If not hedged properly, inflation can erode portfolio returns in real terms. This can be damaging for investments making regular payments that need to match inflation. Infrastructure investments have long been considered a source of reliable inflation protection on account of their delivering inflation-linked returns that typically exceed the consumer price index.
In reality, the level of inflation protection offered by infrastructure varies across the asset class. In order to build the desired level of inflation hedging, investors need to understand three key variables affecting the level of protection offered: the type of asset, the level of regulatory risk and the financial structure of the investment opportunity.
Regulated assets typically offer the most direct and immediate link with inflation. Assets subject to regulatory frameworks, such as energy and utilities, usually have a direct inflation link built into their remuneration structure.
In the UK, for example, the Water Services Regulation Authority (Ofwat) explicitly links revenues generated by assets to the retail price index. Similarly, longer-term investments allow for pricing adjustments linked with inflation under the contract terms, thus providing an explicit hedge.
Unregulated assets, such as transport hubs and networks, also offer a less explicit degree of inflation protection. Where assets have a strong strategic position in the market and limited competition, they often have the required pricing power to implement price rises to offset inflation – railway operators in the UK are a prime example of this.
In addition, concessions are often built into infrastructure investments to allow for the passing on of price increases to consumers. However, where such assets are not in a position of sufficient strength, price increases under concession structures may drive users elsewhere, exposing investors to the downsides of traffic risk.
The assets that provide the least protection are those that have fixed tariffs or contracts with a defined price or revenue-escalation rate. These assets have the potential to see revenues reduced in the event of rising inflation.
Whether an asset provides a strong and explicit inflation hedge built into their remuneration formula, or an implicit, lower level of protection, investor returns are always exposed to risks associated with the regulatory regime governing the asset.
The independence and experience of the regulator, the complexity of its structure, the political and economic environment, and the affordability of tariff structures in a given country all have a bearing on regulatory risk, which investors should consider at length.
Importantly, regulatory risk can sometimes be hard to plan and price for. For example, in January 2012, a growing deficit in the Spanish electricity system, exacerbated by the onset of the financial crisis, led the regulator for renewable energy to impose a series of retroactive rule changes on the industry. The negative impact this had on tariffs substantially hit the revenue of renewable assets, which was passed on to investors.
Unanticipated regulatory changes can dramatically change the risk-return profile of assets, leaving investors with reduced downside protection. For infrastructure assets, such changes can significantly alter the level of inflation protection offered.
In addition, investors should be familiar with regulatory lag – the time between the investment commitment and revenues that benefit from regulatory assistance – which also has an impact on the level and timing of inflation protection delivered to investors.
Finally, the financial structure of infrastructure investments has a direct effect on obtaining inflation protection. An asset’s performance is influenced by the inflation sensitivity of its operating costs and capital structure.
For instance, whether operating costs are contracted at a fixed price or linked to inflation will result in different inflation exposures. Similarly, contracts may allow the passing on of rising costs to ‘off-takers’ (the project-finance term for contractual buyers of production), which further reduces investor exposure to unanticipated inflationary cost increases.
Leverage on an asset also affects investor returns by increasing the real value of nominal debt as inflation increases. However, fixed-rate funding can protect a large part of an asset’s cost structure in an inflationary environment. Investors should consider that a high degree of financial leverage may expose them to higher debt costs and refinancing risks.
Moreover, different revenue structures will affect the inflation hedging properties of an asset, as there is typically a trade-off between protection and returns.
Regulated assets, where there is a direct inflation link, will tend to provide modest returns. For instance, the Regulated Asset Base model used by regulators in the UK and the Scottish Non-Profit Distributing PPP model, place a cap on private-sector returns.
Furthermore, assets that provide a direct inflation link are scarce compared with the high demand of long-term investors, and competition reduces returns. In comparison, investors in unregulated assets and assets with fixed tariffs and contracts generally expect the lower level of inflation protection to be rewarded with higher returns.
Depending on the nature of assets, the level of regulatory risk and the financial structure of assets, investors will be looking at varying levels of inflation protection from infrastructure in their portfolios.
When considering an inflation-hedging allocation to infrastructure, investors should look at all the components of the asset and how the risk and return aligns with their requirements.
Evidence in the market shows that this is something that investors are increasingly aware of as they turn in greater numbers to infrastructure as a source of both short and long-term inflation protection.