Written By: Pádraig Floyd
Pádraig Floyd surveys the burgeoning field of infrastructure and assesses its development and future potential
Infrastructure has long been touted as the “perfect” asset class for long-term investors and defined benefit (DB) pensions in particular.
Consistent, long-term bond-like, indexed returns is the promise for investing in the essential building blocks of modern society.
Not everyone has agreed in the past, with problems with access, transparency, alignment of objectives between investors and founding partners and the fees they charge all cited as obstacles to a satisfactory relationship.
Getting your hands – and portfolio – dirty
The fact that many of the traditional forms of infrastructure are associated with transport – bridges, toll roads, ports, airports, and so on – brings new difficulties when attempting to deal with the conundrum posed by environmental, social and governance (ESG) concerns.
Yet, LGPS funds intend to increase infrastructure allocations beyond their current level, which according to pensionperformance.com was under £16 billion of a total £407 billion at the end of March 2020.
This is in part due to growing realisation – or acceptance – that if infrastructure provides the essential fabric of society, it extends far beyond transport. This is why the government in Februray 2022 published its Levelling Up white paper, which seeks to encourage large institutional investors – not least the UK’s LAPFs – to dig deep and do their bit for society and their members.
The government paper borrows heavily from the work done by The Good Economy report “Scaling up institutional investment for place-based impact”, published in May 2021, that suggests: “If all LGPS funds were to allocate 5% to local investing, this would unlock £16 billion for local investing, more than matching public investment in the £4.8 billion Levelling Up Fund and associated government initiatives.”
A growing asset class
Now, some might argue that local and place-based investing is not infrastructure, but in fact, the working definition of infrastructure as an asset class has extended to incorporate all manner of assets that were previously defined solely in another silo.
“Infrastructure investors have a concept that it’s a physical asset, providing an essential service to the global population. We would argue that it should be a critical service to the global population,” says Peter Fox, a product specialist at KBI Global Investors.
Fox acknowledges that oil and gas supplies, roads and airports are all essential for modern life, but we managed to survive during the worst of the Covid-19 pandemic when they were seriously affected.
The Russian invasion of Ukraine in February 2022 has exposed our vulnerability to oil and gas. The concept most people have of infrastructure is what Fox defines as “traditional infrastructure”. “It is traditional infrastructure, because it starts with an index that is market weighted, based upon the winners of yesteryear” said Fox. “In order to achieve that concept of levelling up, you need to be investing in the future of infrastructure.”
And there needs to be an understanding that even though infrastructure projects might have a lifetime of 15 to 20 years or longer, there is disruption in infrastructure, too, and this is most evident within energy, says Fox.
Wind and solar were still emergent technologies even 10 years ago, but commercialisation is disrupting the field, so offshore wind, onshore wind, solar farms, geothermal, could potentially disrupt the market.
The same is true of telecoms. Telecoms used to be focused on mobile masts offering 1G, 2G, 3G, etc, and were not disruptive technologies. But 5G and the internet of things (IoT) have changed things.
“For us, it is about forward looking infrastructure, as opposed to backward looking structure,” says Fox. “That provides us with a really good indication of where future money will be prioritised.
“Traditional – or old fashioned – infrastructure is really all about maintenance. Whether a bridge, toll roads or airports, there’s very little growth in those areas.”
Fox says that traditional infrastructure is more suitable for a liability-driven investment (LDI) portfolio, not growth, and there’s always the danger of political interference, which is why few people allocate infrastructure budgets to emerging markets.
Even in the USA, one of President Biden’s priorities was to initiate the decarbonisation of the economy, but he has had limited success and many of his plans have been stalled by political interference.
But for Fox, even putting aside net zero targets, you’d be mad to be building new oil and gas projects today.
“Wind and solar energy are now cheaper than oil and gas and all forms of fossil fuel,” said Fox. “There’s no cost for extraction. They’re not priced on the market, apart from carbon credits. So all you have is the input costs, and they’re coming down constantly.
“The current geopolitical issue really heightens the necessity for us to remove our dependence on countries like Russia, on fossil fuels like oil and gas.
“Infrastructure as an asset class shouldn’t have commodity sensitivity. It shouldn’t have economic sensitivity, because pension plans will have that in other parts of their portfolio, in our view, because it’s critical.
“Infrastructure should really be about providing stable, long-term, predictable, strong regulatory contracts, that aren’t vulnerable to movements in commodity prices, or according to the size of GDP.”
Do you know where you’re going to?
This form of infrastructure is still new and many institutional investors are probably seeing the opportunity in renewables. While renewables are great, the more forward thinking investors are looking ahead, in the knowledge that renewables won’t fix all the problems.
