An attempt to compare the United States and Europe for infrastructure investors by Serkan Bahçeci
In infrastructure investing, the two dominant markets in terms of the size of the investable space are Europe and the United States. Both markets are, of course, large; consist of many national- or state-level jurisdictions; and are not homogenous. However, neither market is large enough to provide an adequate level of diversification alone.
There are significant differences at the sector level as well, with the United States currently leading the world in digital infrastructure investments, while Europe is the leader in institutional investors’ involvement in transportation. Having exposure to both markets improves diversification and should provide better stability in the long term, which is an essential part of the attractiveness of infrastructure as an asset class.
Expected returns in infrastructure were on average higher in the United States compared with Europe between the Great Recession of 2008–2009 and the increase of interest rates in 2022. The main reason, which was easy to observe, was the difference in the risk-free rates, proxied by the 10-year government bond yields. But that differential does not fully explain the difference between infrastructure expected returns.
In my view, the U.S. market provided slightly more value-added and opportunistic investments, while Europe tended to be slightly stronger in core to core-plus approaches. There are not reliable aggregated return data, but my guess is that European infrastructure has been overperforming the United States since 2022 during the ongoing high rates cycle.
We will know in a few years when the dust settles on asset valuations. Looking at Europe and the United States from a portfolio construction perspective, there are a few observations that make Europe slightly more advantageous for a core investment approach.
EUROPE IS MORE DIVERSIFIED IN INVESTABLE INFRASTRUCTURE
U.S. infrastructure is dominated by energy and, more recently, digital investments, so diversifying a portfolio across sectors has been challenging. Transportation infrastructure, for instance, is mostly not investable, as it is financed via tax-exempt municipal bonds.
The sponsor of the municipal bond, usually a local government entity as the name suggests, can issue bonds up to 100 percent of an infrastructure project’s cost, retaining the full control of the project during the construction and operational phases. As the debt is tax exempt when sponsored by a government entity, financing the project by a private sponsor can never be cost-effective.
The result is that although all European airports look like expensive shopping malls where customers arrive by aircraft, there are no privately operated airports with commercial traffic in the United States — except a handful of public-private partnership (P3) projects restricted to individual terminals in Denver, La Guardia and JFK in New York City, and LAX in Southern California that do not give full operational and financial control of the entire airport to the private operators.
Toll roads and seaports are quite the same, with the overwhelming majority financed by municipal bonds and operated by local government entities. There is an irony here that needs to be highlighted for those of us that remember the Cold War: U.S. transportation infrastructure has always been in a state of communism (everything is owned and operated by the government), while the old continent with its socialistic tendencies embraced the private sector. As a result, U.S. transportation infrastructure remains underinvested.
EUROPE IS MORE DIVERSIFIED ECONOMICALLY
Europe has a higher intraregional variation than the United States in terms of macroeconomic trends, so it provides a larger diversification opportunity. The United States has 51 jurisdictions at the state and federal level that control and regulate infrastructure, each with its own economic and demographic trends.
Europe is a bit harder to count, as the drawing of the border depends on the context; it has 44 countries, according to the United Nations (50 according to Wikipedia), and the European Union has 27 members, while there are 23 high-income OECD countries. Just to highlight the macroeconomic variation, the difference between the U.S. states with the highest and lowest GDP per capita is less than two times.
The same difference is five times within the European Union. The ranges of population and GDP growth rates are also wider in Europe compared with the United States.
EUROPE IS MORE DIVERSIFIED IN REGULATORY CYCLES
Quantifying the variation in rules and regulations is admittedly challenging. In my opinion, Europe is more diversified in that regard as well. Though there are strict political differences among the so-called red and blue states in the current environment in the United States, the federal rules and regulations are generally binding for the individual states, and more importantly, the federal tax and subsidy programs apply throughout the country.
The European Union, which only covers about half of the continent demographically, does not have such federal powers, so individual countries are completely free in their fiscal approaches to infrastructure.
EUROPEAN INFRASTRUCTURE PROVIDES BETTER INFLATION PROTECTION
The long-term contracts in the United States tend to be based on nominally fixed prices, while they are mostly inflation indexed in Europe. The canonical long-term contract, the power-purchase agreement (PPA) that needs to be approved by the state utility regulator in the United States, traditionally has no inflation indexation.
So, independent power producers in the United States always shouldered the inflation risk through the contracted period. In the meantime, long-term contracts in power generation in Europe, mostly feed-in tariffs provided directly as government subsidies, have always been inflation indexed.
As inflation stayed subdued until very recently, the historical financial performances of assets with fixed-price PPAs versus assets with inflation-indexed PPAs did not vary much until 2022. However, in assessing the discount rate for the discounted cash flow valuation, many investors added an inflation risk premium for contracts with no indexation.
Based on the break-even inflation rate that determined the inflation risk premium for the bond market, I estimate a 30-basis-point to 80-basis-point premium applied for nonindexed revenues in the pre-2022 period. In hindsight, as the cumulative inflation in the past three years was in the 15 percent to 20 percent range in the OECD, that premium was not high enough to cover the inflation risk.
The effect of nominally fixed-price PPAs spilled over to other sectors as well. Albeit not as pronounced in the energy sector, contracts in digital and transportation sectors and regulated tariffs for regulated utilities have, on average, much stronger inflation indexation in Europe compared with the United States.
HOME BIAS AND CURRENCY IMPACT
For core infrastructure, when expected returns tend to be relatively low and expected cash yield is expected to be a bond replacement, there is still a rational case for an investor to stay home regardless of the attractiveness of the other side of the Atlantic.
The currency impact and the fluctuation of cash flows solely based on FX volatility when repatriating the return on and of capital also should be considered. Currency impact tends to get lower (on an annualized basis) through time, and infrastructure, which is naturally a long duration investment, performs better with stability in the long term.
CONCLUSION
European infrastructure has more investable sectors, has a longer track record in more sectors, provides better inflation protection and enjoys more direct government subsidies when needed. In other words, the overall risk profile in European infrastructure has been lower compared with the United States, making Europe more appropriate for a core investment approach.
As investors build their infrastructure exposure, diversifying through risk profiles ranging from core to opportunistic, they should consider both the United States and Europe for a well-balanced portfolio.
Extract from Institutional Investing in Infrastructure November 2024 Issue
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