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Magazine Issues » July-August 2022

Infrastructure’s case is proven

AirplaneQueueIn the midst of market volatility, the theory that infrastructure provides consistency has turned out to be correct. The asset class also provides a great ESG engagement opportunity, writes David Blackman.

The past few months have been pretty bleak for investors as returns on mainstream asset classes of bonds and equities have slumped in the face of stagflation fears and the war in Ukraine.

However, amidst this wider gloom, infrastructure funds have stood out. In the first week of June, returns for both the MSCI World Core and S&P Global infrastructure indices were within 1% of where they were on December 31.

That may not sound too exciting. But in an environment where both bonds and stocks are down around an eighth of their value over the same period, a return of zero represents a “very, very solid outperformance”, argues Nick Parsons, head of research and ESG at ThomasLloyd.

“In the current environment, that’s tremendous,” he adds. “Anybody who’s got a total return of zero in their investment fund is probably a top decile performer. Zero makes you a hero.”

This strong recent track record for infrastructure shows that the theoretical case for investing in the sector has been proven, says Amarik Ubhi, global head of infrastructure in the alternatives group at investment consultancy Mercer.

“Infrastructure has finally proven that investment thesis,” he notes. “Ex post, we can say by and large, it has delivered on those expectations in terms of lower volatility returns, lower correlation and lower downside risk as well. You’ve now got real, tangible evidence of the ability of the asset class to deliver when under stress.”

Parsons agrees. “They’ve done what they were supposed to do. It really is a classic example of turning textbook theory into practice. Infrastructure is supposed to be a non-correlated asset, which is very good for portfolio diversification and ought to perform well at times of high inflation. That’s where we are and that’s what it’s done.

“It’s done what it’s supposed to. It provides portfolio diversification by clearly not being correlated with stocks or bonds and it’s held its value.”

Grown from a niche
His own firm’s Asia Renewable Energy Fund, which Parsons says is the first to be launched on the London Stock Exchange with an exclusive focus on the region’s emerging economies, appreciated by more than a fifth between its launch in mid-December and his comments to Funds Europe in June. This solid picture of recent performance builds on a growing appetite for infrastructure investment over the past decade, during which ‘infra’ has grown from a niche element in asset allocations.

In its latest annual ‘Global Infrastructure Report’, published in January, data gatherer Preqin forecasts that assets under management in private infrastructure will reach $1.87 trillion by 2026, exceeding property to become the biggest ‘real asset’ asset class.

This has seen many investors, inspired by the likes of the Canadian mega-pension funds, scale up what were only marginal allocations to the asset class as recently as the mid-2010s, says Thomas Le Grix de La Salle at boutique asset manager RMII: “A lot of institutional clients are exiting or reducing their fixed income bucket and reinvesting into alternatives in the infrastructure space.”

Mercer’s Ubhi agrees. “We’re seeing more investors allocate over time, and we’re seeing those that have allocated generally increasing their allocations,” he says.

Investors “really like” the current lack of correlation between infrastructure and the rest of the markets, says Parsons at ThomasLloyd.

Greener infra
Meanwhile, private infrastructure funds are adapting to the rush to more environmentally friendly assets.

A decade ago, airports were one of the key mainstays of many infrastructure funds. Investors liked these airports because they offered steady returns and what Ubhi describes as an “essential” service that people must use in order to fly from their hometown or city

And like utilities, another mainstay of infrastructure funds, airports are often regulated by governments to deliver returns with a link to inflation rates, like the landing charge regime for London’s Heathrow Airport.

Viewed through an environmental lens, though, airports no longer look as attractive now as concerns about the impact of rising emissions have risen up the agendas of both governments and investors.

Funds Europe recently reported on the pressure put on Macquarie Asset Management to square its ESG commitments with its ownership of an airport at Farnborough, near London, which caters for private aviation. The Farnborough Noise Group claims that flights by private aircraft, which tend to be owned by high-net-worth individuals, generate 18 times more emissions per head than their commercial equivalents.

The airport was acquired in 2019 by Macquarie Infrastructure and Real Assets, which two years earlier had taken over the Green Investment Bank following its privatisation by the UK government. Macquarie, which has committed to cutting its emissions to net zero by 2040, told Funds Europe that Farnborough has made strong progress on decarbonising its activities.

This spat illustrates the real-world challenges infrastructure funds face as they seek to negotiate the transition to net zero. The picture has been further complicated by the boom in oil and gas prices this year, caused by potential restrictions in supplies of these commodities as a result of the Russian invasion of Ukraine.

