Risk Premia: Good times are over, now it gets harder

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Risk Premia: Good times are over, now it gets harder

2 minutes
August 30, 2023 10:59 pm

This is a grim headline, but with the economic shifts over the last two years, we might be seeing a more difficult market for infrastructure investment. From our perspective, we are observing some interesting shifts in the market. Firstly, despite the evidence that inflation may be cooling in major economies, there is evidence that interest rates might be higher for longer. This will affect the views of infrastructure managers in two key areas, greenfield development and infrastructure mergers and acquisitions (M&A).

Greenfield infrastructure has never been an easy investment involving as it does the identification, de-risking and development of assets. In a climate where there are supply bottlenecks causing shortages, rising inflation and interest rates, the job just gets harder. A key example of this is the offshore wind assets off the UK. Recently Vattenfall has cancelledits Norfolk Boreas wind farm. This was to be a 1.4GW wind farm. Reuters reported that the project was awarded a Contract for Difference (CfD) revenue support with a minimum price of approximately 45 pounds/MWh. That this project was only awarded a CfD last year. To bid for a CfD Vattenfall would have to firm up expectations of financing, construction and operating costs. To cancel the project implies that now management sees that it is no longer economic to pursue at the CfD price shows just how fast the economic conditions have been changing. Whilst this is a rather large project to cancel and hence it is newsworthy, recent commentary from Vestas ($) highlighting a lack of approvals for new wind farms indicates that there is slowing appetite from developers to build new infrastructure assets.

For infrastructure M&A we have seen reports ($) (with corresponds with our own observations) that infrastructure activity is decreasing. Transaction volumes have fallen significantly in the first two quarters of this year. This, despite the large dry powder reserves of infrastructure managers and the increasing expected equity returns demanded by infrastructure invested, as documented in our infraMetrics® platform indicate that the managers are being more risk adverse.

Global Infastructure Expected Equity Returns
EDHECinfra Newsletter February 2023

*Source: infraMetrics®

How long this risk aversion remains is an interesting question. The sharp recent moves in bond yields around the world will have a significant impact on funding costs for new infrastructure investments. If new infrastructure funds are raised, perhaps there might be some push for new transactions. In my view this is unlikely. With bond yields higher, and most likely for longer, infrastructure needs to find ways to justify its place in investors’ portfolio (given other investments provide as good a running yield and also are more liquid). Infrastructure investors and managers will have their work cut out in today’s economic environment.