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Should pension funds be jumping in the infrastructure finance bandwagon?

Ever since the Group of 20 decided to tackle infrastructure as part of its development agenda, in 2010, the push for increasing investment in infrastructure never ceased. Today, infrastructure finance is not only top of the agenda at the Group of 20 – where its sheer continuity would be already remarkable –, but also at public lending institutions, led by the World Bank, and at the United Nations where it is expected to feature prominently in a new financing for development deal for the post-2015 era.

Within the new infrastructure finance agenda emerging in such forums, the USD 85 that institutional investors, and in particular pension funds, are estimated to hold in savings, are seen as playing a starring role.

One could see why pension funds could welcome this move. For over two decades, the collapse of publicly-financed retirement systems, characterized by privatization or precarization of social security systems and the growing ratio of ageing citizens to working citizens, left pension funds looking for alternative investment outlets that can help them respond to the demands of their beneficiaries. The depressed-interest rate environment of the last few years has only made this need more acute.

The new infrastructure agenda posits that increasing investment in infrastructure is a logical path for plugging the financial gap pension funds face. At first sight the claim makes sense. Unmet infrastructure needs, only in the developing world, are estimated to require some additional investment of USD 1 trillion a year. Infrastructure is a long term investment, just as are the liabilities pension funds typically hold.

So this explains why pension funds are, of all institutional investors, the ones most eagerly jumping in the bandwagon of this new agenda. A 2010 survey showed some 800 investors in infrastructure funds worldwide, of which the largest shares corresponded to public and private pension funds, respectively.

But, before jumping into this bandwagon, pension funds would do well to interrogate the model further.

Infrastructure: a higher-than-average return asset class ?

A big assumption that underpins claims about the performance of infrastructure as an asset class is, of course, that it is an asset class. That, however, would call for a degree of homogeneity and standardization across infrastructure projects that hardly exists today. There are some infrastructure projects that performed well in the double-digits, for instance in the energy sector. There are others that did not. High leverage during the “Great moderation” era preceding the financial crisis is also a distorting factor. Moreover, the available information does not allow the creation of time series to make serious claims about the performance in the long term of even specific sectors.

The new infrastructure finance model shows a bias towards public-private partnerships as a preferred method of execution. What not many offers pitching infrastructure investment discuss are the enormous gaps in knowledge about the success rate of public-private partnerships.

The new model also shows a bias towards mega-size projects. Contrary to the expectation that infrastructure projects will generate the increased growth and productivity to pay their financiers, “bridges to nowhere” and other unproductive projects undertaken for political purposes tend to be the rule rather than the exception. In this context, bigger projects are better for political reasons, but carry with them bigger risks. The debt crises that followed the boom in large investment projects in the 1970s should be a reminder that ultimately, no matter how many guarantees accompany a project, investors can never be fully shielded from a mega-project that fails.

Managing risks in the long term

Looking for assets that can be held in the long term also leads to the examination of whether the assets can withstand long term risks. For instance, infrastructure projects typically rely and affect large swathes of land and create large environmental footprints. The way some asset managers are looking at infrastructure reveals that the returns are expected to come at the expense of a presumed unlimited ability by the State to raise user fees and exorbitant guarantees for risks such as inflation or lack of minimum demand, backed up by public funding. The longer the asset has to be held, the likelier that shortcuts that might make projected returns for such investments look very good are going to be challenged by the reality on the ground.

Strong environmental and social safeguards, and ensuring institutional frameworks with adequate checks and balances that ensure a fair risk- and benefit-sharing is built in contracts since the beginning, are not only important from the perspective of citizens, consumers and taxpayers in the infrastructure host countries. They are crucial protections for the retirees whose funds are at stake.

However, while this is good in theory, the way the new infrastructure agenda is being rolled out will in practice severely undercut such standards. In the name of rapidly piling up “bankable” projects, multilateral development banks are being asked to rush project preparation. This will make environmental impact assessments more of an item to check on the list than a tool for effective dialogue with affected stakeholders on ways to avoid or mitigate impacts. Requirements such as or a robust comparison with public works to ascertain private finance involvement is the best option, and shield the project from legitimate citizen questioning in the future,  will become less viable. In order to reduce the risk to make projects commercially viable, countries are encouraged to maintain an “enabling business environment.” Oftentimes this is code for freezing regulations needed to protect workers, regulations in the public interest or citizens’ due process in taking of land or the approval of PPP contracts.

