What does responsible investing mean to infrastructure investors?

By IFM - 8 September 2011

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Infrastructure Work Stream Discussion Paper

This paper was written to inform the UNPRI Infrastructure Steering Committee about the actions signatories are currently taking to implement the Principles for Responsible Investment for infrastructure assets under management. Azhar Abidi, Director Sustainable and Responsible Investment at IFM, Chairs the Committee. Please click here for a copy of the paper.

Over the last year, the PRI Secretariat has been engaging with signatories on what responsible investing could mean to different kinds of infrastructure investors. During the course of these discussions, the Secretariat recognised that signatories required support to aid implementation of the Principles in this asset class. In response, the PRI Secretariat spent a number of months researching the challenges infrastructure investors face when implementing the PRI. This paper summarises the findings from this research, with the objective of highlighting the key areas where signatories say support is needed.

With this background knowledge, it is hoped that the agenda for the Infrastructure Work Stream can be refined.

What is a PRI Work Stream?

A work stream is a set of activities focused on a particular area that has been identified by the PRI Secretariat as one where specific implementation support is needed. By establishing a work stream, the PRI Secretariat, in partnership with signatories, can start to create the tools needed to help signatories with specific implementation needs. The outputs of a work stream can include, for example, webinars, case studies, guidance documents, fact sheets, surveys and events.

PRI signatories can be involved in a work stream in a number of ways. They can:

  • be part of a steering committee
  • be part of a working group that is focused on a specific topic related to the work stream
  • be a thought leader by providing case studies highlighting current and emerging best practice
  • raise awareness and drive debate by contributing to webinars and publications
  • make use of any resources created

Infrastructure as an asset class

Infrastructure is a unique asset class. Depending on one’s definition of the term, infrastructure assets may include roads, railways, ports, airports, other transport facilities, telecommunication facilities, waste processing, gas or electricity generation, transmission or distribution, water supply and sewerage, hospitals, education, public housing or recreational facilities. This list is in no way exhaustive. In general, infrastructure assets typically provide a core essential service, often involving governments as regulatory or funding counter-parties and are characterised by high barriers to entry, regulation and capital costs. Revenues from these assets may be generated based on demand or availability.

Railways, ports, airports, toll roads and utilities are examples of demand-based assets, where the investors are exposed to the actual use of the facility for the generation of revenue. In contrast, availability assets receive a payment from a public body for making the asset available for use under a contract. In both cases, investors can expect stable returns over a long-term, often with high cash yields and a relatively low level of operational and economic risk.

However, infrastructure assets come with a distinctive set of risks quite different than those in listed equities, property or private equity. A primary or greenfield infrastructure project includes a construction phase prior to commencement of operations and thus a very different risk profile than that presented by a mature asset. Examples of the risks associated with construction include delays, cost overruns, government approvals and commissioning risk. Demand forecasts for greenfield projects add a further level of risk because they have a weaker or no record of historical demand and a longer lead-time before the first operational revenues can be expected.

The following diagram illustrates how the equity risk premium of an infrastructure asset declines over the construction and development stage and beyond:

 

Source: Capital Innovations, LLC

 

In contrast to a greenfield project, a brownfield infrastructure asset is typically an existing asset with a mature demand profile, lower capital expenditure and a well-established operational track record. The risk profile of a brownfield asset can also change, however, particularly through leverage, or if the asset is allowed to run down, but generally the risk is lower compared to a greenfield project. However, brownfield assets that require substantial capital improvements can involve additional risks more akin to greenfield developments.

Infrastructure assets also have many stakeholders other than their 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 their long-term nature, investors need to ensure that they take into account all possible issues that these investments might face over the long-term, such as economic cycles, inflation and demographic shifts, climate change impacts, public concern over user fees and/or state fiscal indebtedness, and legislative and policy changes. 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. Investments in greenfield infrastructure face a different set of risks again and 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.

