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How is the increased cost of debt impacting valuations of potential acquisition targets and existing assets?
Base rates have clearly gone up. However, in terms of the financing of new acquisitions, we have seen a relatively small increase in margins of 25 to 50 basis points and no real softening in terms of lender appetite for tenor or quantum of debt. We do expect to see some impact on valuations, but as yet not much evidence has emerged, partly because there is still strong competition for good assets.
Furthermore, the forward curve shows interest rates coming back down in most markets in 2023. I do believe long-term debt will increase from the days of zero-base rates, but we are not predicting anything dramatic. In terms of assets that are already in the portfolio, we have just gone through our annual valuations exercise, taking account of the increased cost of debt where floating rate debt in place. However, crucially, many of our assets are financed with long-term fixed rate debt. The best example are the fleets of trains we own that have circa 30-year fixed-rate financing, and as a result are not impacted by the increased cost of debt.
Furthermore, even in the cases where there has been an increase in debt costs, that has been partially off-set by higher revenues for inflation-linked assets due to the higher inflation environment. Overall, our portfolio has not seen a material impact on valuations from the higher cost of debt.
How is the energy crisis impacting infrastructure assets, both negatively and positively?
The energy crisis was a huge part of the story for all participants in the infrastructure sector in 2022. Assets that consume a lot of energy were hit by the three- or four-fold increases in energy costs. Many governments stepped in with some level of support for businesses but often only for a limited time frame. In the UK, for example, that subsidy regime will fall away soon. Energy prices have now started to fall quite significantly, but I think it is inevitable that European energy prices will remain at permanently higher levels than those we experienced prior to war in Ukraine.
On the positive side, higher energy prices will accelerate Europe’s move away from reliance on Russian gas and in due course speed up wider energy transition to a low carbon future.
We have also experienced some positive impacts on particular assets. We own a large portfolio of solar PV assets, but most of the energy is sold under contracts for difference. There is, however, a small proportion of volumes not covered by the CfD where we have been able to enjoy the higher power price environment. Solar also had a very positive year in 2022 because of high irradiation levels, leading to production levels exceeding budget. Overall, however, I would say that energy prices have been broadly neutral for our portfolio.
Is it realistic to push through inflationary price rises in the context of a cost of living crisis?
I don’t think any of us anticipated an environment with the double-digit inflation that many European economies are experiencing today. It has been extraordinary how quickly prices have risen and the level of inflation.
Many infrastructure assets have contractual protections around CPI or RPI linkages, which were put in place in anticipation of 2 or 3 percent increases per annum, or perhaps 5 percent in an outlier year. That has raised real questions around whether it is possible or advisable to push through increases which are, in fact, much higher than that.
Our experience has been that where the counterparty has also benefited, for example energy producers, pushing through the inflation linkage is possible and has been achieved. But almost all infrastructure assets operate on the boundary between private sector investment and public service. Therefore, whether or not to pass price rises on to end-users isn’t only a financial decision.
We own a number of district heating assets where in theory it would be possible to push through full inflationary rises. However, given the cost-of-living crisis, we don’t believe that would be responsible behaviour. We have therefore moderated our approach and sought only modest price increases in the first instance, recognising that this is a more responsible approach.
Is this approach partly a recognition of the regulatory risk that exists in a period such as this?
Inflation is a double-edged sword, there is a danger that when inflation is running high, a regulator could step in if you try to push through too high a price increase in a particular sector. The flip side, however, is that higher risk-free rates could in theory translate into higher allowable returns under some regulatory return equations/mechanisms. Overall, it is about managing individual regulatory relationships in the context of the current environment.
How concerning is the prospect of a prolonged recession and which assets are likely to be most exposed?
The prospect of recession is a concern for us all. Clearly subsectors where there is direct consumer spending exposure are most vulnerable. That would include certain transport assets and airports in particular, which are exposed to discretionary spend.
Airports are currently experiencing a reasonably healthy recovery as customers have begun flying again post-covid-19. But given the cost of living crisis and the scenario of a prolonged recessionary environment, it seem prudent to expect some softening in demand for leisure travel.
Elsewhere, the transport sector is harder to read. We have a series of train rolling stock assets which are funded through longterm leases and so not exposed to consumer demand. However, when we consider procurement of new rolling stock and we look at demand for rail travel here in London, for example, it seems to be settling down at around 85 percent of pre-pandemic levels, which may in turn impact decisions concerning future passenger train procurement.
We have also seen slight softening of demand for toll road assets, and demand risk needs to be considered with assets such as ferries and bus companies also.
On the other hand, the majority of other sectors within infrastructure performed resiliently through the pandemic and that should give us some comfort if we do head into a difficult recession.
Which sectors look well-positioned for the months ahead?
Traditional regulated utilities remain attractive, though there is some debate about appropriate valuations. Meanwhile, as we look at the market today, it is clear that energy transition remains a dominant theme.
There are two subsectors within that, that I believe are particularly exciting. The first is biogas, where abrdn is currently active across a number of geographies including the UK, Denmark and Italy. We also like biomethanol facilities, which can support areas such as producing sustainable aviation fuels, as well as reducing emissions when blended with diesel and gasoline.
The other area of the energy transition that we see as crucial involves the replacement of dirtier fossil fuels with cleaner-burning alternatives. For example, we looked at an asset promoting the use liquified natural gas as a replacement for marine bunker fuel in shipping, which is among the dirtiest fossil fuels in terms of carbon emissions. This form of replacement has the potential to make a huge contribution to the reduction of CO2 emissions.
Beyond the areas where you choose to invest, what does it take to succeed as an infrastructure manager in this type of environment?
Infrastructure is never a pure play financial investment. You must be an active manager of your portfolio. These are long-term assets that lend themselves to patient capital, but you also need to be suitably resourced to manage these assets over a long period of time. We have invested heavily in our bench strength for asset management.
In parallel with building an investment team, we have built a 20-strong team of senior advisers and non-executive directors who have been selected from different industries and geographies.
These people sit alongside us and provide industry expertise and guidance to individual management teams as they weather the various challenges and opportunities that come their way. In fact, abrdn insists on having at least one experienced non-executive on the board of every investee company. This is more important than ever when there is a crisis.
What are you seeing in terms of investor appetite for infrastructure?
We are currently raising our third fund, and we saw some softening of demand towards the end of 2022 as interest rates ticked up and investors began looking at their portfolios more closely.
What is encouraging, however, is that demand appears to be returning in 2023. I think the resilience that the infrastructure asset class has demonstrated, first with covid and more recently with war in Ukraine and the higher inflation environment, has struck a chord with investors who are looking for consistent performance. Those investors are now coming back, with new budgets to allocate, and we are confident of raising the balance of our fund by the middle of 2023.
What would you say is your number one cause for optimism in 2023 and what still gives you concern?
I think my biggest cause for optimism is that both inflation and interest rates appear to have turned a corner. One would hope that means that any recession may be more shallow than previously anticipated. My biggest cause for concern, however, is the ongoing geopolitical situation. War in Ukraine is a huge tragedy and how it plays out over the course of this year remains a big unknown. At the same time, we will need to watch the situation in China carefully, with regards to further covid restrictions, as well as relations with Taiwan. The scope for China to influence the macroeconomic environment should not be underestimated.
Dominic Helmsley is head of infrastructure at abrdn