Infrastructure Spotlight - Autumn 2022

Infrastructure M&A has continued to be very busy during 2022 and has demonstrated a greater resilience than the wider market. Deal activity has remained stable throughout the sector both in the UK and Europe with transactions in the transport, telecommunication and energy transition space gaining a greater significance in contrast with a decrease in renewable transactions.

The uncertainty in pricing caused by macro-economic conditions (including questions on inflation, interest rates, geopolitical conflicts – including the war in Ukraine and disruption of supply chains) and the possible reallocation of assets in portfolios by investors following the downturn in the public equity markets, is likely to decrease the volume and speed of infrastructure M&A. However, even though a slower pace in infrastructure transactions is expected in the near future, we continue to experience a high volume of deal activity.

ESG and energy transition have become part of the agenda globally. This has allowed governments, including in the UK, to create incentives for private investment in such areas. As detailed below, the UK Government has continued to introduce initiatives to reach net zero in the UK by 2050. We continue to see deployment of equity and debt into energy transition such as EV charging, battery storage, district energy and hydrogen. 

Traditionally in a high inflation environment, energy, infrastructure and other real assets can be expected to attract investment due to their softer or harder linkage to inflation. These factors can provide a safe harbour for investors in times of greater uncertainty. It should not be seen as a coincidence that recently a number of core infrastructure mega-funds have been launched and that H1 2022 has set the record for annual fundraising for infrastructure funds.

Considering the cash availability, asset stability and political agenda, we remain optimistic that past the current global turbulence, the sector will remain an attractive value proposition to investors.

Two steps forward, one step back - the road to net zero in UK energy

'Net Zero' has always presented an appealing, if somewhat intangible, vision of a clean, robust and secure energy system supporting an ever more efficient business and residential user base by 2050. But viewed from the current perspective of a society facing steep inflation and a cost-of-living crisis driven by energy prices, which are in turn shaped by and influencing global conflict, all the while still relying heavily on fossil fuels and their consequent toll on the environment and well-being, it feels nothing less than essential. And yet, the road to Net Zero seems more uncertain now than it has been at any time over the last decade.

The rapid expansion and subsequent challenges of renewable subsidies

From a regulatory support perspective, the drive for clean energy got off to a flying start following the turn of the millennium. In the ensuing decade, an almost dizzying array of feed-in-tariffs, renewable obligations, renewable heat incentives, renewable fuel obligations and other incentives drove a surge in uptake and innovation. At that time, the future seemed to be (and perhaps still is) a fully decentralised grid based on the production of energy on an individual, community or local area led basis (rooftop solar; small scale wind turbines; micro anaerobic digestion etc).

However, the subsidies came to be seen by decision makers as expensive and complex. They were also long term (20 or more years), which was effective in providing investor certainty but is now presenting challenges. Perceptions of what is 'green' can change over time - as seen in the recent scrutiny of the sustainability credentials of wood biomass at Drax power station, which provides 12% of the UK's renewable power and receives around £500 million of Renewable Obligation subsidy a year. In addition, when wholesale prices rise sharply, suddenly highly profitable generators continuing to receive subsidy can present political difficulties (hence the government now engaging with those generators in the hope of restructuring subsidies). Finally, the storage solutions and grid (including smart) capabilities required to make this small-scale renewable revolution work to its fullest potential haven't yet caught up, for a variety of reasons.  As renewable technology has matured and cheapened, government has therefore eased off the regulatory accelerator pedal in recent years. The hope was that there was enough momentum for the market to carry energy production in the UK through to a Net Zero future.

A possible weakening in regulatory resolve?

The momentum towards cleaner energy seems to have now stalled slightly. The government instead seems to be increasing its emphasis on pragmatism and the role of oil and gas as a transition fuel. This seems intended to foster a sense of stability – for the grid, but also for a market made up of various actors (including the government) with an economic interest in the continued exploitation of oil and gas resources. Hence, we see:

• the British Energy Security Strategy, released in April 2022, declaring that "Net Zero is a smooth transition, not an immediate extinction for oil and gas" and establishing the snappily titled 'Gas and Oil New Project Regulatory Accelerators' to support and facilitate the development of new oil and gas projects;
  
