7. ESG and institutional investment in infrastructure
The quality and design of infrastructure play a key role in shaping how we live, what we do, and how we interact in almost every aspect of life. It determines economic structures and outcomes, social systems, personal well-being, and environmental impact, as well as development pathways. Policy makers are increasingly aware of the contribution environmental, social and governance (ESG) and broader sustainability factors make in ensuring quality infrastructure investment.
As institutional investors gain exposure to infrastructure through their portfolio investments, there is increasing recognition that ESG factors are relevant for their infrastructure investments. However, there are challenges in implementation, due in part to the particularities of infrastructure markets. This chapter analyses the growing use of ESG criteria in institutional investment in infrastructure, including investor motivations and objectives, as well as ESG frameworks and tools and related implementation issues. It concludes by offering options for the way forward.
As the COVID-19 crisis has highlighted, infrastructure systems such as healthcare, power, water and sanitation, transport, and telecommunications provide essential services, contributing to economic and social activity and promoting broader economic and social resilience. Yet they can be vulnerable to shocks and stresses, particularly as they are often organised in complex networks through which even small local shocks can propagate quickly (OECD, 2019c). Disruptions to, and stresses on, infrastructure can amplify chronic infrastructure challenges such as underfunding, poor maintenance, and mismanagement.
Extreme weather, water and other climate-related events are increasing in frequency and severity, and a focus on trying to limit their impact through adaptation measures has become essential.1 According to a recent study, the frequency of coastal flooding is set to rise by around 50% over the next 80 years and could threaten human lives and habitat, in addition to affecting assets worth 20% of global gross domestic product (Kirezci, E. et al., 2020). These developments will have implications for infrastructure assets, which may be impacted.
Institutional investors have been increasingly seeking to make allocations to infrastructure, largely driven by a search for enhanced diversification and yield. This has occurred while governments have – given limits on public investment – made efforts to mobilise institutional capital for sustainable and resilient infrastructure investment, to address the need to renew or build infrastructure, especially in emerging markets. From an investor point of view, particularly institutional investors who typically have long investment horizons, the long-lived nature of infrastructure assets exposes them to risks of disruption over time, often arising from environmental, social and governance (ESG) factors. If not managed and mitigated, these risks may ultimately impact the performance of an asset and the rate of return for investors.
Chapter 4 concludes that pension funds and insurance companies are increasingly choosing to integrate ESG factors in their investment decisions but that major challenges remain. Major barriers to ESG integration are also obstacles to the elaboration of better risk management strategies for investors and the allocation of finance to infrastructure investments. As infrastructure investing exhibits different characteristics from other asset classes, this chapter looks at specific barriers to ESG investment and analysis.
ESG factors often lie beyond the time horizons of investors and policy misalignments or market failures (such as the disconnection of risk pricing) do not provide correct market signals.2 Specific to private markets and infrastructure, further complications include the capabilities and expertise of investors, potential short termism due to market structures (for example, the principal-agent issue between asset owners and asset managers), and a lack of financial data and track records on the financial and ESG performance of infrastructure projects.
ESG factors can present risks across the infrastructure lifecycle – from the pre-construction phase through to the operational phase – for financing providers, from banks to asset managers and institutional investors. Furthermore, the central role of infrastructure in economic and social activity, and its broader environmental and social impacts, may serve to accentuate ESG risks, by introducing policy, regulatory, and reputational risks. While focusing on the financing of infrastructure by institutional investors, this chapter leverages the expertise and views of different stakeholders (engineering, academic and policy) beyond the investor community.
The first section discusses the growing relevance of ESG for quality infrastructure investment and the increasing role of institutional investors in infrastructure investment. The second section analyses the range of motivations for institutional investors to consider the adoption of an ESG lens for their infrastructure investments. The third section describes the large number of ESG frameworks and tools applicable to infrastructure that can assist institutional investors. The final section describes sustainable investment strategies for infrastructure being adopted by institutional investors, with a focus on large pension funds and their “green” investments and low-carbon infrastructure investments. Selected directions for the way forward are provided at the end, including further research, data, and policy actions.
7.2.1. Sustainable and quality infrastructure investment
The quality and design of infrastructure3 play a key role in shaping how we live, what we do, and how we interact in almost every aspect of life. These aspects determine economic structures and outcomes, social systems, personal well-being, environmental impact as well as development pathways. Investment in sustainable and quality infrastructure, implemented through appropriate delivery mechanisms, and managed efficiently over the life cycle, contribute to economic development, and enable the achievement of ESG objectives and the Sustainable Development Goals (SDGs). In fact, goal 9 of the SDGs calls for the development of “quality, reliable, sustainable and resilient infrastructure, including regional and trans-border infrastructure, to support economic development and human well-being, with a focus on affordable and equitable access for all.”
In developed economies, a significant share of existing infrastructure is reaching the end of its life cycle and is outdated or does not adequately meet today’s requirements. This could be the result of obsolescence, economic growth, demographics, shifts in values, or environmental sustainability. In less developed economies, infrastructure investment needs to be scaled up, in some instances massively, in order to provide access to basic services like energy or drinking water, and to enable the flow of goods and people. Recent estimates show that emerging markets will invest an average of USD 2.2 trillion, or 3.9% of GDP, annually in infrastructure to 2040, close to double the aggregate spent in advanced markets over the same period (Swiss Re, 2020). Numerous estimates of the needs for global infrastructure investment all point to the need to increase investment in order to meet growth and sustainability targets.
Responses to the COVID-19 shock for economies and societies are expected to include renewed infrastructure investment as a stimulus measure. This presents an opportunity to steer the infrastructure sector onto a more resilient and sustainable path, avoiding a ‘lock-in’ of fossil fuel infrastructure and carbon-intensive assets. The IEA estimates that an additional USD 1.1 trillion will need to be invested annually in both supplying power and altering how end users consume power between now and 2040 to meet the IEA Sustainable Development Scenario (IEA, 2018).
