The Infrastructure Moment

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July 2011

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Infrastructure generates relatively predictable,

growing and low volatility cash flows that exhibit

little correlation to equity and fixed income returns.

The severity of the Global Financial Crisis, combined

with certain “tipping point” changes to long-term

trends we have identified, make now a particularly

compelling time to invest in infrastructure.

One tipping point, the development of major deposits of shale gas in the United States and more cost effective extraction techniques, will have a material impact on U.S. energy prices, security and infrastructure investment opportunities. At the same time, the likelihood of higher interest rates and inflation over the next several years will have a positive impact on regulated utility returns on equity allowed (RoEs), cash flows and valuations after 30 years of declining interest rates and declining RoE. Forecasts and various early indicators and surveys suggest that the major OECD economies have entered into a period of recovery (Exhibit 1). All OECD economies, including the periphery of the Euro area, are forecast to post positive GDP growth rates in 2011. The growth will likely be well diversified across economic sectors as well. Following solid gains in consumer confidence indicators in the OECD economies, industrial and service sectors have reported activity exceeding prerecession peaks.

The rise in commodity prices, particularly the recent increases in crude oil and

agricultural product prices due to supply shocks and geopolitical developments, provide a short term downside risk to global economic growth. As a side note, the big impact of current events in the Middle East on crude oil prices and the lack of a material impact

AUTHORS

Mark Weisdorf

CEO and Head of OECD Infrastructure Investments [email protected]

Serkan Bahçeci, PhD

Vice President

Head of Infrastructure Research Global Real Assets Group [email protected]

EXHIBIT 1: REAL GDP GROWTH RATES

Source: Bloomberg and J.P. Morgan Asset Management. As of April 29, 2011.

Real GDP Growth, Q/Q annualized rates (%)

U.S. U.K. -8 -6 -4 -2 0 2 4 2007 2008 2009 2010 2011 2012

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The Infrastructure Moment

of such events on natural gas prices reinforce our view that the historical relationship between oil and natural gas has been broken due to the emergence of non-conventional (shale) natural gas sources found in North America.

Most of the central banks are expected to stay accommodative at least towards the end of 2011, ensuring sustained GDP growth. Medium term inflation risk (or short term deflation risk, depending on your vantage point), though still persistent, and monetary policy across the OECD economies, even the European Central Bank’s controversial rate hike, have taken a back seat, according to institutional forecasters.

Infrastructure usage volumes, proving their resilience, are already at or above their prerecession peaks with few

exceptions. With ever growing household and industrial energy demand already close to its peak, weather adjusted electricity and natural gas consumption is expected to enjoy a record year in 2011 on both sides of the Atlantic Ocean.

Two infrastructure sectors, air travel and seaborne trade, are still below their prerecession levels. Air travel began its recovery in the second half of 2010, later than other infrastructure sectors, and is expected to return to prerecession peaks towards the end of 2011 (Exhibit 2). Seaborne trade across OECD economies, the sector impacted most by the recession with 20% to 25% year-over-year volume declines in 2009, is expected to continue to post double digit growth in 2011, following a strong 2010 (Exhibit 3).

Why Infrastructure Now?

Privately held infrastructure investments should not be considered short term tactical plays. Monopolistic characteristics, long demand ramp-up periods, relative

illiquidity, and the cost of required technical and financial due diligence make infrastructure assets more appropriate for long-term investment strategies. In addition, infrastructure assets generate relatively consistent and growing cash flows. Hence asset valuations also tend to grow predictably compared to the volatility experienced in other asset classes. In other words (other than in extreme economic conditions such as the recent financial crisis), buy-low, sell-high opportunities don’t often present themselves in developed economies and thus don’t tend to generate extra risk-adjusted return.

There are, however, various major long-term trends and expected trend changes impacting both the demand and supply of the services provided by infrastructure assets which are creating opportunities for long-term investors:

• The average regulated utility allowed return on equity (RoE), the rate of return measure that regulators set periodically, is thought to be at its trough and should begin to rise gradually over the medium to long term.

