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Infrastructure as a service

Austerity, digitisation and shifting demographics have reignited the legitimacy debate, says Hermes’ Peter Hofbauer.

This article was sponsored by Hermes

What do you think is meant by the term ‘infrastructure as a service’?

Peter Hofbauer
Peter Hofbauer

Changes in the way that a digital society operates mean that people are focused on the end product far more than the mechanics that go into making that product.

Apple’s Steve Jobs got it right when he said some years ago that people don’t need to understand how something works; it just needs to work.

That has implications for us as infrastructure investors. Our job is no longer about providing the infrastructure assets themselves but rather the end product. With infrastructure, that end product is generally an essential service that is required for a community to function.  Infrastructure as a service, therefore, means understanding that the service to the end consumer comes first.

How has the economic environment in the wake of the financial crisis played into that trend?

Austerity has led to an increased focus on affordability, certainly. People have needed to tighten their belts and think about the cost of what they are consuming.

People consume essential services every day. The economic environment has also meant an increased focus on efficiency and on sustainability. In many ways, the financial crisis also altered society’s perspective on what constitutes a fulfilled life.

There has been a growing awareness that it’s not just about money. The financial crisis hit the reset button and made people think about broader issues.

Finally, it has made consumers think about the settlement between private sector investors and them as end users. What is fair? What is an appropriate level of profit for the private sector? These questions are now being asked, and legitimately.

You mentioned sustainability. What role has the decarbonisation agenda played in driving infrastructure as a service?

Decarbonisation is affecting everything that we do. I have personally been involved in decarbonisation investments for over 20 years, having been one of the first investors in wind generation. Back then, everyone looked at us like we had two heads. Now, of course, it is commonplace.

Clearly the energy sector is at the forefront of the decarbonisation drive, but there is also a significant amount of activity building in relation to transportation, for example. Other traditional infrastructure sectors like water are also working hard to consider both the impact their business has on the environment and the impact the environment may have on their business.

Shifting demographics are also key. How have a younger, more vocal and engaged generation of consumers made themselves heard?

Service-level expectations from younger end users are markedly higher given their experiences in a digital world. The iPhone was launched in 2007 and, in the time that has followed, people’s expectations around seamless, efficient, timely service, with high levels of communication, have risen dramatically.

Some of the regulated infrastructure sectors have been slow to adopt these service levels. That’s in part due to the significant amount of investment required to bring customer-facing systems up to date, and partly cultural.

Affordability issues are also important. The younger generation tends to see essential services as something that should be provided by the state. That question of settlement, and whether they accept that these services should be paid for on a user-pays basis or out of the public purse, is being questioned.

The baby boomers still remember the challenges arising from state ownership, including under-investment, as a result of the conflicting priorities faced by governments between education, healthcare, short-term spending and long-term investment, and levels of taxation.

The younger generation haven’t been exposed to those experiences and, as a consequence, they aren’t being factored into their considerations around the role of private sector investment in public infrastructure.

Specifically, these factors don’t feature in their views around the level of service that should be provided and who should pay for it.

What role are underlying investors, acting on behalf of their stakeholders, having on the concept of infrastructure as a service?

We need to not only provide our end beneficiaries with a return on their investment, but also be an activist for positive change to bring about the highest levels of affordable service provision, done in a sustainable and responsible way. There is both push and pull there.

We obviously try to encourage our end beneficiaries to think about more than just economics and increasingly they are engaging robustly with those issues. Demographics also have a role to play, in terms of the population’s weighting towards beneficiary or end customer.

Obviously, that will affect people’s experiences and their perspectives on the role of private sector involvement in public infrastructure.

How do you see the debate over the legitimacy of private-sector ownership of critical infrastructure playing out?

I think the debate is an appropriate one to have. There is merit on both sides of the argument.

I think some of the larger, regulated, B2C sectors have struggled to meet expectations and to change their business approach in order to be more customer-focused. They are seeking to respond, but have large business operations and so find it challenging to respond in a timeframe that other stakeholders regard as acceptable. That will undoubtedly cause them some challenges. But while I think it is appropriate that questions are asked about service, it is also important to remember that ownership doesn’t necessarily correlate with service levels.

