Are pension funds underestimating their exposure to political risk when investing in infrastructure? Shayla Walmsley reports
Pension funds are used to mitigating and managing financial, operational and counterparty risk. When it comes to investing in infrastructure, they might do well to include in their due diligence their growing vulnerability to political risk.
Energy, power and forestry companies are exposed - and most have come up with future-oriented studies of risks. In theory, for example, companies operating anywhere in the world could be prosecuted via the US Alien Tort Claims Act. The letter of international human rights law covers not only torture and labour abuses but also, potentially, environmental degradation, displacement of communities and requisition of natural resources.
But are investors similarly prepared? "When investors look at country risk in terms of social responsibility, they look at ESG [environmental social governance] risk but forget political risk. Or they look at financial and political risk but forget geopolitical risk," says Alyson Warhurst, CEO of risk advisory firm Maplecroft.
Political risks might include not only those from governments and state agencies, including armies, but risks from campaigning bodies that in continental Europe often refer to themselves - somewhat euphemistically - as civil society organisations. The fact that the latter have no democratic mandate is beside the point. Arguably, according to some analysts, the risk of government expropriation is more easily managed because it is more easily understood: the calculation is one of risk and reward.
Add to these, secondary-effect or indirect risks. Although Canadian tar sands have generated much interest as an environmental cause célèbre - not least in the UK because of a campaign by Fair Pensions against investing in them - Canadian pension fund manager CPPIB risks exposure via its acquisition of gas storage assets, even if it were not for its 17.5% shareholding in tar sands developer Laricina Energy.
Canadian pension funds, like their US counterparts, are more likely to be exposed simply because they are more likely to invest their significant infrastructure allocations directly. According to private equity data firm Preqin, Canadian pension fund infrastructure investors have median assets under management of $5.5bn (€3.95bn), and allocate, on average, just over 5% of their overall portfolios to infrastructure.
Forestry is a pertinent example for pension schemes, because US pension funds have long invested in it as a form of quasi-infrastructure. Some, like CalPERS, have included it with real estate and infrastructure within a separate ‘real assets' asset class.
Where North American pension funds have led, European ones have followed. Danish pension scheme PKA recently invested DKK250m (€33.5m) in a private equity fund dedicated to agriculture, specifically in sub-Saharan Africa because of low land prices.
These are investors that have carried out due diligence and satisfied themselves as to their investments' ESG credentials. "It's fair to say the infrastructure business has more public-sector shareholders and more engagement than other real estate or private equity sectors," says Neil King, infrastructure partner at 3i.
Yet a report published recently by UK-based Oxfam criticised HSBC's $10m investment in UK-based New Forests Company, saying that the bank, which has a 20% shareholding and a seat on the board, was overly reliant on the independent audit of external bodies.
HSBC spokesman Brendan McNamara points to the sector-specific forestry policy the bank has had in place since 2004 and the fact that it made investment in the company conditional on certification from the Forest Stewardship Council (FSC). Oxfam denies none of that - in fact, for Oxfam, that is the problem.
"We've published a huge amount of information on reputation as well as operational risk," says McNamara, pointing to specific policies for sectors, including extractives and defence. "We take risk seriously - whether it's currency risk, operational risk or reputational risk."
Does greater exposure result in greater risk? "It's an interesting question," he says. "Let's just say that it's important for higher-risk industries to have specific policies in place."
Warhurst's point is that while one sector or locale could expose a pension fund to significant risk, the investor will not necessarily be exposed to risks in the rest of the economy or country.
"Investors continue to look at it risk by risk, country by country. But they're missing two things. The first is that risks conflate. They are cumulative and can exacerbate each other. The second is that country-level risk doesn't necessarily reflect local risks at one end and geopolitical risks at the other," she says.
It is a point well taken by 3i's King. His firm manages two infrastructure vehicles: one is a listed infrastructure fund that invests in mature European assets, the other is a fund dedicated to Indian infrastructure - power, toll roads, ports and airports - but which does not invest in water assets.
He says that although there are a number of similarities between investing in infrastructure in Europe and India, including high values and long-term predicted cash flows, investing in India poses different risks, notably political risk and macro-inflation, exchange rate and interest rate risk. "It's more volatile," he says. "There is more political risk in infrastructure than in any other sector. It is manageable but it varies sector-by-sector and country-by-country."
3i's four investable infrastructure sectors in India all have government support. "I suspect the water sector has a more competitive environment, it's more politically fraught, and there isn't a private sector investment opportunity in any case," says King.
In European infrastructure markets, political risk has been associated with the occasional volte face from an election-mode government: Spain's abrupt removal of solar subsidies, or Germany's renunciation of nuclear energy. But the most acute political risks are a function of the need to provide essential services to the public. If operators fail to do a good job, there are immediate repercussions from regulators, governments and providers of concessions.
King cites the example of the recent acquisition of Anglian Water in the UK which, by definition, provided an essential service. If the investor does not do a good job, it accelerates up the political ladder.
"About-turns don't happen that often," he says. "Governments don't want investors to withdraw capital - at least sensible governments don't. They draw a balance between political expediency and good relationships with the investor community."
There are two more considerations for pension funds when looking at political risk, and neither is specific to emerging markets. First, there is no such thing as a perennial political risk, even if Russia seems determined to prove otherwise. As Warhurst points out, the dimension often lost in risk analyses is time. "If you analyse the risk of short-term and long-term energy security, you get different results - or in other cases there may be a broad relationship between short-term dynamic risks and longer-term structural risks," she says. "You can't look at risk alone. You have to have a broader understanding of risks over time."
A report published by Lloyds earlier this year on the link between global recession and political risk claimed that although recession would make political risk more acute, for example, the risk would significantly outlast the recession.
The other consideration is that what starts as a whisper ends as a shout - and the fact that a pension fund investor, not a private equity firm, is the target is unlikely to blunt the attack.