While serving as a key means to achieve sustainable development, infrastructure, in both its construction and operation, needs to consider changing community expectations, the increasing power of civil society and social connectivity, as well as potential new legal requirements, all of which add to the complexity of delivering infrastructure projects (Valenzuela et al., 2016; Watkins et al., 2017). Strong community opposition – often due to ESG considerations – can result in delays and cause changes in project scope,4 and prove costly – and potentially be material – for investors. In May 2020, work on the upgrade of the A49 road in Germany was halted due to environmental concerns. Turkey’s megaproject Canal Istanbul has hit a major roadblock over environmental and economic concerns. In July 2020, the works on the expansion of Lisbon’s airport and the conversion of the Montijo airbase in Portugal were halted due to strong opposition.5 In February 2020, as part of a judicial review, the Court of Appeal of England and Wales ruled that the British government’s decision to expand Heathrow was “unlawful”, on climate change grounds, following a legal challenge.6
The importance of ESG and broader sustainability objectives and elements in infrastructure investment is increasingly being recognised at the international level by policy makers, as part of a broader consensus on the ingredients of quality infrastructure investment. Notably, the recently adopted G20 Principles for Quality Infrastructure Investment set out a set of voluntary, non-binding principles that reflect a common strategic direction and aspiration for quality infrastructure investment within the G20, which are: (i) Maximising the positive impact of infrastructure to achieve sustainable growth and development; (ii) Raising economic efficiency in view of life-cycle cost; (iii) Integrating environmental considerations in infrastructure investments (iv) Building resilience against natural disasters and other risks; (v) Integrating social considerations in infrastructure investment; and (vi) Strengthening infrastructure governance7. This increasing consensus at the policy level may translate into reputational risks and pressures for investors expected to meet heightened ESG expectations.
7.2.2. Institutional investors’ investment in infrastructure
As governments make efforts to promote sustainable and quality infrastructure investment, they are also seeking to mobilise private capital to meet large infrastructure investment needs, and thereby achieve more ambitious development, sustainability, and resiliency objectives. While infrastructure investment is generally dominated by the public sector, public budgets are limited and private capital is needed to compliment public investment. Over the years, institutional investors (which include pension funds, insurers, and sovereign wealth funds) have been making allocations to infrastructure, largely driven by a search for enhanced diversification and yield. The infrastructure financing market has in fact gone through a radical transformation since 2005. A number of factors, such as a changed macroeconomic environment, more stringent regulations on financial intermediaries, and a modified appetite for long-term asset investments, have led to a reallocation of flows from the banking sector to the institutional investors sector.
Shifting market trends and growing demand for infrastructure across developed and emerging markets, have resulted in increased private sector participation through both debt and, increasingly, direct equity investment to supplement public capital. Unlisted equity investments have created pathways to directly influence infrastructure project development and outcomes. In public markets, investors can typically access infrastructure through the equity of companies which are exposed to infrastructure such as utilities, energy or transport companies. In recent years, new investment vehicles (e.g. indices, mutual funds, ETFs) have been created for those not able or willing to make their own investment.
When looking at specific infrastructure allocation, it has been through unlisted equity vehicles that the characteristics of the infrastructure asset class have been formulated. As of December 2019, the infrastructure fund industry holds USD 631 billion in infrastructure assets, up from just USD 129 billion at the end of 2009 (see (Preqin (2020) and (Figure 7.1). Totals in 2018 and 2019 both approached USD 100 billion – a substantial increase compared with full-year fundraising of USD 17 billion back in 2009. This is causing major challenges and highlighting structural issues in the market, including competition for limited quality assets and overconcentration of the largest infrastructure funds.
Source Preqin (2020).
In private markets, direct investment is a common method for pension funds to gain exposure to infrastructure, especially amongst large funds that have the size and expertise to manage assets directly. However, as the overall pension market is highly fragmented, many smaller funds do not possess the staff or expertise to directly manage assets. Hiring external consultants and asset managers to manage infrastructure investment is the preferred route to access this asset class. Principal-agent issues between short-term private equity asset managers and long-term asset owners could create disincentives for the adoption of ESG factors in the investment process. This is particularly relevant for the unlisted infrastructure equity market where a number of infrastructure funds have adopted the private equity incentive structure that usually only allows for an investment holding period of 4-5 years in order to make the most of the financial rewards of this vehicle (Clark, G.L. and A.H.B. Monk, 2017 and Bennon M. and R. Sharma, 2018).
The momentum toward greater involvement of institutional investors in infrastructure investment continues. For instance, at the start of 2020, with over 250 infrastructure funds collectively seeking more than USD 200 billion from investors - double the total capital targeted at the start of 2015 - strong growth in infrastructure AUM is expected to continue (Preqin, 2020). Ultimately the primary concern for institutional investors is the investment performance in the context of their specific objectives (such as paying pensions and annuities). Infrastructure can keep growing as an alternative asset class for private investors provided that investors can access bankable projects and an acceptable risk/return profile is offered.
The growth of institutional investment in infrastructure in recent years has been accompanied by an increased effort to apply ESG considerations from other portfolio investments (e.g. investments in publicly traded companies) to infrastructure assets, for those investors with ESG investment decision-making processes in place. The 2019 edition of the EDHEC/GIH survey of over 300 infrastructure investors revealed that close to half of the surveyed investors (asset owners, asset managers) are at least somewhat aware (48%) or very aware (42%) of the ESG characteristics of their infrastructure investments, leaving just under 10% unaware. The ESG approaches followed by investors will vary depending on how the infrastructure investment is accessed. Infrastructure investments can be undertaken in public markets through investment in the stocks and bonds of infrastructure corporates, or in listed infrastructure funds, and through the private markets through direct investments or unlisted funds, and through equity and debt.