The role of asset managers

Like in any other investment, the role of financial intermediaries needs to be carefully examined. The promise of hedge funds and private equity funds was above-average returns, which justified the above-average fees. Recent studies show that the expected above-average returns did not materialize, leaving only the above-average fees. As a result, the largest pension fund by assets, such as Calpers in the United States, recently announced reductions in their asset allocations to hedge funds. But not everybody is following suit.

Since asset managers have an incentive to increase the size of their fees it is only logical to assume that the more intermediaries between the funds of asset owners and the final projects in which said funds are invested, the higher the chances that intermediary fees will tilt incentives towards the short term. One needs only remember the disastrous consequences of complex mortgage-based assets in the United States. Would infrastructure-based assets, more novel and where due diligence is exponentially more complex, create new types of exposure? And how will asset owners be protected from the potential for unscrupulous arbitrage between the true risk of projects and the perceived credit risk of the assets built upon them?

Commenting on the G20/OECD High-Level Principles of Long-Term Investment Financing by Institutional Investors, the Trade Union Advisory Committee for the OECD demanded that they provide further guidance on matters such as asset managers’ capacity and duty to act in line with asset owners’ objectives, prevention of conflicts of interest, duties to act in the interest of ultimate beneficiaries and owners, and asset managers contracts. The Principles in the end left that question as a matter pension funds need to watch for by themselves, with almost nothing to say on regulating asset managers in the public interest. It is worth noting even to the extent they address such matters, these principles are, at the moment, of a non-binding nature unless legislations in different countries incorporate them.

A constructive role for pension funds in infrastructure investment

Sounding a cautionary note about pension fund investments in infrastructure does not mean dismissing them as a good idea. It just means questioning the emerging discourse about how to do them and whose interests are shaping it. There is a constructive role that pension funds could play when financing infrastructure.

Pension funds of state employees are, in many developing countries, a viable option to regain autonomy to fund local infrastructure development. Regulatory developments should be geared to ensure they go to the right projects and fulfill a development vision that could help beneficiaries not only through their returns, but also through the living standards they will enjoy thanks to better infrastructure. But this will not happen if local pension funds are only seen as a small contribution to add to big pools of funds that some far away asset manager is putting together to fund a project that they have no say about.

The long term dimensions of infrastructure investment should be addressed upfront, from the very moment of the project selection and design. Financial regulations on the fiduciary duties of asset managers could go a long way to help address such concerns.

One of the advantages of infrastructure projects is their ability to create jobs in the host countries. Financing locally-created jobs can be perfectly done with local currency, and should not require acquiring debt exposure in hard currency. But the new model for infrastructure finance would make projects large and difficult to unbundle into different pieces according to which components can be best financed from different sources. With a more targeted model, pension fund money invested across borders could be channeled towards the really necessary expenses, reducing unnecessary financial risk in the host country and, with that, also the risk of pension fund beneficiaries.

Summing up, the new infrastructure finance model presents private investment in infrastructure as part of a new TINA (“there is no alternative”) situation for both infrastructure recipients and social security systems. This need not be the case. Even the UK administration that coined TINA, for a long time (1981 to 1989) had something called the “Ryrie rules”—who owe their name to Sir William Ryrie, a Treasury official at the time. Under these rules, projects should only be financed by private sources when they offered a higher benefits and profits compared with publicly-financed. Importantly, projects were not supposed to offer private investors any degree of security greater than that available in private sector projects.

So far in the discussion on the new model of infrastructure finance an elephant moving quite comfortably in the room is the extent to which the very construction of infrastructure as an asset class is driven by financial industry interests, rather than the real economy of infrastructure projects or the interests of the asset owners.

One can easily picture how the mainstreaming of infrastructure as an asset class will create a new “niche” and demand for the new related services in the financial services industry. It will generate business through the trading of the infrastructure assets, but also for armies of experts whose advice will be required on sectors to buy or sell, how to structure the products, and, why not, how to manage the new risks incorporated in the portfolio by designing new derivatives and providing the required advisory services to understand them.

The question asset owners should be asking is: will their interests be served likewise?


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August 2018
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