An extract from The Projects and Construction Review, 12th Edition
The United Kingdom has an established history of using project finance to fund infrastructure projects nationally in most sectors, including transport, telecommunications, schools, hospitals, power and water. A number of different project finance structures have been developed and adopted for this purpose, including the private finance initiative (PFI) (which has since been discontinued) and other variants of the public-private partnership (PPP) model, which have been used extensively to fund key infrastructure projects. The PFI and PPP models are discussed further later in this chapter.
The United Kingdom is also a key hub from where international project financings are structured, negotiated and documented, despite the underlying project being located elsewhere. The international English law project finance market far outstrips the domestic UK project finance market in both volume and size of deals.
Notwithstanding the recent economic standstill brought about by the covid-19 pandemic, in the recent past, there has been substantial demand in the United Kingdom to upgrade existing infrastructure or invest in new, greenfield projects. Each year, the government publishes a national infrastructure and construction pipeline (NIP). In August 2021, the NIP’s analysis confirmed that between £21 billion and £31 billion worth of contracts across economic and social infrastructure will be brought to market in 2021 and 2022. The transport sector accounted for a significant proportion of the 2021/2022 procurement pipeline (with a minimum of £14.8 billion and a maximum of £23.7 billion in contract value), and over two-thirds of procurement contracts for the total 2021/2022 procurement pipeline were for construction work.2
Through these investments and projects, the government aims to improve living standards, drive economic growth and boost productivity. The United Kingdom has also become one of the world’s top destinations for foreign investment in renewable energy projects and, in particular, offshore wind projects; between 2016 and 2019, the country attracted more foreign investment in greenfield renewable energy projects than any other country in Europe. According to EY’s Renewable Energy Country Attractiveness Index for 2021, the United Kingdom is ranked as the fifth-most attractive country in terms of renewable energy investment and deployment opportunities, just below the United States, China, India and France.
Multilaterals and export credit agencies have continued to participate in the market, and existing institutions (rebranded with additional products to help fill debt financing gaps) have continued to invest in the United Kingdom’s energy and infrastructure sectors; however, the United Kingdom’s access to European Investment Bank (EIB) funding, which has been an important source of funding for smaller-scale UK projects and, more recently, the UK renewable energy sector, has been significantly curtailed since the 2016 Brexit referendum.
In 2015, the EIB lent €7.8 billion to 47 projects in the United Kingdom, and in 2016 it lent €7 billion to 54 projects; however, in 2017 this dropped to €1.8 billion for 12 projects, and in 2018 this was halved again to €900 million for 10 projects – a nearly 90 per cent fall in four years. The EIB has made several warnings that funding for the UK renewable energy sector could be impacted as a result of Brexit; to qualify for funding, new projects in the United Kingdom will need to demonstrate that they will further the European Union’s policies.
To meet this gap in funding, the UK Treasury has committed to underwriting funding that would have otherwise come from the European Union. In addition, the government has established the National Infrastructure Bank as a domestic replacement for the EIB, which has an initial financial capacity of £22 billion (comprising £12 billion capital and ability to issue £10 billion of government guarantees).
The year in review
The year 2021 was very much a thematic continuation of 2020. The covid-19 pandemic continued to ravage the world’s economies with the emergence of new variants, which caused disruption to everyday life and commerce; however, the United Kingdom began to learn to live with the covid-19 virus, and though the government reinstated covid-19 restrictions several times, they were less severe than those in the previous year (the country even avoided a lockdown during the winter of 2021).
Covid-19 vaccines and a relatively successful roll-out led to a high vaccination rate and allowed the UK economy to stage a significant recovery. The state’s gross domestic product (GDP) increased by 7.4 per cent in 2021, reversing most of the 9.3 per cent decline in GDP in 2020. Likewise, by December 2021, the construction sector had largely recovered to pre-pandemic levels, with the level of construction output in that month exceeding that in February 2020 by 0.35 per cent.
The government also maintained the commitment it made in 2020 to ‘build back better’ with green energy projects and infrastructure upgrades, promising £100 billion of capital investment in the UK’s infrastructure from 2021 to 2022, which the government hopes will improve the country’s economic growth and boost productivity and competitiveness. Of this initial investment package, the government has pledged record investment in broadband, road, rail and city infrastructure, as well as a £12 billion of funding for the government’s Ten Point Plan for a Green Industrial Revolution (which includes, among other things, an overhaul of the United Kingdom’s wind infrastructure, supply chain and jobs, and the research and development of green hydrogen infrastructure and small modular nuclear reactors).
However, the unintended consequences of domestic and international covid-19 policies began to emerge in 2021. Lockdown and travel restrictions, workplace social distancing, vaccination requirements, furlough schemes, mass lay-offs and other extraneous events led to labour shortages, raw materials, components and equipment shortages, logistical problems and lower worker productivity. Such consequences did not manifest in a vacuum; they had knock-on effects on other related industries, which rippled throughout supply chains – and when multiple side-effects converged, the magnitude of the disruption was often more severe.
