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ESG and infrastructure investing, two sides of the same coin

April 2019  |  SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2019 Issue


With the world facing intensifying challenges as environmental tensions grow and populations age and urbanise, the relationship between environmental, social and governance (ESG) and infrastructure investment will only strengthen.

Addressing these challenges will require a rebuilding of the physical fabric of the global economy. But many governments face challenging fiscal positions, and traditional sources of financing, such as bank lending, have become increasingly constrained.

This is where specialised and ESG-aware asset managers can step up to the plate.

Core to growth and prosperity

Infrastructure projects and companies are core to the growth and prosperity of economies, creating jobs and delivering essential services to the communities that they serve.

A study by the Economic Policy Institute in 2017 estimated that each $100 spent on infrastructure boosts private sector output by, on average, $17 in the long run.

Certain segments of the infrastructure sector can also play a key role in building a greener future and help combat climate change by supporting more energy efficient or environmentally friendly ways of producing energy.

These may include the investment into, and the development of, renewable energy projects, carbon-friendly transportation, such as electric vehicle charging stations, devices to measure and more efficiently use energy, and public transportation facilities that reduce carbon footprints.

Infra challenges

The world invests some $2.5 trillion a year in infrastructure, according to McKinsey Global Institute’s 2016 report ‘Bridging Global Infrastructure Gaps’. However, the world needs to invest an average of $3.3 trillion annually just to support currently expected rates of growth.

Unfortunately, infrastructure is not always fully and adequately served by the traditional avenue of bank finance. Recent developments in the Basel regulations, for example, place more onerous capital requirements on long-dated infrastructure loans, as well as for financing that is not investment grade quality. Banks are more hesitant to lend than before, resulting in lower volumes and less attractive financing.

Asset managers can look to fill the gap by balancing this asset class’ illiquid risk and offering clients access to the stable, long-dated cashflows that these infrastructure projects can provide.

Moreover, the long economic lives and relatively extensive debt horizons of these investments, coupled with their ‘buy and hold’ approach, only serve to emphasise the importance of these projects being run sustainably, and with good governance, for the long-term.

Furthermore, in an ideal scenario, these projects would also contribute to improving the sustainability profile of a region.

ESG philosophy

ESG is also a critical element for investors to consider when it comes to exercising their fiduciary duties. Any infrastructure business, whatever its size, needs to have healthy relationships with its stakeholders in order to thrive in the future. This includes employees, suppliers, customers, the environment, regulators and the communities in which they operate.

These stakeholders assume different degrees of importance according to the company’s specific business activities and strong oversight of these stakeholder relationships is in the best interests of the company, its investors and funders. In our view, integrating this ESG analysis into the investment process has the potential to generate stronger risk-adjusted performance in the long term.

Different ESG approaches

Facilitating this, sustainability analysis can be built into an investment process from both a bottom-up and top-down perspective. This can include a range of exclusions, identifying which infrastructure projects address the greatest unmet need, as well as quantitative and qualitative assessments.

In terms of exclusions, investments should be screened based on their business model or sector. For example, investments into coal-fired power plants or biomass power plants where biomass was supplied from non-sustainable sources and shale gas projects, should raise red flags.

In terms of quantitative assessment, examples of ESG criteria we analyse for prospective investments are the company’s health and safety policy, environmental risk and impact factors, quality of shareholders, governance practices and investment horizon. Having these factors embedded into an ESG investment scorecard means they form an integral part of the credit assessment and may ultimately determine whether investment in a given asset proceeds.

Before making an investment decision, infrastructure investors should also discuss any qualitative ESG considerations that they face today, as well as potential issues that they may encounter throughout the lifecycle of the investment.

These may include topics such as the implications of ageing workforces, job automation and increasing pressures on the use of fossil fuels.

We believe that both quantitative and qualitative ESG analysis should be monitored throughout the lifecycle of the investment and any developments reported to investors in a proactive manner.

ESG commitments

For infrastructure, the long term and illiquid nature of investing means ESG analysis is critical. This is why we believe ESG integration is a crucial component of the investment process, ensuring that the assets selected are of the highest possible quality, helping to ensure they meet infrastructure clients’ long-term investment needs.

 

Claire Smith is director of Alternatives at Schroders. She can be contacted on +44 (0)20 7658 6368 or by email: claire.smith@schroders.com.

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