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Building a better world by integrating ESG into infrastructure investments

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This is a sponsored article from M&G Investments.

Alex Araujo
Fund Manager of the M&G Global Listed Infrastructure strategy

In this Q&A, Alex Araujo, Fund Manager of the M&G Global Listed Infrastructure strategy discusses the themes which are underpinning the sector and explains why he believes ESG principles and processes are inextricably linked to future success

What are the main themes that are driving listed infrastructure?

AA: At the moment, we are seeing the convergence of a number of themes. Coming out of a global pandemic — and its economic consequences means that we have this quite unusual  co-ordinated global set of efforts to revitalise economies.  Whether that’s North America, Europe or Asia, much of it is centred on fiscal stimulus and much of that stimulus is built around infrastructure.

The impetus is also for a green recovery, a sustainable recovery. This is a planetary and societal requirement and renewable energy, cleaner forms of energy generation and sustainability are at the centre of it all.

Digital infrastructure assets, which are an essential part of the unlisted infrastructure strategy at M&G, are an important driving theme because many of us still work remotely and entertain ourselves remotely. If anything, we’ve all learnt over the past year and a half how dependent we are on digital infrastructure to support our work and personal lives. In our view, all of that converges quite conveniently for a strategy such as ours, with so many different sets of exposures which can capitalise on these important themes.

Where are the most attractive investment opportunities within renewables? 

AA: This might surprise you,  because it’s not in the most obvious places. Pure renewable type businesses have been a go-to investment strategy for many investors, particularly ESG-minded investors. This has driven valuations up quite considerably, while increasing volatility in those kinds of cases.

We see greater opportunities in transition-oriented businesses. Examples here could be in electricity generating companies that are transitioning their own energy mix from more carbon intensive sources to renewables. I would argue such companies are actually contributing in a much different, perhaps even more supportive way because they’re affecting both sides of the balance sheet: deploying renewables, but decommissioning carbon intensive energy sources. These two case studies illustrate how we engage with renewable energy champions on both sides of the Atlantic: Enel and NextEra.

At the same time, these are complicated stories. Very often it requires engagement with management teams, with boards on how to accomplish that transition. We have to put pressure on — and sometimes we have to financially support — these initiatives. For that reason and for that added complication, the valuations tend to be more attractive. Therefore, what we accomplish in these investments is, of course, doing significant good for the environment when it all plays out the way we’d like it to, while capitalising on the valuation rerating, which is typically accompanying these kinds of stories.

I’d throw one more element into the mix, and that is transition fuels. We hear a lot about hydrogen as an ultimate fuel source. However, there are crucial transition fuels such as natural gas that can take an intermediate step in displacing coal-fired power and coal-fired heat in certain countries where renewables and cleaner forms of electricity generation aren’t yet available. That’s another interesting opportunity. Again, not obvious, and therefore with some attractive valuations attached to it.

Watch the videos to learn more:

Hydrogen is the cleanest burning fuel yet discovered. It’s already creating opportunities for infrastructure investors, particularly in the utilities sector.
Watch the video
Around the world, governements are prioritising renewables as the way to rebuild infrastructure sustainably. The opportunity to invest for net-zero is immediate and global. Watch the video

How does the investment approach differ from more traditional strategies for infrastructure investment?

AA: There are probably three specific areas I’d highlight here.

Firstly, is our focus on growth, but more specifically on dividend growth that we seek to extract from the businesses in which we are invested. The Global Listed Infrastructure strategy has an objective to grow the income to our unitholders every year in base currency terms, which for most of our audience would be sterling. This is achieved, naturally, by way of growing dividends, and you can only grow your dividends as a business if you have the kinds of assets and growth opportunities that can drive higher and higher cash flows. It’s very simple.

Rather than being more of a defensive-type of strategy, which is the traditional approach in the infrastructure world, we’re focused on the long term, consistent, reliable growth and cash flows and therefore dividends from the businesses in which we invest.

