Aging infrastructure driving opportunities worldwide, Natixis Global AM says
Three Natixis specialists discuss a growing need for modern infrastructure, projects in the pipeline and potential opportunities for investors.
Sinkholes swallowing autos, collapsing bridges and water main breaks flooding busy streets have become all too common in the US – pointing to a huge need to upgrade aging infrastructure.
Certainly the US isn’t the only place with inadequate infrastructure. In fact, a statistic by the World Health Organisation estimates 780 million people lack access to safe drinking water.
To address mounting modernisation needs, governments and investors around the globe are pumping large amounts of money into infrastructure projects.
For example, China aims to spend $6trn on infrastructure over the next decade as part of its urbanisation plan; the UK pledged to update Britain’s infrastructure to achieve sustainable growth, which is expected to lead to private and public investments worth about $375bn up to 2030; Brazil’s massive five-year infrastructure overhaul in preparation for the World Cup and the 2016 Olympics is estimated around $500bn; and in the US a proposal for $302 bn to improve transportation and infrastructure over four years is pending.
A global equity analyst, a European renewable energy infrastructure specialist and a US municipal bonds expert discuss a growing need for modern infrastructure, projects in the pipeline and potential opportunities for investors.
Stephen McCabe, global equity analyst at Loomis, Sayles & Company, highlights that the global demand for new and improved infrastructure is creating an opportunity for many companies globally. “Between 2013 and 2017, total infrastructure investment is estimated at $7.5trn, with 2017 spending levels 50% higher than the $1.2trn spent in 2012.
A significant portion of the capital spent will likely be weighted toward water treatment facilities, power generation and transportation infrastructure,” said McCabe.
The United States, China, the Middle East and India are the areas where the majority of these projects are taking place. President Obama recently proposed a $302bn transportation bill to upgrade the nation’s crumbling highway infrastructure.
As part of India’s current 12th Five-Year investment plan, the government is targeting $1trn in infrastructure investments with a large percentage of this capital spent on upgrading its transportation network.
In the Middle East, $80bn of investment is planned for its electricity infrastructure and an additional $185bn worth of projects are expected to build out its transportation systems.
China’s reliance on coal and growing urban pollution have led to unsafe air conditions in most of its provinces, creating new potential investment opportunities in the industrials sector.
“The Chinese government invested $49 billion on environmental protection in 2013, a 14% increase year over year, and expects a similar level of growth this year to address the country’s pollution issues,” said McCabe.
McCabe believes Honeywell and 3M are two companies that are well-positioned to benefit from the growth in infrastructure spending globally. “According to Chinese government officials, newly constructed buildings will be distinguished by their indoor air quality and Honeywell’s Air Purifying System has won the praise of Chinese developers,” said McCabe.
Of course, McCabe’s views regarding these companies are for informational purposes only and should not be relied upon as a recommendation to purchase any securities.
In the US, refineries are extracting more high-value transportation fuels from the heaviest crudes by utilising Honeywell’s new technology. “The technology can take a barrel of oil and produce 4% more than what is currently being extracted in our refineries,” said McCabe.
Raphaël Lance, head of renewable energies at Mirova points out that over the past several years, renewable energy infrastructure has grown into a major sector in Europe.
Lance believes a game changer for the sector has been the 20% binding commitment that European Union (EU) member states have made in terms of how much renewable energy should be in the electricity production mix by 2020 to fight climate change (to be increased to 27% for 2030 according to the EU Commission proposal published in January 2014).
Such mandates have helped to multiply investment opportunities in renewable energy infrastructures across Europe.
“The resulting support schemes implemented by EU countries to push renewable energy have brought down the costs of photovoltaic (PV) and wind projects through economies of scale, leading to a virtuous decrease in the required government subsidies. In an increasing number of areas, projects are even viable now without any subsidies,” said Lance.
Overall, Lance believes investors in renewable energy projects may now end up with an attractive risk/reward combination in a real asset that is an alternative to real estate, with limited correlation to other types of alternative investments.
European clean energy project finance activity totaled $35.2bn in 2013, a 4% increase on the $33.7bn invested in 2012, according to Clean Energy Pipeline. This marginal increase in finance activity was partially attributed to a 9% rise in onshore wind project finance, which reached $12.1bn.
This was mostly driven by sharp increases in Sweden (+48%) and in France (+158%), alongside stable volumes of investment in Europe’s two largest onshore wind markets, the UK and Germany. “In 2014, we see France and Sweden continuing to be strong markets for onshore wind,” said Lance.
On the other hand, solar project finance declined 32% in 2013 to $7.4bn, its lowest level since 2010. This decline is due to historically low levels of investment in Germany and Italy, Europe’s two largest solar PV markets by installed capacity.
“German solar project finance more than halved year over year as a result of sweeping cuts to Germany’s feed-in tariffs (FiT) in 2012 and 2013. Italy has also significantly cut its FiT to match the sharp decrease in project costs and has specifically sought to halt development of large utility-scale projects,” said Lance. In 2014, Lance expects solar market growth to mostly come from residential units.
Lance believes some of the more attractive opportunities in the renewable energy sector may be found by partnering with local developers/entrepreneurs and leading industrial groups, such as the global energy group GDF Suez or Swedish forestry company Holmen, to build new renewable energy capacities from the ground up in Europe.
“Being involved in projects from the start of the construction has advantages. For example, an investor has the potential to capture a construction risk premium (higher return than on operating assets) that can be mitigated with contractual guarantees from suppliers and a strong alignment of interest with the initial developer that tends to keep a significant shareholding in a project.
“The resulting risk position, compared to the return achieved, has the potential to be very satisfactory,” said Lance.
