Peter Hofbauer is head of infrastructure at Hermes Investment Management 

Institutional investors face unprecedented challenges in a rapidly evolving investment world. The principal agents of change are economic, environmental, political and societal. Some are imminent – the unwinding of monetary policy across the globe and the spectre of rising rates. Others are more profound – the challenge to create outcomes beyond performance by investing in assets that will have a positive impact on society. 

When harnessed effectively, infrastructure is a dynamic asset class that can help mitigate the spectrum of challenges faced by investors. As the contours of our investment world are re-shaped, investors must take a selective, long-lensed approach. Set against this backdrop, infrastructure investors should consider the following factors when navigating a path towards long-term sustainable performance. 

Assess rising real rates

After a decade of unconventional monetary policy, the rules of gravity are set to be re-applied to global financial markets. So should infrastructure asset managers be concerned about interest-rate increases, and if so, what should they be doing to manage this potential exposure? 

Many investors invest in infrastructure to match long-term, inflation-linked, liabilities. Consequently, a rise in long-term inflation and/or long-term interest rates can affect liabilities and deficits. When considered in isolation, the effect of higher discount factors resulting from rising interest rates is generally negative on both liability and asset valuations, and, in turn, often leads to reductions in deficits. 

However, seeking to mitigate potential exposure to rising interest rates only through the application of this macroeconomic assumption is oversimplified. Individual investment characteristics and approaches to portfolio construction can make a difference to investment performance in a rising real interest rate world.

The relationship between changes in interest rates and inflation, particularly the shape of the interest-rate curve, will be key to how investors are affected. Additionally, the underlying factors that result in a rise in real interest rates, such as strong global growth, will be essential in considering the implications of such as rise.

The long-term real cost of money is a key input into all investment decisions and, in turn, asset and liability valuations.

Assets after quantitative easing

Another point to consider is the approach adopted for the valuation of infrastructure assets in the current low-interest-rate environment. We obtain independent valuations, currently on a semi-annual basis. The valuers that prepare these valuations recognise the artificially low interests created by quantitative easing (QE) and incorporate a specific alpha in the discount rate applied to forecast cash flows, thereby partially normalising the valuation discount rate to levels more reflective of a non-QE interest-rate environment. 

As such, we expect this QE specific alpha to be unwound as real interest rates change to reflect a non-QE environment. This will assist in counteracting the effect of increases to the risk-free rates within the valuation discount rate.

Additionally, the cash-flow forecasting models used in our valuations have incorporated the view that interest rates will rise in the future. While the forecasts used might not match the actual timing or magnitude of interest-rate rises, we assume further tightening is probable and it is prudent to partially mitigate the effects of future real interest-rate increases.

Harnessing ESG

Sustainable investing has two principal definitions: first, selecting investments on the basis of their environmental, social and governance (ESG) attributes, and second, truly long-term investing, aligned with the dictionary definition: ‘Able to be maintained or kept going; a system that maintains its own viability… for continual reuse.’

Apply either of these definitions to the infrastructure asset class and it is a fairly logical conclusion that it is an inherently sustainable asset class. It is also a relevant investment choice for pension schemes looking to match long-term liabilities in a responsible, purposeful fashion.

Infrastructure assets have a social purpose to provide public services and are often intergenerational, with long useful lives. This makes them attractive for pension schemes on two counts: the well-understood, lifetime-long investment horizons; and the provision of appropriate financial returns with the potential to influence the quality of life for pensioners, which is a growing area of focus.

Investors in this asset class must also consider the context of its unique position: it sits at the intersection between owners (such as institutional investors), regulators, policymakers, shareholders, long-term partners, local governments and communities, and requires a high level of engagement between stakeholders.

For example, infrastructure owners must engage with policymakers, regulators and politicians to create sensible policies that are predictable, transparent and certain. Businesses that own and operate infrastructure assets must engage with their customers or end-users to uphold responsibility obligations and ensure that they are fulfilling their role as providers of public services.

Future-proof portfolios

Recognising future trends is an important part of ensuring an asset’s long-term sustainability and profitability. For example, reducing carbon emissions is a societal trend, with the longevity of an asset now inextricably linked to its environmental credentials. Through due diligence before acquisition and ongoing engagement with our infrastructure assets, we have been able to gain a good understanding of our assets, and assess their carbon risks and opportunities as well as the strategies in place to address and mitigate them.

Consideration of the potential implications of disruptive technology on existing assets and societal behaviours more generally is an increasingly important area.

Build robust governance

For infrastructure assets, robust governance is paramount in enabling effective stewardship of often critical infrastructure assets for the long term. 

Strengthening governance is an important focus in this asset class and we have been an active voice engaging with the UK government and sector regulators to advocate establishing an enhanced corporate governance code specifically for essential-service infrastructure assets.

The changing investment landscape means that investors must navigate their way through unique challenges. With the right approach, infrastructure is an asset class that can help investors overcome these challenges and help future-proof portfolios for long-term returns.