Is sustainable infrastructure the best way to tackle climate change and emerging market poverty?
The emerging market need for huge amounts of infrastructure spending must be met sustainably for the planet’s sake - and that’s good news for investors.
According to the United Nations (UN), developing countries face an annual investment shortfall of around $2.5 trillion. That’s roughly the 2019 GDP of France. It is a shortfall which needs to be bridged if the UN is to meet its Sustainable Investment Goals (SDGs) by 2030.
Necessary infrastructure investments comprise around 75% of that gap. The scale of opportunity for investors is not in question. However, the economic and demographic growth forecast in emerging markets over the next ten years means that, for the sake of all of our futures, it must be built in a sustainable manner.
Why is sustainable infrastructure so important in emerging markets?
Around the developing world, one billion people (mostly in the least developed countries) still lack access to electricity, according to UN research. 39% lack access to a third generation broadband network (3G), when much of the developed world has already moved into fifth generation (5G) network infrastructure. The US’ first 3G networks were rolled out as long ago as 2002.
In addition, a 2016 Moody’s study found that emerging markets suffer 8 times more from the effects of climate change than developed markets, in terms of the number of people affected by natural disasters. Emerging markets also suffer 5 times more than developed markets, in terms of direct cost of damage, as a share of GDP. This is predominantly driven by the adverse implications of climate change on the agricultural sector.
More than 5 billion people live in developing countries - ~65% of the global total – and the number is growing rapidly. Emerging markets are predicted to grow more than 10% between 2020 and 2030. Sub-Saharan Africa’s population is projected to double by 2050.
Furthermore, the IMF’s World Economic Outlook puts emerging markets' support of world GDP growth at constant level of 3.6%, forecasting emerging economies to account for 63% of world GDP by 2023.⁷
This creates considerable demand for the development of infrastructure in an environment where local governments and other funding sources are far from meeting it. And while it is clearly in the interests of the people that live in developing countries, the benefit of sustainable infrastructure extend far beyond those borders.
Sustainable infrastructure – not different, just better
“Sustainable infrastructure” covers most infrastructure, including everything from e-mobility and ports to renewable energy and data networks. Sustainable infrastructure is planned, designed, constructed, operated and decommissioned in a way that seeks to be sustainable over the entire life cycle of the asset. The economic, financial, social and environmental impacts are all considered from the blueprints to an asset being replaced. Sustainable infrastructure can stimulate economic growth and improve living conditions, while supporting climate change adaptation and mitigation efforts.
An infrastructure asset’s sustainability is typically gauged through environmental, social and governance (ESG) assessment, as well as its compliance with relevant industry standards. Unsustainable sectors and practices are generally excluded. The International Finance Corporation (IFC) – part of the world bank – has compiled a widely adopted exclusion list.
More advanced approaches to sustainable infrastructure go beyond minimising negative effects and aim for positive social and environmental impact. Depending on the sector, this impact is typically centred on providing accessible, affordable essential services in a manner that contributes to economic development goals, climate change mitigation, or combinations thereof.
Pursuing this impact typically entails a detailed assessment of who will benefit from the investment, as well as how and to what extent they will benefit. It also involves setting targets for the intended impact and then measuring and reporting the outcome.
What does it mean for investors? Rethinking “EM risk”
Emerging and frontier markets do present unique and important risk factors for investors, as well as barriers to entry, which vary materially by region and individual opportunity. The main considerations that add to default risk in emerging market infrastructure assets (versus developed market) are regulatory, political and currency risks.
However, while risk factors may vary between developed and developing markets, this has not historically equated to materially more consequential default figures in emerging markets. At the same time, a 1-2% return premium can be obtained in emerging markets infrastructure debt versus equivalent developed markets transactions. Overall, emerging market sustainable infrastructure debt risk-return profiles are typically far more aligned with the developing world than many investors believe.
10-year default rate
Source: Moody's 2018
In a portfolio context, sustainable infrastructure assets provide a number of other significant benefits. These include economic resilience and low correlation with other asset classes, low volatility driven by predictability of cash flows, as well as a high positive impact on the quality of life and economic development of local communities and countries. Moreover, the genuine diversification benefits are attractive to investors with a long-term investment horizon.
Permanent change through vital investment
Infrastructure investment can go a long way to make up for the shortfalls in investment that the developing world faces. Ensuring that sustainability is considered in every phase of these infrastructure projects makes practical sense from the perspective of those that use and live near them. But a sustainable view also makes the prospect of infrastructure investment more appealing to those that invest in the asset class.
Perhaps most importantly of all, without sustainable infrastructure, we cannot hope to meet the UN’s 2015 call to action to end poverty, protect the planet and ensure that all people enjoy peace and prosperity by 2030.