The importance of integrating environmental, social and governance (ESG) considerations when investing in real assets such as infrastructure should come as no surprise. The distinct characteristics of infrastructure — the essential services it provides to society, its predictable long-duration cash flows and inflation-linked returns, its low sensitivity to economic cycles — also suggest this integration will have distinct areas of focus.
While many investors rely exclusively on third-party external providers for ESG insight and analysis, we believe leveraging in-depth knowledge of the asset class is the best way to fully capture sustainability in the investment process. We follow a three-pillar framework when analyzing sustainability for infrastructure assets that is an extension of the core characteristics of the asset class:
- Valuation: To understand both positive and negative risks from ESG factors, it is necessary to model cash flow impacts of sustainability and perform sensitivity analysis.
- Risk pricing or required return adjustment: ESG factors that cannot be captured in cash flows may be captured through an adjustment to a cost of equity. Focusing on the cost of equity enables a more robust global comparison within subsectors and captures improvements or degradations in a company’s ESG profile going forward.
- Engagement or active management: Managers of infrastructure portfolios should actively engage not only with company management but also with regulators, policymakers and other key stakeholders. Monitoring ESG controversies and active proxy voting are also key to influencing change.
Here we offer case studies in how ESG factors might influence infrastructure positioning in two different sectors: North American pipelines and U.K. water.
North American Pipelines: Pressure Will Lead to Differentiation
As the world transitions from higher-carbon-emitting forms of energy generation to more renewable-based generation in an attempt to control climate change, some estimates would have natural gas, which has lower carbon emissions than coal and oil, serving as a bridge fuel for several decades. The market, however, is starting to price in a much faster transition to renewables as renewable capacity growth has consistently surprised on the upside.
From an allocation perspective, increasing exposure to renewables allows a manager to benefit from this multidecade thematic. When considering North American midstream and hydrocarbon infrastructure, rather than assuming hydrocarbon infrastructure will be a perpetual asset, we have made conservative assumptions that more effectively reflect a depreciating asset base over time, as renewables gain market share at the expense of hydrocarbons.
However, it is still possible to discover relative value in the North American pipeline space, where hydrocarbon infrastructure will still be used, albeit at a lesser rate, for decades to come. Those asset owners running trunk or mainline pipelines (transmission pipelines) will likely fare better in our view, as they are difficult to replicate, and are the key conduits that connect the supply to demand centers. Those that are running some of the smaller lateral pipelines and systems (gathering and processing pipelines) face a higher risk of disruption as they have a greater sensitivity to oil and gas production volumes.
U.K. Water: Privatization and Regulation So Far a Good Partnership
The U.K. water sector offers an interesting counter-example to North American pipelines. In the U.K., the water regulator, The Water Services Regulation Authority or Ofwat, requires water companies to meet targets of environmental sustainability and service commitments, to which it attaches incentives and penalties. It also sets principles for board leadership, transparency and governance for the sector to ensure board decisions are aligned with customer and stakeholder needs. On the social side, Ofwat assesses the quality of U.K. water companies’ engagement with its customers and their satisfaction, as well as utilities’ relationships with their communities. This regulatory assessment will have an impact on the companies’ investment plans, cost of capital and forward cash flows. Due to Ofwat’s efficiency challenges, customer bills have fallen. Customer satisfaction levels for the value of water and sewerage service have been high: for water, 91% of customers are satisfied with what is provided by companies, while 76% are satisfied it is “value for money.”
Over the longer term, we believe there is significant room for further growth in U.K. water assets. The sector continues to deploy capital to reduce leaking pipes, sewer flooding, supply interruptions and pollution incidents, while performing other necessary maintenance. Importantly, Ofwat continues to incentivize water companies to deliver long-term resilience against climate change, reduce environmental degradation and improve water quality.
Sustainability factors are therefore deeply embedded into U.K. water regulation. Better-run companies with superior governance will benefit from regulation and legislation, earning incentives for delivering their strong environmental and customer engagement commitments as well as growing their underlying asset base.
ESG Analysis: An Integral Part of Any Infrastructure Portfolio
It is imperative to incorporate an ESG and sustainability framework into any process that analyzes infrastructure assets. Such a framework should consider how ESG factors affect cash flows and the required return of an infrastructure asset and should involve a process for engagement with several stakeholders on material sustainability issues. As evidenced when applied to the North American pipeline and U.K. water sectors, such an approach enables active managers of infrastructure portfolios to identify compelling valuation discrepancies among assets.
 For sewerage, 86% are satisfied with what is provided by companies, while 77% are satisfied it is “value for money.” CCW Water Matters Annual Tracking Survey (6,310 total customers surveyed). Source: CCW; England and Wales, April 2019 to March 2020.