Infrastructure’s Inflation Fighters

By Loretta Clodfelter - 30 September 2011

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A Look at If and How Ports, Roads and Other Infrastructure Assets Can Protect Against Inflation


This article by Loretta Clodfelter was first published in the September 2011 edition of Institutional Investing in Infrastructure and is republished here with the permission of Institutional Real Estate, Inc.

Investors choose infrastructure investments for a number of reasons: diversification, high yields and low correlations are a few of these. In addition, infrastructure can provide some protection against high inflation, and that’s very attractive to institutional investors; however, inflationhedging promises have not always lived up to the hype, and investors seeking this benefit need to set expectations and choose the right assets.

The relationship between infrastructure and inflation is not always a simple one-to-one. Inflation is not one monolithic experience but instead varies across geographies and sectors as well as from one investor to another. And with Western economies in the doldrums, deflation — as much as overheated price growth — has investors on edge right now. Despite this, inflation always poses a serious risk to investors, and infrastructure investments can offer some protection.

“Many portfolios today are insufficiently protected against periods of high inflation,” says Eyal Bilgrai, a real assets investment expert and former senior research analyst with Alan Biller and Associates based in Northern California. He adds that high inflation is one of the key risk factors institutional investors must consider when building a portfolio.

So how does infrastructure investment rate as an inflation-fighting tool investors can use to protect portfolio value?

Leola Ross, senior investment strategist with Russell Investments, says infrastructure offers a variety of interesting and important benefits, but “I would put inflation [protection] at the bottom of the list. That said, inflation is rather topical, and it does come up quite often because infrastructure has a particular relationship with inflation, so it is great to have a conversation about how that works.”

Of course, how important inflationhedging is deemed will vary among investors with different objectives for infrastructure investments and their total portfolios, so the answer also is subjective to a degree.

“One of the many characteristics that is supposed to make infrastructure attractive as an asset class is the inflation hedge, along with the noncorrelation to public equity markets,” notes Brian Chase, senior vice president with Campbell Lutyens. Chase says the first round of infrastructure funds, in 2006 and 2007, did not always provide the inflationhedging that investors desired.

“The second round of funds that has come out post–financial crisis, since 2008, those funds tend to have much more of a focus on inflation-linkage. Investors have become more likely to focus on inflation protection, and in their due diligence, focus on what the track record has been for inflation protection,” Chase says. “It’s something everyone promises, but not everyone is able to deliver on.”

Institutional investors looking into infrastructure or other real assets for their inflation-hedging properties need to be direct with fund managers, notes Bilgrai. He says investors need to say: Explain the inflation exposure of the assets.

“You need to step back and analyze the inflation-hedging potential of an infrastructure investment,” Bilgrai says. “It’s not as straightforward as the pitch books would like you to assume.”

Ross believes investors concerned about inflation should consider the following questions: How will inflation happen? What will be the source? If there is a particular source, then perhaps it can be partially offset with appropriate investments. “However, in most cases, there is a vague ominous inflationary expectation that is rather undefined — and in fact, it may even be deflation that happens,” Ross says. “In the case of this vague, inflation story, investors are best served by building a well-diversified portfolio, with a variety of real assets, and infrastructure is certainly an important component of that.” Ross adds that investors will want to focus on cash flows, another important feature of infrastructure investments, which will be more reliable than capital gains in times of market stress.

The extent to which investors get an ongoing, high proportion of their return through income means that capital appreciation, or capital decline in the case of high inflation, is not so important, says Hamish Mackenzie, who is head of RREEF Infrastructure in Europe, with responsibility for investing the family of Pan-European infrastructure funds that RREEF manages. “One aspect of inflation is yield, and one of the attractions of infrastructure investments is their ability to generate higher yield than private equity. And that yielding profile allows you to offset inflation,” says Mackenzie.

A broad asset space

So let’s say an institutional investor does want to invest in infrastructure assets to provide a hedge against increasing inflation. Infrastructure comes in a variety of subsectors, and there is some variability in how each subsector protects against high inflation. Toll roads, utilities (both water and electric), ports (both air and sea), and gas pipelines can provide some protection against inflation.

“What is most unique about infrastructure is the monopoly nature of the service offered combined with necessity — you can only get it from one place, and you have to buy it,” says Ross. “For this reason, government intervention and regulation is highly commonplace.”

The government intervention often takes the form of contractual obligation, contractual fee schedules and regulatory oversight. Most infrastructure assets have either fees or margins that are contractually based on some measure of inflation, including the Consumer Price Index (CPI) in the United States or the Retail Prices Index (RPI) in the United Kingdom. These inflation adjustments are where the relationship of infrastructure to inflation originates.

