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Infrastructure: Building back better

24 Nov 2020

The Covid-19 pandemic has put a spotlight on existing shortfalls in UK infrastructure. What role can pension funds play in the attempt to build back better?

Sometimes it can take a crisis to tackle existing problems. The Covid pandemic has shone a new light on a plethora of social and environmental issues. From access to healthcare, to biodiversity and climate change, the challenges appear more pressing than ever. At the same time, the forced shutdown of the economy also brought widespread economic damages.

While policymakers have reluctantly steered the country into the second phase of a national lockdown, the demand to build back better resonates across the globe.

Joe Biden used the slogan in the US presidential election, pledging a $2trn (£1.5trn) infrastructure plan focused on the transition to renewable energy production and expanding transport networks. On this side of the pond, Boris Johnson made similar promises, announcing the launch of a “new deal” for infrastructure.

Infrastructure currently only holds a modest 6% share of the average institutional portfolio. But with yields at a record low, more than a quarter of institutional investors plan to increase their exposure to the asset class, according to Mercer.

The need for cash is there. Prior to the pandemic in 2016, the government estimated that around £483bn was needed to plug the infrastructure funding gap. That was before the pledge to make the UK carbon neutral by 2050 and the economy crashing by more than a fifth in a single month. So, what role could institutional investors play in the bid to build back better?

Covid impact

Institutional commitment to illiquid assets must have been scary when the outlook for airports and trainlines suddenly plunged. But the initial panic was most tangible in the liquid side of the market. Inflows into listed infrastructure dropped by 70% between the final quarter of 2019 and the three months to July, according to Prequin.

For those investing directly in infrastructure on a buy and hold basis, the effects have been less dramatic, says Jonathan Ord, investment director at GLIL, a local authority infrastructure investment fund. He stresses that the immediate impact of the pandemic on infrastructure has not been as dramatic as in other asset classes.

“In the portfolio itself, we have a diversified base of assets from renewable energy to regulated utilities, social infrastructure and transport. We have been fortunate in that we haven’t had a
great deal of exposure to the hardest hit sectors within infrastructure, such as airports and other transport demand-based assets, so our portfolio has held up pretty well. Part of that is due to the hard work of the management teams but we have also been fortunate in our asset selection,” Ord says.

Mike Hardwick, investment director for Infrastructure and property at LGPS Central, says that the impact of the pandemic has been mixed, but essential sectors, such as power and utilities, have performed relatively well.

“Even where revenues were initially heavily impacted by an enforced lockdown, it was interesting to note that governmental support was forthcoming due to the essential nature of these assets, and their role in keeping the economy functioning.

“This has lessened the impact on valuations and as a whole the industry has been pretty robust, which is supportive to its longterm attractiveness to investors,” he adds.

Hardwick, whose team at LGPS Central, is due to launch an infrastructure fund by the end of this year, remains optimistic on the outlook for infrastructure as an asset class but acknowledges that a certain amount of re-thinking will be required.

“As with other asset classes, it will be important to differentiate between short-term impacts and longer-term changes brought about by Covid-19, but some degree of re-pricing is likely when those impacts are more certain. For example, we can ask whether airports will ever return to the levels of growth seen in recent years even if a vaccine or level of immunity is achieved whereby Covid-19 is no longer a consideration. The answer to that question would definitely err towards a ‘no’. However, this isn’t a complete ‘no’, but pricing will need to reflect a different growth profile, different revenue streams and different investor appetite,” he predicts.

Paula Burgess, partner and chief executive at Pensions Infrastructure Platform (PiP), now part of Foresight, also stresses that the long-term nature of PiP’s investments has meant that the portfolio was relatively unaffected. “This is not to say that infrastructure as an asset class will emerge totally unscathed,” she says.

A boost for renewable energy?

With train stations, city centres and airports deserted and households switching en masse to working from home and shopping online, Covid has no doubt had a transformative impact on the energy sector. In the first four months of this year, wholesale market energy prices plunged to £42.67 per MWh from £68.27 per MWh. This has hit energy providers across the board, Ord says.

“It is something that most people wouldn’t immediately realise. Most do look at airports and transport, but we are also seeing knock on effects in our renewable energy portfolio,” he adds.

Nevertheless, across the energy sector, renewables have been relatively more resilient to the challenges, compared to nuclear power and coal plants, according to Foresight. This is not to say
that the sector has not faced its challenges.

The International Energy Agency predicts that investment in renewables globally is likely to fall by 10% this year. But renewables have been able to weather the storm relatively better due to fixed prices and regulatory support. The subsidies for providing renewable energy are also inflation linked on either a RPI or CPI basis, and as such form an additional inflation hedge, Ord says.

In contrast, nuclear power deals have struggled to counter the public perception that they rely on uncompetitive subsidised rates for their power to cover the construction costs, says Ted Frith, chief operating officer at GLIL.