In the absence of an understanding in the industry of how ESG factors affect infrastructure returns (see further below), it appears that infrastructure investors use these factors as a tool for managing ESG-related risks, in particular to obtain downside protection. As shown in Figure 7.2 below, ESG factors feature as key sources of risk for infrastructure projects, for instance through the channel of social acceptance, the governance and management of projects, and environmental characteristics and impacts. The long lifespan of infrastructure assets, the central role of infrastructure in economies and societies, and its impact on the environment and communities, mean that ESG factors can present risks across the infrastructure lifecycle and can generate political, regulatory, and reputational risks (e.g. adverse change in regulation). The growing support for ESG and sustainability factors in quality infrastructure investment at the policy level may heighten expectations in regard to infrastructure projects from an ESG perspective.
As investors with a typically long-term horizon, institutional investors have a particular incentive to consider ESG risks in infrastructure, which may materialise in the medium to long-term. This long-term horizon stems from the generally long-dated nature of pension fund and life insurer liabilities, which they seek to match with investments with similar duration, which unlisted (brownfield) infrastructure investments can offer due to their long-term and often stable cash flows. Yet the long holding period creates a long-term exposure to investment risks, requiring investors to consider all long-term risk factors, financial or non-financial (including ESG), that can impact the performance of their portfolios over time and the delivery of payouts. An example of an ESG risk matrix for infrastructure investment can be found in Figure 7.3 below which presents a matrix used by an asset manager to identify “material ESG risks and opportunities” at the sectoral level, a tool complemented by a customised asset-level questionnaire.
Note: OECD (2015) provides a description of the taxonomy of infrastructure risks at the project level.
Source: OECD (2015).
Source: Shroders (2019).
While there is increased investor interest in adopting ESG approaches, the linkage between ESG factors in infrastructure and infrastructure investment risks and returns is not well understood, and the literature is nascent (see Box 7.1). Some findings from the general ESG literature may be relevant; for instance, in regard to energy infrastructure, the shares of renewables over the past decade offered higher total returns relative to fossil fuels, with lower annualised volatility (a measure of investment risk) (IEA and Imperial College, 2020).8
Recent OECD discussions with asset managers9 active in infrastructure investments, and creating infrastructure funds for institutional investors, revealed a consensus on the view that ESG factors are essential for effective risk management of infrastructure assets (especially to protect against downside risks), to preserve and enhance asset value over time (see also OECD, 2020a). It was regarded that consideration of ESG factors or other sustainability considerations in infrastructure is still underdeveloped relative to other asset classes. The environmental aspect is reportedly the most concrete, whereas “S” & “G” measures are less clearly defined. It was noted though that “S” and “G” components are already embedded in regulatory mechanisms governing infrastructure development. These discussions also revealed the limits on the management of ESG risks in infrastructure; as institutional investors often acquire assets after they are built (i.e. brownfield infrastructure), there may be limited scope for them to influence ESG factors, highlighting the importance of incorporating such factors upfront in infrastructure procurement decision-making and the need for investors to including these factors in investor due diligence.
Another key driver includes regulatory requirements related to ESG that have increased the adoption of ESG considerations in infrastructure investment. Funds are also adjusting to new regulations in some markets that seek to clarify the role of ESG in a fund’s investment process. This is part of a broader policy and regulatory push to clarify and disclose climate-related risks in the financial sector, which provides an indirect push for asset owners (and asset managers, who may manage their investments) to consider climate and other ESG-related risk factors, given potential exposures through their investments.
The impact of ESG factors on financial performance is a central issue in the debate around sustainable investment. The long-term nature of infrastructure investments implies a potential major impact of sustainability and resilience-related risks.
Some studies suggest ESG approaches tend to reduce risks and generate higher returns through an ‘ESG factor’ driving the performance of companies (see Amundi, 2019). For example, Fuerst (2015) regressed Global Real Estate Sustainability Benchmark (GRESB) scores on various REIT financial indicators such as ROA and ROE in order to test the link between sustainability and financial performance. The study found that there was a positive relationship between sustainability score and the profitability of real estate companies. The study attributed these results through gains in operating performance, efficiency, and lowering risk exposures.
While analysis in this Outlook finds mixed evidence on the impact of ESG performance on financial performance broadly (see Chapter 1), the long asset life cycles and investor timelines may expose infrastructure assets to particular ESG risks which are material to investors. However, data on infrastructure is often lacking and not comparable as it not being reported in a standardised format or audited by companies’ auditors. Also, the same company can receive divergent ESG ratings, due to problems of inconsistency of criteria and misrepresentation through one single metric of the impact of multiple ESG factors.
As reporting is still immature, scoring has focused on firm’s management approach and transparency of performance rather than direct performance. A recent study by EDHEC cross-references for the first time the ESG scores computed by GRESB Infrastructure and the financial metrics of the EDHEC infra universe, showing that ESG ratings are not positively or negatively correlated with returns, suggesting that the adoption of ESG investment approaches should not harm returns (no trade-offs) but also challenging the notion that ESG is a risk factor (EDHEC, 2020).
These regulations and policy initiatives have put added pressure on the investment community to improve ESG reporting and have also forced investors to consider long-term risks associated with ESG factors, including future regulations or policies that might impact their infrastructure assets. A growing number of investors concerned with the potential impact of sustainability on their long-term financial performance are involved in initiatives on voluntary disclosure of ESG practices.
