John Pickhaver | Executive Director, Co-Head of Infrastructure Utilities & Renewables, Australia and New Zealand, Macquarie Capital

John Pickhaver

Executive Director, Co-Head of Infrastructure, Utilities & Renewables, Australia and New Zealand, Macquarie Capital

Key points:

• The demand for new infrastructure corresponds with a heightened appetite for investment in

Australian infrastructure. • The historically very low cost of debt offers a rare opportunity for enlarged infrastructure funding. • Superannuation and other investors enjoy a growing pool of greenfield and brownfield investment opportunities, but there remains substantially more capital than there are investment opportunities.

It would be useful to begin with a quick tour around the world, for an Australian and global economic snapshot, to provide some context for the current themes in infrastructure financing.

Let’s start off in the United States, which has seen economic recovery, with jobs recovering to their preGFC levels. This recovery has taken longer than in previous recessions, and it is happening without the traditional matching increase in wages. The result is that consumer spending in the United States is still slow, while the lack of inflationary pressures means that the prospect of an interest rate rise continues to be pushed out further into the future. Consequently, interest rates are going to stay lower for longer in the United States.

In the United Kingdom, we’re seeing a very similar theme, with unemployment recovering faster than in the United States, again without the wage increases and corresponding inflationary pressures. The result: the Bank of England still has rates on hold at 0.5 per cent.

In Europe, we are starting to see signs of hope. Unemployment rates, which were much higher at the end of the GFC, have started to turn down, and some of the leading indicators in the eurozone are now turning positive. Things like new manufacturing orders and consumer sentiment are ticking up.

Canada, which, given its resources-driven economy, can be seen as a cautionary tale for Australia, has had significant falls in revenues and commodity prices, leading to a severe downturn in its economy. This has been despite the parallel growth in residential building activity. Canada has announced that it is now in recession, with 0.5 per cent drop in gross domestic product (GDP) following the 0.8 per cent drop in GDP last quarter. It is also worth noting that Brazil, another resource-dependent economy, is also now in recession.

China, which has been garnering significant global attention recently, has seen slightly lower than expected growth, and our economists are forecasting a 6.8 per cent growth rate for the third quarter

of 2015. While that is still impressive, it is slightly below global forecasts, which in turn led to the world market sneezing. What we’ve also seen is the run up and then crash of the equity markets, and monetary intervention followed by significant devaluation of Chinese currency, all in an effort to stimulate their economy. The result has been global falls in equity markets, and a big increase in volatility – none of which has been helping investor confidence.

Looking at a global picture, the United States, United Kingdom and Europe are on the upswing from the global downturn, while Canada and some of the more developing economies are continuing their slowdowns. Focusing on Australia, we’re currently in slowdown mode and heading towards transition. Growth is still positive, but we’re poised either for a further slowdown in growth or, if the right action is taken, a transition to turn around.

Focusing on the Australian economy, 12 months ago, mining investment in Australia was falling off. While this has continued, it has been slightly more gradual than expected. It’s worth noting that this represents between a 20 and 25 per cent annual decline. The June 2015 edition of IPA/BIS-Shrapnel Australian Infrastructure Metric estimates a further 21 per cent drop in mining and resources investment in 2015/16.

We’re seeing this in a context of residential building activity (as measured by approvals and commencements) stepping up significantly. However, this is only in the residential sector; infrastructure spending has continued to decline. On the public side, the continued decline has been evident, and is only now starting to pick up in a state like New South Wales. Private investment in infrastructure, while slow through the mid-2000s, has now, in fact, turned down. While various factors have slowed growth in the economy, we haven’t gone into recession; GDP growth is still in positive territory, with the latest release this week showing a 0.2 per cent increase in GDP for the quarter nationally – albeit with some very stark differences at a state level. What we are seeing is that, on a per capita basis, gross domestic income is falling, so this is leading to the possibility of an income recession. In other words, we’re producing more, but earning less. Consumers are feeling the bite; they’re working harder, but they’re feeling poorer for it.

