A new generation of infrastructure

Written By: Colm O’Connor Senior Portfolio Manager KBI Global Investors

Colm O’Connor of KBI Global Investors outlines the benefits of investing into sustainable end markets such as water and clean energy, which up to now have largely been ignored by many infrastructure managers

Infrastructure is gaining increased attention from investors, right around the world. That’s hardly surprising given the likelihood that huge spending will be required to address the dire state of much of the world’s existing infrastructure and the relatively attractive yields available from many listed infrastructure companies and infrastructure projects.

But are investors looking at the right type of investments? Many people looking at this asset class “default” to traditional infrastructure categories such as energy pipelines, airports and toll roads. That was a pretty sensible approach 20 years ago, but today it’s also important to consider new forms of infrastructure investment, such as water and clean energy.

The case for water
Of the trillions of pounds forecast to be spent on infrastructure between now and 2050, the majority will be allocated across four end markets, namely energy, water, transport and telecommunications. All four categories present compelling investment opportunities for listed infrastructure managers, yet today it is evident that asset managers are predominantly allocating to just three end markets and largely ignoring the investment opportunity across the water utility space.

Water is unquestionably the world’s most critical resource. Many of our cities, all around the world, rely on leaking water systems, designed decades ago to cater for much smaller populations. London, for example, has relied on a 150-year old sewer system built for a population less than half its current size. The 25km long £4.2 billion Thames Tideway Tunnel1, currently under construction at this time, is a good example of the type of critical infrastructure project needed over the coming years to cater for our burgeoning cities.

Inadequate planning around water scarcity and water pollution poses obvious risks to economic growth. More extreme weather events, which are in turn placing a strain on our water systems, are also becoming more common.

While these risks surrounding water are well documented, allocation to water investment remains relatively low. McKinsey estimates that $7.5 trillion in constant prices will be spent on water-related infrastructure projects between 2016 and 2030, one of the largest infrastructure categories globally2.

So why do most investors lack exposure to this important segment of the infrastructure sector? For the most part it appears to be a lack of awareness around the opportunity. Many water companies find themselves down the market cap scale and are somewhat less intensively covered by broker research than large cap companies, which importantly can also create the opportunity for generating alpha (excess return). There is also a misconception among investors, who doubt whether there is a strong enough correlation between listed water stocks and infrastructure stocks.

Clean energy investment
While we argue that water should be considered as a core holding within a diversified infrastructure strategy, investors should take note how their money is allocated across energy end markets.

Today the energy sector is undergoing rapid change, driven by advances in technology and concerns over climate change. Decarbonisation is driving an increased spend on renewable energy projects, while to facilitate the integration of wind and solar energy, grid spend is also ramping up. New investments into fossil fuel and nuclear energy will continue to decline, driven partially by governments’ commitments to tackle climate change, but more importantly by economics; wind and solar are today, in many regions around the world, already the cheapest source of electricity. Further advances in lowering turbine and panel costs will surely lead to greater adoption of renewables over the coming years.

While the public is aware of the need for governments to decouple from fossil fuels, infrastructure managers are still predominantly exposed to old world energy. For instance, most large cap US electric and gas utilities, as well as master listed partnership (MLP) pipeline companies, are widely held by infrastructure managers, while very few managers allocate to clean energy infrastructure, despite most observers agreeing that renewables and grid spend already account for the majority of power infrastructure spend.

The IEA estimate that $330 billion is spent on clean energy investment3 every year, while transmission and distribution spend already surpasses $180 billion. The combined total of coal, gas and oil spend, by comparison, was less than 15% of the total $775 billion total spend in 2018.4 The remaining 85% of power spending was in low carbon power generation plus transmission, distribution and storage spend.

Asset managers are under-investing in the critical areas of power infrastructure, partly because of the perception that wind and solar companies are volatile and reliant on subsidies. Investors looking to allocate to low beta, high yielding stocks have until recently shied away from renewable markets.

Indeed, when you look at the history of turbine and panel manufacturers or the stop/start nature of many government incentive schemes, infrastructure managers could be forgiven for shying away from the sector. But if one looks a little closer, there is emerging evidence that the sector has matured. Demand is increasingly driven by economics, and in most major markets, is no longer reliant on subsidies.

Also, a discerning investor can see that investing in companies producing electricity from wind and solar has been a much more stable investment than investing in the equipment suppliers. Pension funds and insurance companies, for instance, have been major investors in private wind projects for several years.

Wind power projects typically produce stable, predictable, long-term cash flows, not linked to short-term moves in commodity prices. These are ideal investments for investors looking for high yielding assets as an alternative to low yielding bonds.

Finally, the investment landscape has changed dramatically in recent years due to the sharp increase in the adoption of renewables. More and more utilities now boast a sizeable renewables mix across their portfolios. Indeed, many of the world’s biggest utilities have transformed their businesses and are now positioned as leading global players in the transition towards a low carbon future.

The role of regulation and the search for yield
The case for investing in sustainable infrastructure markets such as water and clean energy is furthermore enhanced by the strong regulatory support that exists across the globe. Recent high-profile events, including the South Australian blackout and the Cape Town water shortage, underscore the consequences for policymakers when investments are postponed.

In comparison, the regulatory environment for other infrastructure markets such as telecommunications and oil/gas pipeline are more hotly contested. Pipeline projects, for example, routinely face delays or even cancellations due to the threat of legal challenges, especially projects which move oil/gas across several states and countries. Equally, the overhang over the US-China trade dispute looms large over 5G infrastructure companies where uncertainty is currently plaguing the market.

Finally, in an era of ultra-accommodative monetary policy, where long-term interest rates remain stubbornly low, interest is rising for high yielding asset classes such as listed infrastructure. Investors should take note however; while the trends underlying infrastructure investing – namely population growth and urbanisation – remain steadfast, there will be relative winners and losers. Investing into sustainable end markets such as water and clean energy, provides investors with exposure to growing end markets that have to date been largely ignored by infrastructure managers.

1. https://tideway.london/the-tunnel/
2. Source: McKinsey 2016 report: ‘Bridging infrastructure gaps: Has the world made progress?’
3. iea.org/wei2019/power/
4. iea.org/wei2019/power/