Game change: technological innovation in infrastructure

Very few infrastructure investment managers today would associate technological innovation with infrastructure, an asset class that is considered long-term, stable and reliable. Yet by the end of this decade, every investment manager will be fully proficient
in various technological innovations as well as their respective implications within various infrastructure sectors.

The likely implications will be that various infrastructure sectors’ business models will have been altered significantly – if not experiencing a complete game change.

Infrastructure has by definition always been intertwined with technology, and thus highly exposed to technological change. As an example, airports, ports and railways all rely heavily on technology to keep ‘just-in-time’ processes highly precise. While some take for granted these efficiencies, far too many others do not appreciate when such technologies actually create new business models.

Indeed, a small number of key industry associations, operators, consultants and analysts are presently discussing various disruptive technologies that either exist or are being developed
in supporting or creating trends which could inevitably lead to game change within various infrastructure sectors.

Furthermore, there are efforts currently taking place around the world whereby these aforementioned groups are working with regulatory bodies in seeking to protect incumbents’ capital investments from a ‘stranded asset’ perspective – or to disallow stranded investments from the interests of new entrants in order to enhance their
competitive advantages.

Accordingly, those infrastructure investment managers which are able to identify technological trends in advance (along with their respective implications) and invest or divest accordingly will achieve outperformance; while those which choose to
ignore technological innovation could ultimately realise that the market has turned against them.

Echoing Santayana (1)

Historically speaking, profound technological change is nothing new to infrastructure. For example, from 1980 to 2000 there were profound transformational, even disruptive,
changes. Most notably, the innovations of mobile telephony and fibre optic cables have made many metal or copper wire networks redundant and, with respect to developing markets, virtually non-existent.

In the electric industry, the innovation of gas-fired turbines, combined with emission reduction standards and the availability of cheaper gas (via the advent of fracking technology – see below) have had a material impact on the number of coal power plants in
operation today as well as the location of many networks.

The enormous material impact from these technological advancements affected not only technological suppliers, but also service providers. One only needs to look at the impact
to the (then) monopolistic telephony providers which were providing plain old telephone service (POTS) and compare it to their model of today. Technological innovation in
this market created “The Death of Distance” (2) and changed the whole revenue and cost (along with regulatory) model, which is still impacting these entities.

The indirect impact from technologies has changed the global economic landscape, whereby technology has enabled consumers the ability to make choices. This has altered customer
behaviour significantly, which has required suppliers to change their business models or go bankrupt.

Examples include the large reduction of demand for physical transportation of post, or the massive shift away from public switched telephone networks (PSTN) to Voice over Internet Protocol (VoIP) for essentially free or cheaper communications services (voice, fax, SMS, voice-messaging etc.).

Over time, one should expect innovation to create a new dynamic between consumers and infrastructure service providers. An example is smart home/demand management reducing
overall energy consumption and ultimately enabling load to shift from central to distributed generation.

Innovation in the gas industry

Recent focus has been on horizontal drilling and hydraulic fracturing (“fracking”), most notably in the US. There, shale gas now accounts for more than 30 percent of gas supplies and has transformed the US from the largest net importer of natural gas in 2007 to the largest producer in the world today. The International Energy Association recently predicted that these technologies will enhance further shale oil production and make the US the largest oil producer by 2020.

In turn, this has required an enormous amount of capital to be invested in infrastructure. Global Infrastructure Partners identified this trend in advance and acquired Chesapeake
Midstream Partners L.P. (now known as Access Midstream Partners), which has earned them to date a return of over 3x their investment.

However, several US long-haul companies have not been so fortunate, as the flows of gas are no longer mainly focused from liquefied natural gas (LNG) terminals in the Southern US to end-points, but rather flow from new points of production (e.g. Marcellus shale in the Northeast) to end-points, thus decreasing the value of many traditional transportation routes (3).

Yet the impact of this technology has not only affected the US, but also the world. With the US now a net exporter of gas, the global price of gas has dropped due to the availability
of supply. However, in those regions such as Europe and Asia, where the price of gas is still relatively high, one could expect to see investment into E&P (barring political and social backlash) of identified shale reservoirs, and if these reservoirs are truly large and economic, the build-out of the appropriate infrastructure will occur.

Where there are no shale reserves within large distances, there are discussions about increased LNG production, transportation and distribution networks over time to target these regions.

