Private infrastructure debt still offers a broad spectrum of opportunities, but investors face complex challenges. In this Q&A, our infrastructure debt team contemplate the current state of the market and where it goes from here.
Read this article to understand:
- Recent transaction flow in the UK and Europe
- Where infrastructure debt investors can find relative value
- How escalating costs and permitting issues are hampering project delivery
There have been radical changes in infrastructure investment in the last year. While the US Inflation Reduction Act and REPowerEU have created new investment incentives for projects aligned to the energy transition, higher interest rates and rising costs for raw materials and labour pose challenges. Planned infrastructure projects in several countries have been put on ice, with calls to re-open tendering processes.
Against this backdrop, key questions arise for infrastructure debt investors. Are illiquidity premia still available on private debt, now yields from public debt have risen? Is too much institutional capital chasing too few opportunities – if so, does that mean investors should think again about their appetite for risk? What happens when the policy mechanisms designed to incentivise project delivery fall short in the new economic reality?
In this Q&A, Aviva Investors’ infrastructure managing director Darryl Murphy (DM), director Sinéad Walshe (SW) and head of euro infrastructure debt Florent Del Picchia (FDP) assess the state of the infrastructure market.
How has the higher rates environment impacted deal flow and investor enthusiasm?
SW: The attractiveness of infrastructure as an asset class is that it is comparatively steady and stable. The market does not tend to respond to political or economic developments in a knee-jerk fashion. We have continued to see a relatively steady pipeline on the debt side over the last few months, especially in Europe, albeit with some slowing in merger and acquisition (M&A) activity.
Infrastructure debt is partly sheltered from the acute swings seen in the macro environment, as a lot of the revenues in the asset class are inflation-linked. There may be more of a slowdown in the last quarter of the year. The rates environment has had more impact on the infrastructure equity side. M&A deal flow has slowed because investors in infrastructure equity are having to consider the rising cost of debt, and that may change the attractiveness of the investment proposition for them.
DM: It is worth highlighting the noticeable difference in deal flow between the UK and Europe. There was a dip in the UK in the first half, perhaps reflecting the country’s current economic circumstances, but the supply of euro transactions has held up overall.
FDP: While we saw a slowdown in Q1 and Q2 in transaction volumes in Europe, mostly driven by less M&A activity, the flow of transactions has remained at historically good levels, and greenfield transactions increased over that period. We have been busy and seen a steady pipeline of deals on the euro side.
How buoyant is the secondary market? Is the need to deleverage by banks affecting the flow of transactions?
SW: There is no sense of panic selling, but we are seeing more flow. Banks naturally turn to the institutional market when they wish to reduce exposure because we are not direct competitors, looking to their sponsor relationships for ancillary business. Because we have a large appetite for sterling transactions, we see selective opportunities at scale.
The drivers are varied. Some are addressing an issue with sector concentration, as banks need to keep within certain limits for individual names and/or sectors. Take fibre as an example: this is one area where we have seen significant secondary selling. Fibre has gone from being the sector everyone wanted to be in to one where both debt and equity capital is in short supply, partly because many banks have reached capacity.
What about relative value? Where do you see the best opportunities?
FDP: This is difficult to answer because it depends on what each client is looking for in terms of duration, risk-profile and other criteria, and their appetite may change.
We have seen some clients change their preference for fixed- or floating-rate debt. Some have switched to fixed rate, although on the euro side, the majority of investment opportunities are still floating rate.
In terms of activity, we have been doing a lot of utilities transactions, in particular in the district heating sector. It’s an area where investors may be able to access a premium for a given credit rating. In renewables, we are concentrating on southern Europe and the Nordics because margins are comparatively low elsewhere. Margins also tend to be low in social infrastructure, reflecting the low risk profile, but these transactions might still appeal to clients if they are looking for long duration.
DM: This question might be easier to address the other way round. Broadly speaking, renewables do not offer value now, because there is too much capital chasing assets. That's a frustration – clients want renewables, but the level of interest is keeping pricing depressed, at least for investment-grade (IG) debt.
But if you are prepared to venture into sub-IG debt, you may be able to find more value and a broader array of opportunities. Finding value now in infrastructure is not easy; appetite is compressing value, so you need to take a broad approach. But it is important investors in sub-IG debt have a solid understanding of the risk profile of each specific investment.
Where do you see opportunities in sub-IG debt and where might you suggest staying away?
DM: Let’s take fibre again. Most assets in this sector are sub-IG, and that means those with a slightly higher risk appetite can access a wider field of opportunities. In fact, they are spoilt for choice. The key is to be discerning: to do the work and identify the best opportunities.
There are also opportunities in early-stage technologies like electric-vehicle charging and other energy transition assets, such as battery storage, which fall into the slightly higher-risk bucket. We have done a battery deal recently and I would argue that sector can offer value. Data centres are another interesting area to watch.
As interest rates have moved higher, there have been times where the illiquidity premia on private infrastructure debt over public IG bonds have been eroded or even turned negative. What’s the situation now?
SW: Sterling premia are slightly better now, and certainly in positive territory. We have been involved in some transactions and processes that for various reasons have taken a little longer than usual, but we have achieved reasonably healthy margins and illiquidity premia consistent with where they would have been before recent market volatility.
FDP: On the euro side, public spreads have come down quite a bit since the beginning of the year, so premia have been restored to similar levels to before the point when interest rates started to rise. That is good news for investors. Premia for sub-IG debt are not as high because the equivalent public spreads have not fallen to the same extent.
