Darryl Murphy and Sean McLachlan from our infrastructure team assess how Russia’s war on Ukraine, fears over energy security and surging inflation have changed the prospects for infrastructure investors.
Read this article to understand:
- Which parts of the infrastructure market look most resilient in an inflationary environment
- How the energy crisis has impacted the roll-out of renewables
- Why there needs to be more urgency in the discussions over financing models to accelerate the energy transition
2022 has been extraordinary. Russia’s invasion of Ukraine has brought a new wave of geopolitical risk and highlighted the fragility of energy security. Inflation, which was already rising heading into the year, has soared; central banks have been forced to hike rates agressively to counter the threat; while China has yet to release the restrictions it put in place to prevent the spread of COVID-19.
These factors combined have caused the global economic outlook to weaken and hit investor sentiment. So far, the effects have been felt most in public bond and equity markets, some of which (including US Treasuries and the MSCI World index of global stocks) experienced their worst half-yearly performance in decades in the first half of the year.
Typically, there is a lag between what happens in public and private markets like infrastructure. On the plus side, institutional investors continue to allocate heaviliy to the asset class: closed-end infrastructure attracted over $120 billion of capital in H1 (comfortably a new record), while there were almost $400 billion of new infrastructure debt financings.
Additionally, as part of post-Brexit reforms, the UK government in April released a consultation on Solvency II.1 It claims its proposed reforms to the insurance regulations “will unlock tens of billions of pounds of investment in UK infrastructure and green projects”.
At the same time, there is scepticism that shorter-term fears over energy security could see some countries delay vital initiatives to meet their net-zero commitments.
To understand what these mixed signals mean for investors, we spoke to Aviva Investors’ Darryl Murphy (DM), managing director, infrastructure, and Sean McLachlan (SM), portfolio manager, infrastructure equity.
It has been a difficult year in public markets. How has infrastructure held up?
DM: The beginning of this year was about entering a post-COVID world, with optimism about the state of the market and commitments around net zero and the energy transition. What we didn't anticipate was a macroeconomic shift that has affected all markets since the early part of the year.
SM: On the equity side, the performance of existing renewables assets has been robust, particularly when underpinned by long-term revenue contracts with inflation linkage. There's also the power price impact as energy costs have risen, which is generally a positive for many assets.
Where do you still see value, and which areas are more challenged?
DM: There has been a flight to quality. Infrastructure assets with positive sustainability characteristics are in demand; in these areas, values remain high. We would expect to see some depression in equity valuations given the change in underlying risk-free rates, but we are not generally seeing that yet and certainly not in renewables, as there is a lot of capital seeking green assets.
There is always a lag between what happens in public markets and private ones
In debt markets, our clients continue to question why pricing has not moved to the same degree as public markets. My response is there is always a lag between what happens in public markets and private ones: it is summer, and we may start to see an adjustment in a few months’ time. The main debate in the market is whether this could be a short-term feature, as we saw in early stages of COVID-19, or if it will be a longer-term correction.
SM: With new projects and assets coming to market, we are not seeing any compression in discount rates. Values in infra equity remain high and in some sectors are increasing, particularly driven by the attractiveness of renewables in the context of the climate transition. A lot of institutional capital has been raised for this goal over the past six to twelve months, and that's really supported pricing.
DM: On the other hand, the strain of the pandemic took a toll on transport assets, and the airport sector is beyond doubt the area that's continued to be most affected post-COVID-19. Toll roads and ports have bounced back.
If you have been to an airport recently to go on holiday, you know demand for air travel is recovering, but we are not out of the woods yet. The macroeconomic situation and war in Ukraine have not helped. If you look into 2023, we will start to see the need to recapitalise some of these assets.
With the conflict in Ukraine, there have been opportunities around gas pipelines and associated assets coming to market. That’s something people are cautious about; activity is limited because of the huge shift towards green energy.
To what extent is inflation feeding into higher borrowing, operating, and construction costs?
With inflation where it is, there is some backing away from fixed price contracts
SM: Let's take a wind farm or solar park as an example. Typically, we engage with a developer who would bring a proposition to market and that would include a fixed-price engineering, procurement and construction (EPC) contract. With inflation where it is, there is some backing away from fixed price contracts and there may be attempts to push some inflation risk onto the buyer. A developer can do that now because there is such high demand for renewable assets.
Where should investors be looking if you are seeking inflation protection?
