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WHY PENSION FUNDS SHOULD INVEST IN REAL ASSETS / RENEWABLE ENERGY INFRASTRUCTURE?

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As the need for investment in infrastructure continues to grow, private sector financing for infrastructure projects has developed around the world. Given the long-term growth and (potentially) low correlation aspects of infrastructure investments, pension funds have also shown interest in increasing their exposure to this area, along with their move into alternative assets. Such investments cover a wide spectrum of projects: economic infrastructure such as transport or energy producing plants, to social projects such as hospitals or schools.

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WHY  PENSION  FUNDS  SHOULD  INVEST  IN  REAL  ASSETS  /  RENEWABLE  ENERGY  INFRASTRUCTURE?  

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ent  •   Pension  Funds  are  increasingly  moving  into  new  assets  classes  in  research  for  yield:  they  are  looking  for  new  sources  of  return  and  beNer  diversificaPon  of  investment  risk.  

•   Infrastructure  is  one  type  of  investment  being  frequently  discussed,  given  its  potenPal  to  match  long-­‐term  pension  assets  and  provide  diversificaPon.  

•   Previously  pension  fund  exposure  to  infrastructure  has  been  via  listed  companies  (such  as  uPliPes),  or  via  real  estate  porYolios.  

•   However,  some  larger  funds  globally  are  beginning  to  invest  via  private-­‐equity  funds,  or,  occasionally,  even  directly.  

•   In  the  1990s,  strong  stock  markets  were  supporPve  of  the  development  of  funded  pensions,  and  the  allocaPons  to  equiPes  were  increased  by  pension  funds  in  many  countries.  However,  the  burst  of  the  TMT-­‐  bubble  in  the  early  2000s  and  the  subsequent  recession  led  to  substanPal  funding  and  solvency  problems  for  pension  funds.  Both  sides  of  the  balance  sheet  were  affected.  This  led  to  a  major  rethink  of  the  asset  allocaPon  of  pension  funds.  

•    Pension  Funds  enlarged   their   investment  universe   to   include   corporate  and  high   yield  bonds,   and  invested   more   money   internaPonally,   including   in   emerging   markets.   In   addiPon,   the   investment  industry  started  to  offer  new  or  alternaPve  asset  classes  for  pension  funds.  They  include  hedge  funds,  commodiPes,   private   equity,   currency   and   tacPcal   asset   allocaPon   overlays,   commercial   loans,  infrastructure  investments,  forestry  products,  microfinance  and  other  niche  areas.    

IntroducPon  

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•   The  idea  of  invesPng  in  infrastructure  seems  to  strike  a  chord  with  many  pension  plan  directors  and  members.   Infrastructure   feels   more   tangible   and   real   than   a   lot   of   other   complex   products   and  derivaPve  strategies  presented  to  pension  funds  these  days,  where  they  find  it  difficult  to  detect  the  underlying  value.  

•    In  addiPon,   infrastructure   is  made   for   the   long   term,  and   there  seems   to  be  a  natural  fit  with   the  long-­‐term  liabiliPes  of  many  pension  plans.  For  some  people  there  is  also  a  connotaPon  to  sustainable  or  socially  responsible  invesPng,  which  is  an  increasingly  popular  route  chosen  in  parPcular  by  public  and  industry-­‐wide  pension  plans.  

•    In   a   historic   perspecPve,   private   financing   of   infrastructure   is   not   new.   In   recent   Pmes,   however,  there   have   been   significant   new   developments.   In   post-­‐war   Europe   in   parPcular,   most   of   the  infrastructure  was  owned  and  controlled  by  state  insPtuPons.  Since  the  1980s,  the  trend  has  reversed  as  many  pieces  of   infrastructure  have  been  (partly  or   fully)  privaPzed   in  the  face  of  stretched  public  finances.    

•    The   requirement   for   beNer   infrastructure   seems   obvious   everywhere   in   the  world.   Infrastructure  investment   will   need   a   huge   amount   of   capital   in   the   coming   decades,   whether   public   or   private.  EsPmates  made   by   supranaPonal   insPtuPons   for   global   infrastructure   needs   run   into   the   dozens   of  trillions.  

