By Mark Rudovic, CAIA, Principal, Head of Real Assets, Hodes Weill & Associates.
How private capital can help unlock the Smart Infrastructure opportunity.
The declining state of infrastructure around the world has long been approaching an inflection point. Nowhere has this become more acute than in North America and particularly the US, where the American Society of Civil Engineers (ASCE) in 2021 rated the quality of US assets as a C-.i What’s more, the gulf between the current level of investment and the level at which assets can support forecasted growth continues to widen globally.
While this represents a significant challenge, it also provides a unique, once in a generation opportunity. Asset owners and operators can “build back” by investing reactively in shovel-ready projects. They can “build back better” by investing strategically, with consideration given to critical medium and long-term priorities. However, they can also “build back better, and smarter”, by investing with consideration of all of the above, but also with the application of true innovation to develop the next generation of infrastructure – Smart Infrastructure.
Smart Infrastructure can be defined as the combination of traditional, physical infrastructure with technological innovation to create digitally enhanced assets. Pairing an asset that is ripe for enhancement with a digital solution – particularly one that has demonstrated applicability – can quickly improve asset functionality, enabling better decision-making for owners and better service delivery for users, in a manner that is more efficient, economic, and sustainable for all parties, all while increasing the potential for investors to achieve increased returns.
These digital solutions can be “soft” (e.g., software to develop sophisticated models of assets, also known as digital twins, to help operators anticipate required maintenance and lower capital expenditure requirements) or “hard” (e.g., sensors on toll roads that can detect use in real-time and reduce the need for operationally expensive booths). These types of assets are already proliferating rapidly as stakeholders recognize the dual potential to improve the user experience while also creating new and innovative investment opportunities.
While recent spending commitments will not provide enough funding to immediately upgrade every asset, it may give owners greater capacity to reassess priorities and the role innovation can play in infrastructure development. This in turn represents an opportunity to be thoughtful about how private capital can be attracted to help transform these assets transformed to unlock the full economic potential of Smart Infrastructure.
What Makes Infrastructure “Smart”?
In order to understand why Smart Infrastructure represents such a compelling opportunity, and the role that private capital can play in unlocking its potential, it is critical to understand the key associated characteristics.
If one of the fundamental traits of infrastructure is to provide or facilitate the delivery of an essential socio-economic service or function, then successful Smart Infrastructure applications should optimize this further by allowing assets to make more efficient use of natural, human capital, and economic resources. The integration of digital solutions or technology represents an opportunity to help improve already performing assets, as well as to help remedy underperforming assets. This potential is realized through these key elements:
• Data: This is the basic element that differentiates traditional and Smart Infrastructure. Poor or inconsistent data collection has been a critical challenge for infrastructure development and operation and applying solutions that will improve this function through either higher-quality collection or analysis is an essential first step in creating smarter, more sophisticated assets.
• Integration: Not all digital solutions are appropriate for all types of assets. Infrastructure design, construction, financing, operation, and maintenance is capital intensive, and incremental spending on innovation is often disincentivized. Asset operators need to be thoughtful about which solutions will add the greatest value for money, in terms of both demonstrated applicability and ease of integration.
• Technology: Digital innovation can be inherently disruptive and exists on a distinct risk spectrum, with higher-risk innovation involving more nascent technologies and solutions on one side and lower-risk innovation involving established technologies with demonstrated applicability to infrastructure assets on the other. Managing technology risk is a critical gating issue for Smart Infrastructure.
• Environmental, Social, and Governance (ESG): Improving infrastructure provides inherent ESG benefits. Smart traffic solutions can reduce congestion and therefore pollution, while smart energy assets can ensure greater sustainability on both the supply and demand sides. Additionally, enhancements such as smart streetlighting or smart water toxin sensors can create safer environments for stakeholders. Furthermore, municipalities can leverage data from Smart Infrastructure to improve governance and prosperity, while supporting the protection of sensitive personal information.
Key Infrastructure Attributes
The end result of a Smart Infrastructure transformation may strike a traditional infrastructure investor as higher risk at first glance. After all, terms like “sensor”, “artificial intelligence”, “machine-learning”, and “software” have typically been considered exclusive to venture capital and private equity vernacular. “Even the notion of “digital” has only relatively recently entered the infrastructure investible universe, first in the form of telecommunications assets, and more recently with data centers and fiber. Of course, it is important to note that Smart Infrastructure is not just a subset of digital infrastructure. Whereas digital infrastructure may overlap in some ways, namely that it is often connectivity and data-oriented, Smart Infrastructure can be created in any of the traditional infrastructure subsectors such as transportation, energy, and social, so long as a demonstrated technological enhancement has been integrated. This represents a strong example of how the definition of infrastructure has evolved over the years, without new types of assets necessarily implying additional risk. This topic was explored in Hodes Weill’s 2021 “Let’s Get to Work” white paper.
