Investing in Infrastructure
Infrastructure provides the ability to invest in a long-term stable asset class with cashflow matching characteristics and a target return akin to that of growth assets.
Infrastructure as an asset class
Infrastructure refers to the range of essential assets upon which the economic activity of society depends. Historically, due to their essential nature many infrastructure assets were financed and owned by the State. However recent decades have seen this model change in many countries, as infrastructure assets have been either fully or partly privatised to incentivise the development and efficient ongoing maintenance of essential infrastructure.
Substantial government deficits in the developed world and the need for large amounts of capital to fund infrastructure and increased commitments to de-carbonisation means governments will need to incentivise greater investment from the private sector and pension schemes over the coming years.
Infrastructure provides the ability to invest in a long-term stable asset class with cashflow matching characteristics and a target return akin to that of growth assets. This asset class therefore helps meet the growing requirements of pension schemes as they become increasingly cashflow negative whilst still requiring investment outperformance to achieve a strong ‘low dependency’ funding position.
We believe now is an opportune time to invest as the asset class has a supportive backdrop (particularly relative to yields available in liquid asset classes), as governments increasingly look to decarbonise economies whilst also looking to stimulate a recovery from the COVID-19 crisis.
Infrastructure offers compelling strategic benefits for pension scheme investors.
- Cashflow matching: Returns will largely be provided through a regular stream of ongoing cashflows, which can then be used to fund scheme benefit outgo.
- Stable income: The underlying revenues will typically be contractual, meaning the distributed cashflows will be consistent and predictable.
- Time horizon: The long holding period means investors will typically be well compensated through an additional yield (an ‘illiquidity premium’). Pension schemes as long-term investors are very well positioned to harness this premium.
- Diversification: Infrastructure assets provide essential services and have high barriers to entry. This provides resilience and true diversification in the event of an economic downturn.
- ESG: Quite often, the underlying asset classes have positive ESG characteristics – solar and wind assets are examples, as well as ‘Energy from Waste’ plants which we talk about in this note.
ESG case study
What is it traditionally? Creating a solar farm, i.e. a field of solar panels
Did you know? Whilst it's a cliché to say the British weather is unpredictable, the level of solar irradiation received over a whole calendar year is typically within an extremely narrow range
ESG benefit: Expects to generate a net reduction in carbon emissions versus fossil fuels, even when accounting for the energy consumption in the construction and manufacturing processes. Certain solar energy projects within housing estates can have social benefits too - helping lower income individuals get cheaper, or free, energy for a portion of the year.
The case for investing now
Whilst Infrastructure is an asset class we have been closely monitoring for several years, we believe there are a number of key catalysts for making an allocation now.
Market driven considerations
- Supportive backdrop: A key theme of government (both UK and globally) response to climate risk is a likely substantial increase in the supply of infrastructure projects to decarbonise the economy. A desire to stimulate an economic recovery from the COVID-19 crisis is expected to further accelerate this theme. Hence, we expect a material tailwind for the asset class over upcoming years.
- Relative attractiveness: More traditional cashflow generating assets look extremely expensive at present (e.g. UK gilt yields hit all-time lows in 2020 and UK investment grade credit spreads ended 2020 lower than they started even despite a large spike in Q1 2020). Infrastructure by comparison has been less impacted and offers a material yield pickup.
- Sustained illiquidity premium: Linked to the point above we observe that there has been a sustained and substantial illiquidity premium in this asset class, even accounting for factors that often inflate this premium.
- Requirement for diversification: The unique characteristics of the COVID-19 crisis have created challenges for other diversifying asset classes (e.g. Reinsurance). Whilst we have made new investments and captured opportunities for our clients we would like to include an additional diversifying asset class with clear tailwinds.
- Scope for outperformance: There is no easy way to access the same opportunity in liquid/ public markets (e.g. whilst listed infrastructure funds exist they typically are strongly correlated to broader equity markets). We believe that infrastructure is an asset class where there is a potential material reward/benefit to selective active management.
Pension scheme considerations
- Maturing schemes/cashflow negativity: The continued maturing of UK pension schemes means annual benefit outgo is increasing. Coupled with this Recovery Plan periods are shrinking. This means schemes are increasingly becoming cashflow negative, which creates a demand for cashflow generative assets to fill this gap.
- De-risking requirement: Upcoming regulation (DB Funding Regime) is likely to create a requirement for a schemes to set a long term ‘low dependency’ target with a clear de- risking framework. We believe Infrastructure is extremely compelling as not only can infrastructure form part of a long-term low risk portfolio, but also the expected returns mean that an investment can be made now without needing to compromise the scheme’s current return target (and therefore ability to achieve a long-term low risk funding position).
- ESG: This is an area of increasing focus for many stakeholders across the pensions industry – such as regulators, trustees, and sometimes members. Regulation is expected to further accelerate noting the upcoming Task Force on Climate-Related Disclosures (TCFD). The UK- focussed, ESG-tilt of the specific Infrastructure opportunities we have identified, will further enable our clients to demonstrate awareness and tangible management of ESG risks.
- Expanding the toolkit: Whilst the above themes aren’t new to pension schemes, we believe now is an advantageous time to further expand the investment toolkit in these areas.
Notes: for illustration only - based on an example of a typical pension scheme
ESG case study
Energy from Waste (EfW)
What is it? Building and maintaining power plants which turn waste, which would otherwise be used as landfill, into power used to run factories.
Key characteristics: Average asset life is 30+ years. The majority of revenues in EfW assets derive from the fee taken to dispose of waste – which can be fixed for the long-term.
Did you know? The largest environmental issue of landfill sites is the release of methane, which is over 25 times more potent than CO2 as a greenhouse gas.
ESG benefit: So not only does an EfW plant have benefits in terms of creating long term jobs and generating power, it looks to address the environmental issues of landfill.
Key risks and mitigants
This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).
Please note that this communication is directed at, and intended for, the consideration of Professional clients only. Retail clients must not place any reliance upon the contents.
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
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