Mark McComiskey: Infrastructure’s most important role
As published in the November 2019 edition of Infrastructure Investor
The asset class has many unique attributes, and none more so than its centrality to the wellbeing of our planet and the concept of sustainable investing, writes Mark McComiskey of AVAIO
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The construction and operation of infra- structure account for roughly 60 percent of all carbon emissions. The technological lock-in and inertia of long-lived infrastructure mean that what we build now will determine our climate future. The flip side of infrastructure’s outsized impact on climate change, often under-appreciated, is its unique vulnerability to the consequences of climate change. Long-lived, high-cost, spatially fixed assets are highly vulnerable to the physical, social and regulatory impacts of climate change.
All investors in infrastructure, particularly those, like AVAIO, specialising in the creation of new core infrastructure assets, must focus on the sustainability of the infra- structure in which they invest.
As with many areas of ESG, precise conversations about ‘sustainable infrastructure’ are hampered by the lack of a commonly accepted definition. Definitions matter, as they set the terms of the discussion and lay the foundation for translating concepts into actions. Overly broad definitions are challenging to operationalise, while unduly narrow definitions can lack materiality.
Definitions of ‘sustainable infrastructure’ run the full gamut, from the narrow, more literal ‘green infrastructure’, for example, natural areas that provide water runoff control, to the expansive “an approach to infrastructure based on global and domestic sustainable development goals and durability that accounts for social, financial, political, institutional and public health issues as well as economic and environmental concerns”.
Curiously, many definitions of sustainable infrastructure focus on the impact infrastructure has on the environment while failing to account for the impact the evolving environment will have on the infrastructure. This is a significant oversight: given its role in providing essential services to society, infrastructure must be designed physically and structured economically to be resilient to the effects of climate change. Otherwise it is not, in any sense of the word that matters, sustainable.
For this discussion, our definition focuses on environmental considerations. Infrastructure is ‘sustainable’ if, throughout its lifecycle, it supports the sustainable and efficient use of natural resources, minimises impact on the natural environment, limits all types of pollution with best feasible technology and practices, is resilient to the reasonably forecastable impacts of climate change, contributes to a low-carbon society, and provides an economic return sufficient to attract capital to build and maintain the asset throughout its lifecycle.
This definition is not intended to disregard the importance of social, institutional, political and health issues in the development of new infrastructure. There is sometimes a temptation to dismiss these areas as ‘softer’ or more qualitative. This is a mistake. At a societal level, a failure to systematically address these factors will undermine the social consensus needed to create new infrastructure and to make it sustainable.
Criticality of sustainability
So why is a focus on sustainable infrastructure critical? At AVAIO, our answer to this question is informed by our status as global citizens and as investment managers. But before explanations, some facts.
The reality of anthropomorphic climate change is a fact. On this there is firm scientific consensus.
The quantity of greenhouse gases already introduced into the atmosphere, even if we were to cease all such emissions today, has a warming inertia that means significant physical impacts from climate change are unavoidable. Even if the world manages its carbon budget to the 2-degree scenario, which we are not on track to do, the impacts of climate change will be still more significant. On this there is firm scientific consensus.
While precisely forecasting the specific nature, locale and timing of the impacts is beyond current capabilities, it is clear that the environmental, economic and social impacts of climate change will be in the aggregate negative, material and widespread, and will manifest both in greater short-term event volatility (hurricanes, for example) and in longer-term structural changes (such as rising sea levels and decreased agricultural productivity in some regions). Again, on this there is firm scientific consensus.
The motivation to focus on sustainable infrastructure is therefore two-fold. First, the ethical. As citizens of the world, armed with an understanding of, and, importantly, sufficient options to address climate change, it is incumbent on all of us to do everything we can to mitigate this crisis. Moreover, those of us fortunate enough to be able to direct the flows of infrastructure capital are in a unique position to be impactful. With projections of as much as $90 trillion in spending on new infrastructure in just the next 15 years, and with infrastructure construction and operation accounting for as much as 60 percent of global carbon emissions, for the world to have any chance of meeting the 2-degree targets, the vast majority of this infrastructure will need to be ‘sustainable’. As agents in the industry responsible for the majority of global greenhouse gas emissions, we have the responsibility and the capacity to act through a focus on sustainable infrastructure.
