Wales and Borders Rolling Stock GBP 150m Transaction Launch Oct-17
DLR Rolling Stock GBP 300m Pre-Launch May-17
East Midlands Rolling Stock n/a Shorlisted Proponents Mar-17
Source: Inframation

Despite the unprecedented nature of UK rail PPPs, he is sceptical that they would command a significant risk premium: “We’ve been running the Dutch high-speed rail link for 10 years. That’s not fundamentally different, maybe a small perception premium, but if the contract is well structured, there’s no reason it should be more than a PPP in a different sector”.

“Where I’d get nervous is on technology delivery risk,” he says. By comparison, the last PF2 projects closed in the UK had projected real equity IRRs of 7.7-9.3%, according to government data.

Some smaller projects, particularly digital-led ones which are less capital intensive, could be delivered without debt financing. For larger projects, the likely level of gearing will depend on the risk profile. “If the risk profile is perceived as similar to UK PFI/PF2 then the cover ratios/gearing will be similar,” Murphy says. This appears to be DfT’s intention with the western Heathrow link.

However, a classic project financing is by no means the only option.

Several people spoken to cite the example of the Thames Tideway Tunnel, which modifies project finance norms to allow for large variations in construction cost and relies on government guarantees to insulate investors from high-impact, low-risk events, such as a major cost overrun.

Graham Cross suggests that Tideway-style risk guarantees “have a role to play” in market-led proposals.

As well as this option, Murphy proposes that larger and complex projects could be delivered through a regulated utility structure, which would guarantee investors a return on their investment, subject to regulation. Both the Tideway and regulated asset models could facilitate a bond financing, albeit for projects of a minimum size.

Next stop?
Network Rail plans to publish a pipeline of third-party financed project opportunities later this year.

According to Rupert Walker, NR’s strategy and planning director, this could include a new flyover west of Woking on the South Western Main Line, estimated at around GBP 125m. “We’re quite keen to understand whether the market might be interested in building that piece of infrastructure for us”, Walker says.

This would present much greater interface risks with the operating railway than the western Heathrow link. Nonetheless, Walker says that NR does not rule out including brownfield and online projects in its pipeline.

Beyond the allocation of individual risks on the public or private side, a bigger question is whether private finance can ever work happily in rail infrastructure projects on the UK railway, which is operationally complex, overcrowded and fraught with disputes.

Previous similar efforts have all come undone, for various reasons (see box). While lawyer Elsey says there is “no reason” rail infrastructure can’t be privately financed, he adds: “Scheduling and coordinating maintenance and upgrades is tough enough with rail infrastructure just under Network Rail ownership… If you introduce a range of third parties responsible for different parts of track, that is likely to cause additional complexities.”

Attempts to get the private sector to take on excessive risks may result in project failure, but if substantial risks are not transferred, rail PPPs could be deemed poor value for money for taxpayers and farepayers.

The variety of opportunities currently being pursued, and the lack of consensus on how to deliver them, suggest that it will be difficult to finalise a structure for the debut project, and that it may not generate a replicable model.

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UK Rail