A number of countries have put into place reporting requirements on disclosure of ESG practices by institutional investors, which may have implications for the application of ESG practices to infrastructure investments held within portfolios. For instance, Australia requires pension funds, insurance companies, and asset managers to disclose their ESG practices. France has introduced the most far-reaching requirements in terms of ESG reporting by institutional investors. Under Article 173-VI of the Energy Transition Act, asset managers, pension funds and insurance companies must provide information not only on how they integrate ESG factors in their investment and voting decisions but also on the climate risks they face and how their portfolio construction contributes to the transition to a low-carbon economy.
Furthermore, the adoption of ESG factors in infrastructure investment is enabling institutional investors with an impact orientation to screen and select projects, funds, and companies, and align their infrastructure investments with sustainability objectives, consistent with return objectives. This alignment may be one of principle but it may also be motivated by a view on sectoral growth opportunities or as a way to avoid or manage certain types of risks, such asset stranding.
A number of infrastructure investors are turning to more directly measuring the impact of their investment portfolios for unlisted infrastructure projects. This is following similar trends seen for the use of ESG analysis for listed equity (see Chapters 1 and 4). ESG investment analysis strategies involve benchmark ESG performance, as well as the impact of ESG criteria on financial returns. While the main focus of this chapter is on institutional investors, standards adopted and developed by engineering firms and government agencies are also considered.10
Several international standards and tools have been developed in order to integrate sustainability and resilience aspects into infrastructure development and support ESG infrastructure asset analysis:
Standards and Frameworks related to ESG factors for Infrastructure: International frameworks providing guidance on relevant criteria to be considered in ESG analysis for infrastructure investment (OECD, 2017; WWF, 2019).
Tools for Infrastructure: defined broadly as checklists, guidelines software, and web-based platforms for analysing specified inputs (ESG data) in ESG infrastructure analysis. Outputs (rating, certification, or financial figure) can be qualitative or quantitative (LTIIA, 2020; WWF, 2019).
Several international standards and frameworks are used to determine ESG factors, covering a broad spectrum ranging from sustainable and resilient investment to SRI and impact investment. Among the most used are: the Sustainable Development Goals (SDGs), the IFC Performance Standards, Sustainable Accounting Standards Board (SASB), the International Organization for Standardization (ISO), the International Framework for Integrated Reporting (IR), the Global Reporting Initiative (GRI), and the UN-supported Principles for Responsible Investing (PRI), among others (see Annex 7.A.1).
While there has been growing recognition of the importance of measuring ESG factors in infrastructure, adoption of third-party ESG tools by investors has been limited, partly due to investor preference for internally developed methodologies for ESG analysis. However, as private markets do not have the same disclosure requirements as listed markets, institutional investors must rely significantly more on their asset managers and other service providers to track their exposure and performance. This has implications for the availability of information and explains the lack of evidence-based studies in this area.
In recent years, and building on the frameworks described above, a number of tools have been developed to support infrastructure investors and developers in the implementation and monitoring of ESG factors in investment analysis, with the aim of producing a rating, certification, or financial impact assessment (among others Sure, GRESB, Envision - see Table 7.1 below). A recent review by WWF (2019) makes the following distinctions:
Evaluation tools: assessing the ESG performance of an asset; and/or an assessment of quantitative and qualitative ESG criteria, which may be reported as a set of information, and which typically results in a score or rating. Evaluation tools can be useful during the due diligence process, for benchmarking investments or projects, as a tool for reporting and stewardship, and for considering how a project addresses various ESG criteria across a portfolio.
Valuation tools: quantifying the selected ESG criteria in a way that can be integrated into a financial model: assigning a monetary value to an ESG risk or benefit, which is then incorporated into a financial model. For example, ESG valuation may involve incorporating ESG metrics into a cost-benefit analysis, net present value calculations, or discounted cash flow models.
Despite the number of initiatives, several problems regarding the measurement of ESG factors in infrastructure persist (see also Chapter 1). Among the major issues are: a lack of a common definition and metric for measuring exposure to ESG risks in infrastructure; the heterogeneity of the infrastructure landscape; the lack of quality data and information required to perform analyses; the ability to quantify and monetise ESG criteria; transparency in valuation methodologies across the industry; investors’ understanding and confidence in ESG valuation; and the costs of ESG analysis (LTIIA, 2020; WWF, 2019; Bennon M. and and R. Sharma, 2018; Garcia S. and T. Whittaker, 2019).
ESG scores might be inconsistent in terms of environment, social and governance weightings and inclusion. It will also be important to promote concrete alignment in sustainability expectations considering the multitude of stakeholders involved. The experience with responsible business conduct principles and standards can be useful in this regard.11
7.4.1. ESG classification for infrastructure
Analyses for understanding ESG-related risks and benefits vary among actors and between phases in the infrastructure process, sub-sectors and specific topics, asset or fund level, and impact on the asset or from the asset.
Current methods for ESG measurement and ESG-related analysis for infrastructure can also be categorised based on:
The actors – ESG frameworks and tools are used to inform the decision-making of infrastructure investors, developers, procuring entities and civil society organisations
The project phase – ESG frameworks and tools are adopted throughout infrastructure investment lifecycles
The sectors, sub-sectors and specific topics – ESG frameworks and tools have been developed to address all classes of investments or specific sectors and sub-sectors in order to address their specificities (e.g. biodiversity and climate change matters)
Asset or fund – analysis of ESG risks can be at project level or fund and portfolio level
Impact on the asset or from the asset – infrastructure assets face several external (originated outside the asset) and internal (inherent to the asset) ESG factors
A number of institutions are involved in sustainability measurement throughout the value chain (see Figure 7.4).
Source: Bennon M. and R. Sharma. (2018)
As project initiators, public sector actors (governments, procuring authorities and multilateral organisations) are more active in greenfield projects with assets being constructed for the first time and could be involved at the planning, development or construction stage. Taking into consideration externalities (negative and positive) resulting from a project, these actors are more likely to use valuation techniques to incorporate ESG criteria into their financial analyses. Developers, construction and engineering firms also active in greenfield projects are also accustomed to using sustainability standards in their project analysis.