The Infrastructure Work Stream

In this context, responsible investment is a risk framework that takes account of all material and relevant risks - including those related to environmental, social, and governance (ESG) concerns - during the investment decision-making process. On this basis, the PRI Infrastructure Work Stream has been established to provide guidance to asset owners and investment managers in two aspects:

  • To integrate ESG in the risk appraisal/due diligence of new investments. Investors have a fiduciary duty to act in the best interest of their beneficiaries. The ultimate investors in infrastructure assets are global institutional investors, who are by definition, long-term investors. For such investors, the risk appraisal of ESG factors is completely interwoven with long term financial success because ESG risks often manifest over the long-term. What differentiates the best-in-class investors from the mediocre is how well they are able to identify and mitigate risks – including ESG risks – in order to discharge this duty.
  • To integrate ESG in the management and monitoring of existing investments. ESG risks change with time, for example, the profit margins of coal-fired power stations will decline in jurisdictions where a carbon tax or a carbon trading scheme exists. What differentiates the best-in-class investors from the mediocre is how well they are able to identify, prevent and mitigate risks – including ESG risks - in investments. The better investors are able to manage risk and add value, the more successful they will be.

Case Studies Working Group – The aim of this working group is to develop case studies on current practices within responsible investment in infrastructure

Outreach Working Group - The aim of this working group will be to ensure the right people from the infrastructure world are involved in or aware of the PRI’s work on infrastructure. The working group will reach out to the wider network of infrastructure investors, relevant industry associations, and make the PRI’s work known at conferences

Best Practice Working Group - This working group will provide high level guidance to signatories in their implementation efforts

A number of issues that the working groups may consider are listed below in Table B. PRI signatories interested in participating should contact Kjersti Aalbu ([email protected]).

The current state of play1

Given the diversity of infrastructure assets, investors can gain exposure through a variety of mechanisms. Investments can be made directly or indirectly, through debt or equity, in listed or unlisted companies, individually or collaboratively and represent a spectrum of risk and return profiles. The predominant forms of infrastructure investments include: unlisted infrastructure funds, commonly structured as LPs; unlisted direct investments/co-investments; listed infrastructure funds, listed infrastructure companies and debt instruments and funds.

The PRI Reporting and Assessment survey only captures investments in unlisted infrastructure. 2 Currently, 18 per cent of PRI signatories invest in unlisted infrastructure. 3 44 per cent of these signatories invest directly in unlisted infrastructure investments, 62 per cent invest indirectly, and 6 per cent do both. The Secretariat recognises that these figures do not reflect all the different perspectives of asset owners and investment managers. However it does give a general indication of potential interest in the work stream. More importantly, infrastructure is a relatively new asset class and multiple surveys of investor expectations indicate that institutional investors intend to increase their allocations to infrastructure over the coming years.

Notwithstanding the relatively recent application of responsible investment principles to infrastructure, an analysis of responses to the 2010 reporting and assessment survey highlights certain indicators regarding existing responsible investment practices of infrastructure-focused signatories. These include:

  • 29 per cent of infrastructure investors incorporate their RI policy or approach to internal management processes in their infrastructure investments to a large extent. 40% do so to a moderate extent.
  • 61 per cent of direct investors integrate RI/ESG issues in the investment decision-making process to a large or moderate extent.
  • 53 per cent have a process for monitoring the ESG capability of internal investment analysts, external portfolio managers and other relevant investment professionals on how they integrate the consideration of RI/ESG issues into investment analysis and decision-making processes.
  • 39 per cent of indirect investors specified contractually or via other agreements that RI/ESG issues are or will be integrated into the investment decision-making processes of external investment managers.
  • 53 per cent of infrastructure investors have a specific active ownership policy and/or strategy for infrastructure that addresses ESG issues.

