Europe: politics, merchant risk and the growth of data
While European politics continues to present additional risks for investors, it is important to remember that GDP across the continent grew by 1.9 percent in 2018 and is forecast to increase by 1.7 percent in 2019. This is well above the 10-year average of 0.9 percent.
But changes in the political framework can bring uncertainty for infrastructure assets, especially as private ownership of essential assets comes under increasing pressure from opposition parties. In the UK, we’ve seen less investor-friendly regulatory returns for both water and electricity, partly in response to the opposition’s radical (and popular) plan to (re-)nationalise key infrastructure. Investors will need to assess political risk more closely than ever and manage exposure to regulated assets where political risk is perceived to be high.
European financiers have been very active in the renewables market, with around €300 billion lent to the sector over the past 10 years, but they too have to contend with a changing risk profile. As the era of renewables subsidies comes to an end, project sponsors worry that their support for the sector will wane as regulatory support disappears. More than 10GW of renewables capacity has been auctioned in the Spanish market. However, much of this will not be built ahead of the January 2020 deadline as sponsors struggle to finance projects on their bid metrics. The Spanish market will provide an important case study for the rest of Europe. Aurora Energy forecasts a pipeline of 60GW of renewables across north-west Europe by 2030, much of which will be subsidy free.
These are difficult dynamics for an infrastructure investor to assess. More conservative investors who were attracted by the regulated tariffs provided by renewables may simply disappear from the market. Others will seek to agree to corporate PPAs to mitigate the price risk, although the availability of such agreements is likely to be limited. In order for this ambitious pipeline of auction-based projects to be delivered, it seems that both equity and debt investors will need to get comfortable with taking an element of price risk.
Moving on to newer sectors, 2018 was a record year for infrastructure investment into telecommunication infrastructure, with around $11 billion of equity investment globally. While the growth of data is clearly a worldwide phenomenon, more than 80 percent of the activity relates to European transactions. The majority of these investments were in data infrastructure, such as fibre and data centres.
These sectors have been boosted by the proliferation of high definition on-demand video, gaming, cloud services, mobile data usage and IT outsourcing. This growth is forecast to increase exponentially. In terms of technology, there is a clear political push for fibre. The experience of actual take-up differs significantly by country though – something investors should be aware of. The difference in penetration rates is heavily impacted by price competition and the speed of the existing connection. It is therefore difficult to provide a uniform forecast for take-up rates.
Looking at some of the macro tends, it is not difficult to justify the level of investment and high valuations, but it is worth noting that many of these businesses take on significant risks around price, penetration rates and competition, especially in a sector that has a long history of overinvestment and bankruptcies.
US: trade wars, federal politics and green growth
Investors across all asset classes are inevitably fixated on the trade tensions between the US and China. In our view, the worst-case scenario for an all-out trade war is weak economic growth and above average cost inflation (ie, stagflation).
Ironically, both of those ‘negative’ economic outcomes are potentially positive for infrastructure investments. That is because the defensive nature of infrastructure assets means they tend to outperform more cyclical sectors on a relative basis when the broader economy is weak. And real assets tend to provide a hedge against inflation, since replacement cost rises with inflation. Whether actual cashflows are protected against inflation depends on the revenue mechanism of a specific asset.
The impact of slower economic growth at a sub-sector level is a bit more nuanced and could lead to unexpected outcomes. For example, oil prices tend to decline in a weak economy, as the commodity is generally highly cyclical. But that would also limit the production of associated gas from US shale oil wells, which would actually be incrementally positive for US natural gas prices, and thus US power prices (depending on jurisdiction and location). This would offset some of the negative impact that a weaker economy has on electricity demand. Essentially, US power assets with merchant exposure now have a natural hedging mechanism that did not exist before the development of shale oil.
On the other hand, lower commodity prices and shale production growth are slightly negative for midstream projects. Counterparties within the exploration and production sector will come under more financial pressure – increasing credit risk – while slower volume growth takes away upside optionality for brownfield expansions or increases the revenue risk of assets that lack volume commitments.
Ultimately, infrastructure assets in the US energy sector enjoy structural tailwinds (shale and Chinese gas demand, for instance), which should continue to support investment opportunities.
Domestic US politics is just as volatile as international geopolitics, though, especially with a polarising president and a divided Congress. Since last November’s midterm elections, there has been some optimism that a federal infrastructure plan will finally gain more traction, given that infrastructure is one of the few areas that tends to receive bipartisan support.
