Why are we waiting?

Read this article to understand:

• How macro conditions have weighed on activity this year
• The potential impact of regulatory and political change
• Progress in early-stage technologies

While 2023 has seen some easing in macroeconomic pressures, volatility and uncertainty still hang over global markets. Interest rates remain high, inflation is only inching lower and there has been a mini banking crisis in the US. This has left central banks with a difficult choice between continuing to hike rates to tame inflation or moving cautiously to tackle the threat of economic instability.

Given its long-term focus, infrastructure tends to be more insulated from short-term economic swings than other asset classes. But it has not been immune to recent challenges, particularly in terms of new investment activity. According to data provider Preqin, total capital of $3.1 billion raised in the first quarter was just nine per cent of the quarterly average of the last five years.¹ This was not true for all sectors, however: traditional and renewable energy accounted for 77 per cent of all deals, a new quarterly high.

Despite strong appetite for green projects, more investment is needed if countries are to achieve their net-zero goals, and accommodative measures from policymakers will be critical pace. The UK National Infrastructure Commission’s (NIC) Infrastructure Progress Review 2022 suggested the pace of planning and delivery is currently too slow.² It says a “change in gear in infrastructure policy” is necessary for the UK to remain competitive with the US and the European Union, which have both announced ambitious infrastructure policies as they pursue net-zero targets.

To find out how the macroeconomic uncertainty and the policy environment might affect the asset class in the coming months, we put the questions to Darryl Murphy, managing director of infrastructure at Aviva Investors.

How has infrastructure held up so far this year?

We entered the New Year concerned about macroeconomic pressures; while these have eased, interest rates and inflation remain high.

This is having a knock-on impact on activity, which is light compared with previous years. That is not so much the case in Europe, where there is a broader range of opportunities to invest in projects at various stages, but certainly in the UK, where new investment in renewables is lagging where it needs to be to meet our net-zero objectives.

How are infrastructure investors refining their approach in a more inflationary, higher interest rate world?

Infrastructure has proved resilient through the economic storms of recent years, from the fallout from COVID-19 to the financial shocks of 2022.

The biggest issue has been the stickiness of valuations relative to other asset classes such as real estate. In theory, a higher risk‑free rate would suggest valuations should come down, but we have not really seen that. This has a lot to do with the green nature of some assets coming to market. Demand remains buoyant, particularly in renewable energy, where transactions still trade at relatively high valuations.

It was inevitable infrastructure equity valuations would begin to come down, and they have since the end of Q4 2022, but the extent of the change is empirically difficult to quantify given the lack of deal activity. We have seen some investors test the waters to sell assets, but the deals were mostly withdrawn, perhaps because lower prices were being offered or because the sellers did not really need to dispose of them.

Infrastructure debt pricing saw a small upwards re-adjustment in 2022. Towards the end of the year, wider public spreads proved a challenge to the illiquidity premium in the asset class. That has eased off now public spreads have come down and the illiquidity premium for good infrastructure assets is back on the menu.

There is a lot of attention on the potential for bank lending to contract. What impact, if any, could this have on infrastructure debt?

Bank financing still dominates relative to institutional capital. Evidence from past banking crises shows appetite for infrastructure lending tends to persist, even if long-term lending becomes less attractive to banks.

Infrastructure remains important to many European and international banks, given the alignment with their own green agendas. However, while wishing to remain active, some banks are not keen on growing their asset base and have begun to reinvigorate the distribution market to see how other institutions can partner with them.

At a recent infrastructure conference in Berlin, banks were engaging with other institutions to see how they could work together in terms of financing. Another theme emerging from the conference was institutional investors starting to see more value in debt and considering it as a viable investment strategy. There is a potential synergy there; banks and other investors are not necessarily in competition and can operate together.

Fibre has been an area of focus for institutional investors. How is the sector looking now?

The UK market has been buoyant, with equity capital flowing into the alternative network (altnet) market, but this is now showing signs of stress in terms of a lack of capital. These companies’ voracious appetite for financing was initially conducted through equity funds, but they subsequently moved into debt markets.

While a lot of debt flew into some early-stage companies, there are signs appetite for new investments has been exhausted. An example is the syndication for CityFibre’s £4.9 billion financing, which seems to indicate the bank market has a degree of indigestion with fibre. With reduced interest from the debt market, and even some equity investors, activity has moved to private equity or credit funds.

