Why will decarbonisation and the quest for net zero benefit from increasing infrastructure investment? Phil Kent, lead adviser, GCP Infrastructure Investments Ltd, explains.
There has never been a greater need for infrastructure investment in the UK. It is needed not only to maintain pre-existing social and economic infrastructure, but also as a response to climate change, with decarbonisation and the quest for a net zero economy by 2050 providing favourable investment opportunities for investors in the sector. For example, the UK Government’s 2023 Green Finance Strategy highlights that the transition to a low-carbon economy is not only an environmental imperative, but also a growth opportunity for the UK.
However, while the government has introduced targets to help achieve its net zero ambitions, the policy response so far has been underwhelming. In fact, the government has been net negative in promoting infrastructure investment. This has been further compounded by an unfavourable macro environment and the requirement for high upfront capital to fund large infrastructure projects.
Increased opportunity for private sector infrastructure investors
There’s no doubt infrastructure funds are going through a period of market volatility. Credit markets have experienced a re-rating and have re-priced dramatically over a short period of time in a bid to tackle inflation. Investment is much less attractive in a high-cost environment, particularly when trying to minimise the cost of infrastructure over the long term. Capital has also flooded away from infrastructure alternatives into traditional forms of fixed income like bonds, gilts and money market instruments.
Despite this, the infrastructure sector in the UK is set to grow, with the UK government’s national infrastructure and construction pipeline, published every two years, indicating that £650 billion of investment is required over the next decade. While a significant portion of this is required for economic and social infrastructure, the opportunity for private sector infrastructure investors in the decarbonisation space is growing.
Infrastructure has a key role to play in the UK’s quest for decarbonisation. Europe has just emerged from an extremely hot Summer, with wildfires across Rhodes, Catalonia and Tenerife, and flooding and rainstorms in Central Europe. The period from June to August 2023 was the warmest on record globally, with temperatures in Europe 0.83OC higher than average. We’ve now had flooding in the UK and the nation needs to be able to respond to global warming requirements, even if it is simply adapting existing infrastructure to make it more resilient to climate events. This includes bigger flood defences, increased healthcare resources and increased housing due to migration and climate refugees.
UK policy initiatives fail to recognise the economic constraints of funds
The UK has an impressive commitment to achieving net zero by 2050, along with the aim of decarbonising the electricity grid by 2035 (2030 under a Labour government). While various incentive schemes have been introduced to push forward this agenda, there have also been significant policy failures relating to climate change, with the government failing to adapt to the new high-cost environment the infrastructure sector finds itself in.
A recent example of this is the Contract for Difference scheme, which is a UK flagship policy supporting renewable electricity generation by offering a 15-year fixed price to electricity generators. The Contract for Difference policy was successful for the first five rounds and supported the deployment of new electricity generation across the UK. This is reflected through the high offshore wind capacity in the UK, as well as the UK’s status as a global leader in offshore wind projects. In the latest Contract for Difference round, the government reduced the maximum price cap, failing to recognise that the costs of offshore wind projects have increased by c.50%. This increase can be attributed to increases in supply chain and funding costs, as well as the returns required by investors. As a result of the price cap reduction, no offshore wind projects bid into the last round of discussions, leading to a drop in new capacity procured.
Thus, while the capital required for offshore wind projects is getting larger and larger, the UK is failing to attract the capital to build the capacity it needs. The government has set a target of achieving 50GW of offshore capacity by 2030, which, based on what is currently in construction, does not appear feasible. Power prices are also expected to be impacted if the UK fails to increase its offshore capacity, particularly if low-cost marginal generation gets taken off the grid. Energy will then have to come from more expensive sources, and power prices will increase as a result. This highlights how necessary it is for the government to recognise and adapt to the new paradigm of high supply chain and financing costs the infrastructure sector finds itself in.
Investment needed to meet the UK’s ambitious targets
Discussions around the UK’s net zero commitments are often focused on the decarbonisation of electricity and energy sectors. However, it is also important to consider the ways in which transport, heat, industry, agriculture and other carbon intensive sectors can help achieve the UK’s ambitious decarbonisation targets. While the macro backdrop has changed dramatically over the past two years, making large capital investments difficult and painting a somewhat negative picture of the UK’s infrastructure capacity, it has also highlighted the massive investment required to meet decarbonisation across all sectors of the economy.
Infrastructure as a sector has historically been underinvested in, however infrastructure assets are ones we are going to need for future generations. The sector as a whole needs increased investment to maintain existing, and build new infrastructure, and the government needs to increase policy initiatives to incentivise this investment, particularly if it is serious about achieving its net zero ambitions. This means that existing portfolios have an increasingly significant role to play, becoming more valuable over time due to the scarcity of assets across the sector.
While the infrastructure sector is generally trading at a discount to the NAV, nothing from an asset perspective has happened to justify this. And with dividend yields in double figures in many cases, it’s my belief it is an attractive entry point and investors can enjoy the increasing opportunities for growth the sector offers over the long term.
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