Responsible investment in infrastructure: a paper by Azhar Abidi

By Azhar Abidi, Director, Sustainable and Responsible Investment - 13 December 2011

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Responsible investment is not a mystery. It is a living and breathing part of making investment decisions. When investing in long-term assets like infrastructure, investors need to ensure that they take into account all possible issues that these assets might face over time.

What is infrastructure?

Infrastructure is a unique asset class that shares characteristics of private equity, fixed interest and listed equities. Infrastructure assets are typically physical investments like toll roads, railways, seaports, airports, power stations, electricity transmission lines and gas pipelines. They provide essential services and often involve governments as regulatory or funding counter-parties. Revenues from infrastructure assets may be regulated or based on demand or availability. What they all have in common are long economic lives, high capital costs and high barriers to entry.

Railways, seaports, airports, and power stations are examples of demand-based assets, where investors are exposed to the actual use of the facility for the generation of revenue. Availability-based assets include public private partnerships where investors finance, build, own and operate, say, a toll road and receive a payment from a government for making the asset available for use under a contract. Regulated assets such as an electricity transmission line earn a regulated return on capital to account for operating costs and capital expenditure. In most cases, revenue from these kinds of infrastructure assets is predictable and offers high cash yields.

With these benefits come a distinctive set of risks. For example, a primary or greenfield infrastructure project includes a construction phase prior to commencement of operations and would thus have a higher risk profile than that presented by a mature asset. Examples of risks associated with construction include delays, cost overruns, government approvals and commissioning risk. Demand forecasts for greenfield projects add risk because of the speculation involved in forecasts in the absence of historical demand. At a minimum, greenfield assets need environmental assessments to meet legal and regulatory requirements, but the design should also anticipate climate change risks and this needs a longer-term perspective. Equally, if community concerns are not properly addressed before the project is completed, the risk of future regulation or even litigation cannot be ruled out.

In contrast to a greenfield project, a brownfield infrastructure asset is typically an existing asset with a mature demand profile. Its risks are lower due to lower capital expenditure and a well-established operational track record. However, the risk profile can also increase if debt is allowed to increase or if the asset is run down to cut costs. Brownfield assets that require substantial capital improvements over time have risks more akin to greenfield developments.

“ Unrealistic growth expectations, mergers that make no sense, high leverage, high remuneration packages that incentivise risk-taking are just a few examples of short-termism or ‘irresponsible’ behaviour. ”

- Azhar Abidi

Infrastructure assets have many stakeholders alongside investors, such as government regulators, lenders, communities co-located with and affected by the asset, and the public that uses or depends on their facilities. Due to the long-term nature of infrastructure assets, investors need to ensure that they take into account all possible issues that these assets might face over the long-term. The risk profile for individual assets is also affected by the overall maturity of the infrastructure market in a given country. Those nations with clear legislative and regulatory guidelines in place, a proven ability to manage stakeholder concerns, an established pipeline of new assets, and record of successful asset sales have a distinct advantage.

Unlike listed investments, unlisted infrastructure assets are illiquid and require a greater focus on shareholder arrangements and valuation metrics. All infrastructure assets, regardless of whether they are greenfield or brownfield, need strong boards and an alignment of interest between management performance and long-term shareholder value.

Where does responsible investment fit?

Responsible investment means taking a long-term perspective on risks when making long-term investment decisions. This includes taking into account environmental, social and governance factors rather than looking at financial factors alone.

The key consideration to incorporate responsible investment has been a growing realisation among institutional investors that short-sighted investment decisions are not a smart bet. If long-term investors buy an asset, especially an infrastructure asset, based on a six-month earnings forecast, they will misprice risk because longterm issues do not always manifest in price-to-earnings ratios or six-month forecasts. An infrastructure asset might be facing a looming carbon tax, exposure to litigation from pollution, or it might be located in low-lying areas prone to flooding due to global warming. If investors intend to hold the asset for five, ten or twenty years, then they have to look at all these ESG risks to make a profitable investment.

This realisation has occurred as pension funds have grown larger. Some of the largest pension funds now own entire slices of the economy and market through their portfolios – they are what is called “universal owners”. If they own the whole market then it does not matter so much for them what individual companies do in the short-term. It is the long-term that matters.

Unrealistic growth expectations, mergers that make no sense, high leverage, high remuneration packages that incentivise risk-taking are just a few examples of shorttermism or ‘irresponsible’ behaviour. Responsible investment is the opposite. Pension funds are recognising that a market based on short-termism is not in their best interests because in the long-term, those are the very things that cause markets to decline.

The other aspect of responsible investment is reputational risk. No investor wants to be named and shamed in public for investing in companies that pollute rivers or commit gross violations of human rights. Investors who are cavalier about their reputations damage their own brand.