Investors’ use of infrastructure accounting or rating tools, however, covers management practices and performance indicators of assets already in operation or at the stage of being approved for construction. In fact, the majority of institutional investors such as pension funds insurers and SWFs invest predominantly in brownfield assets (i.e. existing assets that are already operational and have low capex requirements). Sustainability standards may be incorporated directly by asset owners or by asset managers or consultants reporting to asset owners, during due diligence and IRR analyses and NPV calculations.
In the development phase, ESG analyses are used to guide project planning and design. ESG metrics may be incorporated into feasibility studies and cost benefit analyses (CBAs) of procuring entities in deciding whether to initiate a project. The development phase can be further divided into planning, design and finance with different coverage by screening tools as reviewed recently by AECOM for sustainability, climate and resilience for infrastructure. The lack of due diligence has been an issue in project preparation with direct consequences on human rights, as analysed by OHCHR-HBF (2018).
With respect to emerging market investment, funds often partner with entities with a track-record of managing such risks, such as development finance institutions. For example, AllianzGI established one of the first International Finance Corporation (IFC) partnership funds through which AllianzGI invests in IFC-originated and managed infrastructure loan assets. Deals in some emerging economies may also need certain explicit covenants, such as demanding that all parties adhere to the minimum social and environmental standards set out in the IFC Performance Standards on Environmental and Social Sustainability and the Equator Principles.
Another important distinction for ESG analysis relates to impacts on the asset versus impacts from the asset (see WWF (2019) and AECOM (2017) for examples):
ESG criteria with impacts on the asset include risks and benefits posed by the local or regional context in which the asset is being developed that either enable or inhibit the performance of the infrastructure asset (for example policy or regulatory context, social climate, or vulnerability to extreme weather events)
ESG criteria related to impacts from the asset - externalities - include risks and benefits that the infrastructure asset generates on the external environment and community, which can in turn impact financial performance (impacts from the asset on biodiversity, health, or macroeconomic indicators such as employment that can impact long term cash flows of the infrastructure asset).
Hydroelectric power may be considered one of the cleanest forms of energy accounting for the production of almost two-thirds of global renewable energy, according to the International Hydropower Association (IHA). However many big dam projects around the world have turned into ecological, economic and social disasters. This makes them good case studies for the application and use of ESG standards and tools. This case study provides an example of “best practice” according to the LTIIA ESG Handbook.
Case Study - 420 MW hydro dam project, Nachtigal - Cameroon
Since 2018, alongside Électricité de France (EDF), the Cameroonian State, the International Finance Corporation (IFC) and Africa 50, STOA has been investing in the construction of a large hydroelectric dam in Cameroon. The project, led by the Cameroonian company Nachtigal Hydro Power Company (NHPC), aims to develop the supply of electricity in the country. The objective is to build and operate a 420-megawatt hydroelectric dam in Nachtigal, a village located 65 kilometers from the capital Yaoundé.
When it is commissioned - planned for 2023 - the Nachtigal dam will be the largest dam developed on the African continent in project funding. It meets the demand for increased electricity in Cameroon while generating energy at a competitive cost. This low-carbon solution will also play a decisive role in the country's energy transition. Ultimately, nearly 850 kilotons of CO2 could be avoided each year on a national scale.
The environmental and social risks of the project are mitigated through an ambitious management system. This includes in particular a local economic development action plan and measures dedicated to biodiversity and social issues setting out IFC performance standards to protect but also avoid, reduce and compensate for the negative impacts of the project during the construction and development phases. With the support of IFC and specialised NGOs, NHPC trained its staff in the prevention of gender-based violence. In 2019, 29% of the company's employees are women, making it a flagship project on this subject in the world of infrastructure.
Source: LTIIA (2020).
The integration of ESG factors into investment decision-making and risk management, including for infrastructure investment, is part of a broader trend among institutional investors to adopt sustainable investment strategies, which also include divestment, corporate engagement, sustainability themed investment, and impact investing, among others. Sustainable investing assets stood at USD 30.7 trillion at the start of 2018, a 34% increase in two years, in certain regions it accounts for a sizeable share of professionally managed assets, from 18% in Japan to 63% in Australia and New Zealand (GSIA 2018).
Sustainable investments extend across the range of public and private asset classes commonly found in diversified investment portfolios. The latest Global Sustainable Investment Alliance (GSIA) report on sustainable assets shows that in 2018, 51% of total USD 31 trillion assets were allocated to public equities and 36% to fixed income with the remaining 13% in private markets in alternative asset classes such as real estate, private equity and infrastructure (Figure 7.5 and GSIA, 2018).12 There are a variety of investors in sustainable investment with different objectives and mandates among the most active institutional investors such a pension funds and insurers. As Chapter 4 concludes, some investors examine ESG factors mainly via the risk management lens as an opportunity for higher financial returns, while others perceive ESG factors as non-financial objectives such as carbon emissions or other sustainability-performance targets that they wish to promote.
Source: GSIA (2018)
Corporate engagement and shareholder action is a popular and growing strategy among infrastructure investors in private markets. Infrastructure equity investors often have controlling stakes in the business, allowing significant scope in corporate engagement – limited though by the contractual nature of the services provided. Although a debt investor has less control over the operations of its assets compared to an equity investor, there are several ways debt can support equity to be more sustainable, including through setting conditions prior to funding and/or covenants related to the remediation of ESG risks. Projects may also need specific covenants related to environmental considerations, construction permitting, and post-closing remediation monitoring.
