FYI | Apr 08 2021
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Extensive research has led ClearBridge Investments to conclude inflation has little impact on the value of infrastructure assets
-Thirty years of data
-Regulated versus user-pays
-Toll roads and airports
By Mark Story
While investors need to prepare for a world of rising yields after a long period of structural decline, research by ClearBridge Investments suggests not all assets will be directly impacted. Using North America and Europe as a case study, ClearBridge has gone back 30 years and looked at the correlation of infrastructure assets to both core and headline inflation.
What they discovered was the correlations have little if any linear relationship. What’s clear from ClearBridge’s analysis is that inflation is a pass-through directly or indirectly for infrastructure assets.
Given that there’s little correlation between various infrastructure assets and inflation, ClearBridge suspects rising rates and accompanying inflation will have little long or medium impact on valuations of regulated assets. This assumption is based on inflation being directly or indirectly passed through to customers.
Regulated versus user-pays assets
To understand the impact of rising interest rates, ClearBridge believes it’s important to distinguish between regulated assets and user-pays assets. For example, within regulated assets revenues are normally determined by a return on an underlying asset base, which is in turn determined by the level of investment.
By comparison, control of prices for transport (user-pay) assets is usually set out in a contract agreed at the time of grant of the concession, with volume risk (traffic, passenger, container, etc.) borne by the operator.
But the main difference relates to whether prices and the assets are index-linked, and cash returns based on a real cost of capital (with examples in the UK, Australia), or whether the regulator looks at nominal assets and grants a nominal return.
What investors shouldn’t overlook when looking at regulated assets, argues ClearBridge, is returns allowed by regulators depend on how interest rates and the cost of capital develop in the future. For example, if interest rates rise in order to facilitate future funding of capital investment, regulators need to increase the allowed returns.
While such increases happen neither immediately nor in most cases automatically, there is a process by which over the medium term regulated returns should rise and fall in line with rises and falls in the cost of capital – which ClearBridge assumes relates to interest rates.
Given that the requirement for a regulator to offer reasonable returns is usually established in the legal framework supporting the operation of the utility or other asset owner, ClearBridge believes investors can expect changes in interest rates to be reflected in future cash flows over the medium and longer term.
The important point to remember, adds ClearBridge, is that the underlying asset value at an assumed investment exit date in the medium term is likely to be relatively independent of interest rates. This is because any changes to the rate used to discount future cash flows will be offset by changes in cash flows set by the regulator.
In direct contrast to regulated assets, user-pay assets typically have greater exposure to GDP growth, while long-term cash flows for existing assets typically don’t respond to changes in interest rates or the cost of capital.
Their valuations at an exit date respond negatively to increases in long-term interest rates, and the longer the duration, the higher the negative impact. As a result, assets not linked to an inflation index would underperform.
Inflationary impacts on toll roads
Concession deeds under which toll roads have the right to operate, and for how long, define the parameters under which the toll road may operate, and in most cases this stipulates how toll prices may be increased.
While toll price increases are typically linked to inflation, ClearBridge cites a number of variations, including: Full inflation pass-through (eg, the Westlink M7 in Sydney); partial inflation pass-through (eg main French and Italian toll roads’ usual 0.7x CPI); inflation pass-through with a floor (eg WestConnex in Sydney has greater of CPI or 4% until 2040); and no inflation linkage (eg 407 ETR in Toronto and I-95 in Virginia are free to set tolls subject to constraints).
ClearBridge also notes that differences in inflation pass-throughs outlined above tend to drive the following outcomes. Firstly, full inflation pass-through will lead to limited sensitivity.
Secondly, partial inflation pass-through will lead to increased sensitivity, albeit costs are typically fixed and increase with inflation, providing for improving earnings (EBITDA) margins with traffic growth. Historically, adds ClearBridge, this is why partial inflation pass-through exists, as inflation is achieved after costs.
Then there are floor price increases which mean valuations are sensitive below the inflation floor. Hence, when inflation is decreasing, valuation increases and vice versa. Finally, concessions with no inflation linkage will typically mean valuations are affected more by traffic congestion and thus economic conditions.
As a result, ClearBridge concludes that inflation is typically passed through, making toll road valuations less sensitive to nominal bond rate changes where this is driven by increases in inflation.
However, ClearBridge reminds investors that toll road valuations are highly sensitive to changes in real bond rates without an increase in inflation, thus increasing discount rates without the benefit of inflation-driven increases in cash flows.
Inflationary impacts on airports
Given that airports are typically regulated to some degree, inflation sensitivity explains, ClearBridge, depends somewhat on the regulatory model of the airport. While most airports are dual-till – aeronautical activities are regulated and non-aeronautical activities aren’t – both revenue streams can pass through inflation increases.
The interesting point, notes ClearBridge, is how this occurs varies. For example, within Aeronautical activities, the regulator typically sets an allowed return that regulated airport activities can earn.
This allowed return is usually set for a period of five years, and includes an estimate of inflation. But while aeronautical activities can be exposed to inflation risk for up to five years, in many cases they have inflation linkages in actual pricing decisions.
By comparison, when it comes to non-aeronautical activities, commercial revenues are usually negotiated between airports and customers. This means short-term exposure to inflation is often dictated by contractual terms, while longer-term exposure is dictated by bargaining power.
But ClearBridge notes other factors influencing an airport’s ability to pass on price increases include, passenger mix (with high-spending customers influencing revenue outcomes); foreign exchange rates (typically passed through immediately in short-term spending rates); and passenger volumes, with most revenue streams reflecting the number of passengers multiplied by price.
For example, Sydney Airports’ ((SYD)) real price change in commercial activities has increased by 1.1% annually since 2003, while aeronautical has increased by 1.9% annually over the same period.
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