“Infrastructure is a relatively broad asset space,” says Mackenzie. “Even within the European mature infrastructure space, it’s a pretty broad market. Your classic inflation hedges are the regulated assets. And the bulk of the regulation stems from the U.K. model — our tariffs are linked to inflation, so the so-called RPI minus X, where prices charged per unit of usage increase in line with inflation, less an efficiency factor.”

One way in which investments can vary is in the length of their concession, which can be as little as four or five years in the case of regulated utilities and airports, or as long as 99 years in some government-contracted assets such as toll roads.

Russell’s Ross cautions that in the case of infrastructure assets where cash flows are contractually based on CPI or some other price index, the connection to inflation is both externally imposed and generally lagging to inflation. So trying to pinpoint future inflation and respond with appropriate investments can be as difficult as it looks.

“The important point here is to try and get a diversified portfolio of infrastructure assets,” says Annabel Wiscarson, a director with Industry Funds Management (IFM). “So, yes, some assets have a more natural link to inflation, or a more natural hedge to inflation, but investors in general and we as a manager want a diversified portfolio with revenues and underlying assets from all asset classes, so you’re not just relying on one type of company.”

In addition, there is the matter of how inflation-hedging fits in a global portfolio. “Inflation in the U.K. or Europe may be different from the United States,” says Bilgrai. U.S. investors pursuing an infrastructure strategy will find that most infrastructure investments fall outside the United States. In that case, “what exposure are you getting to U.S. inflation?” asks Bilgrai.

When making investment decisions and doing due diligence, “one of the key aspects we’ll look at is a projection of inflation across each business, each asset, each geography that we invest in, recognizing that the returns generated, either implicitly or explicitly, will be linked to inflation,” says Mackenzie. “So inflation forms a key part in our assessment of individual assets and indeed our assessment of the form of ongoing performance of individual assets, and we’ll look to protect ourselves against undue movements in inflation as well as reviewing likely inflation scenarios for each new investment that we make.”

Inflation performance across sectors

Water and Power

A classic example of an infrastructure subsector with a strong link to inflation is regulated utilities, such as electricity or water and wastewater. Demand for utilities services is inelastic in nature, which means there is greater probability that inflation increases can be passed on to the end customer without affecting total revenues.

“Your classic utility has an explicit inflation element to its revenue stream,” notes Mackenzie. “So a U.K. water company’s prices will increase by inflation. Volumes will increase by various factors including GDP for industrial volumes. Retail volumes will be more influenced by weather and such factors but are generally pretty stable. That’s water. Electricity usage will be more linked to GDP.”

In the case of regulated utilities, “you generally don’t have a contract or a concession with the government, but there is a regulatory authority that looks at your revenues that you are charging your water or electricity customers, and they take inflation into account,” says Wiscarson. “So you are protected from inflation typically with regulated utilities.”

With a regulated utility, Wiscarson notes, the regulator will review, generally every five years, a utility company’s costs, its customer base, how much it’s spending to improve the company, and then tell the utility what it’s allowed to charge, taking inflation into account.

As an example of how regulated utilities provide inflation protection, Wiscarson points to a regulated water utility in IFM’s international portfolio. The company is regulated by Ofwat, the U.K. Office of Water Services.

“Ofwat sets water rates every five years based on a number of factors,” notes Wiscarson. “Therefore, we have certainty over revenues for a five-year period.” And Ofwat takes inflation into account when setting the regulated revenue allowances. “Regulation protects the public and provides long-term certainty to investors,” notes Wiscarson.

Paying the Toll

Toll road concession agreements set an upper limit on toll increases, which is typically linked to inflation, giving investors some protection. In addition, notes Bilgrai, inflation has little effect on existing toll roads’ operating costs because of their high operating leverage with low ongoing variable costs.

Campbell Lutyens’ Chase points to the Indiana Toll Road or Chicago Skyway for examples of the type of direct inflation-linkage that an investment can have. “These concessionaires have direct inflation-linkage because they’re entitled to increased tolls linked to the local consumer price index. So that’s directly linked to their future toll raises over the life of their concession, which is 75 years and 99 years, respectively,” Chase says.

Chase cautions, though, that some toll roads do still have significant traffic risk exposure, despite the link between toll rates and inflation. “Even though they can increase the tolls, traffic is still variable based on local economic conditions,” he says. “It turns out the inflation-linkage was less than perfect.”

