Infrastructure Asset Management: Navigating ESG, Inflation, and Debt
In the evolving landscape of ESG, inflation and debt are crucial in shaping infrastructure investment strategies. To gain deeper insights, we interviewed Igor Pakovic, journalist and Real Assets Editor at With Intelligence. He provided an in-depth look at how the sector addresses ESG factors, manages rising inflation, and adapts to changes in the debt market.
Infrastructure and ESG
With Intelligence (WI): How is the asset class addressing the subject of ESG today?
Igor Pakovic (IP): Private infrastructure is increasingly addressing ESG factors due to its long-term time horizon and the significant funding required in this asset class. Compared to other asset classes, infrastructure investments have an impact on ESG factors as they directly involve land acquisitions and resettlements, affecting communities and the environment.
In this scenario, infrastructure investing presents both opportunities and challenges in relation to ESG. Investments in the asset class can make a positive impact through funding renewable energy projects and sustainable transportation infrastructure, while also growing emphasis on projects that benefit local communities and promote access to essential services, especially when it comes to healthcare and education facilities. On the other hand, ESG factors in infrastructure create a number of challenges, particularly the social aspect of ESG, given the sensitivity and risks associated with community engagement, resettlement, and land acquisition.
WI: What opportunities are there within renewables?
IP: Renewables offer a plethora of opportunities for asset managers and investors, as they can benefit from the urgency of scaled intervention in the energy transition and the funding it requires. Legislation like the Infrastructure Investment and Jobs Act and the Inflation Reduction Act (IRA) passed by Congress in recent years also provide an unprecedented financial commitment by the US government to decarbonization, with the latter unlocking around $369bn in funding for energy security and climate change initiatives.
This provides an attractive background for investing in renewables, as investors can participate in the energy transition in the early stages of new projects by funding the development and construction of solar and wind farms, as well as acquiring operating assets that offer stable cash flows over long periods.
At the same time, they can invest in energy storage solutions and modernize electricity grids, expand EV charging networks, or explore opportunities in developing infrastructure for green hydrogen production. This is already reflected in institutional fundraising, as renewables represent most sector-specific funds on the market, while also attracting the biggest chunk of capital in large private equity funds with a diversified approach.
Infrastructure and Interest
WI: Has the rising rate environment diminished the attractiveness of the infrastructure asset class?
IP: High interest rates meant windfalls have become harder to achieve, putting pressure on deals done in recent years and causing asset mispricing. The recent monetary environment has affected valuations, making them more volatile, especially in digital infrastructure, one of the most sought-after sectors in the asset class.
Similarly, offshore wind power generation, especially when it comes to projects in development, has struggled because of higher interest rates, rising costs and contract mismatch issues. Other sectors, such as regulated utilities with long-term contracts, are less affected compared to project finance deals that are more sensitive to financing costs.
And infrastructure is benefiting from a convergence of long-term global megatrends – digitalization, decarbonization and deglobalization – that make the asset class attractive regardless of the current macro environment. Moreover, high interest rates also constrain local government’s ability to invest in infrastructure at a time when significant investments in the asset class are required, unlocking opportunities for private sources of capital.
WI: What is the impact of a global recession on the infrastructure sector?
IP: Given its relationship with essential services and long-term contracted cash flows, unlisted core infrastructure has historically offered protection from economic cycles. The asset class has delivered an uncorrelated low volatility relative return profile, showing long-term resilience compared to other asset classes during the Global Financial Crisis and through the Covid-19 pandemic. Additionally, its long-term nature implies decade-long debt tenors with fixed refinancings costs that remain stable regardless of the current macroeconomic environment.
Different sectors are also impacted differently by a recession. While toll roads and airports might see reduced traffic or passenger volumes, affecting toll and concession revenues, utilities generally exhibit more stable demand but could face challenges if economic downturns lead to lower industrial activity or consumption.