One reason that the infrastructure sector is feeling the bite is because, despite an improvement in residential building, the infrastructure pipeline has continued to slow significantly. The peak was around 2011, with around one and a half years of forward work on people’s books. That’s now dropped to less than a year. This trend is again reinforced by the IPA/ BIS-Shrapnel Australian Infrastructure Metric, which confirms a 28 per cent decrease in infrastructure work won over 2014/15.

I’ve talked about the global context and the Australian economic situation as background to the current low levels of investment and activity in infrastructure. It’s now time to turn to some thoughts to what the macro drivers could be to lead to an increase in infrastructure investment. If this is to occur, how is the market placed to respond to that in terms of investing the capital needed to support this new infrastructure?

Taking a broader look at our economy, we all talk about the mining boom and bust, but it is easy to forget that our economy is, in fact, powered by services. Since 1990, the services industry has grown from about 66 per cent of the economy to 73 per cent, as measured by gross value added. Mining represents nine per cent. Even if you look through the years of the mining boom, which we’ve taken as starting in 2005, the annual value of services as measured by gross value has increased by $256 billion. The annual value of the mining increase over the same period of time was $51 billion. Even if you look at the total cumulative value of those mining boom years, services contributed more than eight times the value added to that of mining. Services represent things like tourism, education, health, and the knowledge-intensive services: IT, professional services and finance.

Services are thus the engine of the economy. It is worth noting where these services are being provided, and the linkage of that location with Australia’s population and our population growth. Our population continues to grow. We have the highest rate of population growth out of all of the developed economies, and this increase in population is largely flowing into our cities. Around 90 per cent of Australians live in urban areas, compared to 81 per cent in the United States and 75 per cent in Germany. In Australia, 64 per cent of the population currently lives in our largest four cities.

This growing concentration of population in our cities matches the growing importance of services. Notwithstanding the improved availability

of mobile technology and the ability to work from home, people still feel the need to be physically connected to those with whom they’re working, to the services that they’re consuming, and to their jobs. This leads to growing cities, and with growing cities come growing pains. The largest growing pain in the Australian consumer economy at the moment is house prices. While Australia’s population has been growing, the rate of dwelling growth has been falling. This is a particular concern when the driver of growth is within our cities.

This situation has led to a significant shift in the affordability of housing, with average prices through the late 1980s and early 1990s averaging around 2.8 times yearly earnings. Post-2003, this average has jumped to around 4.5 times annual earnings. It is interesting to note that this increase in costs is largely to do with the value of land.

For the 1980s and 1990s, around 50 per cent of the value was around dwellings – the bricks and mortar – and 50 per cent was in the land. Currently, two-thirds of that value is in the land, and only onethird is in the dwellings. The access to land and to the right to build a dwelling is one of the key drivers of the cost of housing, which is now our largest household expense. In 1984, we spent on average 7.2 weeks per year working to pay for our housing. In 2009–10, we spent 9.3 weeks working to pay for our housing; more than the 8.8 weeks that we would have to work to pay for our taxes.

We know that house prices decrease as you move away from the centre of cities. This brings a choice for workers: they could move further away from their centres of employment and centres of urban interaction, but that brings with it increased commuting times and greater congestion.

The confluence of housing, transport and congestion is leading to reductions in productivity. In short, commuting steals time and congestion steals time, and that time is being stolen from productive enterprise or leisure.

The population growth of our cities, pressures on housing, and transport needs are driving the need to continually develop and invest in infrastructure to support a productive economy.

If the need is there, how is the market currently placed to invest in the development of that infrastructure, either directly into the greenfield pipeline or by using brownfield assets that can be recycled for new projects?

The answer to that is: very well placed indeed, if we look at the pool of available capital to invest. This pool continues to grow. As an example, let’s look at the total amount of Australian superannuation assets, which, as at June 2015, were valued at $2.02 trillion. This is forecast to double to $4 trillion in around 10 years’ time.

It is not the case that all of that capital is available to invest into infrastructure. One interesting feature of the funds under management at the moment is the amount being held in cash, which is at the highest levels seen in the last 20 years. A good portion of that cash is currently looking for an attractive place to invest and generate suitable returns.