  
• the recent government announcement of a new oil and gas licensing round, which is expected to deliver 100 new licences for extraction of fossil fuels from the North Sea;
  
  
• as mentioned in the introduction, the September 2022 Growth Plan announcing an independent review on how Net Zero can be delivered "while maximising economic growth and investment, supporting energy security, and minimising the costs borne by businesses and consumers" – pointedly noting that the 2022 economic climate is rather different to that in 2021 when the more unequivocal Net Zero Strategy was published (but not highlighting that the strategy was successfully challenged recently by environmental NGOs for lack of detailed plans to achieve Net Zero); and
  
  
• the consolidation and protection of existing imports of LNG from countries such as Norway and Qatar.

Which is not to say the UK government is committing itself to a fossil fuel future. Net Zero remains a legally binding target and a policy commitment. There is also the possibility to off-set some of the impact of future oil and gas exploitation through the development of carbon capture and storage (although the government's track record of supporting the development in this area is spotty at best). And funding is still being made available for the pursuit of cleaner forms of gas, via hydrogen pilots and development (see Update on the Low Carbon Hydrogen Business Model in this newsletter) and through the new Green Gas Support Scheme (effectively the successor to the non-domestic Renewable Heat Incentive) to support biomethane.

Big infrastructure and big unknowns

How to square all of this with Net Zero? Well, it feels like the government is putting many of its chips back on big infrastructure – particularly nuclear and offshore wind. These offer large baseloads of low carbon power. Nuclear has various difficulties (e.g. reliance on overseas technology; dealing with long term environmental impact of waste; safety concerns). Wind also gives rise to some concerns (including impact to bird and marine life). But both also share notoriously long and complex consenting processes (not least due to the aforementioned environmental risks) – which have been getting slower over the last decade. Hence the government proposes to streamline the planning and consenting process for larger (in England, above 50MW onshore and above 100MW offshore) generation projects via a new Planning and Infrastructure Bill. It is not yet clear what this will consist of, but the forthcoming removal of EU laws from the statute book (see Retained EU Law (Revocation and Reform) Bill in this newsletter) creates certain opportunities - with speculation rife that government may be intending to pare back the Environmental Impact Assessment process. Naturally this has NGOs concerned that the government would effectively be trading carbon for biodiversity. In addition to planning reform, the annex to the government's Growth Plan contained a non-exhaustive list of infrastructure projects to be "accelerated as fast as possible" with construction targeted to begin before the end of 2023 (including the Sizewell C nuclear power station and seven offshore wind groups of projects). However, the Autumn Statement rowed back on the specifics of that list, while insisting that the government remains committed to accelerating delivery of projects “across its infrastructure portfolio”. Speculation is inevitably rife that some major projects may be delayed, or even axed.

Beyond this, the hope is apparently that various new technological solutions will unlock the Net Zero future. Further pilot and development funding is being made available to carbon capture and storage, hydrogen and nuclear fusion projects. The concern is (as is perhaps seen in the stalled development of carbon capture and storage) that these types of new technologies and ways of working require more systemic change, support and regulatory reform to truly be effective, rather than sporadic project support. It is beginning to feel like the 'two steps forward, one step back' approach seen in policy to date may need to become a more determined and focused march forwards.

The future of heating

At present, heating buildings accounts for some 21% of all UK carbon emissions and will need to remain a key area of focus for the UK government if it is to achieve its target of net zero greenhouse gas emissions by 2050.

The task however is huge and, at present, less than 5% of heating used in UK homes comes from low-carbon sources and these, and any other new low carbon, technologies will need to attract investment of over £250 billion to fully decarbonise homes, according to the Climate Change Committee. Put another way, the UK Research Energy Centre projected back in 2020 that one million homes will need to be retrofitted every year for the following 30 years to meet the net zero target by 2050.

The plan to achieve this is currently based on three low carbon technologies, namely:

(i) Heat networks;

(ii) Heat pumps; and

(iii) Hydrogen. 

Taking each of these in turn, what is the current state of play?

