Infrastructure offers lessons for ESG investing and diversification 

The investment case for infrastructure has been truly tested by the increasing concerns on climate change and the economic chaos caused by the pandemic.

However, over the past decade institutional investors have already been drawn to investing in this asset class for several credible reasons, whether in public or private markets. Given essential nature of this asset it tends to have secured earnings stream, predictable cash flow generation, which endows it with defensive characteristics. In many cases, these cashflows tend to be significant, historically providing a high dividend yield that is typically offered by listed infrastructure companies. It can also provide inflation protection; due to its real asset characteristic (the ability to raise prices through inflation-linked contracts), monopolistic market positions and potentially favourable regulatory environments.

Together, these qualities bring a level of diversification to portfolios typically dominated by mainstream equities and fixed income securities. Investors that have limitations on private allocations – such as DC pension schemes – can potentially invest in listed infrastructure funds, which are also less encumbered by restrictions and typically have lower fees¹. If investors are looking for defensive characteristics, inflation sensitivity and higher dividend yield (than global equities), we believe an allocation to listed infrastructure should be considered.

ESG considerations and climate change

There is no escaping the fact that building and operating infrastructure assets involves very carbon-intensive activities. Listed infrastructure asset managers have increasingly been challenged by investors, as climate change has climbed their agenda over the last five years. As scope 1 and scope 2 emissions have become primary assessment measures for carbon intensity and emissions, investors have asked themselves on how they can integrate sustainability and climate transition into allocations to infrastructure companies such as utilities, airports and others.

We are quite optimistic in this respect, as we consider this asset class to be one of the most potential to transition – it is where we believe we can make considerable impact. It is up to the people invested in this asset class to encourage investee companies to accelerate their transition from traditional energy sources towards cleaner, renewable alternatives. We encourage all investors to engage with investee companies on these matters and, actually, this is what we are already seeing happen in this space.

At Mercer, we believe that we should not give up on investing in listed infrastructure just because it is perceived to be one of the most carbon intensive asset classes but instead we should focus on what can be done to accelerate its transition towards more sustainable future. We spend significant amount of time on engagement and collaboration with active listed infrastructure managers to help ensure that they have an explicit integration of  climate transition within their investment processes and have strong engagement efforts with their investee companies.

Diversification tested to the limit

Covid-19 provided a stern test for every asset class’ promised contribution to portfolio diversification – and listed infrastructure is no exception. As it is typically categorised as a defensive asset class, we believe asset values should be far less impacted by economic downturns than general equities.

But we have been living through highly unusual times. The pandemic was, of course, primarily a health crisis, rather than a financial or economic one, so its effects were more nuanced. For example, the unprecedented restrictions on people’ movement meant revenues from assets such as airports and toll roads and railways, were hit disproportionately hard. Investment performance in 2020 was therefore disappointing, but entirely understandable.

Valuations of listed infrastructure funds fell sharply during the first half of 2020. But this was recouped to a large degree in the second half of the year – as optimism started to return and government support for the energy transition become more concrete, particularly after the US elections.

In any case, as the experience of 2020 was unique, we believe the diversification benefits and defensive characteristics of listed infrastructure remain intact. The inflation-sensitivity component of the asset class may also come to the fore, with inflation rates well above target on both sides of the Atlantic, an increased willingness from certain central banks to allow inflation to overshoot in the shorter-term and large recovery spending programmes in train.

Emerging opportunities

While Europe has traditionally been the centre of the energy transition, we should not underplay the potential of the US to catch up. There is already a complex web of state-level climate change and transition initiatives and this all now has enthusiastic backing at federal level.

We believe there's also likely to be opportunities in emerging markets. In September 2020, China publicly committed to reach the peak of carbon emissions by 2030, on its journey to net-zero by 2060.  And there are plenty of other governments in the region and beyond making similar pledges. There are certainly a lot of interesting opportunities.

From listed infrastructure investment perspective, we have a preference for an active management given its potential for more explicit integration of climate transition as well as stronger stewardship and engagement efforts

The past 18 months have been challenging for listed infrastructure. However, we believe that appealing investment characteristics exhibited by listed infrastructure companies and their potential to play a significant role in a transition to a lower carbon economy make the investment case perhaps now stronger than ever. 
 

^{1. Fee savings cannot be guaranteed}