I believe we will soon reach a point where we see consolidation. Having around 100 altnet companies in the UK is not a sustainable long-term business model. The process by which consolidation happens is unclear, but the “capital rationing” issue is likely to start pointing markets in that direction.

Europe, on the other hand, is different. You have larger companies with a bigger concession base, which are still managing to raise significant amounts of capital.

Where are you seeing the most exciting progress in early-stage technologies?

There has been progress in carbon capture, utilisation and storage (CCUS) in the UK, which is likely to be helped further with the recent “Green Day” announcement – the UK government’s package of policy statements relating to climate, energy policy and green finance. 

CCUS is moving from theory into practice and seeing activity in both debt and equity. However, institutional investors may be marginalised by banks in the same way they were for offshore wind. Given sponsors of big CCUS projects, the oil majors, have close banking relationships, and banks want a share of this technology of the future, there is a possibility sponsors will not need institutional capital.

The situation feels different for hydrogen. While there is a lot of talk, we are not seeing immediate opportunities. Here, the great challenge for the UK is how it competes against Europe and the Middle East, where some big players are beginning to deploy a lot of capital.

There are other areas, including small modular reactors (SMR) but we will have to wait until 2030 and beyond before seeing this technology developed, and getting capital now will take time. The hottest areas in terms of capital needs and activity in the UK are fibre and battery storage, where there are many storage projects and developers, albeit the deals tend to be small and complex. We do not see as many opportunities in Europe.

What opportunities are the US Inflation Reduction Act (IRA) and European Green Deal creating for net-zero and nature-positive infrastructure?

The main benefit is the impetus they provide to get projects off the ground and in development, without which we would be beholden to large corporations with large balance sheets.

Take hydrogen. The subsidy regime set out in the IRA makes hydrogen look attractive as an investment proposition and could generate momentum in the US. If there is an economic mechanism that provides a reasonable level of revenue for a period, it will help attract investment. In today's market, investors would be reluctant to participate without knowing when the demand will come through and how big it will be.

How much of a problem is red tape/inflexible permitting?

It is a big issue. The UK government recently announced plans to change planning consents for energy projects. But while this will help with planning and ease projects through faster, the biggest challenge continues to be transmission.

Currently, it takes far too long (sometimes five to six years) to get a grid connection if you are investing in a new solar plant in the UK. These waiting times need to be vastly improved. If we are to build the array of offshore wind farms needed to power the energy transition, a huge amount of onshore transmission investment is needed. National Grid can support this, but the speed with which it can be delivered remains a challenge.

In my mind, there is no doubt we will continue to wrestle with delivery in the UK, though many other countries have the same problems. We all have plans and objectives to meet, but there must be progress on delivery, otherwise we will not get there fast enough.

Regulation and policy have a major influence on infrastructure. Given elections next year in the UK and calls to reform Solvency II, what should investors look out for?

On the policy front, we look for the reaffirmation of the importance of infrastructure investment and more focus on delivery in the upcoming elections. Elections tend to slow down delivery and that is our main challenge between now and when they will take place. Elections create pressure for the winning party to be able to deliver quickly. But we do not expect any radical change in policy towards things such as net zero, whichever party wins.

As for Solvency II, it has been surprising to see how many people in the infrastructure market have been really interested in and engaged with the government consultation on what is a very technical and detailed piece of legislation. This shows the interest in broadening the nature of investments that insurance capital can make, which is limited through Solvency II mostly to investment-grade and long-duration debt. This could open investment in new technologies and markets, but you need to be careful about the balance of risk and return.

Have there been any developments in the way infrastructure investors look at environmental, social and governance (ESG) factors?

I think the next interesting area from an ESG point of view will be airports. Airports had the greatest challenge from COVID‑19 of any infrastructure asset class and was the last sector to recover.

We have seen shareholders invest big chunks of capital, but airports are now getting to a stage where they need to look at their balance sheets and perhaps raise new investment. So, activity in this subsector will start to feature quite highly across Europe. This could raise interesting discussions on the ESG position of airports, specifically the extent to which they are considered responsible for a portion of the emissions generated by airlines that use them. This could potentially focus more attention on the decarbonisation of air travel and progress of sustainable aviation fuel, which is a developing technology but still unproven at scale.