This evolution has and continues to create an evergreen and robust opportunity set for infrastructure managers and the institutions that allocate to them. As always, managers must ensure their target investments align well with the fundamental characteristics that have attracted increasing sums of institutional capital (and demonstrated, reliable returns) over the past few decades. The following table illustrates how Smart Infrastructure can maintain a high level of alignment even after undergoing significant technology-enabled transformation.
While Smart Infrastructure remains an emerging opportunity, proof of concept can be found in the market today with the rapid proliferation of assets such as smart meters, a technology with demonstrated applicability to traditional infrastructure operations, proven scalability, and a clear value-enhancement proposition.
Existing Applications and Case Studies
As Smart Infrastructure projects have been increasingly explored, the level of interest from private investors has also grown. The result is that a number of illustrative pilot projects, transactions, and case studies can be observed around the world.
Canada (2022) – Smart City Solutions: A leading telecommunications company is launching a suite of internet of things solutions to be applied to municipal infrastructure. Working with a number of strategic service providers, the proposed solutions include Smart water management (leveraging real-time alerts to monitor water levels, maximize quality, and improve response time), smart parking (AI-powered solutions that cut traffic congestion and emissions, and increase parking revenues), and smart traffic (digitizing intersections through an autonomous traffic management platform, to improve safety and efficiency), among others.iv
China (2021) – Shenzhen Smart Ports: Liantang Port is working with a telecommunications company to enhance its services using digital processing, automatic operations, and intelligent devices. The port connects Shenzhen with Hong Kong and sees approximately 10,000 vehicles each day. Leveraging a Smart Port system powered by advanced algorithms, big data, and cloud computing, vehicles can be inspected and cleared at a single checkpoint, which reduces time spent per vehicle and enables officials to focus on intelligent clearance, visualized collaborative command, convenient clearance services, and efficient management. vi
While the case studies identified above are just a few recent examples, other forms of Smart Infrastructure, such as smart tolling and smart heating, have also begun to attract a growing level of interest on account of the following key advantages that they can offer:
• Decision-making: systems can more precisely control asset structure, status, and condition.
• Revenue generation: new functionalities can create new revenue opportunities.
• Cost efficiency: systems can allow assets to use resources more efficiently.
• Reliability: systems can reduce asset downtimes and unforeseen issues.
• Safety: processes and design can adapt, improving response to human error or natural disaster.
• Sustainability: systems can ensure a sustainable use of all managed resources.
• User experience: systems can provide services that adapt to the changing needs of end users. Investors are recognizing the value and applicability that these assets can offer an infrastructure portfolio, and the potential market opportunity is poised to grow significantly from here.
Although its investible potential may be new, the basic premise behind Smart Infrastructure is not. The concept of enhancing infrastructure assets with data-driven solutions has been around for decades. For example, after the events of September 11th, 2001, many cities installed or upgraded their metropolitan surveillance systems in the name of improving safety. Here is an example of infrastructure (municipally owned and operated cameras) providing a critical socio-economic function (safety) being improved or made “smarter” with technology that allows it to collect better, or just a greater quantity of data. The implementation of urban congestion charging in London in the early-2000s can be viewed through a similar lens.
This type of infrastructure innovation has historically been defined under a different term: Smart Cities. Urban infrastructure lends itself to this manner of asset upgrading largely because projects can be more feasible in densely populated environments. As application has expanded beyond siloed pilot projects to community-wide implementation, increased attention has been brought to the merits of asset upgrading, and in turn, the diverse and growing variety of applications both in metropolitan environments (especially jurisdictions such as the New York, London, Singapore, Tokyo, Austin, and Los Angeles areas) and beyond – the genesis from Smart City Infrastructure to just Smart Infrastructure.vii
While there is no clear consensus on the current total addressable market for Smart Infrastructure, there are several highly evident macroeconomic trends that support figures of $1tn and greater for Smart Cities alone in 2022, rising significantly over 5-to-10-year forecasts. Smart Infrastructure investment opportunities are expected to continue proliferating over the next decade, driven by the confluence of:
i. the critical need to refurbish or replace existing, deteriorating, or urgently needed infrastructure assets in urban, suburban, and rural areas;
ii. the development of technologies that enable faster connectivity, increased data collection, safe cloud storage, and AI-driven insights; and
iii. the accelerating urgency of climate change and the requirement it is creating for infrastructure that is more dynamic, adaptive, sustainable, and resilient
In an investment landscape characterized by increasingly compressed returns for municipal infrastructure concessions, combined with increasing municipal fiscal constraint, the combination of the three elements above creates a significant opportunity for private capital to step in and fill the funding gap, by allocating toward projects with higher return potential.