Relevant for infrastructure, the range of active strategies focused on sustainability as an investment outcome includes thematic and impact investing. Although starting from a low base they have known a huge growth in recent years with thematic investing accounting for USD 1 trillion in 2018, up from less than USD 280 billion in 2016 (GSIA 2018).13 As noted in Chapter 4, environmental factor integration achieved via impact and thematic investing is relevant for infrastructure as it may include social infrastructure or renewable energy projects, green bonds and companies addressing environmental issues.
As the definition of infrastructure typically includes low-carbon projects, it is also important to understand current trends in investors’ infrastructure portfolios related to sustainable and resilient investment. The OECD collects portfolio and infrastructure investment data through a survey of large pension funds (LPFs) and public pension reserve funds (PPRFs) (OECD, 2019a). These data include “green” and “social” investment and portfolio allocation to low-carbon infrastructure. The following sub-section reviews the investment trends in specific products, debt/equity instruments, or through specific mandates for green investment, with a brief analysis of the composition of infrastructure portfolios.14 Green investment includes low-carbon infrastructure investment, which is also discussed in the survey.
7.5.1. Green investment
There are a variety of definitions of green investments, depending on investor standards. For the OECD survey of LPFs and PPRFs, examples of such investments include green equity indexes such as FTSE4Good, the S&P Global Eco Index, and the S&P Global Water Index; green bonds such as European Investment Bank climate awareness bonds, SEB Green Bonds, and Credit Suisse – World Bank/IFC Green Bonds; and alternative investments in real estate that are environmentally acceptable such as those that improve energy efficiency, reduce CO2 emissions, or involve recycling (OECD, 2019a).
Funds have different approaches to green investments. For instance, while AIMCo (Canada) has no pre-determined target allocation for green investment, it tracks the percentage of its investments in renewable energy, its overall renewables exposure, and the climate change related impact of its investments. FFR (France) considers several green factors in its allocation decisions for both listed and non-listed investments, such as low-carbon indexes, environmental technology, infrastructure, clean technology, and the management of environmental issues. Furthermore, FRR targets a CO2 emissions reduction of 50% in its listed equities mandates.
In 2019, sustainable debt issuance was nearly USD 450 billion, up from around USD 250 billion the year before, though it remains a fraction of overall debt issuance at just over 5% (IEA, 2020). New types of debt instruments are also linking financial performance to environmental outcomes. For example, interest rates for a USD 2.5 billion Enel bond issued in 2019 are tied to goals for renewables capacity and emissions levels. This overall growth was accompanied by an increase in the number of pension funds investing in green bonds and in the relative size of their allocations in, particular in Sweden, Belgium, and France.
Funds based in Austria, France, the Netherlands and Sweden reported sizeable allocations to green equities. PMT (the Netherlands) reported that approximately 30% of its portfolio in 2017 was green equities. The categorisation of its entire listed equity portfolio as “green” is the result of how it considers ESG factors in all of its investment decisions, including new investment strategies, product mandates, and investment proposals. France’s ERAFP applies an ESG best-in-class approach to all equity mandates in 27.5% of its total portfolio. AP4 reported that 9.1% of its total portfolio was held in green equities, labelling this allocation as ‘low-carbon’ and ‘ESG’ strategies. For BCIMC, green equity refers to global equity securities whose ESG rating is high relative to sector peers.
Beyond green bonds and green equity, some funds also reported holding alternative green investments, such as renewable energy and cleantech projects. AP2 (Sweden) reported a sizeable allocation to green investments, at 12.1% of its total portfolio, part of which included private equity investment in renewable energy/climate solutions. AP7 (Sweden) reported a small allocation to cleantech, which it defined as new environmentally improved business models and technical innovations that make it possible to use natural resources more efficiently and responsibly. The fund also reported that it was looking to increase its allocation to cleantech over the next couple of years.
Funds are paying increasing attention to European Union (EU) initiatives in relation to green investment. The EU taxonomy adopted in June 2020 aims to define which economic activities are sustainable, including socially and environmentally (OECD, 2020b). In addition, an EU regulation that entered into force in April 2020 defines two types of low-carbon benchmarks, the EU Paris Aligned and the EU Climate Transition, requiring ESG disclosures for benchmarks sold in the European Union.
7.5.2. Low-carbon infrastructure investment
As the renewable energy market continues to expand, a growing number of institutional investors have found that dedicated renewables funds are well-placed to meet their demands for ESG impact. For example, in April 2019, Norway’s NOK 9 trillion (EUR 932 billion) sovereign wealth fund decided to invest up to 2% of the fund’s value in unlisted renewable energy infrastructure.
Transportation and energy are the largest sectors in which the funds surveyed have made infrastructure allocations (see Figure 7.6). This indicates investor preference and the availability of opportunities. While there are differences across funds, corporate information suggests that pension funds are often attracted by the long-term tariff agreements in the transport and regulated utilities sector.
Renewable energy and social infrastructure are relatively new, although increasingly important, sectors in the portfolio of certain investors. While the majority of funds were not investing in renewables in 2015, the same sector represented 20% of the total infrastructure portfolio in 2017. Unlisted equity is only one medium through which funds may invest in renewables – it is likely that actual allocations to renewables are higher through investments in listed equity instruments and other channels.15
(1) AIMCo reported allocations for only a portion of the total portfolio.
(2) Includes land titles.
(3) Other includes multi-sector infrastructure.
(4) Other includes healthcare related investments; includes public and private infrastructure.
(5) Hydro and geothermal energy.
(6) Geothermal heat.
(7) Other includes timberlands, waste management.
(8) Energy includes generation and transmission.
(9) Allocations are for a loan portfolio.
(10) Data are as of March 2018.
(11) Allocations are as of December 2016.
Source: OECD calculations based on responses to the OECD Survey of large pension funds and public pension reserve funds.
