Highway to Hell

This paper presents an assessment of transition and physical risks in the privately invested infras- tructure sector. Leveraging the NGFS scenarios, we quantified the costs associated with delayed or uncoordinated transition and evaluated the potential portfolio value loss resulting from physical risks in the absence of climate action.
We measure transition risk at the company level as the difference in Net Asset Value (NAV) between disorderly and orderly scenarios. First we analyze the statistical relationship between the infrastructure companies’ total assets, revenues, operational expenses (OPEX), profits, and countries’ GDP and inflation using historical data. Second, we apply the estimated relationship between these variables to a reference dataset of about 700 individual infrastructure companies tracked by EDHECinfra’s infraMetrics. Finally, we extrapolate the reference-based results to our universe dataset of about 9000 firms to obtain a calculation of the value of the transition risk faced by infrastructure investors.
Our analysis reveals the importance of transition risk for the infrastructure sectors. A disorderly scenario could result in a substantial value loss of infrastructure investments, accounting for nearly USD 600 billion, equivalent to approxi- mately 30% of the total invested value in infra- Metric’s 9000 infrastructure assets. Moreover, the negative effects of transition risk will be felt across all sectors, including low-carbon ones like the Renewables and Social Infrastructure sectors.
On the other hand, we isolate the physical risk effect by calculating the difference NAV between the hot house world and an orderly scenario. In addition, we analyze the microeconomic effects of physical risk within the hot house world scenario, as this result is of particular impor-
tance for investors with assets highly exposed to climate events. Moreover, to determine the extent to which an investor may be exposed to physical risk, we generate a random combination of assets to show how risky an infrastructure portfolio could be in terms of this type of risk.
The physical risk impacts at significant at the microeconomic level. Our analysis shows that the cost of physical risks within the Current Policies scenario represents, on average, 4.4% of the total NAV in our reference database by 2050, with large variations across sectors. The effect of extreme climate events is negative across all sectors, with a maximum average loss of -27%, impacting the NAV of Transport and the Energy and Water resources sector the most. Moreover, portfolios would only need one or two assets highly exposed to physical risk to be significantly impacted.
Our estimations do not fully capture the transition and physical risk effect. First, the carbon footprint of sectors such as Energy and Water Resources and Network Utilities are underrepresented when considering only Scope 1 and 2 emissions. Second, the transition risk effects go beyond the impact of carbon taxes. Following TICCS® and the EU taxonomy, we show that as countries transition to a low-carbon economy, the market value losses in Europe could reach up to USD9 billion in stranded assets. Finally, the magnitude of physical risk may be underestimated due to the NGFS assumptions.
Based on the evidence presented in this paper, we recommend that investors demand coordi- nated actions and that governments immedi- ately implement carbon taxes to minimize the adverse financial effects of transition risk. The worst impact comes from reacting too late.

It’s Getting Physical

Some investors in infrastructure could lose more than half of their portfolio to physical climate risks by 2050.

This research note shows that the physical risks created by climate change are not limited to a distant future for investors in infrastructure, some of whom could well lose more than 50%of the value of their portfolio to physical climate risk before 2050 in the event of runaway climate change. Moreover, the average investor will also lose twice as much to extreme weather, mostly in OECD countries, compared to a low carbon scenario.

The numbers are significant: over the past two decades, institutional investors have increas-ingly allocated capital to private, mostly unlisted, infrastructure companies like toll roads, airports, power plants and pipelines. infraMetrics tracks a universe representing approximately USD4.1 trillion of enterprise value and USD2.2 trillion of market capitalisation at current market prices in 25 key markets.

Floods and storms are the most common types of climate-related events, but extreme temper-ature events are also on the rise as global warming increasing their frequency and intensity. If climate change speeds up, these trends are also forecast to become more frequent and more severe.nUsing a very granular database of asset-level physical risk estimates and financial data, we find that the impact of runaway Climate Change on the value of infrastructure investments before 2050 is significant. We also find that if no serious measures are taken, financial losses from physical risk (which are never zero) would be twice as high than in a low carbon scenario, for all investors.

In this note, we describe our approach to measure baseline physical risks (today) and how physical risks would materialise from that baseline in different climate scenarios in terms of their impact on cash flows and discount rates at the asset level. We also look at how physical risks, despite being asset specific, are not easily diver-sified for most investors, some of whom could have a high concentration of such risks in their portfolios.

Our research shows that the cost of physical risks within the “Current Policies” scenario repre-sents, on average, 4.4% of the total NAV of the assets in our reference database by 2050. The average maximum loss is -27% and we see that the effect of extreme climate events is negative across all sectors, impacting the NAV of transport (-10% on average with a maximum of -97%) and the energy and water resources sector (-7% on average, with a maximum of -40%).

