“Our culture runs on coffee and gasoline, the first often tasting like the second.”
US author Edward Abbey
If I had a pound for every time I have been asked about infrastructure investment this year … well, just maybe I could afford a latte from the overpriced ‘artisanal’ coffee shop down the road.
While I am unsure as to what the role of rustic artisans is in coffee production – fearing it may be similar to that of the civet – there are two connections between that latte and infrastructure: inflation and climate change. Let’s first consider the inflationary aspect’s pertinence to the strengthening interest in infrastructure.
Frothing inflation
Coffee prices are at a near all-time high, propelled by spiralling transport costs, higher demand and the adverse weather hitting farmers’ yields. The current price of a US coffee futures contract is only exceeded by a previous spike in April 2011.
UK inflation reached 5.4% in December and is expected to hit 6% by the spring. This is a global phenomenon and any hopes it would prove merely ‘transitory’ on the road to post-Covid normalisation – whatever that might mean – have died with the old year. “We tend to use [transitory] to mean that it won’t leave a permanent mark in the form of higher inflation,” observed US Fed chair Jerome Powell in November, adding. “I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”
Investors therefore want to know what is going to help inflation-proof their portfolios. There are a number of answers to this, one of which is through exposure to listed infrastructure funds. At first pass, this may seem unlikely, as these assets are seen as bond proxies because their returns are driven by dividend payments and the capital-intensive nature of many infrastructure projects makes them rate-sensitive.
This, in turn, is because rising rates increase debt-servicing charges – which, being capital-intensive, infrastructure projects can carry a lot of – along with discount rates, which impacts valuations by reducing the current value of future returns.
That is, however, only part of the story. The incomes of many infrastructure companies, such as those of toll roads or water utilities, are inflation-linked – offsetting the negative effects of rising rates. This is particularly the case for regulated utilities, where regulation, concession agreements or contracts link end-user charges to inflation.
It is, therefore, real rather than nominal rates that infrastructure investors need to watch. When inflation rises faster than rates – which is currently the case – infrastructure assets do well. That said, if central banks start to hike aggressively, and rates accelerate further than inflation, the reverse will happen. But there is no sign of this yet.
Infra and climate change
The second link between my richly-priced artisanal latte and the increasing interest in infrastructure is the impact of climate change. Regions growing coffee, cashews, avocados to shift due to climate change, warned a recent study. And while, in a world hungry for inflation-beating yield, the attraction of infrastructure is apparent, in a heating world, the need to link this to sustainable goals is becoming equally if not more so. Ageing infrastructure in advanced economies and structural change in emerging markets, such as rapid urbanisation, underpin this imperative.
Five years ago, the United Nations estimated $90trn (£66.69trn) would be needed over the coming 15 years for global infrastructure. To provide some context, that is more than the value of the whole current global infra stock – and there is an increasing acceptance this must be done in a sustainable fashion.
The persistent shortfall between this requirement and what is being met presents an investment opportunity. Investors are nevertheless underexposed to the asset class: OECD analysis from 2013 showed pension funds’ direct infrastructure allocations were less than 1%, and the ESG component considerably lower. That has undoubtedly grown over the past nine years – not least through the breakneck expansion of private asset markets – but I would hazard that investors’ underweights have been reduced, not erased.
Although ESG is increasingly influential, infrastructure is far from being a green asset class. Of the £74.8bn in assets in infrastructure mutual funds, ETFs and investment trusts, less than 10% (£7bn) is flagged as ethical. Nevertheless, that figure has increased from £1.7bn over the three years to December 2021, while ‘brown’ infrastructure assets have increased more slowly, from £42.4bn to £67.8bn. More and more investors are allocating to sustainable infrastructure, as large institutional investors increasingly adopt targets linked to UN sustainable development goals and Paris Agreement objectives.
Lower-risk renewable play
Renewable energy is the most popular sustainable infrastructure investment. The International Energy Agency estimates the sector will take two-thirds of investment in power plants by 2040. In the UK, onshore wind is now the cheapest form of electricity and, in many countries, renewables are becoming the cheapest source of power generation. Subsectors include geothermal, biomass and hydro, with the fastest-growing being solar and wind, which is expected to continue attracting the most capital.
While alternative energy fell heavily early last year, infrastructure provides a lower-risk (if lower-return) way of accessing the theme, as opposed to the often small-cap tech companies and manufacturers that were victims of the correction.
Infrastructure – whether brown or green – has a long way to run. Old stock, growing populations and climate change underpin the case for growth, as does investors’ need for inflation-beating income. The asset class is well positioned to deliver this and is an area where most investors are underexposed.
Dewi John is head of research UK & Ireland at Refinitiv Lipper
