This article is sponsored by Ostrum Asset Management
The world needs $69 trillion of investment in infrastructure between now and 2035 to support growth projections, according to McKinsey.
However, governments have limited resources and banks, historically major players in financing infrastructure, now face regulatory constraints, especially with long-term maturity loans. This creates an opportunity for institutional investors to enter this global, deep and stable market, which Infrastructure Journal reports comprises over $200 billion transactions annually.
The renewables sector has expanded nine-fold since 2005 and is likely to grow further as part of the infrastructure universe.
As reported by the International Energy Agency, energy and transport are the biggest contributors to CO² emissions – 69 percent of the total CO² fuel combustion – so it’s likely that renewable energy, green mobility and energy-efficient building will offer opportunities for investors.
“Default rates in infrastructure debt are extremely low, averaging just 0.56 percent a year since 2005”
The French Greenfin label was launched in the wake of the Paris Climate Agreement and is indicative of current trends. It requires the majority of investments in a portfolio to contribute to financing a greener economy. It also requires measurement of the environmental footprint of the portfolio, encompassing impact assessments on climate change, natural resources, including water, and biodiversity. Investing in oil, gas, coal and nuclear sectors is prohibited. There is an emphasis on energy transition and green transport, buildings, water and telecoms.
Some investors worry that renewables take high risks for the returns they deliver. But investing in renewables doesn’t have to be high risk.
One way to invest in infrastructure while aiming to reduce the risk of loss is by investing in the financing of infrastructure. Quite simply, debt is less risky than equity. The protection is strongest for senior secured debt instruments; investors in senior secured loans have first call on the asset if something goes wrong. For pure infrastructure project finance, if the covenants and agreements have been properly structured, the protections are far stronger than for corporate bonds.
Default rates in infrastructure debt are extremely low, averaging just 0.56 percent a year since 2005, suffering no spikes even during the financial crisis. The recovery rate when a loan does default is 76.2 percent on average, according to Moody’s. This ensures that overall losses are minimised and risk-adjusted returns increased. The recovery rate of Ostrum AM’s infrastructure debt managers is 100 percent over two decades. The reason for this is careful structuring and close monitoring. Our credit documentation asks that the borrower inform us of any problems, propose remedial plans and allow us to work with them. Plans are validated and we monitor progress.
Mitigating credit risk
Ostrum AM selects transactions with strong covenants to control and protect investments. If there is a problem, we have a strong security package, especially pledge of the borrower’s shares, contracts or bank account, to solve it. Another way to protect capital and income is by investing only in essential assets. Ostrum AM’s strategy invests in many forms of transportation infrastructure, including bridges, tunnels, seaports and railways, but excludes non-essential assets, such as parking lots, which are not strategic.
In the renewables sector, Ostrum AM considers all assets essential, including solar farms, wind farms, biomass and energy from waste. All conventional power and natural resource assets are excluded. Healthcare and education facilities are considered essential, while senior housing is not, because of the significant real estate risk. Countries need essential services as part of their sustainable development, so all parties have a strong interest in defending essential assets that encounter problems. This is not always the case with non-essential assets.
The next line of defence against capital loss is to be credit-focused and conservative. In the renewables sector, technology must be commercially proven to protect capital over the life of a transaction. The minimum internal scoring for a transaction to be included in the portfolio is BB and the overall strategy must have an investment-grade internal scoring.
Diversification of risk factors is another important way to avoid sector or asset-type concentration. Diversification is achievable given the depth of assets available in infrastructure. The difficulty lies in transaction selection and being sufficiently stringent in transaction analysis. Ostrum AM, for example, selects only 4 percent of the global pipeline, favouring the most attractive risk-return transactions.
Transparency helps manage ESG risks
Financial risks are a critical consideration when investing in infrastructure debt but there are also ESG risks – primarily that transactions are less green than they first appear.
A strategy based on project finance transactions, rather than on corporate bonds, enables better control of this. Ostrum AM selects transactions where the issuer must stick to the agreed terms. A solar project, for example, must produce green electricity and nothing else. If the asset operator wants to change its business model, it has an obligation to ask the lender. The project finance structure provides useful transparency. In addition, environmental studies are carried out to assess the effectiveness of each project. In France, precise carbon measurements must comply with Greenfin.
Risk management is more than risk reduction – the key is to manage risk to optimise returns. At Ostrum AM, we divide risks into two buckets: risk reducers and return enhancers.
These buckets are used to create a risk profile that targets risk-adjusted returns superior to investment-grade corporate bonds. Assets in core countries such as Germany, France, the US and Canada, are seen as risk reducers. Assets in the periphery, often in southern European countries such as Spain and Italy, are considered return enhancers because of their less certain business and legal environment.
Similarly, core sectors such as solar, roads and hospitals are risk reducers because of the relative lack of complexity involved in building and operating the assets. For instance, it is fairly straightforward to operate a school – the operator is responsible for providing a sturdy building with light and power. On the other hand, offshore wind is a return enhancer, because it is typically assembled in the deep sea, where conditions might prohibit easy building and maintenance.
The nature of cashflows is also considered. Schools and hospitals are risk reducers because they normally have long-term agreements, and therefore long-term and stable income streams. Cashflows from broadband networks may depend on shorter-term contracts with operators and ultimately with individuals, so they are less secure and are considered return enhancers.
Construction risks are also distributed across the two buckets. Brownfield assets have already been built, so there is no construction risk involved. The Ostrum AM strategy is focused predominantly on brownfield; however, from-scratch projects can be financed. When well-managed, this can enhance returns. The key is to balance risk reducers with return enhancing projects that justify some extra risks.
Access to deals
Unlike listed assets, infrastructure loan origination requires deep sourcing and structuring capabilities to ensure access to transactions with high relative value. The sourcing network includes industry and financial sponsors and a variety of banking activities operating across regions and sectors. The breadth of the network facilitates access to deals of all sizes, diversifying the portfolio.
Experience is essential to successful sourcing. Ostrum AM’s former lending-side bankers each have over 20 years’ experience, structuring over 300 transactions with only five defaults and a 100 percent recovery rate.
The strategy suits institutions looking to match long-term liabilities, with a liability profile that allows for illiquidity. Investing in infrastructure debt can also reduce volatility in the overall portfolio. The strategy also appeals to investors that want to allocate to assets that favour energy transition, and therefore a beneficial climate change impact.
“The renewables sector has expanded nine-fold since 2005 and is likely to grow further as part of the infrastructure universe”
While the strategy typically matches durations of around 10 years, it is possible to match even longer duration liabilities. Ostrum AM’s active portfolio construction allows it to reinvest repaid loans in order to maintain invested capital at a maximum. This can lead to longer horizon returns, enabling investors – when required – to match liabilities of longer than 10 years.
Reinvestment also allows the strategy to benefit from potential rises in interest rates over time. The strategy allocates to both fixed and floating rate loans favouring 0 floored Euribor to minimise interest rate risk. As a result, the gross target return is above 2 percent in euros and 3.5 percent in dollars.
For European insurers, the strategy may offer favourable treatment under Solvency II, with a SCR spread reduction of at least 30 percent compared to corporate issuers.
Green investments are growing faster than most asset classes, as governments and investors push towards more sustainable practices. With a robust, methodical approach, investors should benefit from the continued expansion, and infrastructure debt is crucial to this.
It inherently delivers stable cashflows and naturally gravitates towards sustainable assets.
Infrastructure debt can appeal to investors requiring both consistent income and ESG-compliant assets.