When we look specifically at funds set up to invest in infrastructure itself – infrastructure funds that have raised capital – we can see that there is around $110 billion of equity ready to invest in infrastructure projects. Gearing them up at around the 60 per cent level turns the total capital available to $320 billion of debt and equity ready to invest. While the capital is there, it is interesting to note that this capital in today’s environment can be deployed at historically low rates.

We have measured rates of return required against infrastructure investors since the mid-1990s, since investors started investing in infrastructure as an asset class in the real sense. The trend has been downward. It ticked up post-GFC around 2009, but that otherwise steady decline of returns required has been due to a couple of factors. First is the increase in competition – there are more funds looking to deploy their capital to this space, and those funds have grown. Allocations of funds towards infrastructure from the superannuation point of view have also continued to grow. Investments in property and real assets represented, on average, around eight per cent of superannuation funds allocations. That’s now grown to 25 per cent as of 2013.

The cost of available capital isn’t just limited to equity capital. We are at historically low rates of debt finance in the market and, from the economic discussion earlier, our view is that those low rates will stay low for some time to come. Combining the availability of capital with this low-rate environment makes this the best time in a generation for the financing of infrastructure.

As a final theme, the types of infrastructure that investment is attracted to are also evolving. With the competition for assets increasing, there is an

increased appetite among infrastructure investors for a different risk return requirement, and to look outside core infrastructure investments to those with higher returns and different structures. Looking at the last 15 years of investments in infrastructure, between 2001 and 2010, core infrastructure – things like transport, energy, ports, roads and airports – represented 66 per cent of the investment made in infrastructure during that 10-year period. In the last five years, that’s dropped to 50 per cent, with the other 50 per cent representing investments in things like resources infrastructure, telecommunications, oil and gas infrastructure, and waste.

The spectrum of what is considered infrastructure that can attract private capital for investment is expanding – from the Port of Newcastle to waste collection in New Zealand, and from regulated utilities to merchant wind farms. With an appropriate risk return structure, infrastructure investments in these sorts of assets can be made. These sorts of structures can include a range of different methods to minimise some of the noninfrastructure-type risks that infrastructure investors won’t be prepared to take.

These might include commodity risk or oil price risk, taken out of structures through take-or-pay or tolling arrangements; usage risk through sale and leaseback structures; or single-use risks through the aggregation of assets into a suitably sized portfolio. Such approaches mean that assets not previously considered by infrastructure investors are now available for investment.

To draw the various strands of this update together, the demands of a growing population and the reliance on our service industries is a big driver of demand for increased investments in infrastructure – in particular, in our cities, which is ultimately an investment in productivity and our economy. The capital is available to invest at historically low rates, and the range of infrastructure that investors will consider is at the broadest that it has ever been. The combination of these themes presents a once-ina-generation opportunity to drive the next wave of projects off the drawing board and into delivery.

Important notice This article is not research, has been prepared by non-research personnel of Macquarie Capital (Australia) Limited ABN 79 123 199 548 (‘Macquarie’), and has not been independently produced by a research team. This article is provided for general information purposes only, without taking into account any potential investors’ personal objectives, financial situation or particular needs. It is not an offer to buy or sell, or a solicitation to invest in or refrain from investing in, any securities or other investment product. Nothing in this article constitutes investment, financial, legal, tax, accounting or other advice. Macquarie, its related bodies corporate and other affiliates, and their respective directors, employees, consultants and agents make no representations or warranties as to the accuracy, completeness, timeliness or reliability of the contents of this article, and accept no liability arising from its contents (to the maximum extent permitted by law). This presentation may contain forward-looking statements, forecasts, estimates and projections (‘Forward Statements’). No representations or warranties are made that such Forward Statements will be achieved, will prove to be correct or that the assumptions on which they are based are reasonable. Actual future results could vary materially from the Forward Statements.