(i) Heat networks – also known as district heating, heat networks take heat from a central source and deliver it to multiple domestic or non-domestic buildings. It currently accounts for 480,000 customers or 2% of heat demand in the UK and is targeted to deliver around 19% by 2050 if the UK is to meet its carbon targets. The new Energy Security Bill introduces a regulatory framework to enable heat zoning in England – this is envisaged to require heat networks developed within zones to meet a low carbon requirement and also for certain buildings, principally new buildings and those with communal heating, within zones to connect to a heat network within a specific timeframe. From a consumer perspective, Ofgem's role as regulator will expand to cover heat networks, so that consumers are ensured a fair price and reliable supply of heat. Heat network developers will also be allowed to access powers equivalent to those for gas and electricity so that heat networks can be built out more quickly and cost effectively. 

(ii) Heat pumps – the UK is some way behind other countries in Europe and North America when it comes to the use of heat pumps for hot water and heating households. The government's plan to bridge this gap is to replace old gas boilers with low-carbon heat pumps and install 600,000 of them a year by 2028. In addition, all new heating systems from 2025 will not be allowed to connect to the gas network. There are however a number of challenges ahead – the age of housing stock and need for external space to house a pump, the cost of replacing radiators and pipework to accommodate a heat pump's lower temperature and the cost of the pump itself.  Given these challenges, it is likely that the new build market will be the initial focus for heat pump roll-out.

(iii) Hydrogen – still the new kid on the block, there are hopes that hydrogen could provide a credible and clean alternative to heat pumps in heating homes. However, some doubt has recently been cast on the viability of hydrogen for heating our homes, given the likely high cost and need for technical alterations including in-home pipework. Nevertheless, it remains a potential part of the future mix of heating solutions of the future and five hydrogen projects feature on the list of priority infrastructure projects in the UK Government's recent Growth Plan. See below for our update on the Low Carbon Hydrogen Business Model.

The age of government and regulator interventionism in M&A transactions, much-discussed for several years, seems to have arrived. Whilst competition regulators have sought to expand their jurisdiction to investigate transactions that previously escaped scrutiny, governments and the European Commission (EC) have also become increasingly concerned about the public interest implications of inward investment, particularly in sectors of core importance to national security or civil society.    

Perhaps one of the biggest shake-ups of the UK's regulatory landscape in recent years is the introduction of the UK's National Security & Investment Act (NSI Act). The regime focuses on the risk of a deal to the UK's national security, but unlike other 'foreign direct investment' regimes, does not only apply to deals involving a foreign investor: it focuses on the activities of the target relevant to national security. Whilst 'national security' is undefined, several sectors within the UK's Critical National Infrastructure may well also be considered important to national security (e.g. energy, communications, transport, health and water).

Coordinated regulatory action

Under the NSI Act, the UK Government expects its Investment Security Unit (ISU) to review approximately 1000-1850 notifications per year (although the number actually received is slightly below that).  Acquisitions in 17 mandatory sectors (including e.g. energy, communications and transport) require clearance from the ISU prior to closing.    

Inevitably, a number of these cases will also be reviewed through a competition lens.  Since the untangling of the UK's merger control regime from the EU's "one stop shop", transactions may fall for parallel 'merger control' review by both the EC and the UK Competition & Markets Authority (CMA). Deals may also need to be notified to the national competition authorities of other countries.

Regulation of foreign investments in Europe appears only set to increase, with the Commission now also set to introduce another new notification regime for M&A deals that have been facilitated by 'foreign' (i.e. non-EU) subsidies: the 'Foreign Subsidies Regulation'. That regime is set to come into force mid-2023.

Expansive jurisdictional reach

Merger control regulators around the world have become focused on the extent to which they should be able to expand their jurisdictional thresholds to review, in particular, acquisitions of disruptive nascent or start-up businesses by large firms potentially seeking to protect their incumbent position (so-called "killer acquisitions").  

An example of the EC's willingness to apply an expansionist approach is Illumina's acquisition of GRAIL, a healthcare company developing cancer detection tests. Despite GRAIL not having generated any turnover in Europe (and therefore not meeting the financial thresholds for notification under the EU Merger Regulation), six Member States referred the deal to the EC for review. The transaction has now been prohibited by the EC.

The CMA considers that its very flexible jurisdictional test is an advantage of the UK merger control regime, enabling it to review transactions which could not be investigated in other countries. However, an expansive approach to that test comes at the price of legal certainty for parties, who risk having their deals subject to a UK merger control review, even post-closing. 

