An alternative perspective
16 May 2016
Valuing Utilities and Infrastructure
Dieter Helm, Professor of Energy Policy, University of Oxford & Fellow in Economics, New College, Oxford
Of all the asset classes that have survived and prospered after the financial crash back in 2007-2008 and the economic recession that followed, the utilities stand out. Share prices for the few remaining quoted companies have been impervious to the tribulations of the rest of the economy, and the yields in Britain have been remarkably stable at around four to five per cent.
Why? The conventional answer is that they have stable revenue streams – that they are patronage assets, and whatever the economic weather, the customers do not go away. Yet this is at best only part of the story. The real reasons lie with the underlying political and regulatory contracts and with the negative real interest rates that have been reinforced by the crash.
What is Special About Utilities and Infrastructure?
To see why these twin factors matter, we need to start with the underlying economic characteristics of utility and infrastructure – what makes them different? A utility is a system, not just a series of disaggregated projects. These systems are very capital intensive. The assets have no other uses. The result is that the marginal cost is way below the average cost. Put simply, investors put a lot of capital up front, and yet the cost of using the networks once built is very low.
The problem is that politicians and regulators know this. Throughout the twentieth century, time and again investors sunk their money into these assets, only to find politicians tempted to force the prices down to marginal costs afterwards. In economics, this is called the time inconsistency problem. How could the investors rely on getting their money back?
These systems are natural monopolies, and since there can be only one player, they have a lot of monopoly power. It is just that they are not allowed to use it to get their money back and earn a reasonable return.
The Regulatory Deal
The political and regulatory deal is that they carried out their functions in exchange for a reasonable rate of return. What has made British assets so attractive is not only that this contract is credible, and backed by a legal duty on the regulator to honour it, but that the British regulators have been setting prices in advance, for fixed periods into the future. This has the happy result for investors that the companies can outperform and earn a greater return.
The aim of this forward-looking approach is to incentivise efficiency. But the truth is that the vast bulk of the performance has come not from the day-to-day management of capital projects and operating costs, but from interest rates turning out to be lower than the regulators have assumed. There has been a systematic bias on the regulators’ interest rate predictions. Valuing utilities is therefore very much about guessing how bad the regulators’ forecasts will be. Over time the assumption is that they will get better.
The Cost of Capital
This should dampen some of the valuation premia, and it has. But share prices and acquisition values have masked this by the rush to stable long-term, inflation-linked assets. In effect, utilities have become proxies for government index-linked bonds. The difference is that they are asset backed, whereas the government is taxpayer backed, and taxpayers can vote. Given the choice between a cost of capital and yield at around the four per cent mark and a government bond at close to zero, it is not surprising that utilities remain highly valued assets.
The position for large infrastructure projects is different because most of them do not have an explicit utility-style protection. Instead, a huge variety of government-backed contracts have been offered with wildly different returns. In some cases, such as the Channel Tunnel and the M6 toll road, the investors bet that they could charge unregulated prices, which would give them a good return (which it didn’t). In others, the government was obsessed in keeping the projects out of the public accounts, and offered big returns in exchange for weakening the contract guarantee. The Public Finance Initiative in its various guises underpinned the building of hospitals, schools and bridges. Then there was the Public Private Partnerships to run and upgrade the London Underground.
Try as governments might, almost all of these infrastructure projects turned out to have very high costs of capital, for the very good reason that without government commitment, the temptation to resort to time inconsistency would prove too great to resist. In the end, unless there is a substantial amount of market power, the only way to get the projects built at a reasonable cost was to provide a credible government contract. The cost of capital for the Thames Tideway Tunnel, a super sewer running under the River Thames, is very low because there is both protection against some of the construction risks and the guarantee that customers of the utility company – in this case Thames Water – will pay. The result is a cost of capital of less than four per cent. The contrast with the costs for the Hinkley Point nuclear power project is stark. Here, the cost of capital is ten per cent real for 35 years, making it the most expensive power project in the world.
In many cases, the right answer is for the government to directly invest at its incredibly low cost of borrowing. Think how much cheaper Hinkley would be at say two per cent cost of capital. Every one per cent on a project of this scale makes a big difference – bigger than most efficiency savings, and these can in any event be gained by putting the construction project out to tender backed by a guaranteed purchase price. This is what happened in HS1 (the Channel Tunnel Rail Link) and now HS2 (a planned high-speed railway linking London with other major cities in the UK). The government raises the money and the private sector does the building.
Can the Party Last?
Are the current share prices, and the acquisition premia of around 30 per cent to the underlying regulated assets (and in some cases even 40 per cent) sustainable? The answer depends on whether the low interest rates will continue indefinitely; and whether politicians and regulators resist the temptation to resort to popularism.
On interest rates, the futures markets suggest the party will run for quite a while yet. Long-dated gilts are incredibly low. The real risks are political and regulatory. Why are the utilities allowed to get away with it? The regulatory push back starts with the cost of capital.
This can be indexed. With inflation indexing too, this only leaves outperformance on efficiency to justify the higher returns. There are benefits that come from the wider application of information technology. Networks and utilities lend themselves to digitalisation and smart coordination. Labour costs could fall further. But it is a big leap of investor expectations to think that these add a premium of up to 30 per cent.
How will it all turn out? At some stage interest rates will rise. Those utilities with both cost of capital indexing and inflation protection will remain a very safe haven. The fact that they are backed by real assets, and that these are hard to move or compete with gives extra solace. For those of a risk-adverse disposition, this could still be a good place to be.
These risk-averse investors include financial institutions which have long-term liabilities to worry about. Pension funds need to match their promises with stable earnings. Their mainstay for the last century has been government bonds. Yet the surge in government debt and the resort to monetisation of that debt through quantitative easing has cast doubt on these assets. On the one hand, the demand has driven the price to zero and in some cases, like Germany, below zero. On the other, the utilities offer a safe haven without monetisation, and a very considerable premium.
Government Has Not Gone Away
Perhaps the important question to ask is not why are the utilities trading at a premium to their regulatory asset bases, but how high is the premium relative to government bonds. For the economy as a whole, this suggests that utilities and infrastructure could be better financed through channelling these same pension fund monies through government bonds and into investments, rather than directly into the higher cost of capital in the utilities. This gap is significant, but nothing like the gap for the standalone infrastructure projects, like Hinkley. That is why HS1 and HS2 are going the state-financed route.
Valuation is of interest to investors. Value for money is of interest to governments and taxpayers. It is for this reason that the UK government is very much back in the utilities and infrastructure business. The Chancellor has no lack of ambition. His list of big projects gets longer and longer. But as the actual level of investment falls, he has repeatedly been forced to provide guarantees. Try as he might to keep these off the public balance sheet, they won’t go away. The recent renationalisation of Network Rail, together with its £30 billion of debt, is a sign of things to come.
Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.