Other than Macquarie Bank Limited ABN 46 008 583 542 (‘Macquarie Bank’), none of the Macquarie Group entities noted in this article is an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of Macquarie Bank. Macquarie Bank does not guarantee or otherwise provide assurance in respect of the obligations of these entities. © Macquarie Capital (Australia) Limited 2015

John Pickhaver Executive Director, Co-Head of Infrastructure, Utilities and Renewables, Australia and New Zealand, Macquarie Capital

John Pickhaver has 16 years of experience in the infrastructure sector, both as a civil engineer and in infrastructure finance.

While at Macquarie, Mr Pickhaver has advised on corporate and project financings, mergers and acquisitions, and arranging debt and equity for transactions including power stations, electricity transmission, gas pipelines, wind farms, energy storage, rail, light rail and road infrastructure, including public-private partnership transactions. Mr Pickhaver has also provided strategic financial advice to corporates in relation to capital structure reviews, and governments in relation to energy and transport infrastructure assets and financing.

Previously, Mr Pickhaver worked for a number of years as a civil engineer in Australia on infrastructure projects, before completing his Doctorate at Oxford University in civil engineering, and subsequently his Master of Applied Finance.

Some recent examples of transactions that Mr Pickhaver has led: • Adviser to AGL Energy for the sale of their 50 per cent participating interest in the Macarthur Wind Farm, ongoing 2015 • Adviser to APA Group for their successful US$4.5 billion acquisition of the QCLNG Pipeline from BG

Group, and $1.8 billion equity raising, 2014–15 • Adviser to the Bombardier Transportation consortium for the successful $4 billion Queensland New

Generation Rollingstock public-private partnership, 2014.

Mr Pickhaver holds a Doctor of Philosophy (DPhil) (Civil Engineering) from Oxford University, United Kingdom; a Master of Applied Finance, Securities Institute/Kaplan, Australia; and a Bachelor of Engineering (Civil) (Hons), University of Sydney, Australia.

PATIENT INVESTMENT: HARNESSING SUPER FOR INFRASTRUCTURE

BY MICHAEL HANNA, HEAD OF INFRASTRUCTURE – AUSTRALIA, IFM INVESTORS

Australia, like many developed economies, faces significant challenges in meeting current and future demand for essential infrastructure; however, unlike many countries, Australia has significant collective savings held in superannuation, which gives us a significant competitive advantage.

Port Botany

Super fund assets in Australia are expected to grow to $6 trillion by 2030, and our retirement savings model is the envy of many G20 countries. Australian super funds have significant long-term capital available, but often lack favourable long-term investment opportunities. At the same time, governments are limited in funding essential infrastructure by often-changing political needs. If infrastructure continues to be governmentowned, essential upgrades are reliant on increasingly cash-strapped governments that need to balance their requirements against other competing demands.

IFM Investors’ view is that ‘asset recycling’ – by which governments sell brownfield infrastructure assets to super funds, and invest the proceeds in greenfield infrastructure – creates ‘social privatisation’ – a virtuous cycle that benefits both parties. The public benefits, both as taxpayers from a budgetary position, and as superannuants from a long-term return position. The investment is for the full life cycle of an asset, not for an investment cycle.

Through infrastructure ownership, super funds can focus on delivering the best possible outcome for an asset over the long term, without the limitations of shifting government priorities and budgetary pressures. If an upgrade makes sense for the long-term success of an infrastructure asset, a responsible super fund will make the investment.

IFM Investors, on behalf of super funds, has invested in infrastructure for more than 20 years, providing benefits to Australia in terms of infrastructure capacity, economic uplift and attractive long-term returns.

The New South Wales Government’s 2013 lease of Port Botany and Port Kembla is a prime example of the benefits of asset recycling. New South Wales taxpayers received $5.1 billion from the lease to invest in new infrastructure, the ports are now run with a long-term focus, and more than five million Australian superannuants benefit from the returns.

Equally, in Queensland since 2002, nearly $5 billion has been invested in capital works by the super fund owners of Brisbane Airport, which is currently delivering the world’s largest privately funded runway development, boosting productivity and creating jobs.

The long-term return profile of infrastructure matches the long-term needs of super fund members, while super funds are proven to be responsible custodians of Australia’s essential infrastructure. The interests of super funds are closely aligned with governments, in respect of investing in long-term essential infrastructure. There is significant potential for Australian governments to harness our world-leading superannuation system to address our infrastructure gap.