• With the emergence of non-conventional natural gas sources, specifically shale gas in North America, natural gas is expected to stay relatively cheap, creating opportunities for transmission infrastructure as well as gaining market share against other fossil based fuels.

• The exceedingly fragmented nature of the U.S. water and wastewater sector led to decades of underinvestment and the sector is ripe for consolidation.

• During and in the aftermath of the Great Recession, transportation-related usage diverged from utility usage, proving the fact that there is a spectrum of volatility for infrastructure assets and that risk-adjusted returns have to be re-calculated accordingly.

EXHIBIT 2: AIR TRAVEL IN THE U.S., U.K. AND AUSTRALIA EXHIBIT 3: CONTAINER TRAFFIC IN MAJOR PORTS IN U.S. AND EUROPE

Source: J.P. Morgan Asset Management. As of December 31, 2010. Source: J.P. Morgan Asset Management. As of December 31, 2010. Passenger enplanements, Y/Y growth rate (%)

U.S. U.K. 4 8 2007 2008 2009 2010 10 Australia 6 2 0 -8 -4 -2 -6 -10 -25 -20 -15 -10 -5 0 5 2006-Q3 2009-Q3 10 15 20 2007-Q2 2008-Q1 2008-Q4 2010-Q2 2006-Q1 2006-Q2 2006-Q4 2007-Q1 2007-Q3 2007-Q4 2008-Q2 2008-Q3 2009-Q1 2009-Q2 2009-Q4 2010-Q1 2010-Q3 2010-Q4

TEUs, Y/Y growth rate (%)

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• A “wall of refinancing” is approaching for many

infrastructure assets which were financed just prior to the Great Recession. Given the strong deleveraging trend, a significant number of assets both in the energy and transportation-related sectors will require additional equity over the next few years, which in turn will create

opportunities for new equity investors.

Average Utility Return on Equity is at

Its Trough

RoE decisions by U.S. regulators over the past 30 years have exhibited an overwhelming declining trend. Coincidentally, long term interest rates, e.g., the costs of debt for utilities, have also been declining over the same period. On the other hand, between 1970 and the early 1980s, both the average allowed RoE and the cost of debt were increasing. It is quite apparent from Exhibit 4 that the two are highly correlated. As the cost of debt is mainly determined by central bank policy, it is straightforward to see that the cost of debt is a major factor in determining return on equity decisions, i.e., cost of debt is an input for utility returns.

There are, needless to say, other inputs considered when regulators fix the allowed return on equity. Theoretically, efficiency gains in operations and the corresponding decline in costs provide regulators with the ability to raise end user tariffs to a rate slightly below the level of inflation, known as CPI-X (RPI-X in the UK), but this does not address the change in nominal return on equity.

Public Service Commissions, are independent, in most cases politically bipartisan bodies, aiming (i) to ensure reliability so that service interruptions are kept at a minimum even during peak demand periods or forced outages due to natural causes, and (ii) to minimize end user rates while allowing the utility to earn a reasonable rate of return.

Regulators mainly focus on the reliability of infrastructure and impose technical conditions and restrictions on physical infrastructure and its maintenance. In addition, restrictions on supply contracts (procurement of commodities such as natural gas, electricity or water), operating and maintenance costs, and the capital structure of the utility are imposed to keep the costs to end users low.

After the total cost structure is determined, the regulator sets end user rates to allow an RoE to the equity holders of the utility. The allowed RoE is the most closely followed variable by investors and analysts, since it is comparable across jurisdictions and differences in capital structures.

U.S. RoE Trends

In order to understand the underlying determinants of allowed RoE decisions by state regulators in the U.S., a regression analysis was conducted analyzing 585 rate case decisions for electricity and natural gas utilities between 1990 and 2010 (Exhibit 5). The findings of this analysis are summarized as follows:

Source: Regulatory Research Associates, Barclays Capital and J.P. Morgan Asset Management. As of December 31, 2010.