Being state- or private sector-owned doesn’t automatically mean service provision will be better or worse. State ownership comes with certain conflicts and challenges. And while private sector ownership may bring additional costs to the end consumer, in terms of profits for the operator, it also adds discipline in terms of the efficient allocation of resources and alignment with long-term sustainability.

We believe that responsible investment is fundamental to retaining legitimacy. We also very much believe there is a role for private-sector involvement in public infrastructure. Quite frankly, governments around the world don’t have the levels of capital required to meet the world’s infrastructure needs.

The trend has been for governments to progressively invest less and less, going back to the 1950s, and rely instead on private sector capital and user-pays models. That trend will need to continue.

The questions are: in which sectors, and what settlement applies?

There is a delicate balance to be struck between providing an appropriate reward to investors and ensuring that the end customer receives an efficient and sustainable service.

There is also a delicate balance to be struck to ensure that investor trust is retained, and thereby ensure that governments can continue to attract and retain the cost-effective private sector capital required to fund the world’s infrastructure needs.

How are investors embracing this concept of infrastructure as a service? What opportunities does it create?

The changing societal landscape certainly does create opportunities. The questions we ask ourselves when looking at these opportunities are around sustainability of service, which will include factors such as affordability and barriers to entry. Will that service be substituted, or is it something the end users will want on a long-term basis?

It comes back to this point of focusing on the service rather than the hard plumbing that sits behind it. With changing technologies, changing business practices and changes in consumer behaviour, we also need to ensure there is sufficient agility and flexibility in those services to adapt in the years to come.

Which sectors are most susceptible to these societal changes?

I think it is a lens that needs to be applied to all sectors. In some cases, it is obviously more about retrofitting – where the businesses are already highly established and significant investment has been made. Substituting those with a completely new model of service delivery is not realistic.

Equally, in a world that is subject to so much disruptive force, opportunities are being presented to really drive change. There are exciting prospects out there that very much deliver the investment characteristics our clients are looking for.

How does the concept of infrastructure as a service affect the way you manage existing assets and their stakeholders?

We have come at this initially from the perspective of governance. We believe that the business culture in our portfolio companies is key and that the people in those businesses need to be mindful of a broad range of stakeholders, rather than just the needs of financial investors, when it comes to how they conduct their business.

This is particularly true for those businesses that have a social contract. However, without ensuring or indeed transforming the underlying culture, it is very difficult to change anything the business does. People are the most intransigent aspect of any business.

For infrastructure assets, with a very long life, you also need to ensure the governance framework is sufficiently agile to adapt to the changing needs of society.

You have to make sure the business is attentive and open to listening to those shifting needs, and not closed and entrenched in a certain way of operating.

People talk about a licence to operate. To what extent do you think the terms of that licence are changing or are likely to change?

The licence to operate will need to ensure it embraces the requirements of all stakeholders. At the same time, it is important to ensure there is a fair return to the investor for the risk they are accepting, and that investors have sufficient trust in the framework and the settlement to continue to deploy capital.

It is a delicate balance, as I said. But money is fungible and there are significant investment needs around the world. Capital will migrate to areas where investors believe they will generate the best risk-adjusted returns.

Peter Hofbauer is head of infrastructure at Hermes. Since joining the firm in 2010 he has led all fundraising and investment activity including the raising and deployment of HIF I and all co-investments

Customer-centric regulation

Hermes has created an enhanced governance toolkit for infrastructure businesses that aims to ensure the interests of all stakeholders are considered.

Regulators have followed this trend. UK water regulator Ofwat’s new framework, for example, provides incentives for water companies and investors to improve customer service, the environment and society, and seeks a fair balance of consumer and investor interests.

Ofwat requires UK water companies to take an inclusive approach to understanding the different customers they serve. This involves engaging directly and regularly with customers, and ensuring that decision-making is well informed by their priorities, interests and changing expectations. Ofwat’s customer-led approach for the next regulatory cycle includes an emphasis on service, affordable bills, operational and financial resilience, and innovation.

Ofwat has also assessed water companies’ business plans across nine test areas: engaging customers; addressing affordability and vulnerability; delivering outcomes for customers; securing long-term resilience; targeted controls, markets and innovation; securing cost efficiency; aligning risk and return; accounting for past delivery; and securing confidence and assurance. This approach to assessment clearly shows that the customer has now been placed at the heart of the regulatory agenda.