What were recently being written off as legacy or even potentially stranded assets, amidst the enthusiasm surrounding raised emissions-reduction targets at last November’s COP 26 UN climate change summit, have a fresh lease of life. Many European countries are even building new fossil fuel infrastructure, such as the new liquid natural gas terminals Germany is building to cut the dependence of the continent’s economic powerhouse on piped Russian supplies of the fuel.

However, these same geopolitical shifts are also fuelling an appetite among governments for low carbon, renewable sources of energy, as those same countries belatedly seek to wean themselves off volatile imported fossil fuels.

“The higher the price of crude oil, the greater the attraction of the alternatives. When looking at a mix of energy, solar and biomass become that much more attractive,” says Parsons.

There is increased demand from governments, cash-strapped following huge pandemic bailouts, to secure private investment to plug net-zero infrastructure deficits, says Richard Sem, investment manager for Pantheon Infrastructure. “Post-Covid, governments will increasingly want the private sector to step in.”

And renewable energy is becoming viewed as an increasingly mainstream asset by institutional lenders, says Le Grix. Solar PVs, for example, were seen as “quite risky” transactions in the mid-2010s but are now common, he says.

So-called ‘clean energy’ accounted for almost 50% of infrastructure deal volumes between 2012 and 2019, according to a UBS briefing note.

Ubhi says there is typically a “very high” correlation between those infrastructure managers rated highly from both an investment and an ESG perspective.

“Real impact”
A search for ESG-compliant investment can be a driver for seeking out private infrastructure funds. Parsons says: “Turmoil in traditional markets is making private markets and real assets look far more attractive, as the turmoil in the oil market and fossil fuels is making renewable energy that much more attractive. Those are two big shifts which are occurring and can be expected to happen for some time to come, because we are going to have to live with higher oil prices.

“The more concrete you pour, the less interest there is from investors.”

And investing in private rather than listed assets enables investors to feel they are making a more tangible contribution to the activity that will ultimately help to cut emissions, according to Parsons.

He adds: “There is clear demand from investors to look at energy and those companies and those funds which can offer them direct exposure, not indirect exposure.

“They want to invest where the money makes a difference and you do not have any impact by buying equities in the secondary market: all you do is change the ownership of the share certificate, so you don’t provide any new funds for investment.

“There’s a growing realisation amongst investors that just going down the traditional route is not giving them what they want. When you can show the difference their investment is making, it’s much easier to attract funds. There is clearly real impact.”

Infrastructure provides unique opportunities to access direct investments in sectors such as clean energy, says the UBS briefing.

The private infrastructure sector was initially slow to integrate ESG best practice, it says. However, the past five years have seen a rapid transformation, with infrastructure investors finding innovative ways to measure an asset’s ESG performance, the bank adds.

Cutting carbon footprint offers opportunities to engage with infrastructure managers and owners, says Ubhi. “Even in assets that are carbon-intensive, there are things that can be done to those assets to help reduce their carbon footprint.”

As an example, he points to how renewable energy can be incorporated onsite, like installing solar panels and batteries at land-hungry airports, and making more efficient use of other resources such as waste water.

By picking a baseline for carbon emissions (for example, the point at which the asset is acquired by a new owner), how well they are performing in terms of cutting their carbon footprint can be tracked.

Infrastructure assets can be ideal for engagement, says Ubhi, because they are typically owned outright and privately, meaning potentially greater discretion for implementing sustainability initiatives. In addition, these private assets are commonly held over a longer time horizon, he says. “They don’t have to mark-to-market and report to shareholders publicly every three months, so they can take a longer-term view on the capex and opex that is needed to get to that desirable end point.”

Sem agrees that rather than exiting climate-unfriendly assets, more good can be achieved by pushing their managers to up their environmental game, not least because it looks like the underlying demand for their services won’t let up in the short to medium term.

“We need to be able to invest in more efficient use of these assets, and drive towards reduction in emissions,” he says.

Flight delays
As an example, he suggests more fuel-efficient aircraft could be offered a rebate to land at an airport, while less efficient aircraft may have to pay a premium, thus offering an incentive to decarbonise.

Taking the airport example again, other measures management teams can take is to reduce unnecessary fuel-burning by cutting air traffic control delays, Sem says. “There’s an opportunity there for engagement to improve their performance.”

In addition, while the environment has recently been grabbing the headlines in the ESG debate, social infrastructure offers opportunities too, says Le Grix, whose firm makes relatively small-scale private investments in areas such as nurseries and care homes.

“What we really like about that sector is they’re very much critical infrastructure: they’re non-discretionary spending items, so they’re broadly uncorrelated to the economic cycle. Regardless of how the economy performs, you’ll still need somewhere for your kids to go to.”

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