The net-zero policy environment in the UK seems to have shifted, and the Climate Change Committee has been critical of the government’s progress in its latest assessment.1 What is needed to speed up the transition and deliver the opportunities investors are looking for?
DM: I've been in numerous conversations with government about the slow pace of delivery of the energy transition. It's a problem. Tangible things like planning consents and grid connections are not happening fast enough and there is a dearth of opportunities for investors. We are just not seeing renewables being brought to the market in the volume you would expect.
We are not alone in driving our environmental, social and governance (ESG) agenda with the search for green assets. Most institutions say they would like to tilt portfolios in that direction, but there is a real danger of going further and suggesting these are the only assets that are acceptable. Is there any appetite for carbon-positive assets, like natural gas infrastructure, which may still be needed as part of the transition? And what about vital transport infrastructure, such as airports or roads?
Prior to now, we have invested in those assets, but we know when a greener opportunity arises at the same time, many institutions would prefer to hold the latter. Perhaps we have already reached the point where financial institutions want to go faster on the transition than the market can deliver. The big issue now is not how much capital can be invested, but how many opportunities there are. The market doesn't need more money; it needs more opportunities. We are sitting here today with arguably more appetite for assets than we can find.
Adding a further layer of complexity, there are issues with rising costs and higher energy prices, which means the economics for some renewable-energy projects no longer stack up. In the offshore wind sector, we now have companies halting projects because the pricing of Contracts-for Difference (CfD) – the UK government’s main mechanism for incentivising investment in low-carbon electricity generation – is too low for them to be commercially viable in light of rising supply-chain and labour costs.
Can you explain the issues with CfD pricing?
DM: The short answer is that the CfD mechanism was invented at a time when power prices were lower than they are now. The mechanism ensures the project developer gets the market price, up to a cap; the idea is to insulate developers from volatile wholesale prices while keeping consumer prices low. When electricity prices are low, developers might benefit from the stabilisation mechanism. But now interest rates are higher, as are costs in materials and labour, there is a question whether the CfD cap is sufficient to meet these costs and the developer’s return.
By way of illustration, let’s say the CfD strike price is £50 per megawatt hour. If the market price is £30, the developer gets £50, and that margin is to their advantage. But if the market price increases to £100, the developer still gets £50. One year ago, that price might have covered all their costs. But now that the market price is higher than the strike price and costs have risen, the margin is clearly inadequate for some projects.
CfDs are agreed in an auction process. To set new prices, there needs to be a new auction where interested parties can bid. The problem is that they must bid for a price in an auction about 12 months ahead of the point when they strike the price. Lots of variables can change in that time, as we have seen over the past year.
Do cost pressures extend beyond UK offshore wind?
SW: Cost pressures are hitting supply chains for most large-scale projects involving renewables. This is not just isolated to the UK; there are examples in the US and other European countries too. Developers and other interested parties are pushing governments to react to the changing cost landscape by, for example, revisiting subsidy pricing.
Supply-chain inflation is not just impacting renewables. We have seen a couple of public-private partnership (PPP) projects retendered in Europe due to construction-price inflation. Clearly the “need” for these social projects in healthcare and education has forced governments and the private sector to find solutions, with increased costs being renegotiated and shared to allow the developments to proceed.
Investors have expressed frustration over how long it takes to obtain permits for new energy projects. Do you expect this situation to improve?
FDP: The UK is just one of the countries with huge backlogs in permitting for renewables projects, primarily because the authorities have not been able to process requests fast enough.
A number of governments have now ramped up capabilities and the backlog is expected to start hitting the market in the next 12 to 18 months. We expect a large volume of renewables transactions to come onto the market, which may mean more secondary opportunities as banks offload existing assets to make room for newer ones.
Have there been any other important strategic developments related to net zero recently?
FDP: Sweden has announced it intends to build new nuclear plant power plants, with the Climate and Energy Minister Romina Pourmokhtari proposing ten new reactors by 2045 and changing the target to “100 per cent fossil-free” electricity, from “100 per cent renewable”.2 It is the latest country that wants to add to its nuclear capacity to accelerate the energy transition (Figure 1 shows planned nuclear expansion worldwide).
DM: Nuclear projects are difficult to deliver, however, because going from concept to delivery takes so long. In the UK, the government is preparing the ground for the construction of a new nuclear reactor at Sizewell but the day of reckoning, when we will discover the level of investor appetite for the project, won’t occur until next year.3
Figure 1: Developing nuclear energy generation worldwide, 2023
Note: Planned = approvals, funding or commitment in place, mostly expected to be in operation within the next 15 years. Proposed = specific programme or site proposal, timing very uncertain. Sweden’s plans not included in totals.
Source: World Nuclear Association, May 2023.4
With the effects of global warming becoming more immediate, are you seeing appetite and opportunities for investments in adaptation infrastructure, like flood barriers?
DM: There is a big difference between what we should be doing to prepare for the physical impacts of climate change, and what is available for private investors to invest in. Discussions about forms of climate adaptation are like the discussions we had 20 years ago, around whether it is better for the private sector or the state to deliver schools and hospitals.
Take a simple example like flood barriers. The UK government’s choice has been to fund these projects through public investment. But would there be investor appetite if that changed?
The construction of sea defences has been looked at under a PPP model, but this takes us straight back to the old problem: where is the revenue? If there is no revenue, how will the debt be serviced? If you use the PPP model, that starts a whole debate around whether you get a better outcome by transferring the risk to the private sector and allowing it to finance and deliver the works. But current opportunities in this area are limited.