This obligation to act is frequently challenged in some venues. Many in the US remain rooted in the belief that the only fiduciary duty of investment managers – and corporate management and boards – is to maximise the economic return on their assets. This is a false dichotomy, especially for those investing in long-lived infrastructure. Leaving aside for a moment the false paradigm of the “inherent” environment/ return trade off, it is worth noting that outside of the US much of the developed world is moving to a new understanding of fiduciary duty, one that requires an active consideration of ESG factors. Canada, the UK and Germany are moving to codify this. In Sweden, the national pension funds are required to become ‘exemplary’ in the field of sustainable investment. The Dutch pension fund ABP is fully integrating ESG across all asset classes. There is an increasing consensus that those who can act, must act.
Investors are forward looking
The second motivation is practical. As investment managers, even the narrowest conception of our duty is to try to earn the best risk-adjusted returns possible for our clients. In this context, we must all be cognisant that the consequences of climate change, while uncertain as to precise timing and extent, are certain to occur and to be material. As the impacts become more frequent, severe and widespread, there will be an inevitable societal response, with shifts in people, capital, industry, and increasingly intense regulatory responses intended to decarbonise society. There will be real, significant impacts on infrastructure, both from the physical effects of climate change and from the changes in societal behaviours and regulation. These climate risks must be considered at least as carefully as more traditional risks, such as commodity prices, volumes, interest rates and taxes.
As these trends become more pronounced, they will be increasingly factored into capital flows and valuations. This is not a theoretical observation. A recent study has shown that sea-level rise has cost $14.1 billion through the reduction of home values on the east coast of the United States just since 2005. A recent NBER working paper found that private real estate lenders are increasingly shifting mortgages on properties in areas vulnerable to climate change to Fannie Mae and Freddie Mac, government sponsored enterprises. The Bank of England now requires financial institutions to run climate-impact scenarios in their stress tests.
Public market investors and commercial lenders often have much shorter time horizons and the ability to quickly shift capital in response to emerging risks. Infrastructure investors are the converse: their investments are often in illiquid assets that are inherently long-lived, static and high cost. As such, infrastructure investors are more exposed to the potential return impacts of climate change and so need to be on the leading edge of incorporating a clear-eyed view of the risks and opportunities into their underwriting and asset management programs. A focus on the sustainability of infrastructure is thus inherent to an attempt to achieve the best risk-adjusted returns for clients.
Operationalising sustainability
How to operationalise a focus on sustainability in an infrastructure investment organisation is beyond the scope of a brief article. Properly done, it requires an integration of environmental considerations and risks into all stages of the investment life cycle: investment selection, underwriting analysis, asset development and construction, and asset management.
At a high level, many organisations have focused on investment selection, adopting a variety of approaches: exclusionary screening (avoiding industries deemed objectionable or business/countries that violate a set of norms); positive screening (selecting businesses/assets with a focus on sustainability); and sustainability-themed investing (focusing on renewables, clean water, energy efficiency, etc.)
Less common is the integration of sustainability risks into the underwriting process in a quantitative manner. This is vital, especially for those focused on the creation of new core infrastructure.
There is no single, standardised approach to this. When underwriting a new project, we engage experts to perform a physical risk analysis of the asset under various climate scenarios for time periods ranging from five to 20 years forward. In the case of a coastal desalination plant, this might forecast items such as air temperatures, water temperatures and acidity, sea-levels and severe-weather frequency. As with all forecasts (GDP, interest rate, traffic volume), there are uncertainties, but when well-informed they provide a basis for quantitative analysis.
These forecasts are used in multiple ways. They are considered in the design of the infrastructure, to ensure it is sufficiently resilient to operate effectively in a wide range of climate scenarios. They are considered in the negotiation of offtake contracts, where we seek to pass through increases in operating costs that may arise as a result of climate change. And they are integrated into our underwriting, where we run scenarios that reflect the impacts on the economic performance and exit valuations that may arise from climate change. Assets with higher negative climate impacts show lower risk-adjusted returns, and so must have higher unrisked returns to meet our hurdle rates. Factoring this kind of analysis into underwriting does not imply lower returns; on the contrary it is a key to achieving better returns.
Infrastructure is unavoidably exposed to the impacts of climate change. Many investors in the sector have long investment horizons and hold illiquid positions. As climate change impacts increase in frequency and severity, and as the investment community begins to extrapolate these trends and factor them into valuations, infrastructure investors will face real consequences in their portfolios. Prudent infrastructure investors need to act now to factor sustainability analysis and management into all stages of their investment cycle, or risk both disappointing returns and a badly compromised planet.