Wake up, regulators

In a new report on global infrastructure needs to the year 2030, the Organisation for Economic Cooperation and Development (OECD) found the investment requirement to be in the region of $50 trillion. With over $65 trillion in assets under management at the end of 2009, the report says institutional investors “could be” a key source of capital for infrastructure projects – especially given the all-too-obvious pressures on public funding.

But if “could be” sounds to you a little like a lament, it’s no coincidence. In a report on pension fund investment in infrastructure, which accompanies the bigger “2030” survey, the OECD notes that less than 1 percent of pension funds worldwide are currently invested in infrastructure projects (excluding investments in the equity of listed utility and infrastructure companies).

Given the innate characteristics of infrastructure investing, including its ability to match the long duration of pension liabilities, this lack of pension exposure to infrastructure has the whiff of a huge missed opportunity. What explains it? It’s not the only reason, but a big one is regulation. The report points out pensions are, in general, heavily regulated with regard to risk profiles and the way in which risky assets are treated in their accounts.

Short-term pressure

Given the necessarily long-term outlook of pension funds, it’s a peculiarity that they face considerable short-term pressure from regulators. The report points to the close scrutiny on the short-term funding levels of defined benefit pension schemes and the pressure to redress funding shortfalls when they arise. Further, assets and liabilities may be valued according to today’s market prices.

New regulations threaten to further erode pensions’ ability to make long-term commitments. It is understood that Solvency II rules, which appear poised to penalise institutional investment in infrastructure, may bring occupational pension schemes into their sphere of influence. Pensions will also look nervously at regulatory developments impacting other infrastructure investors that may damage the overall investment ecosystem: the hit to long-term lending some banks will take as a result of Basel III, and the effects of the Volker Rule and AIFM Directive on infrastructure funds and fundraising.

The OECD makes a number of policy recommendations in its conclusion to the report. Among these is the following: “Regulators…need to address the bias for pro-cyclicality and short-term risk management goals in solvency and funding regulations, and relax quantitative investment restrictions to allow institutional investors to invest in less liquid assets such as infrastructure.”

The report has its more encouraging aspects – noting the wholehearted embrace of infrastructure by Canadian and Australian pensions, for example, and some positive signs that American and South Korean pensions are following their lead.

Canada stands as a shining example of what could happen elsewhere. The report finds that some Canadian investors have portfolio allocations to infrastructure equity of more than 10 percent. According to the Pension Investment Association of Canada, at 31 December 2009 aggregate assets invested in infrastructure amounted to C$34.9 billion, representing 3.84 percent of total managed assets. The report notes Canadian pensions’ ability to co-invest and take leading roles in bid consortia, “competing with other funds and financial sponsors”.

Furthermore, the report notes that Canadian pensions have the resources to produce their own research and risk assessments without recourse to external consultants. And for those investing in funds, many have specific infrastructure allocations – a characteristic of a mature infrastructure investor, given that many allocations to infrastructure still come from the fixed income or private equity silos.

But Canada is not representative of the rest of the world. The report notes that, in Europe, allocations to infrastructure have slowly crept up but still typically represent a mere 1 to 3 percent of total portfolios.

If pensions are to become a useful source of capital in addressing what is likely to be a huge global infrastructure funding gap in the years ahead, regulators need to start thinking about some fairly fundamental change to the frameworks they have laid down.    

As the report itself concludes: “Before pension funds will commit large amounts of capital to infrastructure there must be transparent, long-term and certain regulations governing the sector in countries where this is not currently the case.” Regulators, please take note.