Moreover, most investors in infrastructure hold a few individual assets and therefore have potentially high concentration in physical risks. Investors who hold direct stakes in infrastructure assets, be they fund managers or asset owners, usually have fewer than 20 investments. The average asset owner typically has fewer than 10 direct stakes. As such, when an investor finds themselves exposed to the riskiest assets in the same portfolio, losses can mount to 27% in the orderly transition scenario and to 54% in the “Hot House” scenario.

2050 is still 30 years away and past the investment horizon of investment funds, but many are now exposed to much longer-term investments. Moreover, the next generation of funds will pick up the same assets.

Climate change risks are already material for a number of investors in infrastructure assets even if these are located in developed economies. This challenges the intuition of many investors that these risks would impact first and foremost the poorer populations of the global south. Instead, the reverse is true: more value will be destroyed in places where more valuable assets exist. It should also be noted that our loss estimates can be considered very conservative in the light of the very limited impact of physical risk on the economy implied by the scenario used by the Network for Greening of the Financial System (NGFS). A ‘too little, too late’ scenario, by which emissions keep rising and climate change happens faster, would show a rapidly decreasing value of infrastructure assets due to their loss of future revenues, itself the result of a less active economy, mostly due to chronic heat.

This focus on the materiality of the physical risks allows climate risk to be seen not solely as the result of a public policy decision but as a reality that, without action from all stakeholders, including governments, will have a very signif-icant impact on the value of investments.

Infrastructure Strategy 2023 – Building the Green Hydrogen Economy

Executive Summary

Infrastructure investments are increasingly becoming mainstream. They have emerged as one of the most attractive alternative investments today because data shows that they can withstand inflationary pressures and demand fluctuations better than other kinds of investments can. Although assets under management in the infrastructure industry were only around $0.3 trillion in 2015, they increased over the next seven years to reach $1.1 trillion in 2022—a growth rate of 21%, almost twice the 11% at which investments in all alternative assets grew. The large infrastructure funds got bigger, too; the ten largest funds that closed in 2022 raised $36 billion more that year than in 2021.

As governments try to rebuild the world’s infrastructure with an eye toward ensuring a carbon-neutral world, the infrastructure investments market will continue to expand. Several governments have sought to create environments more conducive to private sector investment in infrastructure businesses, especially since public finances are limited. In the US, the Infrastructure Investment Jobs Act (IIJA) and Inflation Reduction Act (IRA), enacted in 2021 and 2022, respectively, will boost infrastructure development. In the EU, the RepowerEU strategy will reduce the region’s dependence on fossil fuels. Our studies indicate, however, that the recent rise in infrastructure asset prices—along with the global economic uncertainty and changes in interest rate regimes—has introduced an element of volatility into the market.

The BCG-EDHECinfra study of the risks facing infrastructure investors and the returns that their investments generated found that asset owners did better than asset managers in 2022, and that infrastructure investors in Australia and New Zealand were the best performers geographically. Specialized infrastructure fund managers generated higher returns than multi-asset managers did last year, and UK pension funds topped North American pension funds, global insurers, and sovereign wealth funds.

The study also found that success in the current environment requires fresh approaches to investing and value creation. In fact, an analysis of the drivers of infrastructure investment performance over the past three years indicates that investors’ yields came primarily from declining debt and rising price-earnings multiples and that their performance on operational value creation was, at best, mixed.

Going forward, infrastructure funds will invest more in larger projects, which will take longer to evaluate, especially since there is currently a dearth of megaprojects. The larger funds will invest through development platforms, which channel public and private funds into projects that aren’t commercially viable. And the smaller funds will specialize by geography or sector. According to a survey that BCG conducted last year, infrastructure asset managers will continue to increase their investments in digital businesses, such as network utilities and data
infrastructure, and in sustainable businesses, such as renewable energy. This sector contains both older segments, such as solar power and wind energy, and newer ones, such as hydrogen, which is turning into a lucrative investment opportunity.

In 2021, demand for hydrogen was around 94 million tons, most of it in the form of gray hydrogen, which is produced from methane or natural gas and therefore isn’t environmentally friendly. But by 2050, demand for low-carbon hydrogen will approach 350 million tons per annum (mtpa) under a 2°C global warming scenario or 530 mtpa under a 1.5°C scenario. Governments and companies will have to invest approximately $6 trillion to $12 trillion between 2025 and 2050 to produce and transport enough low-carbon hydrogen to meet demand, according to BCG’s calculations.

Although investment opportunities will extend across the hydrogen value chain—from feedstock development and generation to hydrogen transportation and storage—$300 billion to $700 billion of that amount must be deployed soon, from 2025 to 2030. At each link in the value chain, the need for capital will vary by geography, with regional economic policies influencing infrastructure investors’ choices. Crucially, four novel strategies can help infrastructure investors gain first-mover advantage in the hydrogen industry.

Building Portfolios with Infrastructure. Performance, Cash Flows & Portfolio Allocation

Using asset- and fund-level data, we highlight important differences between infrastructure assets and funds, and compare their historical performance and cash flow characteristics with both public and other private investments. An infrastructure asset’s age, sector, business risk and corporate structure all influence the asset’s risk-return profile. We examine the sensitivity of infrastructure asset and fund performance to public markets by regressing infrastructure returns (at the aggregate, sector and age group level) on public asset market returns.