14 12 10 2 6 8 4 0 1978 1990 2002 1970 1974 1982 1986 1994 1998 2006 2010 Percent

EXHIBIT 5: ALLOWED RETURN ON EQUITY DECISIONS BY STATE REGULATORS, 1990–2010

Electric Natural Gas

Average utility bond yield

Percent 14 13 12 11 10 9 8 7 6 5 4

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The Infrastructure Moment

• The cost of debt, as reported to the regulator as part of the rate case filing, is the single most important determinant of the allowed RoE.

• Past regulatory decisions likely play a role also, as a lag effect influencing the other variables.

• The difference between the utility’s reported cost of debt and the average utility bond yield (the spread) is also significant and positively impacts the allowed RoE. In other words, utilities that are less creditworthy enjoy higher allowed RoEs. Since the perceptions of risk for debt and equity holders should be aligned, this result should not be a surprise. The riskier the business plan is (perhaps due to significant capital expenditure and more aggressive organic growth rate projections), the higher is the reward for both the debt and the equity (Exhibit 6).

• Compared to natural gas utilities, electrical utilities, on average, enjoy a slightly higher allowed RoE. On the other hand, there are no structural differences between the two subsets, i.e., regulators treat both sectors very similarly. • The size of the utility, measured by the rate base, impacts the

allowed RoE positively (the relationship is statistically significant only at 10% confidence level).

• Regulators take economic conditions, measured by the rate of change of the number of employed in the state, into

consideration and mandate lower RoEs when the state economy is struggling (Exhibit 7).

• Politics, measured by the timing of gubernatorial elections, does not seem to play a role in regulatory decisions.

Going forward, the consensus forecast is that interest rates will rise from current record lows in the short to medium term, and simultaneously the economy will continue to improve gradually. Based on the forecasts of such inputs and the insights from our modeling exercise, one can assume that the long-term declining trend of allowed returns is at a tipping point.

Allowed returns on capital employed will eventually move up following the normalization of interest and unemployment rates. The time lag, our model suggests, may be as long as two years but will also depend on the length of periodic regulatory review cycles.

EXHIBIT 7: ALLOWED RETURN ON EQUITY VS. CHANGE IN EMPLOYMENT IN THE STATE

-8 -6 -4 -2 0 2 4 6 Change in employment in the state (%)

Allowed RoE (%) y= 0.0764x + 0.1098 R = 0.02875 8 9 10 11 12 13 14

EXHIBIT 6: ALLOWED RETURN ON EQUITY AS A PERCENT OF COST OF DEBT

8 5 6 6 7 7 8 8 9 9 10 10 9 10 11 Allowed RoE (%) Cost of Debt (%) y= 0.5805x + 0.0688 R = 0.58426 12 13 14

EXHIBIT 8: PRICE OF NATURAL GAS AND OIL TO GAS PRICE RATIO

Source: Bloomberg and J.P. Morgan Asset Management. As of March 31, 2011. 0 5 10 15 $/MMBtu 20 25 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Natural gas price Crude oil to natural gas price ratio

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throughout the past decade. The ratio of crude oil price (in $ per barrel) over natural gas price (in $ per MMBtu) is a well known and widely used figure by energy market insiders, even used for long term natural gas procurement contracts. Up until mid 2009 that ratio fluctuated around ten, e.g., a $100 per barrel oil price implied natural gas price to be $10 per MMBtu. Right after the Great Recession however, oil price quickly moved to $80 to $110 per barrel band, while natural gas price remained low around $4 per MMBtu, raising the price ratio above twenty (Exhibit 8).