So while toll road investors can raise tolls in line with inflation, there is no guarantee that people will drive on the road and pay the toll — at least for such investments that do not involve an availability payment structure. In a situation of rising unemployment, for example, fewer people will need to commute to work, and that will mean lower returns from the toll road.

“As seen in the last recession, toll road usage is not immune to lower economic activity,” cautions Bilgrai. “An inflation scenario that will include high gas prices without a pickup in economic activity may have a negative effect on toll road usage.”

Taxonomy of Infrastructure (Private Sector) GDP linked Inflation linked Natural Monopoly or Oligopoly Revenuebased (i.e. User Pays)
Renewable energy No Yes No No
Toll roads Yes Yes Yes Yes
Utilities
Electricity Yes No Yes Yes
Gas distribution Yes No Yes Yes
Water and waste No Yes Yes No
Transportation services Yes Yes Yes Yes
Telecommunications Yes No Yes Yes
Social infrastructure No Yes Mixed No

Classification of Infrastructure Subsectors According to Institutional Investors’ Needs

Chase notes that some of the most recent road investments have been negotiated on an availability payment basis, for example the Port of Miami Tunnel or I-595 in South Florida. “One of those roads has a toll and the other one doesn’t, but they both have inflation-protection built in for some element of the availability payment, but not the full amount,” Chase says.

Any Port in a Storm

Airports are another example of a subsector with some inflation protection. Although there hasn’t been much privatization of airports in the United States, it has become quite common in Europe as well as Australia. Airports have a number of revenue streams, including aeronautical charges — the fee an airline pays to land — as well as commercial leasing and car parking revenue streams.

“Airports are basically three separate business lines: runways operations, retail and parking,” says Bilgrai. Runways operations are similar to regulated utilities, although they face greater capital expenditure. Retail is similar to commercial real estate and typically includes guaranteed minimal rents that are inflation linked. Car parking enjoys monopolistic power, although substitutes exist.

Seaports, meanwhile, are less regulated than airports, and have stronger pricing power, but are more susceptible to dropping economic activity, Bilgrai adds.

In the Pipeline

Energy pipelines also can offer investors some inflation protection. In the United States, the Federal Energy Regulatory Commission (FERC) is responsible for setting the allowable tariff charges, which are based on PPI, the Producer Price Index for Finished Goods.

Wiscarson points to the Colonial Pipeline as an example of an inflation-linked infrastructure asset. IFM has invested in the pipeline, which is the largest refined petroleum products pipeline in the United States, taking petroleum products from the Gulf Coast up through the Southeast, mid-Atlantic and Northeast United States.

“Our customers tend to be major independent oil companies, airlines, trading companies and even the U.S. Department of Defense,” says Wiscarson. “So they use our pipeline to transport refined petroleum.”

The regulator, FERC, sets the tariff escalation index for a five year period. Wiscarson says the latest agreement was announced in December 2010 and became effective in the beginning of July.

“So we know for the next five years what the company is allowed to charge customers, and that index is linked to inflation,” says Wiscarson. “And more than half of Colonial Pipelines are regulated and therefore linked to inflation.”

Bilgrai points out an important distinction in power generation models: “Private infrastructure, such as unregulated power generation, can be either long-term contracted or merchant in nature. Long-term contracts usually include inflation indexing, whereas merchant revenues, by nature, are determined by market conditions.” Or, in other words, merchant prices will fluctuate without adjustments and invite the risk of inflation.

The bottom line

According to Ross with Russell, inflation means something different to everyone, based on their particular basket of expenses, and can mean different things for different institutional investors.

“Many macroeconomists expect inflation to rise at some point, and all will differ on when and how much,” says Ross. “What that general rise means to any institution or any individual will differ.”

Bilgrai notes that it remains uncertain when, if at all, the risk of high inflation will materialize.

“Given the persistent high unemployment and the deleveraging cycle of OECD economies, inflation risk has subsided for the near future,” Bilgrai says. “It is true that recent increases in food and energy prices have contributed to higher headline inflation, but core inflation has remained muted.”

Chase does expect inflation to increase at some point in the near future. “And more importantly,” he says, “most of the investors I talk to believe we’re going to be going into an inflationary environment. That’s making them more interested in the infrastructure asset class, and it’s making them specifically more interested in the inflation protection aspect and how it works for the various types of infrastructure investments.”

Ross says infrastructure’s potential for inflation hedging should not be overemphasized. “First, the relationship is solely in the cash flows and not necessarily linked to the capital appreciation. Second, the relationship is often lagging. Third, the relationship is multi-currency,” Ross notes. “Therefore, while there is a linkage between infrastructure cash flows and inflation, it is not by any means a silver bullet. There is no silver bullet.”