GREEN AND SOCIAL INFRASTRUCTURE: HOW CAN GREEN AND SOCIAL BONDS ACCELERATE INFRASTRUCTURE INVESTMENT?

BY CATHERINE BREMNER, HEAD OF SUSTAINABLE FINANCE SOLUTIONS, ANZ AND KATHARINE TAPLEY, DIRECTOR SUSTAINABLE FINANCE SOLUTIONS, ANZ

‘We have developed the (green) bond in response to investor demand, and to deliver on our commitment to deploy capital for the transition to a lower-carbon economy. Importantly, the continued development of Australia’s green bond market should enable ANZ to increase funding allocated to green projects in the future.’ – Rick Moscati, ANZ Group Treasurer

Since 2006, ANZ has provided more than $6 billion of project and export finance to large-scale wind and solar projects. Currently, ANZ has an extensive portfolio of renewables-based project and export finance assets, covering wind, solar, geothermal and hydro across Australia, New Zealand, Vietnam, Taiwan and the Philippines.

ANZ is also one of the leading institutional property lenders in Australia. Our clients are international leaders in the construction, design and operation of low-carbon and low–environmental impact buildings.

More recently, ANZ announced a commitment to fund and facilitate at least $10 billion by 2020 to support our customers to transition to a low-carbon economy.

Why green bonds?

A green bond is a ‘normal’ bond with a very specific ‘use of proceeds’ clause, which essentially stipulates that the proceeds of the bond will be applied to green projects. What qualifies as ‘green’ in this regard can be broad, and we have seen three primary means of qualification: self-verification, verification against the International Capital Markets Association’s Green Bond Principles, and verification against standards issued by the Climate Bond Initiative. Green bonds can be issued either to finance new assets or to refinance existing assets. In the majority of cases to date, these bonds have been for refinancing purposes.

Project

Bald Hills Wind Farm

Collgar Wind Farm Mumbida Wind Farm

Taralga Wind Farm Wonthaggi Wind Farm Macarthur Wind Farm

Hallet 5 – Bluff Range Boco Rock Wind Farm

Royalla Brookfield Tower Place 1, Perth Brookfield Tower Place 2, Perth Tower 4, Collins Square, Melbourne 161 Castlereagh St, Sydney Mahinerangi Wind Farm Tararua Wind Farm

Changbin Wind Chungwei Wind Miaoli Wind Farm

Burgos Wind Farm Current Aggregate Volume

By asset class

Solar 2% Solar 2%

Building 40% Wind Building58% 40% Wind 58%

Class

Wind

Wind

Wind

Wind

Wind

Wind

Wind

Wind

Solar

Building Building Building Building Wind

Wind

Wind

Wind

Wind

Wind

Country

Australia

Australia

Australia

Australia

Australia

Australia

Australia

Australia

Australia

Australia

Australia

Australia

Australia

New Zealand

New Zealand

Taiwan

Taiwan

Taiwan

Philippines ~A$1.1bn

New Zealand 7%

New Zealand 7%

By geography

Asia 16% Asia 16%

Australia 77% Australia 77%

Insurance 21%

Banks 6%

Investor type

Semi’s 3% Private Bank 1% Central Bank 3% Council 3% Middle Markets 7%

Asset Manager 56%

The green bond market, while relatively small, has demonstrated strong and consistent growth, particularly in the last three years, and it is certainly emerging as a credible means by which to raise capital for, and invest in, new or existing projects with environmental benefits. In 2012, when the Climate Bond Initiative issued its first report, Bonds and Climate Change: the State of the Market in 2012, there was US$3.1 billion of green bonds on issue. The recently issued 2015 report states that there is now US$65.9 billion on issue.

ANZ’s inaugural green bond

In May 2015, ANZ launched and priced its inaugural green bond for A$600 million. The five-year fixed-rate bond was priced at 99.384 and an 80-basis-point spread over the swap rate, with a coupon of 3.25 per cent. It is the largest climate-related bond yet by an Australian issuer, and was primarily distributed with Australian institutional investors, as well as funds in Asia. ANZ was the sole lead arranger for the transaction.

