Unlevered infrastructure: challenging convention

Pension schemes looking for low risk inflation-linked cashflows offering the potential to generate significantly higher yields than index-linked gilts should take a closer look at unlevered infrastructure strategies.

3 minute read

The UK’s decision to leave the European Union and recent easing measures by the Bank of England has left gilt yields in unchartered territory. Given the uncertain macro-economic environment, with gilt yields expected to remain low for longer, and returns in traditional asset classes exposed to heightened volatility, there is an obvious rationale for pension schemes to consider alternative income assets to help meet their long-term liabilities.

Infrastructure is one option; either through a stand alone allocation or as part of a wider multi-asset alternative strategy. Infrastructure assets have certain characteristics that should appeal to pension funds, namely they are long-term investments and are designed to withstand periods of volatility and economic uncertainty.

Challenging conventional approaches to investing

The conventional way to invest in infrastructure is through debt or equity; participating in the financial returns of an underlying infrastructure project and getting exposure to the market. An alternative approach is to invest on an ‘unlevered’ basis, where the investor buys the whole infrastructure project capital structure and gains full control of the assets. This can reduce financial volatility and provide low risk inflation-linked cashflows at significantly higher yields than index-linked gilts. In other words, it offers the chance to generate ‘equity-like returns whilst taking debt-like risks’.

Until recently, this approach was predominantly the domain of pension schemes with significant governance budgets or in-house expertise, but now there is a range of products available to suit the needs of pension schemes of all shapes and sizes.

What infrastructure projects could form part of the strategy?

Infrastructure investments can be sourced from lower-risk sectors, such as utilities, renewable energy and social infrastructure, to higher-risk sectors, such as ports and mobile telecoms. Where the objective is to generate low risk inflation-linked cashflows, the focus needs to be on lower-risk infrastructure projects.

There is a diverse range of opportunities that fulfil these criteria whilst aiming for attractive - high single digit - returns; in particular ‘low carbon’ infrastructure assets such as renewable energy or energy efficiency projects. Revenues from these types of projects tend to be contractual or from regulated mechanisms rather than based on economic usage, making them especially attractive from return and diversification perspectives. The stable, long-term income streams they can provide make them a good fit for pension schemes with liabilities to match.

Energy centres for hospitals offer one such opportunity. An energy centre is a mini power station, providing both electricity and localised heat distribution to the hospital at a lower cost than taking energy from the grid. Energy efficiency is increasingly important to the UK’s National Health Service (NHS), which has an estimated annual energy bill of around £750 million1. Powering lifesaving equipment and large hospital buildings is a growing strain on public finances, so it is not surprising that energy efficiency facilities have been gaining favour.

In Dundee, a £15.4 million2 project is underway that will include the construction of a new energy centre for Ninewells Hospital and Medical School. The energy centre will supply 100% of the hospitals’ heat requirements and c.90% of power requirements. The project is forecast to reduce energy costs by c.25% and CO2 emissions by c.13%3.

As well as providing savings for the NHS, it should also provide stable and low-risk cashflows to investors that funded the project. All cashflows for this project are contracted with NHS Tayside.

Renewable infrastructure assets such as solar panels and wind turbines qualify for regulatory support through Feed-in-Tariffs or Renewable Obligation Certificates. These provide payments for the electricity generated as an incentive to invest in the sector and also offer predictable returns.

Equity-like returns with debt-like risks

Investing on an unlevered basis gives investors the opportunity to capture all of the returns on the whole project. An unlevered asset will be subject to exactly the same project risks as debt on that asset - including operational, revenue and counterparty risks - but have a different return profile.

The traditional model of structuring an asset using debt and equity tranches introduces financial risk that is not present in the unlevered approach. The chart below illustrates how the return forecasts, defined as Internal Rate of Return (IRR), from a typical windfarm project, assuming different levels of leverage, are affected by a fall in wind speeds and hence energy generation.

Illustrative example of the IRR impact from a 20% drop in wind speed
Source: Aviva Investors. All information is based on the internal forecasts and estimates of Aviva Investors and should not be relied upon as indicating any guarantee of return.

The green line on the chart represents the central forecast return for different levels of leverage, and the red line the impact on returns should wind speed fall by up to 20 per cent. The return dispersion is illustrated by the blue boxes. For an unlevered investor, the forecast base return may be eight per cent with downside volatility limited to approximately three per cent – equivalent to an IRR of around five per cent – if the electricity generation drops by 20 per cent over the 20-year life of the project as a consequence of the fall in wind speed4. For a levered investor, the same drop in wind speed could result in significant losses or even default. The downside risk increases with the level of leverage employed.

Investing on an unlevered basis in ‘low risk’ infrastructure projects can significantly reduce the volatility of returns associated with equity investing. Volatility can be further reduced by investing in a diversified portfolio of unlevered infrastructure assets, which could form part of pension schemes’ matching strategies with significantly higher yields than comparable index-linked gilts.

Opportunity knocks

As with any innovation, it often takes time for the market to catch up. To date, a small number of pension schemes have invested in low risk infrastructure on an unlevered basis, but there is growing interest in this type of strategy. There is certainly enough capacity for pension schemes, large and small, to benefit. Those that have invested have received stable high single digit, inflation-linked income from their investments.


1 Green Investment Bank. A healthy saving: energy efficiency and the NHS. April 2014

2 Aviva Investors 31 August 2016

Vital Energi, July 2015 (Date of Assessment)

Aviva Investors

Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: St Helens, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.