Adjusting for inflation

Globally , a great deal of concern and uncertainty exists regarding the rate and direction of inflation. In North America, given the pace of the economic recovery, inflation seems unlikely to pose an issue for investors in the near term. RBC forecasts that core inflation in the US and Canada will rise steadily in 2011, but will not result in a dramatic increase in the core inflation rate.

Nancy Mongraviti

That said, the US economy is growing again and many investors have concerns regarding the longer-term outlook for inflation. Meanwhile, in Europe, Asia and particularly in emerging markets, inflationary pressures appear to be mounting. For investors sensitive to movements in inflation – particularly those investors with long-term obligations – the opportunity to capture a degree of inflation protection without sacrificing return potential is a key attraction of infrastructure.

While infrastructure assets may share a number of attributes, they are not homogenous. Infrastructure assets vary by user, method of regulatory control, revenue model, risk profile and inflation linkage. The extent of inflation linkage depends on the individual asset and its specific characteristics. Not every infrastructure asset will have an explicit (or even indirect) inflation adjustment mechanism, but most typically do. Below are examples of how inflation protection differs across infrastructure sub-sectors, geography and asset types.

Examples of inflation-linked infrastructure assets

Regulated utilities: Electric, gas and water utilities go through a formal process with their governing regulatory bodies to set the rate at which they are allowed to charge consumers for their services. In a general rate case, a utility accounts for factors such as its customer base, consumption growth, inflationary factors and consumer price index (CPI) in its revenue requirements and thereby proposed rate increases.

In the US and other developed countries, regulators will often increase allowed “returns on equity” during periods of high inflation to protect regulated utilities’ real earnings. Furthermore, since demand for light, heat and water are relatively inelastic, price increases can, for the most part, be passed on to consumers.

Renewable power: Renewable power purchase agreements in many jurisdictions have “feed-in tariff” (FIT) regimes whereby the government sets prices that regulated utilities are required to pay for certain types of renewable electricity generated and connected to the grid (this can vary across wind, solar, hydro, for example). Contracts are typically long term in nature (e.g. 20 years) and often contain explicit inflation adjustments.

As of 2010, feed-in tariff policies have been enacted in 63 jurisdictions around the world. Globally, there is a wide spectrum in terms of the degree of inflation linkage contained in FIT regimes. Some jurisdictions, such as Ireland, have established FIT payment regimes that provide for annual adjustments that are fully indexed (100 percent) to inflation while others provide for an adjustment of only 20 percent of the tariff price to inflation (e.g. Ontario, Canada). Other countries take a more indirect approach. For example, in Germany, there is not an explicit inflation adjustment every year, but rather, Germany’s regime assumes a fixed 2 percent annual inflation rate and FIT payments are made based upon this built-in assumption. In France, the wind tariff can be increased annually based upon increases in wages in the utility sector.

Aside from FIT regimes in the renewables sector, many privately negotiated powe purchase agreements and other utility concession agreements contain similar escalation provisions linked to the inflation rate.

Throughput assets: An operator with a long-term concession agreement with a governmental authority to operate a toll road will often have an explicit provision that permits the operator to increase tolls in line with an increase in inflation. For example, the Chicago Skyway can increase tolls by a maximum amount of 7.9 percent per year from 2008 to 2017. From 2018 to 2104, tolls can be adjusted by the greater of 2 percent per year, CPI or the increase in nominal GDP per capita. On the Autoroutes Paris-Rhin Rhone in Europe, cars pay 85 percent CPI (ex-tobacco) plus 0.5 percent in 2011 to 2013. After 2013, cars pay 70 percent CPI (ex-tobacco) until new contracts are negotiated and agreed upon with the French state.

In the case of roads operating under a public-private partnership model (PPPs), the governmental authority often makes indexed “availability payments” to the operator of the road based upon a specific inflation indexing mechanism. The operator of the Port of Miami Tunnel shares inflation risk with the Florida Department of Transportation (FDOT). FDOT makes indexed availability payments that provide 85 percent inflation protection. The Sea to Sky Highway, which also operates under an availability payment contract, has 35 percent of its revenues indexed to inflation, with an underlying assumption of 2 percent inflation.

Social infrastructure: In PPPs in schools, hospitals or courthouses, a government body enters into an availability payment contract with a private sector owner/operator. The availability payment contract will often contain an explicit provision that increases all or a portion (operation and maintenance costs) of the availability payment in line with an increase in inflation. While many governments have standardised their PPP contracts, the terms of individual PPPs are negotiated, and therefore the degree of inflation linkage in the availability payment may be a trade-off that becomes part of the negotiation process.

In the UK, PPP projects typically have a strong correlation to UK inflation. The degree of linkage can vary, but will often follow a model where there is an indexed income stream from the concessionaire and an un-indexed income stream related to the asset’s operating costs. In North America, the Canadian PPP market is generally known for having favourable inflation linkage provisions. The US, however, is in the early stages of developing PPP regimes on a state-by-state basis, so there tends to be more variation.

Some social infrastructure assets may have an indirect inflation linkage bakedinto the availability payment contract, whereby the equity sponsor will model expected inflation rates into the pricing of the availability payments over the life of the contract. This approach runs the risk that the equity holder’s inflation estimates were too low and inflation outpaces their models. While not as direct as contractually adjusted formulas, this approach delivers a degree of inflation protection.

Summary

Most infrastructure assets contain a degree of inflation protection, but the nature of inflation-linkage will vary asset by asset and depend upon the type of contractual or regulatory arrangement in place. An appreciation for the nuances of the asset class will help investors construct a portfolio of assets or funds well positioned to deliver the appropriate level of risk and return for their investment objectives during various inflationary environments.

Nancy Mangraviti is a managing director in the infrastructure investment group at RBC Global Asset Management in Boston.