However, we remain somewhat sceptical. Without looking back too far, investors need to remember that even under a Republican-controlled Congress between 2016 and 2018, President Trump’s $1.5 trillion infrastructure plan did not go anywhere. History has shown that politicians may like to complain about poor infrastructure, but few take concrete action from a policy point of view. When actual dollars are on the line, attention is often prioritised towards taxes, healthcare, defence, social security and other issues that have a more tangible and immediate impact.
In the next few years, regardless of where the current push for a new infrastructure bill shapes up, most infrastructure investment opportunities will likely remain in the energy sector, which has traditionally been more welcoming to private investments.
Within energy, however, it’s worth dwelling on renewables. Following the global trend of falling renewable subsidies, federal subsidies in the US are also being phased out. Production tax credits will fall to zero after 2019, while investment tax credits will begin to decline after 2019. Although the sunsetting of subsidies could be a headwind for the sector, the end result may not be as dramatic, given the existing safe harbour rules. This will allow developers to defer project commissioning dates and still enjoy the tax credits, as long as they make a small amount of investment up front.
If anything, 2019 and 2020 should see a rush in project development – especially for wind – as owners try to capture the higher 2015 and 2016 PTCs after exercising the safe harbour rule’s four-year time limit. There will also be an incentive to safe harbour the current 30 percent ITC before it falls in 2020, meaning we could potentially see a large number of new project starts, especially for solar.
In addition, rising demand for renewables from the private sector through corporate PPAs also helps offset the headwinds from falling subsidies. Last year, over 6GW of long-term contracts were signed with corporates.
Finally, although federal support for renewables under the current administration remains weak, state-level support is robust.
The combination of strong demand from corporates, aggressive state renewable targets, continued improving costs, and the safe harbour rules for tax credits should continue to drive renewables expansion in 2019 and 2020, offsetting any headwinds from fading federal subsidies.
Private markets: booming equity, modest debt growth
Investor sentiment for infrastructure equity is at record highs, with Infrastructure Investor data showing over $80 billion raised for unlisted funds in 2018. But we observe that the increased capital flowing into the infrastructure sector is causing a shift in investment style to more non-core strategies: almost 50 percent of funds launched in 2018 and 2019 target a value-add strategy. It can sometimes be difficult to read through the real estate nomenclature of core, core-plus, value-add and opportunistic. It is perhaps easier to think about style in terms of the income and capital composition of total returns.
Core strategies tend to be more income focused, whereas value-add and opportunistic strategies rely more on capital growth to meet total returns. Over the past five years, the capital component of total returns has made up around 65 percent of total returns, highlighting the move from non-core strategies.
In addition to the shift to riskier strategies, the inflows into private markets have also resulted in valuations that are high by historical standards. Looking at the EV/EBITDA multiples, valuations appear to be at 2007 levels. However, the risk-free rate in late 2007 was around 4 percent, versus circa 1.5 percent today. This has implications for both the cashflow of an infrastructure asset and the attractiveness of the asset class.
Infrastructure assets are typically highly leveraged, so the impact of lower rates on an infrastructure company’s cashflow can be material. However, as EBITDA is calculated pre-debt service, the EV/EBITDA multiple does not adjust for the impact of lower rates, making the over-time comparison less meaningful.
The risk of further correction in public markets also provides a potential headwind to private infrastructure valuations. Listed infrastructure equities were down in 2018 but performed better than the broad equity markets, especially defensive sectors like utilities. But public valuation multiples have not increased since 2016, whereas private infrastructure valuations have continued to grow.
Overall, we believe that if listed infrastructure continues to have flat-to-declining valuations, then private markets should adjust, albeit with a lag. In our view, if there is a market correction, income strategies will outperform capital growth-orientated ones, as the latter face a higher risk of multiple contraction.
Finally, we note that infrastructure debt is increasingly becoming an important part of institutional investors’ allocations. However, it is also worth noting that bank financing still makes up between 80-90 percent of total financing in the infrastructure market.
Coinciding with the correction in equity markets, there was also a repricing in public debt markets. In the private market, we have not seen a noticeable repricing on European senior infrastructure debt or in the term loan B market in the US. However, if public market spreads continue to widen, we expect this to translate to higher spreads in the private markets.
Most infrastructure investors target an illiquidity premium over equivalent corporate bonds, therefore the private market will need to adjust. The structure of the private market means that any repricing will typically lag any public market correction.