Exploring the Importance and Benefits of the Infrastructure Industry

Infrastructure industry managed to set itself as a separate asset class within alternative investments that continuously attracts hefty financial allocations mainly due to its characteristic traits. In the case of this particular sector, however, the investment is a major two-way street, as it also ensures primary services and functions of the economy. Thus, it provides crucial support to potential productivity growth and thriving economic development in the country.

The industry can be divided further into several specific sub-sectors, each of which also exhibits mildly different behavior with respect to the macroeconomic factors. The sub-sections that we generally understand under the infrastructure industry term comprise:

• regulated assets consisting of electric power industry, water distribution, processing, and waste systems and oil and gas midstream;
• transportation assets such as toll roads, airports and ports;
• telecommunications infrastructure including wireless and broadcast towers or satellite networks; and in some cases mentioned social infrastructure assets comprising school, hospitals, and other public service houses.

This has not been, however, included in the previous research. With respect to the level of underlying risk, infrastructure real assets are (similarly to the real estate assets) classified into the categories of core, core plus, value-added and opportunistic categories (described in the order from the lowest to the highest risk exhibited).

Despite the potentially high initial deployment of financing going hand in hand with the capital intensity of this industry, it possesses several unique traits perceived as benefits for the investors. Firstly, the stable demand considerably insensitive or resistant to the economic cycles, as the assets provide the backbone and essential services of the well-functioning economy. This ensures the investors with stable cash flows. Secondly, the industry is monopolistic in nature with high barriers to entry. Thirdly, the inclusion of the asset class in the portfolio provides investors with substantial benefits from diversification. Not only is the infrastructure correlated with other asset classes to a very low level, diversification is also possible within the asset class by investments in the above-mentioned sub-sectors of the industry or in terms of geography. Fourthly, investors are incentivized to engage into this capital-intensive industry by regulations employed by governments, which ensure appropriate compensation for risks and return on investment through long-term contracts (often with a length of 10 to 15 years). Finally, private-owners can also benefit from indexation of the contracts in question with respect to the inflation or potentially other economic indicators, which is, however, disputed by several papers such as Rödel & Rothballer or Bird et al.

A reward does not come without risks and infrastructure sector is subject to several specific ones. Scholars also suggest that in terms of investments in infrastructure stocks, traditional asset pricing models are not applicable or capturing the risk exposure sufficiently and infrastructure-specific factors should be added to the traditional Fama-French three-factor model or others. Private-owners might suffer from the unavailability of a substantial amount of return data in comparison to other asset classes due to the novelty of the asset class. In case of opportunistic assets, the construction and demand uncertainty risks appear and the capital-intensity of the asset along with the regulatory processes upon acquisitions, the liquidity of such investment is also substantially reduced unless the investor participates in an open-ended fund. Altman divides the risks in infrastructure sector into endogenous and exogenous ones. Endogenous risks comprise the generally manageable risks such as performance or operating risk, whereas the endogenous risks are not inherent and comprise economic and social aspects, technological advancement risks and political and regulatory factors, which are of particular interest of ours.

Regulatory factors represent the double-edged sword in the infrastructure sector. On one hand, the close monitoring and regulations due to the monopolistic nature of the industry generally provide substantial certainty of future cash flows from the company though set rates that can be charged (e.g. given the regulatory asset base) and indexation setup in the contracts. Yet, on the other hand, the instability of the regulatory environment disincentivizes potential private owners or can have a substantial unfavorable impact both on the returns, as well as the economic development in the country that would occur, was the financial resources deployed.

Political factors are closely related to the regulatory ones and there are two major types of those: geopolitical and national. On the geopolitical level, political risk comprises sanctions or anti-trust proceedings, whereas on the national one, we perceive the political risk mainly as unfavorable enactments implementations. These can be in relation to taxes, unrestored concession or renationalization in case profits are perceived as higher than adequate. Infrastructure projects are often subject to the financing of up to 30 years which poses a severe uncertainty given the conventional election period of 4 or 5 years. The political and regulatory risk might be, however, mitigated to a certain level by an allocation of the financial resources to specific, more favorable political, legal or regulatory regions. However, several cases of large impacts due to the regulation changes could be witnessed in recent years including the Spanish retroactive tax implementation leading to bankruptcy of over 50% of solar power companies since 2008 or disincentivization of the investors by unprecedented elimination of Levy Exemption Certificates for renewable energy in the UK in 2015. On the international level, the ratification of the Kyoto Protocol obliging the countries in question with CO2 emissions cuts, thus inducing shifts in the energy industry consumption, is worth mentioning. From the regulator’s point of view, long-term investors may be perceived as more desired, given that short-term ones might be seeking a short-sighted profit maximization at the expense of the users of the service itself.

Recent development in the industry has been vastly determined by opening to privatization and deregulation inducing companies’ attempts to restructure themselves in order to face the changing competitive landscape. M&A activity thus becomes more important and capacity of capital to be deployed increases. Starting in the late 20th century in the U.S. and Western European Countries, it has been spreading to Central and Eastern European region. The World Bank’s Reforming Infrastructure policy research report identifies significant improvement in the performance of the sector in terms of quality, productivity and coverage thanks to the reforms introduced. Therefore, although not without its critics, private capital deployment into infrastructure can well serve as a tool to generate shared social benefits in the economy. Yet, reasonable and efficient regulation is crucial to achieving such a goal.