In 2017, the average fund that reported the sectoral allocations of its unlisted infrastructure equity portfolio invested 28.6% of its portfolio in transportation, making this the largest sector. This was followed by renewable energy, with an average of 20% of the unlisted infrastructure equity portfolio. Two funds based in Iceland allocated 100% of their infrastructure allocation in geothermal energy and heat. Funds in the United Kingdom, including the BBC Pension Scheme and RBS Group Pension Fund, allocated sizeable allocations to renewables: RBS has financed onshore wind energy, while BBC has financed solar, onshore, and offshore wind investments. A number of Brazilian pension funds, including Banesprev, FAPES-BNDES, Petrobras, and Valia, also reported sizeable allocations to renewables.
As has been noted, investors have a strong preference for brownfield (operational) assets with proven abilities to generate cash flows. Some infrastructure assets offer cash flow stability and predictability over the long term, making them suitable for objectives related to diversification. Prospective risk and return are perceived to be higher for new greenfield assets and may require more due diligence on the part of the investor.
That being said, increased return appetite in relation to construction risk is pushing investors to acquire the expertise to be able to provide creditor oversight on new-build construction. For example PGGM has been investing in new projects through its partnership with Royal BAM in Holland. Lifeyrissjodur Starfsmanna Rikisins, based in Iceland, reported that 100% of its unlisted equity was invested in greenfield assets, likely linked to geothermal heat. Publica, based in Switzerland, reported allocating 93.1% in greenfield investment, which consisted of infrastructure loans, likely at construction stage.
Market development in infrastructure is offering new opportunities to investors. Beyond “core” infrastructure there is increasing interest among investors in what are considered to be value-added brownfield opportunities. These investments are focused on assets that need to be refurbished - either addressing operational or structural issues - or funding expansion. Expected returns on such projects already generating cash flows for the investors are higher than core projects. New fund structures try to align asset owners’ long-term horizon with asset managers, to achieve specific ESG goals, including resilient urban infrastructure and energy transition (see Box 7.3).
Investment needs to meet the Paris Agreement include decarbonising industry and transport, building smart energy systems, and increasing access to affordable, clean energy. In the IEA Sustainable Development Scenario for example, spending on renewable power would need to double by the late 2030s (IEA Imperial (2020) and Bardalai A., Della Croce R., 2019). A study by McKinsey (2018) estimated that roughly USD 1.6 trillion of renewable power investments will be made available to institutional investors by 2030. Roughly 70% of that investment opportunity will be composed of unlisted assets that do not trade publicly.
Trends transforming traditional power and energy infrastructure systems are reshaping customer expectations and opening up new business models. The growth of renewable energy has significant technical implications in this area, particularly the need to adapt to intermittency. Funds active in the energy sector are trying to capture as much of the value chain as possible –as buying renewable energy assets together with storage.
Energy transition funds are adapting to these trends, focusing on the resiliency of the electricity system including the networks, biogas and the circular economy and energy efficiency. SUSI Partners was aiming in 2019 to first close on its EUR 1 billion SUSI Global Energy Transition Fund. An evergreen structure, this fund aims to invest in a diversified portfolio of around 20 construction and development-stage assets with a focus on infrastructure relevant for the energy transition.
Given the central role played by infrastructure in our economies and societies, and its broad economic, social, and environmental impacts, delivering quality infrastructure requires, amongst other things, gaining community support and the social licence to operate, highlighting the relevance of ESG factors for infrastructure investment. As institutional investors gain exposure to infrastructure through their portfolio investments, as providers of infrastructure financing, and start adopting ESG strategies for their investment portfolio(s), there is increasing recognition that ESG factors are relevant for infrastructure investments – in particular for the management of risks, to ensure downside protection and preserve if not enhance asset value over the holding period.
ESG approaches adopted by investors will vary depending on how the infrastructure investment is accessed, taking into account that the preferred route to infrastructure investment in the last decade has been through unlisted equity. In private markets, for pension funds and other institutional investors not capable of investing directly, hiring external consultants and asset managers to manage infrastructure investment has been the preferred way to access this asset class. Principal-agent issues between short- term private equity asset managers and long-term asset owners could cause disincentives to the adoption of ESG factors in the investment process.
The fact that infrastructure investment is often undertaken through private markets makes the adoption of ESG decision-making more challenging, as private markets do not have the same disclosure requirements as public markets. Given the often indirect nature of their infrastructure investments, through funds or managed separate accounts, institutional investors must rely significantly more on their asset managers and other service providers to track their exposure and performance. Hence asset managers play a key role in implementing and measuring ESG criteria in institutional investors’ portfolios.
Despite broad recognition of the importance of ESG criteria and interest in incorporating these factors into infrastructure investment decision-making, the implementation of these criteria in asset valuation remains at an early stage. Several international standards and tools have been developed to integrate sustainability and resilience aspects into infrastructure development and support ESG infrastructure asset analysis. Current methods for ESG measurement and ESG-related analysis vary among stakeholders at different phases in the infrastructure process. Despite the number of initiatives, there seem to be several problems with the analysis of ESG factors in infrastructure. Among the major issues are: a lack of a common definition and metrics for measuring exposure to ESG in infrastructure; the lack of quality data and information required to perform analyses; the ability to quantify ESG criteria in financial terms; transparency in valuation methodologies across the industry; investors’ understanding and confidence in ESG valuation; and the cost of ESG analysis.