Procedural issues

The need to navigate parallel reviews, across a range of issues, inevitably risks a more complicated coordination task for parties, potentially impacting the timeline to closing and key terms such as financing.

This is exacerbated by the fact that different regimes operate different timetables and trigger points (e.g. remedies may be accepted at Phase I in a CMA merger control review, whereas in a UK national security review, a full assessment - akin to a 'Phase II' - is required before remedies can be accepted).

In the merger control sphere, a significant implication of the UK's voluntary regime is that it has the power, almost always used in post-closing reviews, to impose a hold separate order (known as an initial enforcement order, or IEO), requiring the target business to be operated entirely separately from the buyer. The CMA has imposed significant fines for breaches of IEOs (Facebook was recently fined £50.5 million in the Facebook/Giphy case).  For international transactions, the CMA's starting point is that an IEO applies globally, such that, to begin with, all parts of the parties' businesses will be subject to the IEO.

Deal documents should therefore cater for all relevant processes, with appropriate gap periods. Approaches to regulators should be coordinated so far as possible in order to manage deal timetables and, when planning for acquisitions with a UK dimension, parties should carefully consider whether there might be a realistic basis for the CMA and/or ISU to take jurisdiction (and whether any associated 'clawback' protections need to be included in deal documents).

As the private infrastructure market has continued to evolve into a wider range of “core-plus” and “value-add” infrastructure investments, there is a continued crossover of investment opportunities that are attractive both to private equity (PE) funds and infrastructure funds, particularly in areas such as social infrastructure and TMT.  

As a result of this interchangeability in PE/infrastructure ownership across certain assets, we are increasingly seeing, in the core-plus/value-add infrastructure debt market, infrastructure investors wanting to benefit from the flexibility in debt terms that PE funds have been able to obtain for similar assets.

Infrastructure finance partner Ben Thompson’s chapter Core-Plus Infrastructure and Leveraged Financing: The Continued Convergence of Terms in The International Comparative Legal Guide - Lending & Secured Finance 2022, sets out some of those terms that we are seeing more commonly being sought by infrastructure funds for the debt financing of their assets, which traditionally would have been more commonly seen in the PE/leveraged buyout (LBO) debt market.

Read the full chapter.

In April 2022 the UK introduced a new tax efficient vehicle: the qualifying asset holding company (“QAHC”, generally being pronounced “quack” in the market). This new regime provides a simplified basis of taxation, and a host of generous tax benefits (both for the QAHC and its investors), which should allow the UK to compete as a go-to jurisdiction for holding companies.

Please see our briefing from March, which provides a simplified overview of the tax benefits and consequences of QAHCs, exploring how they will benefit infrastructure funds and investors and commenting on how QAHCs compare with Luxembourg's offering.

It is understood that HMRC is trying to improve the regime and we have been engaged with
them on a number of deficiencies within the rules. Indeed, since the introduction of the QAHC regime in April, there have already been amendments to make access to the regime easier for funds in corporate form and for other fund structures, and there are additional changes expected next year. It is generally encouraging to see that HMRC is responding to feedback from taxpayers to make improvements to the new QAHC regime, including making the regime more accessible.

The Government is proposing a wide-ranging reform of retained EU law.  For many businesses, the most significant point to be aware of is the proposal for a large proportion of retained EU legislation to be revoked at the end of 2023, unless expressly preserved by Ministers.  This creates the risk of another Brexit-related cliff-edge for business, as it may not be clear which measures are being allowed to expire until close to the initial deadline.  From an infrastructure perspective, a wide range of measures relating to the environment would – in theory at least – be at risk of revocation, although recent press reports suggest that the Government may be rethinking its approach to at least some aspects of the Bill. In combination with the Government's Growth Plan which includes proposals to streamline processes and expedite approvals for some energy and infrastructure projects, developers may see this as good news in the short term at least, if they can handle the inherent uncertainty that it brings.

Our briefing examines the Bill in more detail and discusses whether it will help to drive growth (e.g. through deregulatory measures) or just create further uncertainty for business.  We also look at some potential examples of EU-derived measures which might be considered candidates for revocation under the Bill, should it become law.  For an explanation of the current position on retained EU law, see our detailed guide.