By Hamlin Lovell, NordicInvestor
The potential for infrastructure investments to protect against inflation is well understood, and worth revisiting, but there are many important caveats: valuation, revenue risks, weather, safety, and politics.
The income streams – such as rents, utility fees, and tolls – from regulated infrastructure assets are often explicitly linked to inflation. Permitted returns on capital are also usually defined in real terms – so they will automatically increase with inflation. The next question is what value is applied to those assets and income streams.
It is hard to predict what impact higher inflation might have on infrastructure valuations.
Where infrastructure investments are valued more on assets than income, the replacement costs of roads, airports and buildings should keep pace with inflation in raw material costs, labour costs and so on.
Arguably, if infrastructure was perceived to be a useful or unique inflation hedge, investors might be prepared to pay higher valuations. This year, the UK stockmarket has seen takeover offers made at premiums ranging from 23% (John Laing Infrastructure Group) to 93% (CityFibre). In Asia Pacific, Australian gas pipeline operator, APA Group received an offer from CK Asset Holdings at a 33% premium. These examples suggest that there could be scope for valuation upside in some cases.
On the other hand, if faster inflation leads to higher interest rates, that should, all else equal, reduce the valuation of all private and public equities, including those owning infrastructure assets. All else has not been equal in 2018: the global economy is seeing strong and synchronised growth, and corporate tax cuts have boosted US profits.
The revenues from infrastructure projects are not always rock solid however. Assets such as airports and seaports can show some economic sensitivity – and may see weaker demand in a recession. And even a utility like electricity is sensitive to GDP growth. Although the price per unit sold may rise with inflation, if volumes fall, then overall revenues could decline.
Public transport seems pretty dull but it is not immune from the forces of competition and fashion. The UK’s East Coast Main Line train line (between London and Edinburgh) franchise, was renationalised in May 2018, after the operators, Stagecoach and Virgin Trains, lost money on the contract. They had been overly optimistic about levels of traffic growth. Low cost airlines like Ryanair, EasyJet and Wizzair– and super cheap buses – have been competitors for the East Coast trains, and train operators could soon face more familiar rivalry.
Countries such as Italy and Sweden have already liberalised train travel markets, and railway networks all over Europe are opening up to competition, in 2020. It is likely that some uncompetitive and inefficient, high cost, operators (such as the French SNCF railways, whose staff retire with big pensions aged 50) may be squeezed by sharper competition and new entrants.
Global warming is increasing the incidence of extreme weather conditions, such as droughts, floods, storms, lightning, hurricanes, cyclones, tsunamis. These can destroy individual infrastructure assets, which underscores the need for diversification. Japan’s Fukushima nuclear reactor was damaged by the 2011 Tsunami, and in the same year, Cyclone Thane ravaged an oil refinery on the Bay of Bengal coast in India. Also in India, in Uttarakhand, floods in 2013 damaged ten hydropower dams.
The Fukushima nuclear disaster is held to be the reason why several countries imposed moratoriums on new nuclear construction (although on the other hand, nuclear can be characterised as a “green” power source due to its low carbon intensity).
More recently, the Genoa bridge disaster in August 2018, which has killed at least 43 people, has provoked a severe response. Italy’s government is threatening to revoke the bridge operator, Autostrade’s, licenses for other infrastructure concessions, including 3,000 kilometres of toll roads.
If the bridge collapse is put under the broader umbrella of safety and reliability, then there are plenty of other similar examples. Investors in infrastructure need to get comfort over the quality and longevity of their assets. If there are electricity power cuts and blackouts, or if water is not safe to drink eg in Flint, Michigan USA, or if trains do not run on time, the companies involved may be fined or lose contracts.
This illustrates two related risks: safety and politics. The yields on infrastructure are partly a compensation for these risk factors.
The positive interpretation of the Genoa disaster, is that it should galvanize governments into action in terms of investing to upgrade and replace ageing infrastructure assets. This could lead to a multi-year boom in infrastructure spending. Indeed, Italy’s Government promises unprecedented spending on infrastructure. On the flip side, if all this investment is vital, then one must ask if depreciation charges have historically been too low – and if some assets are over-valued.
The Italian case is a very extreme example of political risk, which is worse than forced nationalisation. Rather than taking away the business, it is more common for politicians to impose tighter price controls, or taxes.
In what feels like a throwback to the 1970s (or even the 1940s just after the Second World War) UK nationalisation is back on the agenda. The UK Labour Party, under “hard left” leader Jeremy Corbyn, has a policy of renationalising the railways and other infrastructure such as water, energy, Royal Mail postal services and private infrastructure contacts. Shareholders would get some kind of compensation, but there is uncertainty over how much this might be. Share prices of firms that might be affected have generally fallen by 10-20% since the policy was announced. In the 1990s, the UK’s Labour party imposed a backward-looking “windfall tax” on utilities.
In some emerging and frontier markets, politics is jettisoning projects. In Asia, various dams have been cancelled after locals agitated against them. Plans for coal-fired power plants in Bangladesh seem to have been put on hold after local protests.
ESG investing could also play a role. For instance, as many pension funds and others decide to stop investing in coal, this could lead governments or companies to cancel projects.
Inflation and politics
Is there a link between inflation and politics? Possibly. Minimum wages, wages and salaries are not indexed to inflation in every country, and in some countries, such as the UK, the link between welfare payments and inflation has been broken.
If a spike in inflation leaves some voters worse off, there could be political pressures to cut the costs of essential utilities, such as water, gas and electricity.
In conclusion, infrastructure assets can offer a high probability of inflation protection, but this varies greatly between types of assets- and investors should always keep an eye the full range of risks.