A major factor is the emergence of the non-conventional shale gas as a reliable source. Shale gas is natural gas produced from shale, a rock formation abundant in the eastern United States. Although shale gas has been produced for more than a hundred years in the U.S., recent advances in hydraulic fracturing and horizontal drilling technologies have made extracting shale gas more economic. Shale gas tends to cost more to produce than gas from conventional wells, because of the expense of massive hydraulic fracturing treatments required to produce shale gas and of horizontal drilling. However, this is often offset by the low risk of shale gas wells. Shale gas has become an increasingly important source of natural gas in the United States over the past decade, and interest has spread to potential gas shale formations in Canada, Europe, Asia and Australia. U.S. shale gas production has been booming in recent years: U.S. shale production was 2.02 trillion cubic feet (TCF) in 2008, 3.11 TCF in 2009 and 4.87 TCF in 2010. For comparison purposes aggregate natural gas usage in the U.S. was 23 TCF in 2010, and the market share of shale gas has increased from 2% in 2000 to 21% in 2010. Moreover, in its Annual Energy Outlook for 2011, the U.S. Energy Information Administration (EIA) more than doubled its estimate of technically recoverable shale gas reserves in the U.S., to 827 TCF from 353 TCF, by including data from drilling results in new shale fields. Shale production is projected to increase to 45% of U.S. gas usage by 2035.

The environmental impact is the big open question at this point. Hydraulic fracturing technology uses chemicals to break the shale formation, and there are concerns as to whether these chemicals are far away enough from drinking water deposits. The environmental risk makes it harder to estimate a levelized all-in marginal cost.

mostly one-directional pipelines bringing gas to the Northeast has to be modified and plenty of new pipelines have to be built to take gas from the Northeast to other areas. U.S. natural gas imports will diminish significantly, and by optimistic forecasts U.S. may become a net exporter of natural gas, creating a global impact. Low and stable natural gas prices could make natural gas utilities even less volatile in terms of revenues. Natural gas would then gradually become the main source for power generation, replacing coal and reducing green house gas emissions as natural gas emits one-third as much CO₂ than coal for the same amount of generated electricity.

A significant transformation of the energy markets is highly likely, subject to resolving the environmental concerns of hydraulic fracturing technology. The opportunities for infra-structure investors focusing on natural gas are considerable.

U.S. Water Sector Is Ripe for Consolidation

Yet another tipping point is the U.S. water sector. U.S. water and wastewater systems consistently score the lowest grades in the report card for infrastructure sectors that the American Society of Civil Engineers publishes periodically. They represent one of the most inefficient infrastructure sectors, dominated by extremely small public systems. Not counting the private wells and seasonal systems, there are more than 54,000 independent systems providing drinking water in the U.S. For comparison purposes, the number in the UK is 27. The highly fragmented industry structure cannot benefit from economies of scale, resulting in higher costs and lower quality. More than 86% of America’s community water systems serve less than 3,300 people, and 86% of these small systems are within five miles of another system. The proximity of these systems to potential partners holds many opportunities for consolidation.

On top of deferred maintenance and capital expenditure, increasing populations in the South and the West are creating serious issues throughout the country. Consequently more attention than ever before is being directed at the water needs and infrastructure condition of communities around the United States. The U.S. Environmental Protection Agency recently estimated that the amount of funding that will be needed in

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The Infrastructure Moment

A Refinancing Wall is Approaching

As one of the excesses of the prerecession era, leverage levels for many infrastructure assets were quite high. The total annual debt issued by infrastructure assets and holding companies between 2005 and 2008 was twice the annual average of the preceding ten-year period. A significant amount of debt issued between 2005–2008 is estimated to have five- to seven-year terms. Over the coming two- to five-year period, many infrastructure assets, especially those which were underwritten before the Great Recession, will need to refinance all or part of their existing debt (Exhibit 10). Given the de-leveraging trend imposed by regulators, banks and rating agencies, equity infusions will be required.