Current infrastructure and responsible investment practices

Although responsible investment in infrastructure is not yet a widespread practice amongst PRI signatories, those who do it use a range of responsible investment strategies to implement the Principles in infrastructure investments, for example negative screening, positive screening, ESG integration, active ownership and thematic investing.

Table A provides examples of activities that signatories are undertaking to implement the Principles in relation to infrastructure investments. Please note that the list is not exhaustive. Please also note that in many cases only a minority of signatories are undertaking these activities.

Table A: Aggregated list of actions that signatories may take to implement the PRI within infrastructure investments
  • Black text: applicable to both asset owners and investment managers
  • Blue text: Direct only
  • Green text: Indirect only
   Actions
Governance, policy and strategy
  • Create a responsible investment policy including or dedicated to infrastructure. Address ESG issues within the policy
  • Incorporate the RI policy into strategic and business planning for management of infrastructure investments
Research and analysis
  • Carry out research on the link between ESG integration and investment returns
  • Train analysts and portfolio managers on ESG matters
  • Issue RFPs requiring managers to disclose how they will incorporate ESG factors into their investment decision-making and monitoring processes
Execution
  • Integration of ESG in due diligence risk framework and investment appraisal
  • Assess or rate managers on their success in integrating ESG analysis, where appropriate, into risk frameworks and the investment decision making process
Portfolio construction
  • Incorporate ESG issues in asset allocation and portfolio diversification (e.g. asset concentration issues with respect to climate change risk, leverage)
Management and monitoring
  • Develop and implement an engagement policy on specific ESG issues
  • Develop and implement attribution or analysis of asset management initiatives
  • Ask investment managers for periodic reports on engagement activities
Exit position
  • Develop and implement policies on liquidity, redemptions and valuations
  • Adapt ESG measures and transparency to better meet broader market expectations.

Key challenges for infrastructure investors

Some of the key ESG related challenges the infrastructure investors face are summarised in Table B. The topics form the basis of the short and longer term strategies of the work stream. Suggested topics for the various working groups are italicised.

Table B: Common challenges relating to responsible investment and infrastructure assets under management
TopicSpecific issuesQuestions for consideration/Proposed actions
What are the material and relevant ESG factors for infrastructure?

There are probably three or four key factors that are systematically material and relevant to most infrastructure investments, such as climate change, environment, demographic change, community and labour relations.

Alternatively, a range of factors need to be considered on a case-by-case basis. The consideration of these issues might assist GPs in improving risk management and due diligence practices. It might also assist LPs in obtaining better disclosure from GPs and in assessing whether the latter have a long-term focus aligned with that of the investor.

  • How do we define materiality and relevance?
  • Is there a one-size fit all approach to ESG factors?
  • Will there be a need for a best practice guide or checklist?
  • The Outreach working group should investigate what checklists or risk frameworks have already been done in this area (e.g. IFC guidelines)
  • Publish case studies
How to identify, prevent, remedy and mitigate ESG risk?

What do best practice risk management frameworks look like? How do GPs conduct due diligence and how rigorous are their investment decision making processes? When investments turn bad, is it because of poor investment decisions or poor processes? Do the GPs recognize and manage to the investment horizon of their LPs?

The consideration of these issues might assist GPs in improving risk management and due diligence practices. It might improve fund design, portfolio design, team organisation and incentive structures. It might also assist LPs in obtaining better disclosure from GPs on their investment process

  • Risk committees, investment committees, peer reviews, independent expert advice, incentives – what processes, policies exist to mitigate risk? Is there a need for a best practice guide?
  • Publish case studies
Partnerships Many infrastructure investments are financed by banks who are Equator Principle 4 signatories. This raises the question whether banks are ticking the box or if there is an opportunity for them to mitigate ESG risks by greater enforcement of Equator Principles? What can we learn from the practices of banks or insurance companies?
  • Can Outreach investigate if the Equator Principles are still best practice?
  • Should Outreach engage with banks or with Equator Principles directly?
  • Can Outreach investigate if the IFC Guidelines have a role to play?
  • Publish case studies
Greenfield and brownfield investments

Investors in greenfield infrastructure assets often face a different set and pacing of risks (including ESG risks) than investors in brownfield assets. Investors may have different business units to manage their assets, different funds, different incentives schemes for their executives or a different range of skills and specialisation depending on whether they have greenfield or brownfield assets, or both.

