In just two years, the world has faced two economic crises, first from covid-19 in the Spring of 2020 and this year from spiralling inflation, record high fuel costs and the looming threat of a major global recession. Interest rates are rising, public markets are volatile and government debt is reaching danger levels in many countries around the world.
With so many risks today, many investors will be looking to safer asset classes to cushion the blow. One that has become popular in recent years is infrastructure debt. But given the huge challenges facing businesses, has the infrastructure debt space lived up to expectations?
Inflation levels are hitting almost 10 percent in places, some of the highest levels most Western countries have seen in four decades. It is one of the top issues facing businesses, consumers and politicians. Patrick Trears, partner and head of Ares Infrastructure Debt, says that, as a long-term asset class, infrastructure contracts are built with inflation in mind.
“We believe inflation is a key topic everywhere at the moment, but infrastructure debt is designed to weather periods of high inflation with key protections,” he explains. “In the market, contract terms are typically designed to account for the impacts of inflation, and issuers are requiring borrowers to hedge themselves against the accompanying risk of rising interest rates.”
In addition to contractual protections to ensure projects can keep pace with official measures of inflation, the ability to pass on increased costs is also a key requirement for infrastructure projects.
Claus Fintzen, chief investment officer and head of infrastructure debt at Allianz Global Investors, says: “In operational infrastructure, revenues are frequently linked to CPI or RPI numbers. In areas like electricity or gas transmission and distribution, these costs for consumers are very low and the regulators allow the operators to pass through costs to the customer.”
The standard response to growing inflation for central banks is to increase interest rates to dampen demand and bring prices under control, which is likely more impactful for debt providers than inflation itself. So far in 2022 the US Federal Reserve and the Bank of England have both been increasing interest rates, having cut them at the height of the covid crisis. The European Central Bank, meanwhile, has been slower to act.
“The ECB has now for the first time in 11 years increased interest rates,” says Fintzen, “but our project finance loans are typically fully amortising so we don’t face refinance risk from higher interest rates. For infrastructure corporates we have to be more careful, as corporate loans typically require refinancing at the end. So we need to know if there is enough cashflow to service the debt if interest rates increase.”
Part of the modelling process AllianzGI uses when underwriting includes examining how highly levered companies are, how they would perform with significantly higher interest rates and how the risk can be mitigated.
“EV multiples in core infrastructure have been high and there’s significant leverage there. If rates climb to 6 percent, then there could be stress,” Fintzen explains. “When we model the effect of rates we look at how fast the rates are rising and try to spread the risk with loans of different maturities to mitigate refinancing risk.”
Conflict changes views
For more than a decade, infrastructure investment in the energy sector has been heavily focused on achieving climate change goals to reduce carbon emissions across the power network. However, rising costs of energy, which have been one of the biggest drivers of inflation for more than a year, and growing energy insecurity may lead to a temporary shift back towards dirtier forms of electricity generation, particularly if the conflict between Russia and Ukraine drags on for many more months or even years and this weighs on investors.
“We have seen a shift across the spectrum in the first six months of this year,” says Ares’s Trears, “with tension in Russia causing investors to be more cautious on eastern Europe. While previously governments have been pivoting to renewables, Germany is facing big power supply issues now. With energy price volatility in the US now starting to subside, we expect to see the US start exporting gas to Europe to make up the shortfall in supplies from Russia.”
Energy supply has been particularly concerning within Europe, where many countries, including Germany and Italy, have been heavily dependent on natural gas supplies from Russia. With some EU members pushing for tighter sanctions on Russia, there are fears that President Putin could retaliate by reducing supply and causing a major energy crisis across Europe when winter approaches. While renewables might partially alleviate gas dependence, lack of battery storage to level out demand and supply means they cannot fully replace other forms of electricity generation at present.
“If you run a gas-fired power plant and the cost of gas is increasing, then someone needs to take that difference. What we have seen so far is that this is taken up by the utilities, and they are typically protected by governments,” says Thomas Bayerl, head of illiquid assets debt at MEAG.
“We saw governments step in to protect the banks during the global financial crisis and today we need them to step in to protect the energy industry.”
He adds that politicians have become more interested in investing in their natural gas networks, such as increasing gas storage capacity and facilities to import more liquid natural gas to reduce dependence on Russian supplies, but that more clarity is needed on their long-term plans for the energy sector.
“When we back a project, we are looking to finance it for 10 or 15 years so we need guarantees from the politicians that they are in this for the long term,” he says.
Bayerl believes gas will be essential to European energy supplies until at least 2045. By then, renewables will hopefully have reached sufficient supply and storage needs to take over.
Fintzen agrees: “Prior to the invasion in Ukraine we had been scaling down our fossil fuels business as part of a desire to pursue net zero. However, we must recognise that we will require gas for some time as part of the transition to net zero, until we have the storage in place to manage the volatility of renewable energy supply.”
But Fintzen also believes now may be an appropriate time to review the way investors and asset managers approach their environmental investment goals.
“When we look at divesting from fossil fuels it is tempting to just pursue companies that are already green to bring down CO2 emissions in the portfolio, but there is some merit in saying we should invest in ‘dirty’ companies and allow them to make their business cleaner as this would have the effect of reducing overall emissions within the economy.”
Infrastructure debt is, by its nature, structured to weather short-term volatility in markets and the economy and over the past two years it has done well in a time of unprecedented disruption.
But with many of the challenges currently facing the economy showing little signs of abating soon, the industry will need to become more adaptable in order to ensure it can meet the medium-term needs of wider society while also continuing to work towards long-term goals of reducing emissions and providing financing for infrastructure that can bolster growth for decades to come.