Conclusion: Improving Infrastructure Outlook

A core to core-plus infrastructure investment strategy can be attractive, offering potentially stable cash flows rivaling those of fixed income assets, albeit with higher expected returns. Many infrastructure assets are natural monopolies, whereby additional supply or competition is non-existent or extremely restricted. For example, competing water pipes going into a dwelling or a second airport in a city, unless the first one is the next 20 years to bring water infrastructure to acceptable

quality level is between $300 billion and $1 trillion. With increased competition for limited federal funding available to the utilities to meet their structural, technological upgrade and other demands, many systems have been looking for support from the private sector. Contrary to the belief that public/private partnerships are detrimental, municipalities have realized that a well-thought-out contract between the public and private sector is beneficial in the long run.

Risk Perception for Transportation Assets

Have Changed

Utilities, especially the ones serving residential and commercial customers enjoyed robust demand and had minimal impact on their revenues during the Great Recession. The impact of the Great Recession on transportation sectors was quite significant; traffic and hence aggregate revenues for all transportation sectors had their largest declines since the Second World War.

Though the recovery is equally strong for most transportation sectors, it has been empirically proven that the income elasticities for transportation sectors are very varied and the risk perceptions of the pre-recession era have to be modified and revised (Exhibit 9). Going forward, trans-portation assets are expected to have risk-adjusted returns more consistent with those of the utility sector.

EXHIBIT 10: TOTAL ISSUED DEBT IN THE UTILITIES AND TRANSPORTATION SECTORS, U.S. AND EU-15

Source: Dealogic and J.P. Morgan Asset Management. As of December 31, 2010.

1997 2000 2003 2006 2009 1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 350 400 300 250 50 150 200 100 0 450 Billion USD

EXHIBIT 9: INFRASTRUCTURE USAGE IN THE U.S.

Source: Energy Information Administration (Electricity and Natural Gas consumption), Federal Highway Administration (VMT), Bureau of Transportation Statistics (Passenger enplanements), Ports of LA, Long Beach, NY-NJ, Oakland, Savannah, Seattle, Tacoma (collectively handling more than 70% of the container traffic in the U.S.), and J.P. Morgan Asset Management. As of December 31, 2010.

* Natural gas and electricity consumption by residential and commercial consumers only. 0 -1 -4 -5 -12 -17 0 2 2 2 10 17 -20 -15 -10 -5 0 5 10 Percent 15 20 Natural gas consumption* Electricity

consumption* Vehiclemiles traveled

Passenger enplanements freightRail

containers Port container

volumes 2009 vs. 2007–2008 2010 vs. 2009

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This relative stability may make infrastructure asset values less volatile compared to equities and even real estate, where supply can be built up quickly and demand volatility can lead to declining sales volumes or vacancies in office buildings. In terms of tactical plays that require timing, infrastructure does not provide an abundance of opportunity.

At this point in time, however, we have identified what we believe are various material changes to long-term trends. As economies improve and interest rates rise, expect increases to average allowed RoE for regulated assets. Low and stable natural gas price will lead to significant investment

opportunities as natural gas gains market share. In addition, the forthcoming capital needs of assets underwritten before the Great Recession, with overly optimistic demand projections and high loan-to-value ratios, may create attractive equity investment opportunities for infrastructure investors.

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The Infrastructure Moment

Important Disclaimer

This material is intended to report solely on the investment strategies and opportunities identified by J.P. Morgan Asset Management. Additional information is available upon request. Information herein is believed to be reliable but J.P. Morgan Asset Management does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The material is not intended as an offer or solicita-tion for the purchase or sale of any financial instrument. J.P. Morgan Asset Management and/or its affiliates and employees may hold a posisolicita-tion or act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lender to such issuer. The investments and strategies discussed herein may not be suitable for all investors. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recom-mendations. Changes in rates of exchange may have an adverse effect on the value, price or income of investments.

Real estate and infrastructure investing may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate and infrastructure investing may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrower.

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