In this context, Industry Funds Management (IFM) is differentiated from other fund managers through its alignment focused on investors. It is owned by some of the largest not-for-profit pension funds in Australia who are also heavily invested in infrastructure assets managed on their behalf by IFM. As the success of these investments is crucial to IFM’s own success, consideration of ESG risk is crucial.

IFM has a 17 year track record managing infrastructure, with over $9 billion currently invested in assets including airports, toll roads, utilities, public-private partnerships, sea ports and renewable energy companies globally. We are invested in 26 assets across two portfolios.

Our Infrastructure Group focuses on all aspects of acquisitions and asset management, supported by in-house legal counsel and tax specialists. IFM has a board approved ESG policy that applies to infrastructure and all other asset classes we manage. The policy objective is to protect and enhance the value of our investments for the long-term.

IFM’s decision making approach

As infrastructure assets have long life spans, the investment appraisal and asset management processes must consider all risk factors to ensure that the value of investments is maintained over their lives. Being a long-term investor, IFM considers all material environmental, social, governance and reputational factors (alongside financial, tax and economic factors) in our risk assessment.

The investment process commences with an initial review by our Infrastructure Group, followed by comprehensive due diligence to final approval by the Investments Committee. For very large transactions, the investment decision is referred to a sub-committee of the IFM Board (Board Investment Committee) for final approval. Where we are concerned that a potential investment may not accord with the intent of our ESG policy, we undertake preliminary approval prior to commencing due diligence. All investment decisions are formally peer reviewed providing an additional level of scrutiny within our process.

The weighting given to different ESG factors depends on their materiality on asset risk and returns. Depending on whether they are qualitative or quantitative, we integrate ESG factors into the revenue and cost profile or in the valuation through the discount rate.

Due diligence process

During the due diligence process for new investments, our Infrastructure Group uses a detailed guide to assess ESG risks against IFM’s policy criteria. Developed on the basis of our experience of investing in this sector, and with reference to international benchmarks such as the IFC Sustainability Guidelines, the purpose of this guide is to highlight ESG issues that may not be readily identifiable during the course of routine due diligence. The checklist has over 100 comprehensive questions on topics such as greenhouse gas emissions, water supply, waste, environmental pollution, labour and community relations, governance and workplace safety. Findings from this review are factored into the investment decision. See Figure 1.

Figure 1

We routinely engage environmental, legal, commercial and other technical consultants to assist in due diligence. We also have access to a range of specialist advisors who bring insight and knowledge in their sectors and are invaluable in ensuring that IFM’s investments are ‘world class’ when it comes to safe, profitable and sustainable operations.

IFM’s ESG policy is closely aligned to the UN Global Compact, which enjoys global consensus and supports a set of core principles in the areas of human rights, labour standards, environment and governance. Our ESG policy seeks to ensure that new and existing investments are not culpable of environmental damage, gross corruption, systemic violation of human rights or any other particularly serious violations of fundamental ethical norms. Our approach is based on the belief that well-governed companies with responsible environmental, governance and social policies make for better long-term investments. This approach is summarised in our investment process below.

Environment

Environmental risks are reviewed in terms of potential costs (carbon taxes, costs related to reducing pollution), legal and compliance issues and reputational impacts. The risk management protocols of companies are reviewed, including their historical performance. Environmental considerations are also relevant to asset valuations. For example, climate change may not be apparent in the near future but it may impact an asset’s operational and financial performance in the long-term. In a recent sea port acquisition, we used a technical consultant to ascertain that a rise in sea levels and flooding would not impact port operations for the foreseeable future.

Social risk

To avoid the risk of industrial action and litigation, we review social issues such as labour relations, enterprise agreements and workplace safety to identify and mitigate areas of concern. Human rights violations are unusual for infrastructure assets in OECD countries but nonetheless, we require compliance with international human rights accords which is over and above the usual requirement to meet local and national laws.

Governance

We acquire equity stakes in companies with significant influence and control to ensure that our interests as shareholder are represented at board level. Governance risks are reviewed in terms of shareholder rights and protections through legal documents as well as board representation. We strive to ensure that shareholder agreements are negotiated with favourable indemnities and warranties as well as voting rights.

Key takeaways

Risk management is always changing. Twenty years ago, few investors would have considered climate change. Now, they would be breaching their fiduciary duty if they fail to appraise it. There is no right way to go about becoming a responsible investor but if there is one lesson that we have learnt, it is that ESG research and analysis should be undertaken by mainstream investment professionals. ESG specialists, if used, should be financially numerate, familiar with the infrastructure sector, and have a strong commercial, technical and legal focus. They should be integrated and working together with investment professionals.

Readers will inevitably draw their own conclusions about IFM’s approach and other investment firms may, of course, have a different view, but at least one thing should no longer be in any doubt – that responsible investment is not a mystery. It is a living and breathing part of making investment decisions. It is not an “add-on” or something separate. It is simply about doing things better.

This article by IFM's Azhar Abidi was originally published in the Journal of Superannuation Management and is republished here with permission.