DM: Generally, infrastructure performs well in a more inflationary environment. A lot of assets have contractual or regulatory connections to inflation, as we see in regulated utilities. Offshore transmission assets, for instance, are one example of this.
But there are areas you might have concerns about, including assets where there is an assumed linkage of revenue to inflation, but the users may not be able to bear the cost. With student accommodation, for example, the inflationary element may be capped.
What impact is the energy crisis having on the renewables market?
SM: It's supportive on several levels. From a pricing perspective, higher energy prices allow bidders to rationalise a higher value for the same return. But the crisis has also generated momentum, so we are seeing more policy statements about plans to install this many gigawatts by 2030 or 2040, to support net zero.
DM: At the same time, new investment into renewables is too slow. We have not seen a real step change in the pace of delivery. It still takes a long time to get through the planning process, and there are issues with grid connections too. This is not just the case in the UK; it is true in Spain where projects are taking longer to move into the construction phase. It is far slower than it needs to be.
SM: Part of that is because a lot of countries and regulators are winding down subsidy programmes. In the UK there was initially a wave of new projects, but that slowed when investors had less clarity about the revenue model.
We are seeing new structures emerge that will support more private capital moving into renewables
We are starting to see new structures emerging, like corporate power purchase arrangements (CPPAs), which will give more visibility on the revenue side. That will support more private capital moving in, as debt investors to date have been risk averse when it comes to taking merchant revenue risk.
DM: Post-2021, it was all about cost and the government’s net zero strategy, and we already have a lot of planning pieces in place with good goals and objectives. Now, it’s all about delivery, delivery, delivery.
What about nascent technologies like carbon capture and storage and hydrogen? Are there any green shoots, as capital is directed to them?
DM: There have been a lot of early-stage discussions. We have been engaged as part of a wider group of potential investors around some of those technologies by government consistently over the past year.
There has been some development around revenue models for carbon capture, utilisation and storage (CCUS). They are looking at contracts-for-difference (CfDs - private agreements between solutions providers and a government-owned entity), and a type of regulated asset base (RAB) model (where the solutions provider is licenced to charge a regulated price for providing infrastructure) for the transport system.
The pace must continue and that can only come from a political push
A lot of work is being done, but it is not easy to do quickly. Discussions are heading in the right direction. The key thing is that that the pace must continue and that can only come from a political push to see results.
Hydrogen remains more challenging. There are conversations, but it’s a longer-term opportunity rather than a short-term one.
Are we any clearer about where nuclear might fit into the energy mix?
DM: Support at a government level in the UK appears to have strengthened. You may have seen Boris Johnson wearing a hard hat on nuclear sites: nuclear has suddenly become a topic people are less embarrassed to talk about, probably helped by the crisis around energy security.
Appetite for nuclear is very different from country to country
The challenge, of course, is the pace of delivery. We can't develop capacity overnight. Appetite is very different from country to country. In Central and Eastern Europe, for example, there has always been greater receptiveness towards nuclear, and some nuclear plans have been resurrected. There have even been discussions about retaining nuclear plants in countries that had hitherto been planning to phase them down.
We know we need to shift to a new economy with green energy, but also a circular economy with more recycling. Are we seeing any significant investments there?
DM: The area that gets most focus is energy generation, but it's hard to pinpoint any large-scale investments designed to address recycling. It's an interesting point because it boils down to the individual on the street. The big focus now is energy security and affordability.
SM: We are seeing increasing focus on forestry and, more widely, natural capital as part of a net-zero approach. Ultimately this could evolve into its own asset class, but it is early stage now.
What about regenerative agriculture?
Regenerative agriculture is probably not quite investable at scale today
SM: We have seen opportunities where you acquire land of low quality that has been depleted, improve it, with the expectation the value of well-managed assets grows over time. It's probably not quite investable at scale today, but there are many more people looking at these schemes and trying to develop them into viable propositions.
What are your thoughts on potential changes to Solvency II in the UK to allow insurers to make larger investments in infrastructure and green projects?
DM: It's been interesting how closely the sector has been caught up by this. It's a technocratic area, and the proposed changes could in theory have a profound impact. That said, it only applies to a few UK insurers where Solvency II is a major constraint. We saw record fundraising for renewables in the first half of 2022 and the debt market remains extremely buoyant. There is no shortage of capital.
