Inflation and Infrastructure

Infrastructure would seem to offer investors a fairly safe refuge from inflation, and on the whole it does. Operators of infrastructure have at least some scope to raise user fees, and can expect to recoup the depreciated cost of maintenance and improvements upon exit from their position. However, some forms of infrastructure may offer more certain inflation protection than others. In particular, the ability of public infrastructure to insulate against inflation cannot in all cases be counted upon.

First, a digression on inflation, three measures of which are shown below. The best indicator for the aggregate economy is the GDP deflator. It is not more widely used because it is released with a lag – note that the figures after 2007 are still not final – and because inflation in the total economy is too broad a measure for many purposes. The CPI, although widely used, is an imperfect measure, neglecting interest costs, which account for more of consumers’ budgets than many of the items that are included, and since it calculates on a fixed basket of goods, it ignores the price elasticity of consumer demand. The third indicator is rather obscure, but it is probably the best available gauge of the cost of maintaining infrastructure. It tracks the costs of labor, equipment and materials used in heavy construction − pipelines, roads, bridges, earthworks, pumping plants, transmission lines, etc. Although it covers only the seventeen Western states within the Bureau of Reclamation’s remit, it is unlikely that the picture it creates would differ greatly if it included all fifty. The point of showing these indicators is to draw attention to the fact that different portions of the economy can experience different rates of inflation.

The contracts under which public infrastructure is operated are fixed at the time of purchase or lease, and usually include limits on permissible increases in user fees. These will typically be linked to the CPI, the rate of inflation that is most familiar to most users. Given the political sensitivities involved, operators are often restricted to less than the increase in that Index. As the chart indicates, this can put operators of public infrastructure in a squeeze: since 2003, the Bureau of Reclamation series has risen at twice the rate of the CPI. Operators of infrastructure whose user fees can at best increase no more rapidly than CPI are experiencing deteriorating margins, which the decline in their costs in 2009 did not relieve. In principle these should be recoverable on exit from the position, but given the time horizon of infrastructure investments, that could be a long wait. In the meantime their investors experience less than perfect inflation protection on their cash flow distributions.

In contrast, operators of private infrastructure do not risk such pressures. Although the commercial relationships between providers of private infrastructure and their customers vary, pricing is in almost all cases a matter of regular negotiation. Most of their customer contracts are annual, on a take-or-pay basis. Where contracts are of longer duration, operators are generally in a position to assure themselves that any anticipated cost increases are reflected in the charges they negotiate. Providers of private infrastructure have an obvious negotiating advantage over their customers, most of whom cannot easily turn to other providers, and who therefore also have a strong interest in the maintenance of the facility. In any case, inflation is likely to affect their customers’ revenues positively, reducing their resistance to increases in usage charges provided that they are not egregious. With respect to inflation risks, operators of private infrastructure can be relied upon to take care of themselves (and their investors) to an extent that may not be possible for operators of public infrastructure.