real assets
DESCRIPTION
As the need for investment in infrastructure continues to grow, private sector financing for infrastructure projects has developed around the world. Given the long-term growth and (potentially) low correlation aspects of infrastructure investments, pension funds have also shown interest in increasing their exposure to this area, along with their move into alternative assets. Such investments cover a wide spectrum of projects: economic infrastructure such as transport or energy producing plants, to social projects such as hospitals or schools.TRANSCRIPT
WHY PENSION FUNDS SHOULD INVEST IN REAL ASSETS / RENEWABLE ENERGY INFRASTRUCTURE?
Akuo Investm
ent • Pension Funds are increasingly moving into new assets classes in research for yield: they are looking for new sources of return and beNer diversificaPon of investment risk.
• Infrastructure is one type of investment being frequently discussed, given its potenPal to match long-‐term pension assets and provide diversificaPon.
• Previously pension fund exposure to infrastructure has been via listed companies (such as uPliPes), or via real estate porYolios.
• However, some larger funds globally are beginning to invest via private-‐equity funds, or, occasionally, even directly.
• In the 1990s, strong stock markets were supporPve of the development of funded pensions, and the allocaPons to equiPes were increased by pension funds in many countries. However, the burst of the TMT-‐ bubble in the early 2000s and the subsequent recession led to substanPal funding and solvency problems for pension funds. Both sides of the balance sheet were affected. This led to a major rethink of the asset allocaPon of pension funds.
• Pension Funds enlarged their investment universe to include corporate and high yield bonds, and invested more money internaPonally, including in emerging markets. In addiPon, the investment industry started to offer new or alternaPve asset classes for pension funds. They include hedge funds, commodiPes, private equity, currency and tacPcal asset allocaPon overlays, commercial loans, infrastructure investments, forestry products, microfinance and other niche areas.
IntroducPon
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• The idea of invesPng in infrastructure seems to strike a chord with many pension plan directors and members. Infrastructure feels more tangible and real than a lot of other complex products and derivaPve strategies presented to pension funds these days, where they find it difficult to detect the underlying value.
• In addiPon, infrastructure is made for the long term, and there seems to be a natural fit with the long-‐term liabiliPes of many pension plans. For some people there is also a connotaPon to sustainable or socially responsible invesPng, which is an increasingly popular route chosen in parPcular by public and industry-‐wide pension plans.
• In a historic perspecPve, private financing of infrastructure is not new. In recent Pmes, however, there have been significant new developments. In post-‐war Europe in parPcular, most of the infrastructure was owned and controlled by state insPtuPons. Since the 1980s, the trend has reversed as many pieces of infrastructure have been (partly or fully) privaPzed in the face of stretched public finances.
• The requirement for beNer infrastructure seems obvious everywhere in the world. Infrastructure investment will need a huge amount of capital in the coming decades, whether public or private. EsPmates made by supranaPonal insPtuPons for global infrastructure needs run into the dozens of trillions.
Infrastructure
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Infrastructure assets are tradiPonally defined by their physical characterisPcs. One can split them into two main categories, and a range of sectors within those:
Economic infrastructure • Transport (e.g. toll roads, airports, seaport, tunnels, bridges, metro, rail systems) • UPliPes (e.g. water supply, sewage system, energy distribuPon networks, power plants, pipelines, gas storage)
• CommunicaPon (e.g. TV/ telephone transmiNers, towers, satellites, cable networks) • Renewable energy
Social infrastructure • EducaPon faciliPes • Health (hospitals and health care centers) • Security (e.g. prisons, police, military staPons) • Others (e.g. parks).
Infrastructure
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Financial industry analysts emphasize the existence of limited compePPon, resulPng from different sources.
• Economic: natural monopolies (e.g. energy distribuPon networks), public goods (e.g. broadcasPng • RegulaPon: controlled charges and fee increases (e.g. toll roads), regulated uPliPes • Concessions from public authoriPes: long-‐daPng contracts (e.g. hospitals).
Infrastructure assets typically show one or more of the following stylized economic characterisPcs: • High barriers to entry • Economies of scale (e.g. high fixed, low variable costs) • InelasPc demand for services (giving pricing power) • Low operaPng cost and high target operaPng margins • Long duraPon (e.g. concessions of 25 years, leases up to 99 years).
Infrastructure with a financial twist
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From this, the investment industry deduces a number of favorable investment characterisPcs of infrastructure assets:
• Stable and predictable cash flows • Long term income streams • Oien inflaPon-‐linked (helping with liability-‐matching) • In some countries, tax-‐effecPve • Returns insensiPve to the fluctuaPons in business, interest rates, stock markets • RelaPvely low default rates • Low correlaPons with other assets classes (offering diversificaPon potenPal) • Socially responsible invesPng (SRI) (providing public goods essenPal to society)
Infrastructure with a financial twist
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It is an essenPal part of the fiduciary duty of those involved in pension fund invesPng to understand the specific risks of infrastructure assets. Risks go much further than the usual volaPlity staPsPcs, and certain factors are just genuinely uncertain.
.At the level of infrastructure projects and companies, key risks include: • ConstrucPon risk (e.g. the project is not completed on Pme; costs are higher than budgeted…) • OperaPonal risk (e.g. poor management, systems) • Business risk (e.g. more compePtors entering; change in consumer preferences and demand; technological advances)
• Gearing risk (typical leverage of 30-‐90%, resulPng in a high exposure to interest rate risk; refinancing risk with higher inflaPon and interest rates; downgrade risk)
• Legal and ownership risk (unknown future liPgaPon, planning consents not granted; lease running out…)
• Regulatory risk (e.g. fee rises fall behind schedule) • Environmental risk (unforeseen environmental hazards; acPon groups) • PoliPcal and social risk (opposiPon from pressure groups; poliPcians may change their mind; corrupPon)
Risks
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Pension funds are presented all sorts of graphics with stylized risk-‐return profiles: somePmes showing infrastructure with risk and return both higher than equiPes, somePmes both lower, and somePmes at higher returns and lower risk…
When the global infrastructure boom started, return expectaPons were oien given as 15% plus pa by some providers.