He is currently finding the most exciting projects in France and in the Nordics due to a number of favorable conditions being met: high insulation/sun in the South of France, strong wind resources in both areas, solid electrical grid, projects close to consumption centers, potential upside linked to the current low level of local electricity prices, political pressure to prohibit new nuclear capacity, and unsustainable low price of coal.
“In addition to focusing on the domestic market (France), Sweden has been interesting for the past two years. In fact, I think one of the more attractive projects in recent times involves a wind farm in Jadraas, Sweden. Not only is it one of the largest onshore wind farms in Northern Europe, but its project financing structure was quite innovative,” said Lance.
In France, he points out that the development of new onshore wind projects was limited in 2012 and to some extent in 2013 following a legal claim against the French feed-in tariff.
“We believe the topic should be completely dealt with in 2014, resulting in a strong momentum in that market,” said Lance. Lance believes solar in France and wind in the Nordics are also expected to be growing faster than the overall renewable market.
James Grabovac, senior portfolio manager at McDonnell Investment Management highlights that it is commonly accepted that strong and well-maintained infrastructure is essential to a nation’s prosperity and long-term sustainable growth.
To illustrate just how much the United States’ infrastructure has deteriorated over the past few decades, he refers to a 2013 report by the American Society of Civil Engineers (ASCE) that assigned a cumulative grade of D+ to America’s infrastructure.
“This grade reflects decades of delayed maintenance and a lack of investment across the infrastructure spectrum, leading to near failing grades for most categories since 1998,” said Grabovac.
The grades for certain important categories include D for water and wastewater, D for roads and D+ for energy. The ASCE estimates that the amount of investment necessary to achieve a grade of B by 2020 is $3.6 trn, and further estimates that there is a funding gap of approximately $1.6 trn today.
“It is worth noting, if only as coincidence, that the $3.6trn price tag estimated by the ASCE is nearly equal to the entire size of the current municipal bond market at $3.7trn ,” said Grabovac.
Integral to modernising the nation’s infrastructure is the need to generate long-term funding sources. State, local and federal budget constraints caused by the Great Recession have made funding of much-needed infrastructure projects difficult, a problem that is exacerbated by the U.S.’s slow economic recovery.
Going forward, Grabovac believes private investment in infrastructure projects will likely be a key component to meeting funding needs, as will projects supported by federal grants, tolls, gas taxes and general obligation bonds. Also, funding via the municipal bond market will most likely be substantial.
If historical trends project forward, municipal investors will continue to provide much of the capital pool required for infrastructure spending in the coming years. “The municipal market has traditionally been an efficient and effective source of funding for capital expenditures on infrastructure projects in the US However, fiscal pressures following the Great Recession resulted in the temporary delay of needed investment.
“But a growing economy will require a renewed effort to invest in projects necessary to provide for the maintenance of existing quality of life standards and to help harness the economic innovations and technological advancements that future generations will create,” said Grabovac.
As the majority of infrastructure investment in the US today is provided at the state and local levels, the Great Recession has created significant funding challenges. Current financing trends highlight several key challenges facing the transportation, power, and water & sewer sectors.
Collectively, these sectors compose more than 30% of the municipal market currently outstanding (as represented by the Barclays Municipal Bond Index) and can be expected to represent an important source of opportunity for municipal investors going forward.
A critical issue with regard to federal spending on surface transportation projects (highways and mass transit) has been the imbalance in the receipts and outlays of the Federal Highway Trust Fund (HTF).
In the latest fiscal year, tax receipts totaled $36bn while authorised spending totaled $51bn. The shortfall was funded with a transfer from the Treasury’s General Fund and by a drawdown in the Federal HTF’s balance.
Grants from the Federal HTF flow mainly in to state and local transportation authorities – which in turn utilise the pledge to help secure capital project funding through issuance in the municipal bond market.
Grabovac warns that current authorisation for federal spending on surface transportation projects expires September 30, 2014. Without some combination of growth in HTF tax receipts and continued transfers from the general fund, authorisation of spending on new projects could drop by nearly 100% in 2015.
Energy needs in the US will require extensive infrastructure repair and expansion in order to improve both the delivery and the reliability of power.
A “smart grid” is often touted as the solution to the aging electric grid in the US, which would deliver two-way communication that would provide feedback on use and interruptions in real time, and allow for “self-healing” capabilities to automatically work around outages.
The expansion of transmission capacity will also be vital. “More transmission lines are also necessary to access renewable power, such as wind and solar, as renewable resources are often concentrated in rural areas far from high demand areas,” said Grabovac.
The likely retirement of older coal plants will only intensify the need to tap these renewable resources.
Accomplishing these objectives, Grabovac believes, will require cooperation and forward thinking on the part of policymakers and regulators, as many areas of the existing grid transcend state boundaries and are subject to a complex mix of federal and state regulation.
“Not only are the rules and regulations cumbersome, but costs are high for these projects, and the ability of public and private entities to fund extensive upgrades can be financially and politically challenging,” said Grabovac.
He points to the use of P3 financing as an innovative approach to help address some investment challenges. P3 financing (“PPP” or Public-Private Partnership) involves a contract between a public sector authority and a private party. While P3 financing is relatively new in the United States, there are now more than 30 states with some level of P3 legislation.
“The use of P3 financing can reduce the cost and length of time it takes to complete a project, which, in the end, saves taxpayers money. One of the biggest benefits of P3 financing is the ability to share in the risk of projects, which entices private investment,” said Grabovac.
The majority of P3 financings have been in the transportation sector. Over the last five years several large projects have been financed using the P3 structure, including the I-595 Corridor Roadway in Florida, the Denver Eagle P3 Rail Corridor, and the Presidio Parkway and Long Beach Courthouse in California.
Overall, Grabovac expects capital investment in infrastructure maintenance and improvements to be an important source of potential opportunities in the municipal bond market for both individual and institutional investors over the medium term.