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.

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.

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.

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.