Another knock-on effect is the growing trend of chemical companies relocating to the US (due to low energy costs) or the impact of lower pricing on US chemical companies, which are scaling up their production. This could have a material effect on various investors that have some existing infrastructure business tied to these entities.

Innovation in the electric industry

While fracking technology has had an enormous impact on the gas industry and related industries; the electric industry is poised for huge transformational change, which some argue will be even larger than that of the gas industry. Specifically, a combination of
economics, social trends, technology and yet-to-be-determined regulatory determinations, could create the perfect storm for this industry.

With respect to economics, there are several factors to consider. Generally speaking, the cost of electricity is increasing across the world. With respect to the Western world, refurbishment of aging infrastructure (i.e. grids), build-out of new power plants, regulatory decisions (i.e. decommissioning of nuclear) are all contributing to upward pricing pressures.

The developing markets are being required to build-out new power plants and infrastructure as well as refurbish older investments in order to meet demand. For the most part, every
region in the world is now required to lower emissions targets via emissions retrofits, which is also pushing capital investment much higher. That’s the good news for infrastructure investors.

The bad news is that growth in capital investment is not being balanced by an increase in revenues. The effects of the global financial crisis (GFC) and energy conservation have been significant in various regions, resulting in “permanent demand destruction” (4). Many regions are seeing historical consecutive negative growth.

Operating costs are also expected to go up as the global price of fuel is expected to increase over time. Therefore profitability is declining, which is impacting the credit quality of many of these assets, thereby further increasing the cost of capital to these entities.

With regards to social trends, the rise of “collaborative consumption” (5) is a growing trend that could create more problems not only for the electric industry, but for other industries
as well. In summary, consumers are collaborating more with one another to reduce their overall cost by sharing assets or aggregating their purchasing power to obtain wholesale prices.

As discussed, energy conservation has had a major impact on demand consumption and is expected to take an even greater toll over time. This consumer sentiment can lead to a
political groundswell, as exemplified by Germany’s Green Party. With sentiment against high energy prices continuing to increase as prices go up and the ever-growing environmentalist
lobby gains momentum, consumers’ resentment against incumbent energy providers will only grow further. Consumers will therefore be looking for new networks through which to procure energy, and technologies will be developed to enable new means of procuring energy.

On this note, one should carefully follow the discussions in Germany surrounding
Rekommunalisierung, whereby local governments are considering not renewing their concession agreements with larger utilities as a reflection of their unhappiness with high energy prices. These local governments will then own (and likely manage) their respective local distribution network with the idea of aggregating their customer base to procure power or build, own and operate their own power (conventional and/or renewable).

Here lies the transformational power of technology, which can create greater efficiencies, enable trends or create new business – which may prove disruptive (6).

Distributed energy resources (DER) are being optimised to exploit the aforementioned economic and social trends and are having a disruptive effect in the electric sector. Upon
assessing the high retail prices of energy in Europe, it is expected that unsubsidised solar can replace up to 14 to 18 percent of conventional power from utilities in Germany, Spain and
Italy with some 6 to 9 percent of shrinking grid demand by 2020 (7).

The large subsidies for DER in Europe have increased the supply of power with little variable costs, whereby this surplus of supply from DER is now replacing fossil fuel-fired power plants. Many of them (including very modern new-build plants) can no longer run economically and therefore are stranded investments and will shut down.

In the US, where energy prices today are relatively cheaper, Bloomberg New Energy Finance estimates that distributed solar will nonetheless account for some 10 percent of capacity in key markets by 2020. The impact on utilities is material. In a recent analysis assessing a market where solar is being fully subsidised, it is estimated that a drop of load of 10 percent from DER equates to an average impact on base electricity prices to non-DER customers
of 20+ percent (not including the cost of serving DER). (8)

The growing portfolio of DER will have a further impact on transmission and distribution grids as load loss (i.e. rooftop panels) hits revenues. In addition, these operators will be increasingly required to invest in smart grid technologies in order to balance the various loads as well as invest in other developing energy storage technologies.

It is likely that a portfolio of various storage and back-up technologies will be required in order to maintain a high reliability of supply. Yet most of these technologies are still in development (batteries, microturbines, compressed air, etc.) and for the most part are not fully commercial. Regulation will then have to be further created to take into consideration these new storage and back-up systems.

