Portfolio Manager - Core Infrastructure Fund
Depending on their nature, infrastructure assets can operate in different regulatory environments. In this article, we consider some of the regulatory factors that need to be taken into consideration when assessing the merits of a regulated infrastructure investment.
Certain types of infrastructure assets are regulated. The nature of the regulation can vary according to a range of factors including the type of asset, and the geography in which the asset is located.
Why are they regulated?
Infrastructure assets generally provide ‘essential services’ but can have monopolistic characteristics, meaning consumers may have limited alternative choices. The regulatory framework seeks to balance the rights of consumers, with the need to ensure the asset is financially viable and remains on a sustainable footing. There can be potential for tension between these objectives, and the role of the regulator is to balance the different interests and deliver a fair outcome.
The location of an asset can have a significant impact on regulatory issues that need to be considered. Within some countries, the regulator is a national body with power to regulate all infrastructure assets of a particular type nationally. This is the case, for example, in the UK water sector. This tends to result in relatively consistent regulatory outcomes across similar assets. By way of contrast, in the US there is a range of state-based regulators which do not have a nationally consistent approach. This can lead to significant differences in regulatory outcomes for similar assets.
In other instances, assets can be subject to multiple levels of regulation. This could occur where an asset is subject to regulation by both national and state regulators, or where an asset operates across multiple jurisdictions, such as across state lines, which can be the case in the US electricity market. Having multiple levels of regulation can significantly increase the complexity of owning an asset.
In addition, the nature of what is actually regulated can also vary by jurisdiction. For example, Australian electricity assets are subject to revenue cap regulation (meaning there is a limit on revenue they can receive), whereas in the US similar utilities are subject to limits on the rate of return they can earn from their asset base.
Frequency of regulatory reviews
Regulatory reviews may be conducted at set points in time. For example, UK water utilities, as well as Australian water utilities, are subject to a regulatory review every five years. The position is different in the US, where regulatory reviews tend to be done by exception (for example they may arise out of consumer or political activism as a result of perceptions of high pricing) rather than according to a pre-defined timetable.
Whatever the model, the outcome of such a review process will essentially determine prices that can be charged for services provided by an asset. It therefore has a significant influence on the rate of return that an asset can generate for its owners, so this process is crucial to the investment.
In addition to regular periodic reviews, in some instances regulators may initiate an off-cycle review. Similarly asset owners may be able to approach the regulator to request an off-cycle review. This would generally occur where certain circumstances may have changed in a way not contemplated during the periodic review process.
Track record of regulator
The track record of a regulator is critical when evaluating a regulated infrastructure investment. Consistency across regulatory periods is a major consideration for investors. Where a regulator has a history of surprising the market participants with regulatory outcomes, this can be considered as a potential investment risk, and should increase the required rate of return for the investment in order to compensate for that increased level of risk. On the other hand, where the regulatory environment is predictable, the required return may be lower, reflecting a greater degree of confidence on the part of the investor.
Economic and political factors
Regulators operate in a landscape that can be influenced by both political and economic factors. When an economy is under stress, there may be political pressure to lessen the burden on consumers at the expense of asset holders. This could materialise through a lower allowable return at particular regulatory reviews. Asset owners seek to mitigate this risk by ensuring that there is a long and stable regulatory regime with a history of rational and predictable behaviour. In addition, this risk is mitigated to some extent by the fact that private funding is needed in many countries in order to fund their infrastructure requirements and, if private investors are not able to achieve a reasonable return, they are unlikely to invest, or maintain their investment in, these types of assets.
In the current low interest rate environment, high yielding investments are attracting a lot of attention from investors. The attractive cash yields offered by many regulated infrastructure assets may make them well worthy of consideration by investors. However, regulation in itself has its own set of risk factors which need to be understood and carefully evaluated on a case by case basis before any investment decision is made.
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Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.