Inflation figures are rising steadily. In the eurozone, inflation recently climbed to 7.5 percent. Investors can partially hedge against inflation through infrastructure investments.
In times of rising inflation, companies that own or operate infrastructure are an attractive investment option. Investments in infrastructure that are linked to real assets and generate stable, transparent and predictable operating cash flows offer a partial hedge against inflation. Investors who expect rising inflation can therefore at least partially protect their portfolio from creeping monetary depreciation with infrastructure investments. In a long-term comparison, infrastructure generated a return well above the inflation rate.
The reasons for this lie in the specific characteristics of infrastructure companies, as can even be seen in the example of several toll road operators. The road concessions awarded by the regulator often contain appropriate clauses for adjusting tolls. Regulatory framework conditions, concessions and long-term contracts can explicitly link the revenues of the infrastructure company to inflation.
Difficult market entry strengthens market position and price setting power
Even if there are no explicit, i.e. contractually secured, price adjustment clauses, infrastructure operators can rely on significant price setting power and pass inflation rates on to customers, at least partially. This is based on their generally strong position in the value chain, the – in some cases – systemic relevance of their products and services or a quasi-monopoly position found in many sectors.
In addition, there are considerable barriers to market entry for the infrastructure area, mainly due to the regulatory framework conditions, availability of space and high initial investments. As a result, customers often have hardly any alternatives to infrastructure services. Consequently, even consistent price increases have rarely led to volume-based decreases in demand for infrastructure operators. However, the extent to which infrastructure companies’ revenues are protected against inflation mainly depends on the sector and the country-specific regulatory operating conditions. From an investor's perspective, transparency in the regulatory decision-making process and regulatory security are key. Account should also be taken of the time lag with which inflation-induced price increases can and are allowed to be achieved.
Inflation protection depends on sector and regulator
Regulated utilities are generally known for their very good inflation protection. The rules for this segment are usually clear and are based either on a generally accepted inflation index or on the evolution of prices and costs of the goods and raw materials purchased. Certain system-relevant suppliers also have state-defined tariff models that define a specific target profit or allow full coverage of production costs through corresponding premium rates. Moreover, companies from these segments have been around for a long time and are known for their high transparency in the implementation of repricing.
Socio-political importance of infrastructure investments
Equity participations in energy and infrastructure companies are real values. Generally speaking, such equity participations have the advantage over nominal values that not only input factor prices but also customer sales prices can be adjusted, i.e. increased during periods of inflation. This also has a positive impact on future cash flow, which affects both dividend and capital appreciation potential. It is said that such total shareholder returns exhibit a positive correlation with inflation in order, for example, to maintain the purchasing power of pension assets. Against the backdrop of the current inflation outlook, which poses an increasing challenge not only for institutional investors, this infrastructure feature is also very valuable from a socio-political perspective. As well as the positive correlation effect due to the mix with traditional investments, the infrastructure asset class is thus even more important within the available investment spectrum.
Author: Domink Meyer, Client Portfolio Manager Infrastructure and Head Products, Swiss Life Asset Managers
Infrastructure as an asset class