Infrastructure Debt and ESG: the importance of strategic prioritisation

2018/04/12

Summary

Infrastructure debt stands out due to its usually low risk profile and positive ESG impact. But for institutional investors, it can be worthwhile to invest in infrastructure projects with potentially higher ESG risks.

INFRASTRUCTURE DEBT

Infrastructure debt investment generally presents a low risk profile in terms of ESG (environmental, social and corporate governance) factors and often exhibits positive-ESG-impact features. The highly structured characteristics of Infrastructure debt – covenants conferring some degree of control of their investments by debt investors post-investment – makes strategic segmentation of sub-sectors by ESG risk meaningful, and provides mechanisms for positive engagement if investors choose to invest in infrastructure with higher ESG risk potential.

As “sustainability” becomes a core requirement for investors there is a danger that a ‘box-checking’ culture develops. A clear strategy focuses finite ESG engagement capacity in those areas where ESG risk is greatest, but also where the potential positive impact of marginal sustainable investment is highest.

THE IMPORTANCE OF A STRATEGIC APPROACH TO ESG

Without an efficient strategic risk assessment framework, there is production of large volumes of low-value data and inconsequential commentary about inherently low-ESG-risk investments. This adds unnecessary costs to investment management – ultimately borne by investors.

At worst, a failure to focus ESG efforts in areas where ESG returns are greatest distracts managers and investors from positive engagement where such engagement is needed. In extremis it may lead to ‘ESG protectionism’ – the theory being that emerging markets or challenging sectors such as energy generation can be avoided entirely. Not only does such an approach increase investment risk for investors because of reduced diversification, it also fails to recognise that whatever the risks of investment in more ESG-challenging sectors, the “do-nothing” option is often the worst option from an ESG perspective.

Questions of environmental impact need to be looked at in context and not in absolute terms. While air pollution in densely populated western cities where there is a high penetration of petrol and diesel-burning vehicles is of concern, the areas of the world where life expectancy is most adversely impacted by air pollution remain emerging markets, where burning of fossil fuels or animal waste within homes to generate heat is a far greater risk to health. In such circumstances migration to any modern energy source would be likely to have a positive impact, whether it is renewable energy or traditional energy generation.

THE ADVANTAGES ARE EVIDENT

ESG strengths are generally reflected in higher credit ratings and lower cost of debt. These parameters inform infrastructure project debt, because infrastructure projects will benefit in terms of their own rating and pricing from having well-rated counterparties.

Infrastructure debt benefits from additional features not seen in general fixed income, which may address ESG:

1/ The terms of infrastructure debt normally prescribe the purpose for which funding is to be used e.g. to build a new road or a wind-farm.

2/ Infrastructure issuers are typically subject to additional tiers of governance not seen in most general fixed income issuer businesses, either via law or contract.

3/ The covenants of infrastructure debt typically go beyond financial matters (e.g. leverage restrictions) into how the issuer performs its business.

RISK PROFILES

LOW ESG RISK
An example of a low ESG risk project financing would be the construction of a university accommodation project in partnership with a University in a mature democracy such as the UK.

The EU provides a mature legal and regulatory system, including strict environmental laws, employment rights for workers, anti-discrimination laws, strict anti-money laundering regulations, robust Health & Safety rules – particularly relevant to the construction phase, but applicable throughout the life of the project.

Beyond ESG risk defensive features, university growth represents a positive impact investment – increasing life chances of students, and enabling research and economic development.

MEDIUM ESG RISK
A medium-risk project would be a new road in a middle income country. A road has the potential to impact the local environment, but it may also relieve worse pollution and congestion elsewhere e.g. a by-pass of a city should improve quality of life within the city.

For a medium-risk project a short-form summary of ESG risks and mitigants will be considered as part of the general risks and mitigants review prior to investment.

HIGH ESG RISK
An example of a higher-risk project could include thermal electricity generation in an emerging market country. To date all of our emerging market infrastructure investment has been in partnership with IFIs with a track record of managing such risks. For example, AllianzGI established one of the first IFC (International Finance Corporation) partnership funds, through which AllianzGI investors invest in IFCoriginated and managed loans.

When co-investing with IFIs, our initial due diligence establishes the adequacy of their ESG policies and procedures, rather than repeating the exercise for every single investment. For unforeseen situations we retain participation-veto rights.

At AllianzGI we first assess the ESG risk profile of a potential issuer based on fundamental context, and rate them low, medium or high.

"ESG STRENGTHS ARE GENERALLY REFLECTED IN HIGHER CREDIT RATINGS AND LOWER COST OF DEBT."

FRAMEWORK

For low-ESG-risk project debt issuance, compliance with general law, issuerspecific regulations and counterparty contract terms represents an indirect comprehensive suite of ESG assurance. This can be very cost-effectively policed by the inclusion of market standard finance contract covenants and typical sanctions for any breach of such covenants – equity distribution block for minor breaches until remedied, enforcement and acceleration for major breach. A specific ESG review is typically only required for higher-risk investments.

When projects are in mature democracies, themselves subject to international agreements on environmental goals, it is questionable that a debt financier “knows best” on questions of public policy, or even how best to achieve a given ESG goal. However, such questions of public policy in a mature democracy with international obligations should, in our view, be left to the elected governments of mature countries, and investors should focus on the creditworthiness of the asset being financed within the regulatory or contractual framework, established by the government in furtherance of the policy.

CONCLUSION

Investors who take ESG seriously have the opportunity to diversify their fixed income portfolios by allocating assets to infrastructure debt, safe in the knowledge that the fundamentals of the sector permit responsible investment. Moreover, the covenant structures of the underlying transactions allow active managers to behave as responsible stewards by enforcing compliance with best practice as required under the laws and regulations of advanced democracies, whose electorate are concerned about the environment and sustainability1.



Adrian Jones Adrian Jones,
Director, Infrastructure Debt,
Allianz Global Investors

 



1) A performance of the strategy is not guaranteed and losses remain possible.

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The Difference between Productivity and Innovation – and the Implications for Growth and Equity Markets

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Summary

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