In their 2005 analysis of the Australian market, Mercer say that ―most managers‘ products fall into the category of diversified infrastructure funds that have an objecPve to deliver returns of 9 – 12% net of fees.
RREEF makes the disPncPon between the total return expectaPons of mature (10 % – 14% pa) and early-‐stage assets (18% plus). It should be noted, however, that such expectaPons are fuelled by leveraging the returns of the underlying porYolio. RREEF put a typical leverage rate of 40–80% for mature and 30–75% for early-‐stage assets.
The analysts‘ projecPons also vary across infrastructure sectors. JP Morgan Asset Management, e.g., expects the lowest expected internal rates of returns for toll roads (8-‐2%) and PFI/PPP (9–14%), and the highest for airports (15-‐18%) and broadcast network (15-‐20%), this against an infrastructure average of 10-‐ 15%.
(All references available on demand)
Risk / return profiles
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How do these return expectaPons compare to other asset classes? According to a survey of 2007, return expectaPons for the asset class infrastructure over 10 years are an annualized 9.5%, pusng it in second place behind private equity (11.3%). In comparison, stocks are expected to return 9.0%, bonds 5.1% and cash 3.7%. Nowadays, the returns for cash namely would be much lower.
What is the expected risk profile of infrastructure? ExpectaPons for volaPlity are typically set somewhere between equiPes and bonds. The asset-‐liability model used by Morgan Stanley Investment Management, e.g., compares five main asset classes.
It puts infrastructure (volaPlity 7.9%, return 9.3%) second only to bonds (4.4%) in terms of expected volaPlity and second only to private equity (10.0%) in terms of expected return.
As an example for pension funds, the Dutch APG, expects a 10% return from infrastructure with a 7% risk. In comparison, the corresponding figures are 6% / 9% for property and 15% / 25% for private equity. CalPERS are looking for an annual return of inflaPon (CPI) plus 5% -‐ 7%.
(All references available on demand)
Risk / return profiles
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Since the first wind turbines were built at the late 1980s, power generaPon from wind energy has seen dynamic growth. The reasons for this unprecedented boom in the last 15 years lie in the support programs from naPonal and state governments. Recent market trends are in large-‐scale building operaPons ranging from 50 to several hundred MW of power generaPng capacity.
Sun energy is harvested through thermal solar plants, or photovoltaic solar plants on rooiops or ground-‐mounts. Although development costs are sPll on the high-‐end, tariff policies have made this area very aNracPve. We intend to focus on plants with greater than 1 MWp of installed capacity.
Renewable Energy
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Biogas plants produce a gas similar to natural gas and use anaerobic digesPon processes. The adopPon of this waste processing technology is revoluPonizing the agriculture sector in many countries and is being used to now produce both energy and food. It is likely that in the future, electricity generaPon capacity will increase substanPally.
Biomass is mankind's oldest source of energy. Market trends are focusing on co-‐generaPon plants using mixed fuels: wood, bagasse, and straw with up to 40 MW of capacity.
Renewable Energy
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We focus mainly on mini-‐hydro projects with up to 50 MW of capacity. Larger hydro projects had been the trend, but the market is now shiiing to smaller units creaPng an aNracPve niche market.
Renewable Energy
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Technologies in which Akuo Investment does not invest are omi=ed here: ocean wave energy, large hydro, CSP…
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The specificiPes of renewable energy infrastructure are:
• Absolutely No (or minimal for biomass) commodity price correlaPon: resources are “free” • Growing and poliPcally supported market • Socially welcome as sustainable investments • Moderate size of the projects/investments per project compared to other infrastructure asset classes (airports, toll roads…) • Asset class growing in developed countries where tradiPonal infrastructure projects are less frequent • Electricity generaPng assets are about the future of energy and the energy of the future • Electricity cannot be stored on an industrial scale, has to be consumed • Very liNle correlaPon to business cycles • Feed in tariffs or PPA’s (very long term commitments) • No bad client risk (UPliPes buy the energy) • Quality of the cash flows (banks accept generally much lower DSCR’s then for tradiPonally gas or coal powered staPons: 1.1-‐1.2 vs 2.0) due to nature of the availability of the resources • Excellent Pming due to the pressure regarding climate change policies
What is special about renewable energy?
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Akuo Investm
ent Five essenPal driving forces to successful development
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As in any new sector, several misconcepPons circulate in the common press:
• Renewable Energy is intrinsically not profitable, and it would never exist without subsidies (see the next 2 slides in addendum)
• Renewable energy cannot replace any fossil fuelled power plants, and is just another gimmick • Renewable energy is for rich naPons only which can afford subsidies (Renewable Energy has some its greatest developments in emerging countries where the energy demand increase is the highest)
• Renewable energy infrastructure is like cleantech (Renewable Energy Infrastructure is to cleantech what programming languages are to new web ventures)
…
There are misconcepPons about renewable energy which need to be cleared away
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For more details, or a complete bibliography on this topic please contact us:
Akuo Investment Management [email protected]
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ent Wind energy is compePPve to most other sources
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(All references available on demand)
Akuo Investm
ent Solar energy is soon to be compePPve relaPve to nuclear energy (US stats)
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(All references available on demand)