Infrastructure  

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Infrastructure  assets  are  tradiPonally  defined  by  their  physical  characterisPcs.  One  can  split  them  into  two  main  categories,  and  a  range  of  sectors  within  those:  

Economic  infrastructure  •   Transport  (e.g.  toll  roads,  airports,  seaport,  tunnels,  bridges,  metro,  rail  systems)  •   UPliPes  (e.g.  water  supply,  sewage  system,  energy  distribuPon  networks,  power  plants,  pipelines,  gas  storage)    

•   CommunicaPon  (e.g.  TV/  telephone  transmiNers,  towers,  satellites,  cable  networks)    •   Renewable  energy  

Social  infrastructure  •   EducaPon  faciliPes    •   Health  (hospitals  and  health  care  centers)    •   Security  (e.g.  prisons,  police,  military  staPons)    •   Others  (e.g.  parks).  

Infrastructure  

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Financial   industry   analysts   emphasize   the   existence   of   limited   compePPon,   resulPng   from   different  sources.  

•   Economic:  natural  monopolies  (e.g.  energy  distribuPon  networks),  public  goods  (e.g.  broadcasPng  •   RegulaPon:  controlled  charges  and  fee  increases  (e.g.  toll  roads),  regulated  uPliPes  •   Concessions  from  public  authoriPes:  long-­‐daPng  contracts  (e.g.  hospitals).  

Infrastructure  assets  typically  show  one  or  more  of  the  following  stylized  economic  characterisPcs:  •   High  barriers  to  entry    •   Economies  of  scale  (e.g.  high  fixed,  low  variable  costs)    •   InelasPc  demand  for  services  (giving  pricing  power)    •   Low  operaPng  cost  and  high  target  operaPng  margins    •   Long  duraPon  (e.g.  concessions  of  25  years,  leases  up  to  99  years).  

Infrastructure  with  a  financial  twist  

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From   this,   the   investment   industry   deduces   a   number   of   favorable   investment   characterisPcs   of  infrastructure  assets:  

•   Stable  and  predictable  cash  flows    •   Long  term  income  streams    •   Oien  inflaPon-­‐linked  (helping  with  liability-­‐matching)    •   In  some  countries,  tax-­‐effecPve    •   Returns  insensiPve  to  the  fluctuaPons  in  business,  interest  rates,  stock  markets    •   RelaPvely  low  default  rates    •   Low  correlaPons  with  other  assets  classes  (offering  diversificaPon  potenPal)    •   Socially  responsible  invesPng  (SRI)  (providing  public  goods  essenPal  to  society)  

Infrastructure  with  a  financial  twist  

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It  is  an  essenPal  part  of  the  fiduciary  duty  of  those  involved  in  pension  fund  invesPng  to  understand  the  specific  risks  of  infrastructure  assets.  Risks  go  much  further  than  the  usual  volaPlity  staPsPcs,  and  certain  factors  are  just  genuinely  uncertain.  

.At  the  level  of  infrastructure  projects  and  companies,  key  risks  include:  •   ConstrucPon  risk  (e.g.  the  project  is  not  completed  on  Pme;  costs  are  higher  than  budgeted…)  •   OperaPonal  risk  (e.g.  poor  management,  systems)  •   Business  risk  (e.g.  more  compePtors  entering;  change  in  consumer  preferences  and  demand;  technological  advances)  

•   Gearing  risk  (typical  leverage  of  30-­‐90%,  resulPng  in  a  high  exposure  to  interest  rate  risk;  refinancing  risk  with  higher  inflaPon  and  interest  rates;  downgrade  risk)  

•   Legal  and  ownership  risk  (unknown  future  liPgaPon,  planning  consents  not  granted;  lease  running  out…)  

