Towards a Scientific Approach to ESG for Infrastructure Investors

This paper explores the role of environmental, social and governance (ESG) issues in an investment context, namely how institutional investors should incorporate ESG elements into the financial management of their portfolios. A growing number of investors are pursuing ESG objectives to directly improve environmental and social outcomes, either to satisfy mandates from their members or to conform to the expectations of society. This is increasingly the case even though these organisations have primarily been created to deliver investment outcomes, in particular retirement income. Consequently, investors may wish to exclude certain types of assets from their universe such as coal-fired power plants or projects mired in social controversy. However, regardless of motivation, ESG-related decision making will have a financial impact on portfolio performance. It is this area that we investigate here – the role of ESG within an infrastructure portfolio from a strictly financial standpoint.

EDHECinfra Research Insights – July 2020

In this issue of EDHECinfra Research Insights, we first discuss the surprising persistence of absolute return benchmarks in unlisted infrastructure investment. Today, absolute return benchmarks are the norm in the unlisted infrastructure investment sector, yet they are completely inadequate to understand the risk, performance and contribution of infrastructure assets to the total portfolio. The vast majority of investors agree with this assessment. We review what investors have to say about it, the reasons why these benchmarks are inadequate but also why they have tended to persist.

We establish that while long-only infrastructure investment cannot be considered an absolute return strategy (since it not market-neutral) the usual alternatives of using appraisals or listed proxies have been even worse options because they mis-represent the asset class. Absolute return benchmarks have persisted as the lesser evil.

However, recent innovations have increased the range of available choices to benchmark unlisted infrastructure. We show that that the Q1 2020 release of the EDHECinfra indices captured the impact of Covid-19 on infrastructure investment with a high degree of granularity; each sub-index capturing a different risk profile for different segments of the universe.

Leveraging this granularity, a complete analysis of the sources of risk and performance of any infrastructure portfolio can be conducted. In a second article, we use this data to better understand the performance of two peer groups of infrastructure investors: large asset managers and large asset owners.

We show that large infrastructure asset managers outperform the market and large asset owners thanks to the better asset selection skills. We also find they are not able to use asset allocation to different sectors or business risk segments to improve their performance. Instead, they often underperform the benchmark because of their implicit or de facto asset allocation choices.

Next, we summarise some of the findings of a new paper exploring whether infrastructure companies exhibit statistically significant differences from other investable assets. Controlling for variables like size, profitability, leverage, investment opportunities and industry, we show that they do indeed demonstrate unique fundamental characteristics including higher asset tangibility, asset illiquidity and inflexibility and lower operating leverage than a control sample of non-infrastructure firms.

A fourth article presents the first steps of our research program on the ESG characteristics of infrastructure companies: it highlights some of the key findings of a comprehensive review of ESG standards used in the infrastructure sector and argues that as the standardization of ESG follows its path towards consolidation, a scientific, theory-based approach to designing and implementing ESG assessments still remains to be built.

EDHEC Research Insights – Infra Special

The next generation of EDHECinfra indices is ready. They are computed quarterly, use meticulously curated private data for hundreds of companies in the 25 most active markets in the world, and cutting-edge fair value asset pricing methods. A key element in this project was the definition of the universe. Infrastructure may not be easily defined but infrastructure investment has to be.

When we started working on this topic at EDHEC we decided to focus more on what “infrastructure investment is like” i.e. what drives risk and less on what “infrastructure does” (move people or electricity from A to B, etc). This is because at the heart of any financial investment decision lies the trade- off between risk and future value.

Even in highly illiquid, opaque private markets, as we show in a series of new papers the systematic factors driving prices in unlisted infrastructure debt and equity, investors make choices that reflect perceived risks and price these risks accordingly.

ESG Reporting and Financial Performance: the Case of Infrastructure

This paper represents the first attempt at studying the relationship between the Economic, Social and Governance (ESG) and the financial characteristics of infrastructure companies.

The relationship between the impact of certain companies’ activities on their social and natural environment on the one hand, and their ability to deliver a certain level of financial performance on the other, is now a central question in the debate around responsible investment, especially when investors represent large constituencies of pension plan members, whether they belong to collective or individual schemes.

Unfortunately, such claims about the links between impact and returns in infrastructure are hard to substantiate. They are not verifiable, let alone falsifiable, in the current state of available data, because data on the actual impact of individual infrastructure companies on their immediate or distant social and environmental milieu simply does not exist today.

In this paper, as a first attempt to address this topic, we investigate the role of ESG reporting in relation to the financial performance of infrastructure companies. Indeed, data on ESG reporting is available and there is ground in the academic literature for arguing that the tendency to report ESG practices and the quality of this reporting are related to actual sustainable outcomes.

This paper is made possible by cross-referencing two unique databases covering the behaviour of infrastructure firms: the ESG scores computed by GRESB Infrastructure since 2016, and the financial metrics corresponding to the EDHECinfra universe.

infraMetrics® by EDHECinfra

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