“Investing in assets that have a real, defined sustainable outcome will be more valuable in the long term because anything that’s not sustainable has a risk of becoming a stranded asset,” says Peter Bachmann, managing director, sustainable infrastructure at Gresham House.
“It might even get additional taxation, because of its social impact, so a sustainable approach is almost a defensive strategy.
“If you’re not doing sustainability in your infrastructure, you are really risking assets that become less valuable over time.”
While renewables are very important, energy is between 20% and 30% of global emissions. And that’s just in terms of climate change.
There is a growing realisation about the changes in – and needs of – society that can’t be solved simply with new technology.
“Technology can only do so much and you fundamentally need new products and services,” says Bachmann.
“We need to change the way we eat, the way that we care for our elderly and the way that we transport ourselves, the way that we look after nature. Basically, we need to change everything and you can’t really do that with your Amazon Alexa. We need physical, new products and services and that’s where infrastructure has come back in.”
Can we fix it? Yes, we can
Local authority funds have certainly appreciated the potential from an expanded universe of infrastructure, as it allows them to satisfy more than fiduciary duties – which remain paramount – by using money for good through social and place-based investing, just as the government seeks to encourage.
“We’re at a very interesting stage,” says Peter Hobbs, managing director, head of private markets, at bfinance, “in that we see real estate, infrastructure and the whole impact investment dimension being brought together in the aims of funds.”
While climate change and ESG have been the primary focuses for the past couple of years, the built environment – the very thing that society needs to exist – has become a key theme.
“These asset classes have huge potential, because there’s a risk of them becoming stranded assets, because in terms of emissions, they are terrible – and that’s both infrastructure and real estate.”
There’s embedded carbon in all these buildings and the shift to higher EPCs of ABC by the end of 2028 will make many buildings effectively redundant.
There is a huge need for social and affordable housing, and much of the existing real estate stock fails the sniff test on carbon emissions. Refurbishment is often just as costly as building a new structure in carbon terms, says Hobbs, so ways must be found to decarbonise in a less detrimental way.
“There’s a push coming for social infrastructure, which is partly for healthcare, some care type communities such as for the elderly, but there’s also a need for education, nurseries, civic buildings, justice and emergency buildings and any other community centres,” says Hobbs.
“There are a number of groups now targeting those depreciating assets that are tired, very inefficient and difficult to refurbish, and seeking a new route to carbon reduction through minor refurbishment – changing wiring, changing use, or using better technology, insulation, etc – and having a significant impact,” says Hobbs.
“It’s very rewarding to see commercial and retail buildings being turned into community buildings, creating something that’s in demand, while improving the asset’s carbon footprint.”
A hands on approach is required
But, adds Hobbs, investors need to be aware from the start that these new asset types require just as much active management as in the past. Even if ESG is everywhere, don’t think you can tick all the environmental, social and impact boxes by dumping an allocation into an index fund.
“Some people have assumed that infrastructure is like a bond, because of its revenue stream. But infrastructure isn’t an asset that you can buy, park and leave for 25 years,” says Hobbs.
“It’s like private equity. You’re generally in infrastructure to try to improve the business that’s running the assets.”
There are huge operational, regulatory and reputational issues to be tackled, says Hobbs, and unless your relationship with operators is good and you have an understanding of the regulator’s objectives, you’re going to make mistakes.
Harder, better, faster, stronger and greener
Digital connectivity lies at the core of much of these innovations, says Bachmann, but thanks largely to the pandemic, the government understands the gaps and this is one aspect of the burgeoning infrastructure market that has been developing rapidly.
Some of Bachmann’s investments, such as vertical farming, may seem rather esoteric, but his narrative is compelling. He says the resource efficiency and impact is “mind-bending”, because vertical farming uses a fraction of the land and resources, producing the same product and adding up to three weeks’ shelf life for the retailer and consumer. The economic argument has been won, and that’s why these projects are expanding into soft fruit next – a major carbon emitter – before looking at the staples of wheat, rice and soy.
Next to be investigated is what he calls “habitat banks”. We know that there is only so much tree planting that can be done, and these 25 to 60 hectare habitats are being created from under-utilised, non-arable land to increase biodiversity. “Over time, we believe this will become quite a large asset class. But it’s absolutely necessary as we’re experiencing the loss of biodiversity at a level not seen mass extinction.”
Just as insanity has been defined as repeating an action and expecting a different outcome, investors can’t keep investing in the same things and expecting a different outcome,” says Bachmann.
“We have to change everything,” he adds, “and there will be a push for mobilising this capital into these new solutions in order to build knowledge at scale.”