Take UK new car registrations (which partially reflect UK new car production), for example, which grew by a mere 1 per cent from 2020 and is down by 28.7 per cent on pre-pandemic levels. One of the contributing factors was an extraneous event that occurred on the other side of the world – a drought in Taiwan.
The drought, which was the most severe since 1964, spurred local governments to divert water sources away from industrial use. It so happens that Taiwan produces around half of the world’s semiconductors, which uses a significant amount of water in the production process (e.g., Taiwan Semiconductor Manufacturing Co Ltd uses more than 150,000 tons of water per day). The result was a worldwide semiconductor shortage, which in turn meant that vehicular manufacturers in the United Kingdom and around the globe were unable to source a sufficient quantity of semiconductors to manufacture vehicles at previous production rates.
Another contributing factor was the United Kingdom’s lockdown policies. Generous furlough policies discouraged workers from returning to their jobs or looking elsewhere for employment, thereby reducing the availability of skilled labour. Social distancing measures implemented in factories reduced production capacity and meant that training and development was temporarily halted. The ‘pingdemic’ also forced workers to self-isolate unnecessarily. The shortage of HGV delivery drivers caused delays to deliveries of parts and components.
All of this detrimentally impacted the United Kingdom’s car manufacturing industry, and it is no surprise that the average price of used cars in the United Kingdom rose by almost 30p per cent in 2021 to accommodate the lower production of new cars in the United Kingdom and around the world. This also relates to the next unintended consequence of covid-19 policies: inflation.
In 2021, inflation in the United Kingdom reached modern highs, with the Consumer Prices Index including owner occupiers’ housing costs for the 12 months to December 2021 being 4.8 per cent. Inflation was similarly high in the rest of the world: the US Consumer Price Index was 7 per cent year-on-year in December 2021, while the annual inflation rate of the Eurozone was 5 per cent in December 2021.
In the commodity space, the prices for crucial construction materials saw significant price increases that were often accompanied by extreme volatility. For example, the price of copper broke all-time high records set in 2013 and ended the year about 20 per cent higher than it started. Iron ore started 2021 at around US$80 per tonne and spiked at nearly US$230 per tonne in May, before tumbling to US$55 per tonne over the next six months. Similarly, the price of lumber doubled by May, and then crashed over the few months. The price of Brent crude slowly climbed to end the year at nearly double the price it was at the start.
The cause of this high inflation is perhaps beyond our competency as lawyers to explain in this chapter; however, it is perhaps safe to say that a myriad of factors contributed to this:
- domestic and international monetary stimulus artificially inflated asset values and the cost of production;
- lockdown restrictions, along with their side effects, such as supply chain disruptions, reduced the supply of goods and services;
- labour shortages led to wage inflation; and
- pent-up consumer demand returned as lockdown restrictions were lifted.
The two problems of supply chain disruptions and inflation will likely adversely affect the UK projects and construction sector for years to come. A lack of equipment, materials and labour will almost certainly result in longer construction schedules. Higher labour costs and commodity prices will likely shrink profit margins and make new projects more expensive, perhaps disincentivising new projects from being undertaken.
Outlook and conclusions
The United Kingdom continues to be committed to using project finance to finance domestic infrastructure projects, and this will be a key source of funding for the significant infrastructure projects for which there is a commitment that they be completed within the next decade. Furthermore, given the preference of project finance lenders and investors to use English law as one of the preferred laws to govern project and project finance documentation, the United Kingdom is well positioned to remain a key hub for international project financings.
At present, it is difficult to predict the full extent of the impact of supply chain disruptions and inflation on the UK projects and construction sector, especially with the ongoing war between Russian and Ukraine, which has only exacerbated these two problems. Nevertheless, it is widely acknowledged that things will not return to normal for the foreseeable future and that firms can expect severe disruptions to construction work and supply chains and delays to investment decisions.
Brexit will continue to affect project finance, not least the English legal framework relevant to project finance, since much of it draws from EU law. The United Kingdom’s post-Brexit public procurement is largely similar to the EU regime that was previously applicable. The United Kingdom’s departure from the European Union has also led to some important legal uncertainties that could affect projects in the United Kingdom. The Subsidiary Control Bill 2021 is currently being debated by the UK legislature, and it will be interesting to see how closely the United Kingdom’s new domestic subsidy control regime will follow EU state aid rules.
In addition, it is unclear whether the commercial viability of projects in the United Kingdom would be materially impacted as a result of tariffs for services and construction materials and parts that originate from the European Union. Finally, there has also been a concern that English law-governed contracts and English law judgments may not be effectively enforced in EU Member States as they were prior to the United Kingdom leaving the European Union.