ANZ Group Treasurer Rick Moscati said, at the time of issuance, ‘We have developed the bond in response to investor demand, and to deliver on our commitment to deploy capital for the transition to a lower-carbon economy. Importantly, the continued development of Australia’s green bond market should enable ANZ to increase funding allocated to green projects in the future’.

Assets in the bond comprise loans to wind power and solar projects, and to Green Star–rated commercial property buildings in Australia, New Zealand and parts of Asia.

The bond performed exceptionally well, demonstrating strong demand and attracting a diverse range of investors, including, among the domestic super funds and global funds, access to environmental, social and governance (ESG) mandates.

ANZ’s Global Head of Debt Syndicate, Paul White, said at the time of issuance, ‘Strong demand from a diverse spectrum of investors for this transaction highlights the growing number of sustainable and ethical mandates within the institutional investment community. We expect the green bond market will continue to grow, as issuers look to tap the significant liquidity available’.

Investor by geography

Asia 8%

Australia 92%

Verification and disclosure

An important aspect of ANZ’s issuance was to test the verification process. ANZ used a third party, Ernst & Young, to assure the green bond structure and underlying asset pool against the Climate Bond Initiative (CBI) Standard – a not-for-profit organisation that promotes large-scale investments to help to deliver a low-carbon economy. As a result, CBI accreditation was awarded to the issuance, and it also qualified for the Barclays MSCI index.

Where will the market go from here?

ANZ’s green bond cemented our view that there is investor demand for product to fulfil ESG mandates, and that investors have climate change on their radar. Moreover, the investment opportunities are significant – the International Energy Agency estimates that the cumulative investment in energy supply and efficiency to ensure that the planet is on a ‘two degree’ track is US$53 trillion1 .

Indeed, since issuing our green bond, we have seen interest in the market emerging across a number of sectors. In the public sector, all levels of government are also exploring ways in which green bonds, and also social bonds, could be used to provide long-term tenor and investment grade risk behind publicly funded infrastructure projects.

Relative to the strong growth across Europe and North America, however, the green bond market across the Asia-Pacific region, and in Australia and New Zealand in particular, is still in its infancy.

Pleasingly, the bonds have seen further investor demand, and continued to trade well in the secondary market; they are currently outperforming – by five to 10 basis points – similarly rated AUD five-year fixed-rate paper, which was issued on the same day as ANZ’s green bond. This is consistent with recent research, which indicates that green bonds are trading at a premium in the secondary market2 .

Tenor is also an aspect that we are monitoring, as green bonds are showing signs of issuing with longer tenors. For example, New York State and Washington DC have each issued 25-year and 100-year green bonds supporting water supply and treatment assets.

Likewise, we are seeing development banks such as EIB, IFC and ADB structuring bonds with first-loss tranches.

Both of these developments are extremely helpful, particularly in the infrastructure sector. For example, the Institute of Public Affairs (IPA) has reported that Australia needs more than $700 billion over the next decade to fund upgrades to water, waste and power sectors. Developments in tenor and structure also help investors as they seek to reduce risk around asset life and/or project credit standing. Finally, these are key developments for the commercial banking sector, as, given increasing regulatory pressure to reduce riskweighted assets, green bonds could emerge as a highly attractive way to refinance largerscale green infrastructure projects.

The emergence of social bonds, also referred to as social benefit bonds, is also interesting. We have already seen issuance supporting social housing and detention centres in Australia, and ANZ is working with the government in New Zealand on issuance of a ‘contract for service’ social bond in the mental health sector. Australian state governments have likewise begun engagement on issuing social bonds, and are looking at both the ‘contract for service’ and investment-grade-style social bonds.

As a next step, we expect to see the continued issuance of green bonds and the continued emergence of social bonds in the Australian market over the next year, not only from within the finance sector, but also from the property, infrastructure, utilities and government sectors.

The views and recommendations expressed in this document are those of the authors, and may not reflect the views of Australia and New Zealand Banking Group Limited.