Climate change is driving a major reassessment of the role of infrastructure in investment portfolios. For investors seeking to understand the changing landscape of today’s infrastructure markets, it may be very useful to revisit the long history of infrastructure investing.
Consider the example of British railway investment in the mid 19th century. It’s a good illustration of the fact that the financing of major infrastructure projects by private investors is nothing new – and not without risk. The development of stock exchanges across Europe and North America in the 1800s was largely due to the huge capital needs for railway infrastructure. Given our current tendency to worry about the world’s infrastructure investment gap – estimated by McKinsey to be 0.4-1.2% of global GDP annually – it is worth remembering that in the UK alone railway investment in the twenty years to 1850 was over 2% of annual GDP, financed entirely by private investors. This investment increased the size of the British rail network from just 98 miles in 1830 to over 6,600 miles by 1850. That’s not much less than the 10,000 miles it is today.
Of course, these Victorian and Regency period investments were not without risk. Due to over-optimistic revenue cases and increasing capex costs (remember those?), perhaps a third of the £225 million invested 1830-50 was lost. Listed stocks exhibited greater volatility, with one index of railways shares losing 64% of its value in 1845-49, prompting anguish from investors as diverse as Charlotte Brontë and Charles Darwin. Both today and in the past, forecasting the impact of new technologies is not easy and markets are prone to both over- and under-shooting.
Fast forward to 2016, and we have a new wave of technology-driven infrastructure needs and a wide range of investors contemplating investment. This has spawned the renewable energy industry and rippled through other sectors from electric vehicles and batteries. There’s more talk about energy efficiency and the need for adaptation investment in flood defences and irrigation systems. For renewable energy alone, BNEF observe investment volumes have risen 5-fold in the decade to 2015; rapid growth, though not quite matching that of Victorian railway investment.
Interestingly, the financing structures created for 19th– and 20th-century infrastructure investment are changing; most noticeably with regards to long-term institutional investors. Pension funds, insurance companies, and sovereign wealth funds are investing in infrastructure assets more directly, rather than just buying listed shares of utilities and other infrastructure corporations. The causes of this change include the success of similar models in private equity and venture capital, the willingness to hold illiquid assets for long periods, and perceived governance issues around listed corporations. And the effects have been dramatic, with unlisted infrastructure funds increasing from less than $17 billion in 2004 to $309 billion by 2015 (volumes updated regularly by Preqin). This is not far short of MSCI’s weighting for the listed European utility sector of $380 billion, and wider estimates of all unlisted infrastructure exceeding $1 trillion.
One perceived attraction of unlisted funds is they avoid the day-to-day volatility – and occasional dramatic crashes – of listed stocks. These periods of heightened volatility were seen not just in the 1840s Railway Mania, but in recent market corrections. However, just because an asset is not being priced continuously, does not mean that its value is not changing over time. For infrastructure investors, understanding the true risks they are accepting in an ongoing challenge – and one that is potentially limiting the size of the market. Take the Norwegian sovereign wealth fund’s decision this year not to invest in unlisted infrastructure due to a lack of appropriate risk benchmarks. The private equity market offers a number of benchmarking and performance assessment approaches that are starting to be used for unlisted infrastructure, at the fund level and for individual assets, but there remains a need for more data.
Infrastructure investing and climate change are closely linked in two ways. First, infrastructure investors are seen, by the OECD and others, as a solution to the “green investment gap”. They point to the $90 trillion assets owned by long-term institutions and argue that increasing allocations to direct infrastructure (and implicitly away from listed equities and government bonds) can help fill this gap. Similarly, it has been argued that these long-term investors can find new ways to provide patient, socially responsible capital.
On the other hand, climate change is a potentially huge problem for long-term investors. Climate effects can be direct, such as increased flood risks for transport infrastructure, which although potentially decades away are vital for long-term assets. Interestingly, the indirect effects – arising from measures to tackle climate change – can be more immediate. For example, increasing renewable energy capacity has knock-on effects on existing energy infrastructure and, in a more extreme case, widespread use of batteries may eliminate the need for various infrastructure grids. As an infrastructure practitioner, I have seen first hand how hard such risks are to assess rigorously.
A related issue is that infrastructure continues to be marketed as a low volatility investment with predictable cash flows. Whilst this may generally be true overall, it has often not been the case, from rail revenue forecasting issues in the 1840s to the present day. Further, as infrastructure investors are asked to back new technologies, such as energy storage, and invest in new markets like off-grid power in Africa, the “low risk” narrative may become challenged. Understanding what risks should be priced, and how, remain open questions.
Imperial College Business School’s new Centre for Climate Finance & Investment offers the opportunity for me to explore in more depth a number of these themes: the risk/reward trade-off inherent in infrastructure investing, in the context of technology and climate change, and the increasing tendency towards investment in unlisted assets rather than listed stocks. Bringing together business academics, scientists, investors and policymakers will allow for the broadest possible examination of this complex and important area. History is a helpful guide, but there is clearly much work still to be done in charting the future.
Simon Wilde is a Research Fellow at the Centre for Climate Finance & Investment at Imperial College Business School.