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While infrastructure assets may be divided into these four broad categories, investors must also consider other factors that will impact an asset’s risk profile, such as what market an asset is in, the nature of the political environment and regulator (if any), the levels of leverage and the stage of development of the asset (the so-called Greenfield or Brownfield distinction).
Greenfield projects are start-up projects that initially involve a significant outlay of capital and the participation of many parties (e.g., design/architecture, construction, financing and operational) as the project comes online. A significant feature of Greenfield projects is the “J curve” profile of the cash flows, as the asset moves from design and build to project maturity over a two- to five-year period. Greenfield assets usually have little, if any, income or yield component in their return stream to investors and are often sold or refinanced once construction is completed and the risk premium has been reduced.
Brownfield projects are investment opportunities in existing infrastructure assets. Investors in Brownfield assets tend to target more modest returns in exchange for a lower risk profile. The buyer of a Brownfield asset may seek to improve the asset by creating operating efficiencies, increasing revenues or reducing expenses. While any upgrades or maintenance may involve some level of design, construction and/or technological risk, it is normally a shorter duration than Greenfield development and project participants can assess the likely success of the project by referencing historic demand and financial data. Brownfield projects have the potential to provide investors with immediate income or yield, and there is generally a less significant (if any) J curve associated with these projects.
Investors should be careful when characterizing these assets as Greenfield or Brownfield and what these labels imply. An investor will need to take a closer look at each individual asset to understand what this characterization means, and what it does not, with respect to an asset’s risk profile.
The generalization tends to be that all Greenfield projects are, by definition, riskier than Brownfield projects. In reality, while the stage of development at which an investment is made is a key factor that influences project risk and return, it is not necessarily the defining one. A Greenfield project in a regulated asset in a developed market may carry far less risk than a Brownfield asset in an emerging market that is subject to demand risk. The risk profile will always come down to the particular attributes of an asset.
Individual Characteristics Matter
While it is useful to broadly categorize by revenue model, even within those categories (and assets that might be typically considered to fall within certain categories), there can be important differences. For example, some asset types can cross over into multiple revenue models and be subject to different types of risk. What matters most, however, is the assessment of the particular characteristics of an individual asset and its pertinent risks. Consider the following examples.
Toll Roads: At a high level, one might assume that the primary risk for any throughput asset such as a simple toll road would be a straightforward matter of multiplying users by the toll rate. In reality, though, there are five distinct revenue models for a simple toll road that can influence the overall return and risk dramatically. Some roads have significant exposure to traffic volume; others carry no volume-based risk.
PPP models – Some toll roads are structured as a public-private partnership transaction whereby revenue is earned through an availability payment. As with social infrastructure projects, the availability payment is a contract with a government agency that agrees to pay the provider a set amount as long as the road is meeting certain agreed-upon operational goals. In these projects, an investor takes no volume risk. Rather, so long as the road meets its operational goals, the investor will receive the payment.
Shadow tolls – With a shadow toll, the government makes a payment to the investor at a rate based on the number of cars travelled, but there is no physical toll booth on the road. Motorists avoid congestion, and there is no collection cost of operating the booth. Often the government funds the payment through fuel taxes, vehicle registration fees or other charges not directly based on who actually uses the road. In some cases, the government is willing to provide a floor of how much it will pay, so there are characteristics similar to an availability payment and revenue, therefore, is not purely driven by the number of cars.
Regulatory tolls – A regulatory toll road is governed by a regulatory body. Similar to electric companies and other regulated utilities, a government regulator sets the toll rates and, therefore, impacts the ultimate rate of return an investor would achieve (in addition to also having volume risk).
Concessions – Some toll roads have a concessionary agreement with a province or municipality for the right to operate a toll road for a set number of years, normally
25 to 99 years. The concession agreement sets forth the operational and financial rights of the owner. Most concession agreements dictate which toll rate can be charged and how frequently (and by how much) the owner can raise the rate.
Open tolling – In an open tolling scheme, the owner of a road can charge whatever the market will bear. The owner of an open tolling road is completely subject to traffic volume risk. In this case, overall demographics and GDP characteristics of a region would also have a significant impact on the overall return of an investor.
Energy Assets: It is a common misconception that energy assets can be easily identified as falling under a regulated or contracted revenue model. In reality, they are among the most complex and broadly distributed assets along the risk/return spectrum. Energy assets comprise fuel sources, the storage tanks used to hold fuel inventory, the plants that utilize the fuel to generate electricity, the power lines that transmit the electricity from generation node to usage node and the lines that eventually distribute the power to homes and businesses. These assets may or may not operate under a long-term contractual agreement and/or regulatory regime and may even operate under different regulatory regimes within the same country. Target returns to equity can range from high single digits to in excess of 30%, with commensurate degrees of risk. Within the energy sector for infrastructure-like assets, revenue models may vary meaningfully.
Merchant power – With respect to merchant power generation, revenue is purely a function of throughput (price times quantity) of electricity. The owner bears market risk for demand and associated pricing as it sells freely into the open market. As such, these assets behave very much as any throughput asset would. Due to their volatility, these assets are less likely to fall within the investment objectives of a core infrastructure investor.
Contracted power – For contracted power generation, revenue is determined by a long-term contract that specifies the amount of electricity delivered to a buyer and the price at which it is delivered. Renewable energy generation opportunities are virtually always underpinned by a power purchase agreement. As a result, market fluctuations, volume or regulatory action should not be a factor for the investor.
Regulated assets – Regulated energy assets are a large component of the energy sector. It would be highly inefficient for there to be multiple transmission networks to move electricity from generation closer to consumption. As a result, and to ensure free and open access, transmission networks are subject to a regulated return on assets. This typically results in returns within a narrow band with less volatility than might otherwise be expected. The government regulator is responsible for setting the utility rates and, therefore, impacts the ultimate rate of return an investor would achieve (in addition to also having volume risk).
Fuel storage – Fuel storage revenues are, in essence, a blend between contracted and availability payments. In most cases, the end user simply pays for the storage capacity to be available, irrespective of use, as the price of not having storage available when needed would exceed the cost of having it available on standby.
While a diversified portfolio of infrastructure assets has the potential to deliver attractive risk-adjusted returns, it is a complex asset class, requiring large long-term investments in generally illiquid assets. It is important to emphasize that infrastructure assets with the same physical characteristics may represent vastly different investment opportunities. The return/risk profile of an infrastructure asset will ultimately depend on its specific characteristics, including the following:
- stage of development – Greenfield or Brownfield asset;
- ownership and capital structure – debt, controlling or minority stake, equity or preferred stake, tax structure, ownership rights, cash flows and distribution terms;
- geography – developed or emerging market;
- sector – throughput, social infrastructure, regulated utilities, contracted utilities or;
- regulatory environment – level of government oversight, history, experience and political factors; and
- source of cash flow/returns – contracted cash flows, volume-driven versus availability payment and potential for capital appreciation.
Once investors gain a deeper understanding of the return behaviour and risk profile of different infrastructure assets, and find the right mix of infrastructure assets for their portfolios, they’ll be on the road to deliver returns consistent with their investment objectives. BC
Nancy Mangraviti is a managing director with the infrastructure investment group of RBC Global Asset Management.