Secondly, a difference is on the scope and the breadth of what we invest in. I think historically most infrastructure investors have been focused on ‘core’ or ‘traditional’ economic infrastructure. We do that too of course — that’s the bulk of our exposure in the form of utility businesses, transportation infrastructure, energy infrastructure type holdings. But we extend the opportunity set for our investors to include social infrastructure, which has been incredibly important in the past year and a half. Think of hospital infrastructure, for example within primary care or hospital-type facility provision, educational infrastructure, civic infrastructure and so on. These are all involved in social infrastructure, which is a very defensive element of the strategy.

Thirdly, we add on what we call evolving infrastructure. This is the physical infrastructure required for the increasingly digital world in which we live. I have alluded to it earlier, but this is where we get into mobile phone towers, data centres, fibre optic networks etc. These are the kinds of digital infrastructure assets that we can’t do without if we want our internet, our zoom calls and so on.

Bringing these three elements together gives us some diversification within the sector because not all of these sectors and areas move in the same way at the same time. They have different market environments and we’ve benefited from that.

The final point I’ll make here is on ESG integration. This is where we examine and scrutinise the sustainability of the underlying assets and the business’ management teams that are managing them to ensure that those cash flow streams which we seek to grow over time will actually appear. This is particularly so over the long term, because we are long term investors with a very long term investment horizon.

Watch the videos to learn more:

See beyond renewables and discover the real investment opportunities in the decarbonisation of the infrastructure sector. Watch the video Discover the impact of natural gas on tomorrow’s infrastructure and how transition fuels are on a journey around the world. Watch the video 

Why is ESG so important for listed infrastructure?

AA:  For our strategy, it’s the nature of what we’re investing in, the nature of the asset class. We are investing in fixed, immovable, real assets at the core of the businesses that we hold in the portfolio. They typically have impact and they are exposed to potential impact — think of climate-change related events such as flooding, storms, forest fires etc. which pose a risk to those assets. In addition, those assets could become stranded for one reason or another, depending upon what they’re used for. So our ESG approach is one of examining the sustainability of the assets and, the businesses, because that’s the governance element, the societal impact of those assets and any exposures to risk. That is the proprietary approach we take. There are obviously financial implications of these kinds of risks. We aim to protect investors and their capital. That’s how our ESG approach is structured for the strategy.

How does inflation affect the asset class?

AA: That’s a complicated question. Very often, inflation fears can manifest themselves in listed infrastructure types of businesses from a sentiment point of view. It’s the historical linkage between inflation risk and interest sensitive businesses, because these are all dividend- paying companies in our portfolio. This tends to give us great opportunities because our ultimate protection and hedge against inflation in this portfolio is what I discussed earlier: that focus on growth. In my opinion growth is your best hedge against inflation risk. So, if we think about the kinds of businesses in which we invest and where they get the growth, you can see that having inflation accompanying growth— even if that means the higher interest rates that go along with it — can certainly benefit these businesses. Let’s consider a toll road infrastructure business. What does that toll road need? What it wants is growth, it wants recovery, passenger traffic, cargo traffic etc. Inflation allows the business to increase its tolls.

And so you get this effect where the economic sensitivity, the growth, the inflation, even the higher interest rates can positively affect these businesses. About two thirds of our portfolio itself has some form of inflation linkage in terms of protection. Sometimes it’s explicitly contractual,  such as you tend to find in social infrastructure, or it is less direct, such as in certain economic infrastructure businesses. It can even be in commodity price linkages, where infrastructure is serving commodity producing types of businesses.

These offer protections within the strategy. We have an objective to grow our dividends, expecting them to grow at a rate in excess of the G7 inflation rate, and this is how we seek to protect our investors from the eroding returns that inflation can sometimes bring.

The value and income from the fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise. There is no guarantee that the fund will achieve its objective and you may get back less than you originally invested.

The views expressed in this document should not be taken as a recommendation, advice or forecast.

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This is a sponsored article from M&G Investments.

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