How do you assess what the government-owned UK Infrastructure Bank has achieved so far?
DM: A lot. Its first strategy note was not particularly radical but fleshed out a consultation note from earlier in the year.2
We need a gateway for the delivery of ambitious policy objectives
We see it playing an important role getting capital into evolving areas like heat networks and battery storage. As we look at areas like CCUS and hydrogen, I expect the bank will take an even larger role. In my view, it is important it ramps up quickly, gets people in place and becomes a key conduit between government departments, government policy and the wider financing market. We need a gateway for the delivery of ambitious policy objectives.
The bank has completed several public sector-oriented transactions, with at least three deals around fibre networks. That suggests an interesting point around liquidity. It invested in a fund focused on subsidy-free solar and another based on the clean energy theme. It’s quite mixed.
Is demand for fibre network capacity still increasing after a big surge during the pandemic?
SM: Global demand for better digital infrastructure continues to be high. I don't see that changing in the foreseeable future. The more capacity is provided, the more products come out that seek to use it: think about the metaverse and evolution of so many applications and services that will generate data and require more capacity.
In the UK, we have many different parties rolling out new fibre networks. The pace has picked up over the last couple of years. Demand accelerated when everyone was working from home during the pandemic, especially in a rural context, where many people have had poor quality infrastructure. Demand is strong and there is a lot of capital flowing in as a result. In selected areas, we see opportunities to continue to invest and realise maximum value by supporting buildout programmes.
We need to be mindful the fibre network market is starting to mature
But we need to be mindful this market is starting to mature. There is a lot of fragmentation, and networks are starting to be more discerning about where they allocate capital. Those involved are starting to think about overcapacity and consolidation. That’s an important theme for 2022 and next year. Investors in debt and equity are asking: which players do we want to back? Who has a differentiated strategy? Who will be there for the long term and get through the challenging market environment we have now?
DM: In infrastructure debt, fibre is the leading sector in terms of deal volumes across Europe. There has been mega financing of Cityfibre and a number of the smaller altnets getting financing as well.
Why is investment activity in social infrastructure subdued, despite increasing attention being paid to the S in ESG?
DM: Historically a lot of social infrastructure was delivered via the public-private partnership (PPP) model in the UK and across Europe. For the most part, that model has disappeared in the UK. It is being used in a limited way in Wales for the delivery of schools projects and there is a hospital in procurement too.
Social infrastructure assets are mainly being delivered through public financing
Social infrastructure assets are now mainly being delivered through public financing. My concern is whether that could mean a slowdown given the stress on public balance sheets.
Private social infrastructure activity has shifted more in the direction of supported living and the development of care homes. These are smaller, niche sub-asset classes, and the volume of activity reflects that.
SM: At the same time, we are having more discussions about the social aspects of infra than ever before. There are discussions around community engagement and stewardship. Everyone is focused on it, but want more structure and clarity around impact.
Where are the opportunities for infrastructure investors seeking to scale up?
SM: There remain a lot of opportunities around energy transition assets, in addition to wind and solar. The battery sector is interesting as are the opportunities associated with green transport and the rollout of electric vehicles. The profile is similar to fibre; there is a lot of capital expenditure required.
In future we expect to see more opportunities in the energy transition with CCUS and hydrogen. They will become more relevant as those business models mature.
What about opportunities at a country and sector level?
SM: If we take our Real Assets Climate Transition strategy, we will be concentrating on the Nordics, Western and Southern Europe. The value propositions vary by sector and by geography, but you can probably access better value in renewables in the Nordics and Southern Europe.
Renewables are transitioning away from subsidies and merchant revenues vary by country
It is a complex picture, because renewables are transitioning away from subsidies, and merchant revenues vary by country. The appetite to finance also varies by country, and there is some fragmentation around regulation and how the markets will work.
DM: It is worth highlighting the activity and interest in terms of value in Central and Eastern Europe. The war in Ukraine has impacted that, but if you're looking for value on a geographic basis, the evolution of clean energy is an interesting proposition in that region.
SM: Poland is a good example of a country with a strong relative-value opportunity in renewables, while acknowledging challenges on the revenue side in terms of local currency exposure as well as geopolitical risk.
We have looked at an opportunity but were unable to get comfortable with assumptions about the macro environment and currency implications. Another country that is quite interesting from a relative-value perspective is Estonia. Traditionally it doesn't have much of renewable programme, but that's changing.