Cambridge estimates the Smart Infrastructure investment opportunity will grow to between $2.6tn and $6.2tn by 2025, globally.v Hodes Weill believes that after a review of some of the relevant fundamental macro and micro-economic trends at play, the eventual total addressable market may accelerate beyond just these existing projections. As illustrated below, expected connectivity spending and consumption, data usage, automation, as well as new and innovative forms of mobility/transportation and energy solutions, are all categories that will very likely be subject to exponential near-term growth during this decade.ix
Bold Infrastructure for Modern Times: The Role for Private Capital
Infrastructure has always been subject to slow-paced innovation, by virtue of many of the characteristics that make it an attractive investment (e.g., long-lived, highly regulated). It is critical for stakeholders to be mindful that change is incremental, and in many cases, already rapidly advancing. The potential benefits of Smart Infrastructure are ample, but change is unlikely to happen all at once, and are not limited to just one sector. Potential enhancements can be achieved across the energy, transport, water, and social verticals, and include:
• Extending the life of an asset,
• Increasing the ability for owners to manage repairs,
• Reducing waste production,
• Improving preparedness against cyberattacks,
• Enhancing resiliency,
• Creating new revenue streams, and
• Promoting cost reduction
Additionally, as mentioned earlier, ESG considerations have become highly intertwined with investment decision-making and Smart Infrastructure can play a major role in achieving these goals.
Just as this new, innovative infrastructure can offer meaningful benefits, successful Smart Infrastructure investment will also require developers, operators, and managers to navigate potential challenges, many of which are derivative of those associated with traditional infrastructure. These challenges include managing relationships with public sector and industry counterparties to determine most appropriate procurement and contracting structures, ensuring the quality of the data collected by Smart Infrastructure and its management is optimized, protecting the privacy of that data, taking into account the efficacy of the technological solutions being applied, as well as guarding against potential asset vulnerability (e.g., cybersecurity) and even obsolescence.
Investment managers looking to become active in this space will benefit from an ability to mitigate these challenges, with a strong track record of interfacing with public sector and technical stakeholders, and a demonstrated ability to achieve innovation, and therefore outsized returns, without taking on disproportionate incremental risk.
Smart Infrastructure investment managers will need to adopt a coordinated, long-term approach to asset design, construction, financing, operation, maintenance, and broader infrastructure ecosystem integration, to successfully address these challenges, but as highlighted throughout this paper, the potential benefits stand to make the efforts of those who pursue them more than worthwhile.
The confluence of three 21st century realities has driven the emergence of the Smart Infrastructure opportunity. The first is the critical need to refurbish and replace key socio-economic infrastructure assets and the absence of readily available public funding to accomplish it; the second is the rise of technological innovation across all sectors; and the third is the growing recognition of how infrastructure can be put at risk by, and also help combat, climate change. More recently, the COVID-19 pandemic has added strain on the public purse and diverted funding that may otherwise have been allocated towards critical projects, even if the alternative destination of that funding has been equally essential. Today, the notion that we need to build back better has become ubiquitous to the point of over-use. While agreement on this need is overwhelmingly positive, there is a less acknowledged opportunity that is equally worth acting on: the opportunity to build back better, and smarter.
The next generation of infrastructure, Smart Infrastructure, can employ, and offer, solutions that are as dynamic as the challenges that these assets will be deployed to solve. Smart Infrastructure, by its definition, will be able to adapt to a world that is evolving faster and faster, along with the needs of its occupants and the users of that infrastructure. To reiterate just a few of the key advantages on offer, Smart Infrastructure can provide better systems for decision-making, cost efficiencies and savings for both operators and users, heightened reliability, greater safety and resilience, increased sustainability, and ultimately a better user experience. All of this ultimately translates to an opportunity to better provide the elements that are essential for socio-economic prosperity, if key stakeholders deploy the proper approach to capture it.
Thankfully, a significant quantum of private capital stands at the ready to assist in the realization of the Smart Infrastructure opportunity. Investment managers have an opportunity to become more active in the Smart Infrastructure space, initially as a means to improve existing traditional assets in their portfolio, but also increasingly as standalone investments in assets well positioned for digital enhancement have more and more frequently achieved the level of visibility, scale, and infrastructure profile required to make a meaningful investment case. As the Smart Infrastructure thesis achieves greater proof of concept, institutional investors looking for new and innovative ways to deploy capital to strategies with potential to achieve high returns, without sacrificing key infrastructure characteristics and risk mitigants, also stand to play a larger role.
About the Author:
Mark Rudovic, CAIA, is Principal, Head of Real Assets, at Hodes Weill & Associates.