•   Regulatory  risk  (e.g.  fee  rises  fall  behind  schedule)    •   Environmental  risk  (unforeseen  environmental  hazards;  acPon  groups)  •   PoliPcal  and  social  risk  (opposiPon  from  pressure  groups;  poliPcians  may  change  their  mind;  corrupPon)  

Risks  

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Pension  funds  are  presented  all  sorts  of  graphics  with  stylized  risk-­‐return  profiles:  somePmes  showing  infrastructure  with  risk  and  return  both  higher  than  equiPes,  somePmes  both  lower,  and  somePmes  at  higher  returns  and  lower  risk…  

When  the  global  infrastructure  boom  started,  return  expectaPons  were  oien  given  as  15%  plus  pa  by  some  providers.  

In  their  2005  analysis  of   the  Australian  market,  Mercer  say  that  ―most  managers‘  products   fall   into  the  category  of  diversified  infrastructure  funds  that  have  an  objecPve  to  deliver  returns  of  9  –  12%  net  of  fees.    

RREEF  makes   the  disPncPon  between   the   total   return  expectaPons  of  mature   (10  %  –  14%  pa)   and  early-­‐stage   assets   (18%   plus).   It   should   be   noted,   however,   that   such   expectaPons   are   fuelled   by  leveraging   the   returns   of   the   underlying   porYolio.   RREEF   put   a   typical   leverage   rate   of   40–80%   for  mature  and  30–75%  for  early-­‐stage  assets.    

The  analysts‘  projecPons  also  vary  across   infrastructure  sectors.   JP  Morgan  Asset  Management,  e.g.,  expects  the   lowest  expected   internal  rates  of  returns  for  toll  roads  (8-­‐2%)  and  PFI/PPP  (9–14%),  and  the   highest   for   airports   (15-­‐18%)   and   broadcast   network   (15-­‐20%),   this   against   an   infrastructure  average  of  10-­‐  15%.  

(All  references  available  on  demand)  

Risk  /  return  profiles  

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How   do   these   return   expectaPons   compare   to   other   asset   classes?   According   to   a   survey   of   2007,  return  expectaPons  for  the  asset  class  infrastructure  over  10  years  are  an  annualized  9.5%,  pusng  it  in  second  place  behind  private  equity  (11.3%).  In  comparison,  stocks  are  expected  to  return  9.0%,  bonds  5.1%  and  cash  3.7%.  Nowadays,  the  returns  for  cash  namely  would  be  much  lower.  

What   is   the   expected   risk   profile   of   infrastructure?   ExpectaPons   for   volaPlity   are   typically   set  somewhere  between  equiPes  and  bonds.  The  asset-­‐liability  model  used  by  Morgan  Stanley  Investment  Management,  e.g.,  compares  five  main  asset  classes.    

It  puts   infrastructure  (volaPlity  7.9%,  return  9.3%)  second  only  to  bonds  (4.4%)   in  terms  of  expected  volaPlity  and  second  only  to  private  equity  (10.0%)  in  terms  of  expected  return.  

As  an  example  for  pension  funds,  the  Dutch  APG,  expects  a  10%  return  from  infrastructure  with  a  7%  risk.   In   comparison,   the   corresponding   figures   are   6%   /   9%   for   property   and   15%   /   25%   for   private  equity.    CalPERS  are  looking  for  an  annual  return  of  inflaPon  (CPI)  plus  5%  -­‐  7%.  

(All  references  available  on  demand)  

Risk  /  return  profiles  

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Since  the  first  wind  turbines  were  built  at  the  late  1980s,  power  generaPon  from  wind  energy  has  seen  dynamic  growth.  The  reasons  for  this  unprecedented  boom  in  the  last  15  years  lie  in  the  support  programs  from  naPonal  and  state  governments.  Recent  market  trends  are  in  large-­‐scale  building  operaPons  ranging  from  50  to  several  hundred  MW  of  power  generaPng  capacity.  

Sun  energy  is  harvested  through  thermal  solar  plants,  or  photovoltaic  solar  plants  on  rooiops  or  ground-­‐mounts.  Although  development  costs  are  sPll  on  the  high-­‐end,  tariff  policies  have  made  this  area  very  aNracPve.  We  intend  to  focus  on  plants  with  greater  than  1  MWp  of  installed  capacity.  

