Enhancing direct infrastructure returns with an active ESG approach

Written By: Philippe Taillardat First State Investments, European Infrastructure

& Niall Mills First State Investments, European Infrastructure

Infrastructure assets can provide a predictable and reliable stream of long-term returns. Philippe Taillardat and Niall Mills of First State Investments explain the advantages of incorporating Environmental, Social and Governance factors into the investment equation

Infrastructure providers underpin society. In their capacity as owners and operators of large, strategic assets that provide some of the most vital services – water, heat and light, waste management, transport, and communication – they are a key part of society and the communities they serve.

It follows from this that they should naturally operate in a way which is ethical, responsible and sustainable. In a sense, infrastructure management, and investing, is all about sustainability: a sustainable business model delivering sustainable returns. One of the most powerful attributes of the asset class is the highly stable and predictable cash flows it generates. These returns are highly attractive on a risk-adjusted basis: a well-managed infrastructure asset can deliver strong income with higher predictability and lower volatility than similar equity investments in industrial businesses.

Perhaps the most important question we need to ask when taking ownership of an asset – which for us typically means owning a material stake and usually being allocated one or even several seats on the board – is whether it can genuinely deliver attractive cash flows, sustainably, over the long term (20 years or more).

To this end, one of the key signposts for us will be the management’s approach and commitment to environmental, social and governance (ESG) issues. A strong, sophisticated approach to ESG is generally a reliable indication of a high quality business, and most importantly, one which is sustainable.

Reducing risk, enhancing value
For many infrastructure companies, ESG is part and parcel of day-to-day life – managing these issues is what they do. For many of the businesses we invest in, the nature of their operations inevitably requires sophisticated management of environmental, and health and safety regulations. Failure to manage these core areas effectively could lead to value destruction in a sector where public accountability and perception is increasingly important, given the regularity with which it is targeted by politicians looking for a quick and populist policy, or journalists looking for an easy attention-grabbing headline.

In fact, the public profile of infrastructure operators is growing. If we can ascertain that a company has a strong handle on ESG, this gives us great confidence that we are not exposing our clients’ money to some outlying risk that could result for example from a publicity blunder.

Take a water company. Its function is to supply households with water that is fit for consumption and use. The processes involved in this have the potential to be detrimental to the environment while at the same time, water scarcity is becoming an increasingly pressing environmental and social issue. Its role in terms of conservation and society is vital which means good ESG practice is fundamental.

So we must pay close attention to ESG in order to eliminate risks. But it goes beyond that. A strong ESG approach improves efficiency and productivity and therefore can be value enhancing. There are many examples of infrastructure companies which have recognised and embraced this and reaped the rewards. There are also many examples of world class ESG practice in the sector, and an increasingly clear link between good ESG practice and superior returns. As a result ESG is becoming increasingly important to the investment case.

Active asset management
One thing infrastructure operators demonstrate particularly well is how ESG is most effective when it runs right through an organisation from top to bottom. For many businesses in various sectors, the sum total of ESG policy is probably a bi-annual report or compliance with the UN Principles of Responsible Investment (PRI).

For infrastructure operators, and indeed for us, ESG is pertinent to every worker and for some companies for every component of machinery. The PRI initiative, for example, is an enabler for discussion and a starting point from which to build a strategy. However, for it to have a tangible impact it needs to go further.

This is where we can try to add value through active management and dialogue. We have seats on the boards of the companies we invest in and we use this platform to engage and influence. ESG goes hand-in-hand with our active management approach as we find it to be a very constructive way in which to engage management to effect positive change and ensure strong stewardship of assets. It is an extremely effective way to unlock value and achieve incremental increases in returns by reducing costs and improving efficiency.

There is one invaluable benefit which derives from this holistic approach: an empowered, motivated, safe and productive workforce. This is especially important in a sector where many jobs involve tough, manual work, can hardly be described as glamorous and which are underappreciated. Most people would not find the idea of treating sewage appealing, but it is a vital task and is actually water recycling in its more modern context. This is another key route to business sustainability: attracting talented individuals, particularly young people concerned about environmental issues, by projecting the right image and adopting the right approach to ESG.

Anglian Water Group – pioneering CO2 emissions reduction schemes
Anglian Water, the fourth largest UK water and sewage company serving around six million customers, has emerged as a leader in the water industry in carbon emissions reduction and reporting. It has committed to three clear environmental objectives:

• Stabilise operational carbon emissions by 2015
• Halve embodied carbon of capital expenditure by 2015
• Halve greenhouse gas emissions by 2035

One initiative saw the group develop, in cooperation with suppliers, a new nylon-based air-valve lighter, smaller and more resistant to corrosion than traditional ductile iron valves. This resulted in a 93% reduction in embodied carbon as well as a 36% cost saving on the component.

Another particularly effective initiative was developed as part of its Bedford growth scheme, an expansion project to increase wastewater treatment capacity for an additional 30,000 people in Bedford. The group pioneered an approach to emissions measurement involving calculating them at the individual component level. This gives engineers greater detail of carbon footprints in the design phase of new projects and this case resulted in a 67% reduction in embodied carbon and 25% reduction (£5 million) in capital expenditure for the project.

Electricity North West – driving transition to low carbon economy
In order for the UK government to meet its targets to reduce greenhouse gas emissions by 34% by 2020 and 80% by 2050, the UK energy industry is expected to have to cut emissions by more than 80% during this time. For the electricity distribution industry, this will mean the change from a passive “one way” network to an “active” network using “smart grid” technology.

Electricity North West, the sixth largest UK electricity distribution network serving 2.3 million customers, is pioneering ways of providing new distribution capacity at more affordable prices. It launched the Capacity to Customers (C2C) project in January 2012, a pilot programme partially funded by OFGEM’s Low Carbon Network Fund.

C2C will address capacity inefficiencies in the distribution network by making better use of existing infrastructure, using spare capacity by offering industrial customers “managed demand” contracts and new customers an option to have part of their supply interruptible in exchange for lower connection charges. Based on the company’s own modelling, these measures should achieve an 85% reduction in the cost of additional capacity to customers and a 94% lower carbon footprint compared to traditional methods.

Reganosa – strong ESG practices
Reganosa operates the Ferrolterra liquefied natural gas terminal in Spain. The company’s ESG approach is centred around environmental and health and safety concerns, and it has an enviable collection of quality certifications recognising its strong practices in these areas. One key initiative has been the introduction of continuous safety training. During 2010 and 2011 there was not one accident requiring medical leave.

Less pertinent to its business operations, Reganosa also takes an active role in the local community. Its main plant receives large numbers of visitors from stakeholder groups such as students each year, and it is supporting the programme for the Museo del Yacimiento Caldoval dedicated to ancient Roman remains.

Stable, sustainable, uncorrelated
Direct infrastructure can bring a number of benefits to an institutional portfolio. Firstly, through the generation of highly-stable cash flows, infrastructure assets provide a predictable and solid stream of returns over the long term. Furthermore, the returns it generates are attractive on a risk-adjusted basis. As such, the asset class is an extremely effective tool for diversification purposes and to help match liabilities.

It is an effective way of unlocking value through integration and application of sound ESG principles given the link between ESG, and the notion of sustainability which is central to best infrastructure business practice and indeed one of its strongest attributes. The integration of ESG strengthens the stability of revenue streams and can boost returns incrementally – there is a clear link between best ESG practice and sector-leading returns.

Finally, direct infrastructure exhibits relatively low correlation with other asset classes, and has demonstrated resilience even during periods of economic downturn.