We then develop a method to estimate infrastructure equity assets’ income returns and cash flows depending on their age and sector. With measures defined that capture both idiosyncratic and time-series income return volatility, we highlight that a CIO cannot ignore the high idiosyncratic risk of infrastructure assets when evaluating their future performance and cash flow risk. To reduce a portfolio’s idiosyncratic income return risk, we find that adding assets from the same sector may be as efficacious as adding the same number of assets from different sectors. We show how many assets are needed before idiosyncratic income return risk starts to level off.

Inflation and Rising Rates: Impact on Infrastructure Assets

In this report that was produced in collaboration with Ares Asset Management, we illustrate that private infrastructure assets can provide resilience in the current rising rate and high inflation macroeconomic environment. The primary structural reason for this resilience is the ability of private infrastructure assets to increase revenues along with inflation. 

We believe this report will serve to remind readers of the fundamental drivers that have underpinned the development of this asset class and that it will illustrate the widening opportunity set that we believe will unfold in both the primary and secondary markets in the years to come.

Do financial investors need non-financial data? Infrastructure ESG Data Investor Survey, 2022 Edition

In this infrastructure ESG survey, we asked a large sample of investors in infrastructure why they need to have access to ESG data i.e., non-financial data, for the assets they hold or want to hold. We examine three main questions:

1. What is the main purpose or use-case of non-financial (ESG) data for investors in infrastructure?
2. What risks most require non-financial data to make better investment decisions in infrastructure?
3. What kind of data is the most useful and relevant to make such decisions?

In summary, with this survey we have shown that investors in infrastructure have clear priorities and preferences when it comes to non-financial or ESG data.

The cost of international sanctions to investors in Russia’s airports

In this research note, we look at the potential loss of value of Russian airports due to the war in Ukraine. Drivers of impact include the closure of a number of national airspaces to Russian airlines as well as related sanctions that have been imposed since the start of the invasion. We find that the immediate impact on the cash flows of Russian airports so far remains very limited, and it is equity holders who will suffer most; the increase in the price of equity risk is many times more painful for investors marking to market.

As a one-off immediate shock, the loss of value for investors exposed to Russian airports in March 2022 is estimated to be less than 5%. However, we show that this cost will increase rapidly the longer the conflict and the sanctions continue. Domestic traffic will be quickly – and severely – reduced by Russian airlines’ inability to keep foreign-made planes flying and the compounded effect of higher discount rates will rapidly burn through the NAV of these assets.

Infrastructure Strategy 2022: A Pivot to the Digital Frontier

Massive infrastructure funding recently approved by the United States, China, and the EU, as well as ongoing improvements in low- and middle-income countries, are placing a renewed emphasis on infrastructure investments. Indeed, fund raising for public and private infrastructure investments—which include everything from power generation and renewable energy facilities to schools, hospitals, digital networks, water resources, and transportation projects¬—is hitting fresh highs: in 2022, global assets under management of private infrastructure investors are forecast to reach a record $950 billion.

While infrastructure investment opportunities are rife, returns from these projects vary. Some investment strategies are well suited for big gains in today’s environment; others are designed for smaller, albeit consistent, returns. Given the many possible investment strategies and the growing popularity of infrastructure investments as a whole, BCG and EDHECinfra, a provider of indexes and analytics for infrastructure investors, have partnered on “Infrastructure Strategy 2022,” the first in a series of annual reports intended to categorize the universe of investors by their priorities and focus as well as by their risk-adjusted performance.

The centerpiece of this report is the division of infrastructure investors into 16 peer groups that can be further broken down into four categories: global peer groups (which include asset owners, such as pension funds, endowments, and sovereign funds, and asset managers, such as private equity funds); home regions; asset manager styles; and asset owner styles.

EDHECinfra Research Insights – June 2021
The choice of performance test benchmark of Superannuation funds’ investments in infrastructure

Submission to the Australian Treasury

In this contribution to the exposure draft consultation on the “Your Future, Your Super” package, we do not comment on the general approach taken by the regulator to benchmark MySuper products but solely focus on the choice of benchmark for the unlisted infrastructure asset class. We propose abandoning the use of listed equity indices to proxy investments made in the unlisted infrastructure equity asset class in the proposed performance tests of MySuper products. We argue that recent advances in data collection and innovation in asset pricing provide a robust and academically validated alternative to the currently proposed benchmark. This listed equity index (the FTSE Developed Core Index) is wholly inadequate because it is not representative of the universe or of the risks to which Superannuation products are exposed when investing in unlisted infrastructure. Instead, the infra300, an index built to be representative of the unlisted infrastructure universe, constitutes a robust and fair alternative that can benefit plan members and managers alike as well as meeting the prudential objectives of the regulator.