Renewable  Energy  

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Biogas  plants  produce  a  gas  similar  to  natural  gas  and  use  anaerobic  digesPon  processes.  The  adopPon  of  this  waste  processing  technology  is  revoluPonizing  the  agriculture  sector  in  many  countries  and  is  being  used  to  now  produce  both  energy  and  food.  It  is  likely  that  in  the  future,  electricity  generaPon  capacity  will  increase  substanPally.    

Biomass  is  mankind's  oldest  source  of  energy.  Market  trends  are  focusing  on  co-­‐generaPon  plants  using  mixed  fuels:  wood,  bagasse,  and  straw  with  up  to  40  MW  of  capacity.  

Renewable  Energy  

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We  focus  mainly  on  mini-­‐hydro  projects  with  up  to  50  MW  of  capacity.  Larger  hydro  projects  had  been  the  trend,  but  the  market  is  now  shiiing  to  smaller  units  creaPng  an  aNracPve  niche  market.  

Renewable  Energy  

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Technologies  in  which  Akuo  Investment  does  not  invest  are  omi=ed  here:    ocean  wave  energy,  large  hydro,  CSP…  

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The  specificiPes  of  renewable  energy  infrastructure  are:  

•   Absolutely  No  (or  minimal  for  biomass)  commodity  price  correlaPon:  resources  are  “free”  •   Growing  and  poliPcally  supported  market  •   Socially  welcome  as  sustainable  investments  •   Moderate  size  of  the  projects/investments  per  project  compared  to  other  infrastructure  asset  classes  (airports,  toll  roads…)  •   Asset  class  growing  in  developed  countries  where  tradiPonal  infrastructure  projects  are  less  frequent  •   Electricity  generaPng  assets  are  about  the  future  of  energy  and  the  energy  of  the  future  •   Electricity  cannot  be  stored  on  an  industrial  scale,  has  to  be  consumed  •   Very  liNle  correlaPon  to  business  cycles  •   Feed  in  tariffs  or  PPA’s  (very  long  term  commitments)  •   No  bad  client  risk  (UPliPes  buy  the  energy)  •   Quality  of  the  cash  flows  (banks  accept  generally  much  lower  DSCR’s  then  for  tradiPonally  gas  or  coal  powered  staPons:  1.1-­‐1.2  vs  2.0)  due  to  nature  of  the  availability  of  the  resources  •   Excellent  Pming  due  to  the  pressure  regarding  climate  change  policies  

What  is  special  about  renewable  energy?  

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ent  Five  essenPal  driving  forces  to  successful  development  

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As  in  any  new  sector,  several  misconcepPons  circulate  in  the  common  press:  

•   Renewable  Energy  is  intrinsically  not  profitable,  and  it  would  never  exist  without  subsidies  (see  the  next  2  slides  in  addendum)  

•   Renewable  energy  cannot  replace  any  fossil  fuelled  power  plants,  and  is  just  another  gimmick  •   Renewable  energy  is  for  rich  naPons  only  which  can  afford  subsidies  (Renewable  Energy  has  some  its  greatest  developments  in  emerging  countries  where  the  energy  demand  increase  is  the  highest)  

•   Renewable  energy   infrastructure   is   like  cleantech  (Renewable  Energy   Infrastructure   is   to  cleantech  what  programming  languages  are  to  new  web  ventures)  

…  

There  are  misconcepPons  about  renewable  energy  which  need  to  be  cleared  away  

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For  more  details,  or  a  complete  bibliography  on  this  topic  please  contact  us:  

Akuo  Investment  Management  [email protected]  

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ent  Wind  energy  is  compePPve  to  most  other  sources  

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(All  references  available  on  demand)  

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ent  Solar  energy  is  soon  to  be  compePPve  relaPve  to  nuclear  energy  (US  stats)  

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(All  references  available  on  demand)