Overall, the team at GLIL is optimistic about the longer-term outlook for renewables. “Falling energy prices are a short-term headwind for renewable energy. The path for decarbonisation
in the UK is well engrained,” Ord predicts.

Fault lines around social infrastructure

Above all, the pandemic has highlighted the urgency of existing social questions, the need for affordable housing, in particular. Between 2010 and 2017, homelessness and rough sleeping increased by 165%, according to the Institute for Public Policy Research.

Meanwhile, government spending on affordable homes has been slashed from 50% of the construction cost before the financial crisis, to just 12% today, Pension Insurance Corporation (PIC) says.

Since the outbreak of the pandemic, the need for social and affordable housing has increased sharply. A freedom of information request by the Guardian to local councils revealed that more than 90,000 people have faced the threat of homelessness, and almost 47,000 people have been made homeless, despite the ban on evictions.

In other words, the investment case for renewable energy and social housing should now be greater than ever.

Institutional investment in social housing has been on the rise, even prior to the pandemic. In 2018, housing associations raised close to £4.9bn from 48 public bond issues or private placements, doubling the cash raised the previous year, according to the Regulator of Social Housing.

One prominent investor in the UK is PIC, which has committed more than £2bn to social housing and is a borrower to more than 20 housing associations.

But private sector involvement in social infrastructure, from housing to healthcare, is not without complications. Investors, from pension funds to insurers, see their primary duty in delivering the best risk-adjusted returns, not in fixing societies problems.

Meanwhile, private sector provision of social infrastructure has in the past led to an array of social problems. Private finance initiatives (PFI) in particular have not been cost efficient from a taxpayers’ perspective and have often led to adverse outcomes for the people they were meant to help, as Stuart Hodkinson, lecturer in critical urban geography, outlines in his book: Safe
as Houses: Private Greed, Political Negligence and Housing Policy After Grenfell.

At a time of record low interest rates, institutional investors would struggle to justify double-digit returns in social infrastructure, when the government could fund these projects much cheaper by issuing more gilts. It is no wonder then, that former Chancellor Phillip Hammond pledged in 2018 to scrap the controversial PFI I and PFI II contracts.

For Ted Frith, the lack of political clarity is another key obstacle for investors keen on committing to further infrastructure investments. “We are awaiting the publication of the infrastructure financing review, until that’s clear we will continue with the piecemeal approach. My understanding is that Rishi Sunak and Steve Barclay are not in the least in favor of PFI, but we are asking them for guidance on what their plans are.

“There is a lot of footage of Boris Johnson in a high vis talking about the financing of these projects, but the government needs to sell better why infrastructure investment is important.”

In mid-November, UK Chancellor Rishi Sunak announced the launch of a new long-term asset fund with an open-ended structure designed to attract pension fund investment in illiquid and unquoted assets.

There are investors who believe it is possible to reconcile the inherent tension between institutional investors aiming to achieve profitable outcomes for their members and the need
for cash in the third sector. One example is Social and Sustainable Capital (SASC), a social impact investor launched in 2014 which funds housing and community investment projects.

It’s fund range includes the Social and Sustainable Housing fund, which provides secured loans of between £2m and £5m to social sector organisations with experience of providing housing and support to vulnerable individuals such as rehabilitation for drug addicts or domestic violence shelters.

One challenge is that the size of these projects is far below the usual volumes large scale
institutional investors might want to deploy.

“There is a scale issue here in terms of growth, but this is part of the process that we are going through. Over time we can do much larger investments with the underlying organisations.

The constraining factor is finding the right organisations to work with,” explains Ben Rick, SASC’s managing director.

At the same time, he warns that more flexible growth models, such as a structure whereby the investor leases the property to the charities in question, could come with less accountability
and ultimately not deliver the anticipated outcomes for the people the schemes should help. This is also an issue that the IPPR flagged up in a report on the future of supported housing.

As a recently launched investment vehicle, SASC hopes to attract funding from institutional investors over the medium term. Local authority pension funds, in particular, could offer a
suitable partner for its social housing fund, he predicts. “Ultimately, pension funds could have a direct positive impact on the areas they represent, where the people whose money they
are managing live. We will increasingly see organisations that previously said they will consider investments in £100m increments commit, for example, to a £20m investment with a fund
like ours,” he says.

Babysteps

The pandemic has highlighted not just the urgency, but also the opportunities in allocating institutional money to solving societal issues, from climate change to social housing. In the best case, a pension fund investing in infrastructure could not just offer its members a more broadly diversified portfolio uncorrelated from equity and inflation risks, it could also help address societal problems.

But investors might have to start with small commitments and be prepared to compromise on their return expectations as they are now in competition with a public purse that could fund projects virtually for free. Nevertheless, given that about $17trn (£12.9trn) of bonds, including UK government debt, is now trading at negative rates, for a mature defined benefit scheme or an insurance giant helping to address societies problems through infrastructure funding may well be a favourable alternative. For those hit hardest by the pandemic, it would make a world of a difference.

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