Meanwhile, renewable energy infrastructure might benefit from ongoing policy support and long-term sustainability goals. So, if private investment in infrastructure projects may decline due to heightened risk aversion, resulting in delays and cancellations of private sector-led projects with sectors responding differently to challenges, infrastructure has traditionally been agnostic during periods of economic stress.
Infrastructure and Inflation
WI: Why have Infrastructure in your portfolio when Inflation rates are high?
IP: Similarly, core infrastructure has historically offered robust inflation protection, with many market commentators saying the asset class has become a stronger shock absorber than other securities like REITs, TIPS, or gold. Not only does infrastructure offer a natural defense against inflation by having a tangible underlying asset, but investments in the asset class also often have contractual inflation protection on earnings.
Private infrastructure is also supported by regulation, policies, and monopolistic positions, which allows investors to benefit from a consistent cash flow throughout economic cycles. In conclusion, including infrastructure in a portfolio during times of high inflation can provide investors with inflation-hedging benefits, stable income streams, potential for asset appreciation, diversification advantages, and exposure to long-term infrastructure demand dynamics.
WI: What happens when the rate of inflation goes back to normal levels?
IP: Private infrastructure is valued for its ability to provide stable and predictable income streams over the long term. As inflation returns to normal levels, infrastructure assets with inflation-linked revenues such as regulated utilities with tariff adjustments may continue to offer attractive income yields that maintain purchasing power. At the same time, the changing environment offers investors the possibility to move away from inflation-hedging core assets towards growth-oriented opportunistic investments.
Different sectors within infrastructure, such as transportation, utilities, renewable energy, and social infrastructure, may be impacted differently by inflation normalization. Regulated utilities may adjust tariff structures in line with inflation, while transportation infrastructure may see adjustments in toll rates or concession agreements. However, the underlying fundamentals won’t change, as demand for infrastructure remains driven by the rise of AI, the energy transition and supply chains closer to consumers.
Infrastructure and Debt
WI: How will higher rates impact returns, and how resilient to risk is infrastructure debt as an asset class?
IP: While infrastructure equity fundraising had a challenging 2023, infrastructure debt fundraising, high yield in particular, grew slightly, showing levels of resilience appealing to investors. Still, infrastructure debt is not immune to changes in interest rates. Higher interest rates meant lenders were keen to lock in a fixed rate, with private debt linked to infrastructure generating yields of 8-10% compared to 5% before the rates hike, offering opportunities especially to private debt funds who’ve replaced traditional lenders.
At the same time, higher borrowing costs impact transactions volume as borrowers reduce their financing needs. Still, infrastructure debt transaction volumes were not impacted as much as equity transactions last year, suggesting a resilience to economic cycles as the asset class benefits from characteristics inherent to infrastructure.
WI: How will the infrastructure debt market evolve over the next three to five years?
IP: The infrastructure debt market is expected to benefit from the same drivers that will influence equity markets, as a growing focus on green and digital infrastructure projects supported by regulatory incentives will naturally attract investors’ appetite. Investments in broadband networks and transportation networks resilient to climate risks, for example, are expected to drive demand for infrastructure debt financing.
PPPs are also likely to continue playing a significant role in development, with infrastructure debt financing supporting these partnerships. When it comes to investor allocation, infrastructure debt has plenty of room for growth as most investors are under-allocated to the asset class compared to their private debt portfolios, democratizing access to retail investors in the process, while infrastructure debt funds are going to increasingly supplement bank lending.
As environmental, social, and governance (ESG) factors play an increasingly important role in investment decisions, the renewable energy sector presents opportunities and challenges regarding community impact. Despite the challenges posed by rising interest rates and inflation, infrastructure stands out as a resilient asset class, offering a secure and stable investment option in the face of long-term trends such as digitalization and decarbonization.
The changing debt market also offers new opportunities for investors, with a growing focus on green and digital infrastructure projects. Igor's insights highlight the importance of strategic adaptation and the potential for infrastructure investments to foster sustainable growth and stability in an uncertain economic environment.