Infrastructure: the essential ingredient?
15 minutes07 September 2023
Whilst we may be facing challenging market conditions, high inflation, higher interest rates, reduced growth prospects, heightened risk of recession, and likely ongoing volatility don't need to underpin the basis of your portfolios.
Infrastructure can play an important part in a portfolio during these times and in fact, it can perform very well even in these environments, offering key characteristics that have low correlation to many other asset classes that you would normally invest in.
Namely, infrastructure can offer consistent returns throughout the cycle, stable long-term yields linked to inflation, and lastly, infrastructure investors benefit from significant diversification through different types of cash flow. More on these later.
Macro drivers underpinning income
There are also significant macro drivers underpinning how infrastructure businesses make money, from population growth driving key revenue line items in a number of the assets in our portfolio, to the aging population in western countries like Australia driving increased healthcare use – where we're able to get exposure to those growth prospects through PPPs.
The energy transition from high carbon intensive industries is also having a huge increase in the amount of capital required to both deliver new energy production and get that energy production from where it's created to where it's consumed.
Digitisation is another key driver of returns. Twenty years ago, we were not using the sort of connectivity devices that we have today and their broad application across society has been the catalyst for significant asset creation in the last decade.
In developing markets, infrastructure is benefiting from urbanisation, and in developed markets, we have rapidly aging infrastructure, and more money needs to be spent in replacing that every year.
Infrastructure certainly continues to be an area for investment. On some estimates, $94 trillion needs to be invested over the next 20 years and on current spend, we're going to hit a shortfall. Some reports put that shortfall at $2.5 trillion dollars every year.
Finding opportunity in adversity
Infrastructure comprises a range of different sub sectors and, whilst some markets are feeling the impact of higher inflation and interest rates on cashflows, some asset types are able to enjoy some protection from the factors dragging down performance.
Growth linked asset: Melbourne Airport
Melbourne Airport is a major gateway capital city airport. It was sold in 1997 under a 99-year lease, giving the owners full rights over the asset for that time. It services about 39 million passengers a year, has no curfew, operating 24/7, and has the largest landholding of any airport in Australia.
Major capital city airports enjoy a diversified income stream, earning revenue from four primary sources:
1. Aeronautical revenue – about 45% of Melbourne's revenue comes from aeronautical charges.
2. Retail – there are retail shopping and cafes that operate within the airport environment, providing rental income to the owners.
3. Property – we develop land and make that available to third party tenants.
4. Ground transport – including charges for parking and from taxis accessing the airport services.
The three key drivers of return on the aeronautical side are passenger numbers, annual operating expenditure, and capital expenditure. Those elements are considered when negotiating charges with the airlines.
Retail and property agreements both typically have CPI escalators embedded in them so that in a higher inflationary environment the owners benefit from revenue going up because they are able to charge higher rent.
Turning back to the aeronautical revenue, we start with our operating expenditure over a five-year period, or “Opex”. In forecasting five year Opex, airport owners adopt a view on how inflation will play out over that time.
We add to that a return of the assets – i.e. “depreciation”. These assets have to be continually refurbished, and we also get a return on that depreciation.
And finally, we add to that a return on the assets where we have the asset base at the start of that five-year period and a weighted average cost of capital (WACC) is applied to generate a return on the asset. Any capital spent over the five years is negotiated with the airlines and added at the end of the period it's spent.
This generates a total required revenue. Then the way this is charged to users is agreed with the airlines according to how many passengers are going to use the airport over the period, and we smooth out the charge that they're incurring over that five years.
Like all big infrastructure assets, the airport borrows significant amounts so a lot of the capital that goes into those assets is in the form of long-term bank debt and bond debt, which are impacted by rising interest rate environment. However, debt is hedged in these types of assets, and a diversified tenor is used to even out the period of time over which borrowing rates have to be renegotiated.
There is a WACC build up that informs negotiations with the airlines. It's a vanilla WACC calculation that is used and so it still takes into account the risk-free rate, and also the borrowing costs that the airport incurs when funding its balance sheet.