  • Who is the target audience?
  • Is there merit in differentiating greenfield and brownfield investments and providing separate advice on each?
  • Is it possible to provide meaningful advice at this level of granularity?
  • Publish case studies
Asset management

GPs charge a fee for assets under management but what do they do to add value to the investee companies that they manage? How do LPs know that their GPs are building better companies? Most GPs are transaction driven and may be incentivised to focus on new deals rather than asset management. The objective of this consideration on asset management is for GPs to refine and validate their asset management practices leading to improvements in demonstrated value-add.

  • Is there best practice on how to define value creation? What questions should LP ask?
  • Is there best practice on how to measure value creation? What questions should LP ask?
  • Is there best practice on incentives for GPs to create value? What questions should LP ask?
  • Publish case studies
Promotion

Many GPs and LPs are independently refining their responsible investment policies and practices in smaller groups or in consultation with external advisers and asset consultants. How do we make sure that they are aware of the PRI work stream and avoid unnecessary duplication by all concerned?

  • Outreach to promote the activities of the infrastructure work stream?
  • Which organisations outside the PRI network should be involved with this work stream?
  • What lessons can be learnt from other work streams?

Conclusion

This paper has been written to inform the Infrastructure Steering Committee about the actions signatories are currently taking to implement the Principles for infrastructure assets under management. The challenges signatories are facing in their efforts to implement the Principles have also been considered. We hope that the resulting discussion will help to prioritise areas for the Secretariat to focus on for the coming years.

Appendix I: Resources

A list of resources relevant to responsible investment in the infrastructure asset class is provided below. Links to the free online versions are provided wherever possible.

Industry publications

  • Acclimatise: 2009, ‘Building Business Resilience to Inevitable Climate Change’. Available: http://www.acclimatise.uk.com/resources/reports
  • Climate Change Capital: 2010, 'Green Infrastructure Bonds: Accessing the scale of low cost capital required to tackle climate change'. Available: www.climatechangecapital.com
  • DB Climate Change Advisors: 2010, 'Investing in Climate Change 2010: A Strategic Asset Allocation Perspective'. Available: http://www.dbadvisors.com/content/_media/1113_InvestingInClimateChange2010WhitePaper.pdf
  • Eurosif: 2011, 'Infrastructure'. Sector Report. Available: http://www.eurosif.org/research/sector-reports/infrastructure
  • Mercer: 2011, ‘Climate Change Scenarios - Implications for Strategic Asset Allocation’. Available: http://uk.mercer.com/articles/1406410

Appendix II: Contributors to this document

The PRI Secretariat would like to thank the following signatories for their support in putting this document together:

  • Azhar Abidi (Industry Funds Management)
  • Jordan Berger (OPTrust)
  • Ulrik Dan Weuder (ATP)
  • Annie Degen (CDC)
  • Frederique Savel (CDC Infrastructure)
  • Mike Underhill (Capital Innovations)

 


 

Endnotes

  1. The analysis in this section is based on responses to the 2010 PRI Reporting and Assessment survey. The database for the 2011 responses was closed on 15 June and the data is currently being prepared for analysis. This section will be updated as soon as the data is ready.
  2. The PRI Reporting and Assessment survey is now under review. For more information on how to provide input into the new survey: http://www.unpri.org/consultation/
  3. ‘Infrastructure’ in the Reporting and Assessment survey does not include listed equity strategies.
  4. The Equator Principles (EPs) are a credit risk management framework for determining, assessing and managing environmental and social risk in project finance transactions. More information: www.equator-principles.com