However, one should not conclude that the electric utility industry is in a death spiral. Regulation will provide an immensely critical role in determining the future of both conventional and unconventional players and their respective interactions. Various European governments (9) and respective federal and state entities in the US are presently working on regulation (capacity payments, interconnection, net metering, etc.) that will determine “stranded investments” and “transition charges”.

Industry is now starting to take a ‘front and centre’ approach to regulation. In a July 2013 interview titled We are on the wrong path in Handelsblatt (10), the chief executives of Eon and Siemens stated that present energy regulation, including subsidies for renewables,
need to be fundamentally reformed or Germany’s competitiveness will be at risk as electricity prices for households are expected to increase by 35 percent by 2020 (and 30 percent for industrials). Similar issues are now being raised elsewhere in Europe, in the US and across the world.

It is hoped that regulators across the globe will use greater prudence (compared with recent incidents such as retroactive taxes) when arriving at these decisions. The impact of their
determinations, which will likely be used as precedents in other regions, will not only have a major impact on the cost of capital for various assets and the respective price of electricity, but also will determine whether some markets will be disrupted by brownouts as investors pull back from making investments in certain regions.

It is here where infrastructure investors need to take note: the capital markets for the most part have not fully priced these risks and it is implicit for those making (or who have made)
investments in these sectors to reassess their respective valuations at appropriate times.

Other sectors

One should not, however, conclude that technological transformation is limited to the gas and electricity sectors. Indeed, new technology is being utilised to create greater efficiencies in the water sector (11). Various large industrial clients are utilising new technologies that may ultimately lead to their ability to create greater independence from water providers. Other sectors are exploring how new technologies can transform their respective business
models as well.

Armageddon

Yet the most insidious technological threat today to infrastructure is from cyber-attacks. As reported in last month’s article by Ben Beeson and Angel Kuan (Infrastructure Investor,
July/August 2013, p.41), cyber-attacks place large risks in the way of infrastructure owners across various sectors.

A cyber-attack can derive from any number of suspects: a nation, a terrorist organisation, an activist group or even a pimple-faced teenager. Statistically, the number of these attacks is
increasing in the US (12) and most likely elsewhere.

Whatever the source, the impact could be enormous. US Secretary of Defense Leon Panetta identified a “cyber-attack perpetrated by nation states or extremist groups” as capable of being “as destructive as the terrorist attack on 9/11” (13).

This is not fear-mongering – the risks are large and real. One only needs to reflect upon the US Northeast blackout in 2003 when a software bug (not virus) failed to prevent a cascading tripping of some 250 power stations in eight northeastern US states and Ontario, Canada.
Collectively, circa 55 million people were left without power for two days.

The implications politically, socially and financially to the owners of infrastructure assets are enormous. Those owners who are found to be negligent in maintaining their security will likely be held accountable financially and even potentially criminally for their inactions.

In summary, infrastructure investment managers need to be thinking now about all aspects of technology as well as its potential impact on infrastructure and not wait to be surprised by game change at a later time.

Jeffrey Altman is a senior international infrastructure executive.

1. George Santayana – “Those who cannot remember the past are condemned to repeat it”
2. “The Death of Distance” by Frances Cairncross
3. S&P’s “Special Report on US Midstream Energy”, October 2012
4. Deloitte Center for Energy Solutions: “The Math Does Not Lie”
5. “The Rise of Collaborative Consumption”, by Rachel Botsman and Roo Rogers
6. See Clayton Christensen’s book, “The Innovators Dilemma: When New Technologies Cause Great Firms to Fail”
7. UBS Investment Research: “The unsubsidized solar revolution,” January 2013
8. Edison Electric Institute: “Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business,” January 2013
9. Moody’s Investors Service: “Wind and Solar Power Will Continue to Erode Thermal Generators’ Credit Quality,”November 2012
10. Handelsblatt, “Wir sind auf dem falschen Weg” July 8, 2013
11. Ernst & Young: “The US water sector on the verge of transformation” and Plenary Keynote Address by Paul Brown AICP,World Congress on Water, Climate and Energy, May 2012
12. “Report on Electric Grid Vulnerability: Industry Responses Reveal Security Gaps”, Written by the staff of Congressman Edward J. Markey and Henry Waxman
13. “Report on Electric Grid Vulnerability: Industry Responses Reveal Security Gaps”, Written by the staff of Congressman Edward J. Markey and Henry Waxman