The final way in which these types of assets are affected by the interest rate environment is in the regular quarterly valuation. The discount rate applied to equity has the usual build-up of equity discount rate, taking into account the risk-free interest rate and so in periods when the risk-free rate goes up, that will also adjust the discount rate over time. Most valuers use a long-term average risk-free rate for infrastructure assets rather than a spot rate and so during the last rate cycle, where interest rates came right down, we didn't see a huge shift upwards in valuations.
Regulated asset: Endeavour Energy
Endeavour Energy is the electricity distribution company in Western Sydney, the Blue Mountains, Southern Highlands and Wollongong. As a natural monopoly, there's no competition for this electricity distribution service and it is regulated by a national regulator.
Unlike aviation, which is lightly regulated and where outcomes are negotiated with airlines based on WACC and building block methodology, with a regulated business, the regulator sets the rate of return that businesses are allowed to charge. The pricing mechanism that applies takes into account inflation, on a lagged basis, so each year a CPI inflator is applied to the revenue that is charged and if there's overs and unders, an adjustment is made in the following year.
The regulatory building blocks methodology for an asset like an electricity network takes account of the CPI and of interest rate expectations. The overall approach is that regulated businesses forecast annual revenue. hat is set as an expected revenue path, and the forecast volumes are determined in order to set a series of tariffs that are charged.
The Regulated Asset Base or “RAB” lies at the core of a regulated energy asset and that's the operating value of the assets. Depreciation during that period is deducted before adding in any capital that will be spent each year so that the RAB goes up if capex exceeds depreciation. Then asset disposals are deducted and a CPI escalator is applied. Each year the RAB goes up in accordance with the CPI indexation, and so in that way, these businesses get a lot of protection from CPI changes.
The WACC as determined by the regulator is applied to the RAB to determine an overall revenue requirement that the company needs to get from the customer base over each of the five years of the regulatory period.
The company estimates what forecast demand is going to be each year to create an average tariff and that amount is applied to the actual volume of demand during the year. At the end of each year, there's a resetting of that number and to the extent that the company has had more volume than expected, and the revenue was higher, it will pay some of that back the following year and adjust the price. If the if the average volume was less than expected, then the company can charge more the following year to make that up. So, you can see in that the regulatory mechanism offers a reasonable degree of protection in a higher CPI environment.
If we look then at the WACC setting that’s applied to that RAB, the interest rate environment is picked up at in the WACC calculation. The risk-free rate is a factor in the cost of debt, and in the cost of equity used to calculation WACC.
The debt risk premium that applies to these types of businesses is also picked up in the calculation for the WACC. In Australia, the regulator uses a BBB+ credit, the typical risk profile of a regulated business, and so in a rising interest rate environment the higher rates are reflected in the WACC and the overall return that a regulated company earns adjusts as interest rates rise. Since 2014, each year, 10% of the cost of debt rolls off and is reset and you get a smoothing of debt risk premium over that period.
It is in how the WACC is set and calculated that these businesses are able to take into account rising interest rate environments, and investors get some protection as a result, over that period of time.
Public Private Partnership (PPP): Royal North Shore Hospital, Sydney
Royal North Shore Hospital, Sydney, is a typical PPP. It was delivered by the private sector and the owner has a 40 year contract to receive revenue from the state government. These are availability-based projects and so as long as they're available, the state pays. Ninety-one per cent of the revenue from this business is linked to CPI, so when CPI goes up, the revenue goes up.
On the flip side of that is that there are a series of costs most of which are outsourced to third parties, including the whole of life capital program at the at the hospital to repair and maintain the building. These third party contracts are linked to CPI and because revenue has gone up, there is a back-to-back arrangement where that is passed through, so the owner doesn't get caught in the middle where costs and revenue become out of sync.
The other important aspect of these types of assets is how they protect themselves from interest rate changes. PPPs in Australia typically have all of their base rate risk hedged for the entire life. Many projects still have five-year debt refinancing risk, but in the case of this asset, the debt has been termed out entirely so there is no exposure to interest rate changes on borrowing costs. In fact, these businesses benefit from higher interest rates because they hold interest bearing cash deposits as debt service reserve accounts, so when interest rates go up the revenue goes up.
The one area where these businesses can be affected by rising interest rates is the cost of equity used to discount the cash flows for valuation purposes. Valuers in this country typically use a long-term estimate for the risk-free rate, not the spot rate.
So in conclusion, these types of investment offer some protection from rising CPI and interest rates.
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