From the perspective of government in many countries, implementation of quality infrastructure investment is a key priority, which requires, among other things, relevant ESG considerations to be taken into account in government procurement decisions, in the agreements governing public private partnerships for new projects, and in the conditions attached to budget facilities for infrastructure. Policy settings can also assist in overcoming key challenges or issues that impede proper private investor consideration of ESG factors in asset-level analysis of infrastructure, to the extent that the industry is unable to resolve the issues. Suggestions for government action have included better disclosure of private project-level data to investors, government sharing of its own project data, better government communication of priority ESG elements in infrastructure (see OECD 2020 and endnote 9), and clear, consistent guidance regarding ESG disclosures in financial markets more broadly.
A holistic framework aligning objective and definitions among stakeholders is needed. In order to differentiate among the effects of different ESG factors, investors and regulators need more granular data. This chapter highlights the need for work to understand the link between ESG and financial performance, especially on long-term effects and materiality and on asset allocation trends in private markets for infrastructure.
Given the shared interest in the effective management of ESG risks, so as to ensure positive social and economic outcomes for infrastructure investment, further progress could benefit from closer collaboration involving key stakeholders from private and public sectors, to enable a dialogue and identification of priority actions. As part this dialogue, understanding investor motivations, ESG approaches and methodologies used for infrastructure, and data requirements, accessibility, and limitations, would be valuable. Such collaboration could feature as part of broader current G20 and OECD efforts at public and private collaboration on infrastructure, undertaken with multilateral development banks, the GIH, and other stakeholders; indeed, ESG issues have already been identified as an important topic (see OECD, 2020a).
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Notes
← 1. Financial Times 31 July 2020, “Rise in coastal flooding poses threat to economies”, Anna Gross: According to Professor Ian Young, infrastructure engineer at the University of Melbourne, “The sea-level rise is now already baked in, the glaciers are melting and they aren’t going to stop melting for hundreds of years. Even if we reduce our greenhouses gases today we’ll still have significant flooding by 2100”.
← 2. As seen in previous chapters there is increasing evidence of market inefficiencies in pricing ESG risks.
← 3. The OECD defines infrastructure as the system of public works in a country, state or region, including roads, utility lines and public building – in essence the tangible backbone of essential goods and services underpinning an economy. See: https://stats.oecd.org/glossary/detail.asp?ID=4511.
← 4. The Inter-American Development Bank (2017) analysed 200 projects across six sectors in Latin America and the Caribbean that were strongly opposed by local communities and found that a lack of a multi-dimensional approach in project planning, design, and delivery was seriously detrimental for companies, investors, and national governments - 36 out of the 200 projects were cancelled; 162 faced delays; and 116 faced cost overruns.
← 5. See Infrastructure Journal articles covering the period May–July 2020.
← 6. The judgement, which sets a key legal precedent, said the government had wrongly ignored its international climate change commitments under the Paris Agreement.
← 7. See also Reference Note on Environmental and Social Considerations in Quality Infrastructure (OECD, 2019b) and Reference Note on the Governance of Quality Infrastructure Investment (OECD/IMF, 2019), which provide reference material for the implementation of the G20 QII Principles. The forthcoming OECD Compendium of Policy Good Practices for Quality Infrastructure Investment (2020) provides a set of integrated and multidisciplinary good practices for policymakers and practitioners to use on a voluntary basis, and which promote a shared understanding of the elements needed to support QII in accordance with international standards. Complementing the Compendium, which is a policy guidance tool, an OECD Implementation Handbook for Quality Infrastructure Investment will be developed; it will provide an analytical and operational tool, focusing on selected major issues and challenges for QII, and providing implementation solutions through concrete examples and case studies.
← 8. The IEA and Imperial College London are investigating the risk and return proposition available to investors in the energy sector through a series of special reports. The first study focuses on historical financial performance of fossil fuels versus renewable power in listed equity markets of select advanced economies. The methodology used in the report will be extended to other countries and unlisted (i.e. private market) investments in forthcoming work.
← 9. From an OECD Dialogue with the Asset Management Industry on Sustainable Infrastructure, 25 October 2019.
← 10. For more extensive reviews on methodologies used to measure or report on infrastructure sustainability, see LTIIA (2020), WWF (2019), Bennon M. and and R. Sharma (2018), AESCOM (2017) and IDB (2016).
← 11. International responsible business conduct (RBC) principles and standards set out expectations for how businesses and investors should undertake risk-based due diligence to consider impacts on the people and the planet. More information is available at https://mneguidelines.oecd.org/Brochure-responsible-business-key-messages-from-international-instruments.pdf.
← 12. The GSIA survey shows asset class allocation in Europe, the United States, Japan and Canada in 2018. Sustainable investments can also be found in hedge funds, cash or depository vehicles, commodities.
← 13. For example, AllianzGI has a traditional infrastructure allocation in unlisted markets but also an infrastructure equity team that is dedicated to green energy assets. BlackRock currently manages a USD 50 billion fund that supports the transition to a low-carbon economy, including renewable power infrastructure business, which invests in the private markets in wind and solar power, and green bond funds.
← 14. This section benefits from data collected by the OECD for the period 2015-2017 and quantitative analysis. The focus is on two distinct pools of long-term savings: large pension funds (LPFs) and public pension reserve funds (PPRFs). In 2017, the OECD gathered, for the fourth year in a row, data on green and social investments by LPFs and PPRFs. Twenty-six and thirty-seven funds provided information about their green investments in the OECD surveys covering the period 2015- 2017.These data included information on investments that funds have made in specific products, debt/equity instruments, or through specific mandates for social impact and/or green investment. Not all funds included in the survey reported that they actively implement ESG frameworks in their investment processes as In 2017, twenty-six LPFs stated that they were not active in green finance. The sample although subject to bias towards more active investors is still significant to represent current trends and market evolution in recent years.
← 15. In the OECD survey, infrastructure investment is calculated as a % of total assets of funds investing in infrastructure. Infrastructure investment is calculated as a % of total assets of all funds in the survey, excluding the ones stemming from publicly available reports.