For some pension funds, investing in infrastructure projects may be seen as a way of achieving investment returns in a way that is socially responsible, as the infrastructure provides essential services that support economic growth, generate productivity and underpin the operation of society.
Infrastructure includes power generation and transmission, water and waste, railways, airports and roads, ports and communications, plus hospitals, schools and housing. Investment can be indirect (through investing in another fund that then itself invests in infrastructure projects) or direct.
Characteristics of Infrastructure Assets
Infrastructure assets have certain characteristics that differentiate them from other types of asset. These include:
- Key public service requirement – infrastructure by definition is needed to keep society running, whether it be supplying water, producing energy, enabling people to get from place to place (economic infrastructure), or social infrastructure such as hospitals and schools.
- Inelastic service demand – most infrastructure is unaffected, or minimally affected, by upturns and downturns in the economic cycle, as the service it is providing is essential no matter what the economic climate.
- Significant barriers to entry – the costs of bidding to provide a piece of public infrastructure can be very high.
- Long term service life – the infrastructure asset normally has a life of around 20-30 years, which in theory means…
- Long term, stable cash flows with low volatility – this can make infrastructure (particularly regulated assets) attractive to investors.
Value proposition of infrastructure
Due to the above characteristics, infrastructure may potentially offer attractive, risk-adjusted returns, especially once the asset has been built. Because it provides an essential economic or social service, infrastructure generally has low sensitivity to economic and market swings.
Investing in infrastructure is potentially one way that pension funds can diversify their investments and show that they are being socially responsible in their investments. Obviously, before making any investment, scheme trustees (or equivalent decision-makers in a non-trust-based scheme) should satisfy themselves that the investment is appropriate in the light of the scheme's investment strategy and long-term funding objective. This will require them to take investment advice from an appropriately qualified person.
Infrastructure projects can be broken down into four phases: development phase, construction phase, operation phase and termination phase. The risk profile is generally highest in the first two phases; once the asset is built, the risk typically lessens. Pension funds may well be more interested in the secondary market, becoming involved once the asset is operational, as this may fit better with their risk appetite. Some common risks include:
- Environmental and permitting issues in the development phase, meaning the project takes longer than envisaged to get off the ground. Getting legal advice at an early stage can help mitigate this.
- Construction delays and cost overruns – a significant risk for projects in the construction phase, which can be mitigated by careful project management.
- Contractor insolvency – the collapse of Carillion has shown this to be a risk. Having more than one contractor involved will reduce this; in some cases, this risk may be mitigated by obtaining guarantees from the government/project sponsor.
- Revenue risk – this is relatively low for a PFI-type contract backed by central government but can be a real risk for availability-based projects such as toll roads or waste sites whose revenue stream is based on a certain volume of traffic.
- Regulatory risk – the recent cuts in Government subsidies for renewable energy have affected projects that may have been costed based on an expected rate of subsidy. Having legal advisers who are tracking future policy developments can help pick up potential regulatory changes early so these can be accounted for.
- Handback risk – for equity investors who have assumed legal ownership of the asset, there is a risk that the value of it may be lower than expected on handback. This can be avoided/mitigated by investing in debt rather than equity or by careful contract management during the contract lifetime to make sure the asset remains in reasonable condition.
Energy infrastructure: a good bet?
Large and small energy infrastructure assets may offer an attractive investment opportunity for some pension funds. A large asset such as an offshore wind farm offers:
- Proven technology – so less risk of availability deductions.
- Government-backed revenue stream – through the 15-year Contract for Difference, which guarantees a set price for the electricity produced.
- Regulated asset – so not subject to economic changes in the same way as most investments.
- 'Green' credentials – for pension funds that want to show they are investing in low-carbon technology.
Equity stakes in offshore wind farms come to market on a regular basis and we have worked alongside pension funds which have invested in a project, with the developer being responsible for the day to day operation.
Infrastructure investments do not always involve large assets. One pension fund we act for is investing in property and then installing solar panels on the roofs, for an extra revenue stream.