Growth vs stability: do infrastructure investors really have to pick a side?

There’s a buzz around infrastructure at the moment, whether due to new government spending, the growing need for AI-ready systems, heightened concerns about energy security or simply a recognition of the role that listed infrastructure can play in portfolios during times of uncertainty. How can investors best harness this structural potential?

How to capitalise on structural potential 

Investors will be watching closely as structural drivers translate into real-world investment opportunities. Investment pledges — such as Germany’s 500-billion-euro infrastructure bill — will trigger new projects, AI demand will drive real-world infrastructure shifts and energy security concerns are prompting governments to invest in generation, storage and grids. Investors might therefore conclude that the best way to benefit from this wave is to look at more cyclical, volatile infrastructure stocks to capture growth. The problem with this approach? It erodes many of the potential benefits that make infrastructure such a valuable part of portfolios in the new economic era — downside and inflation mitigation and income stability. 

Some investors might consider increased volatility a fair exchange for growth potential. This makes sense if you’re facing a choice between defensive, low-growth utilities versus growth-exposed, volatile infrastructure. But what if this is a false choice?

You don't have to invest in cyclical businesses to benefit from infrastructure tailwinds

The listed infrastructure investment universe is remarkably heterogenous. One part of the infrastructure universe is comprised of more cyclical exposure (such as transport companies or commodity-levered exposures), while steadily growing companies, with regular stable dividends, such as regulated utilities, form the other, more defensive side of the infrastructure universe. Interestingly, increased infrastructure spending will significantly benefit the second group given the drivers of the growth. 

Regulated utilities are not only less sensitive to economic cycles than cyclical companies but they are actually a prime beneficiary of these structural trends given the growing demand for power, specifically electricity. Importantly, regulators recognise how essential this growth is to their overall economy. As such, they are incentivising the utilities to continue to invest in growth by increasing their allowed returns. Furthermore, as part of their commitments to infrastructure, governments will be investing heavily in electrification, upgrading and modernising the grid and network and taking steps to improve resilience, all of which tie directly to regulated electricity utilities. New sources of power, whether traditional or renewable, need not only be connected to the grid but also mean that the grid itself will have to be upgraded in terms of its capacity. 

Resilience will be a particular focus for governments concerned about energy security. Decarbonisation is continuing to drive demand for renewable sources of energy, but investment in flexible generation and batteries is necessary to solve for their intermittency and ensure reliable power. Recent events, such as the blackout in Spain, have prompted a rise in capacity payments for integrated utilities, meaning that they will receive higher capacity payments to ensure that power is available if needed. 

Case in point: Germany’s path to electrification is far more challenging than the one faced by other European countries, such as France, due to its historic reliance on fossil fuels for heating. Its grid infrastructure is in critical need of upgrades, both in terms of connecting new sources of electricity to the grid and upgrading existing grid connections to handle higher electricity demand. As a result, Germany will need to invest more heavily in its networks than other countries. This, coupled with Germany’s new focus on infrastructure investment, provides a positive setup for the regulator to increase returns for utilities. 

You don’t have to reach for yield to capture returns

From an initial glance, returns on offer from utilities may appear predominantly tied to yields. This brings us to another false choice that investors typically encounter when considering infrastructure investments. If I’m stuck with defensive assets, I should reach for as high a yield as possible. However, if you believe, as we do, that the market overpays for current yield but underpays for steady growth and reinvestment, there is another way. We believe that growth implies a need and scarcity, which also tends to result in governmental or regulatory support. Focusing on growing, regulated assets, with exposure to structural themes, can lead to an attractive risk/return profile and faster-growing dividends over time, especially compared to broad equity exposure.

We believe returns on offer from regulated utilities that can reinvest for growth, rather than just pay out excess cash as dividends, are increasing, for a couple of different reasons. First, the key driver of value creation for networks is the level of returns permitted by the regulator. We believe regulators have become increasingly aware that allowed returns must be set at attractive levels to incentivise new investment. This alignment between utilities and the regulator is starting to manifest in proposals to increase the headline-allowed returns for networks for many European utilities. Greater allowed returns mean greater returns on growth investment, which should mean greater returns through time than simply capturing a yield. 

Second, we’ve long been believers that companies that are reinvesting have the potential to earn higher returns, but it's also important to understand that there are mechanisms through which many European utilities can earn higher prospective returns relative to the last few years. Some regulatory frameworks — for example, in Italy, the UK and Germany — allow for incentives. These incentives may include operational incentives (such as beating cost benchmarks or operational targets) or financial outperformance (such as by borrowing more cheaply than the regulator’s set rate). As a result of these incentives, the “better” utilities can earn premium returns over and above the headline returns offered by regulators).

Case in point: For example, the German regulator’s headline-allowed returns may not look especially attractive, but there is considerable scope for beating benchmarked cost allowances, particularly for larger companies. 

Infrastructure is trending — but the real opportunity lies in identifying assets that can benefit from today’s growth opportunities and deliver attractive returns. We believe investors don’t have to expose themselves unnecessarily to cyclicality, compromising the downside mitigation offered by infrastructure, in order to benefit from structural tailwinds. Stable companies that provide steady income while also reinvesting for growth are an underappreciated, yet crucial, part of the next generation of infrastructure.