“Fair” infrastructure finance, defining energy transition investments and carried interest tax
The “Fairest” way to finance infrastructure
I can’t fault Bloomberg columnists for talking their book. They provide news primarily to investors, and their reporting tends to be in investors’ interests. Thomas Black reported last month that ‘toll roads are the way’ to finance infrastructure in America. He may be right, but he goes on to say that
‘the fairest way to obtain money for many infrastructure projects is to get it directly from the users.’
‘Fair’ is in the eye of the beholder.
When Black says fair, he means that users of a service pay for its use. That does seem fair – why should federal tax-payers based in California pay for roads in Ohio that they will never use? Even if you live in Ohio, why should you pay for that road if you do not drive on it? For that matter, why should anyone have to pay for railways or airports if they do not use trains or flights?
Part of ESG investing is understanding the impact your investment has on communities, and not just the environment. These arguments are not fair, for three reasons.
Firstly, charge-for-use infrastructure is regressive, meaning that it hits low-income people harder. A ‘progressive’ tax charges more if you earn more, like income tax. A ‘regressive’ tax is the same for everyone, for example sales tax (flat percentage of all purchases) or fuel surcharges (flat fee per litre). Road tolls and electricity bills make up more of your total spending if you have a lower income, because the price per kilometre or per kilowatt-hour is the same.
Further, people with higher incomes tend to have lower proportional consumption, and save more. Even though they might pay more in sales tax and fuel charges, or can afford to leave their lights on and drive laps up and down expensive highways, their spending does not rise linearly with their income.
Secondly, fee-for-service infrastructure discriminates regionally. States with lower incomes and business activity would receive less infrastructure investment, because there are fewer economic incentives to pay. Saving time by paying for a toll-road matters less if your income is lower. Powerhouse economic states like New York, California and Texas would therefore not subsidise development in less well-off regions, cementing their advantage and reducing the “united” power of the States.
Thirdly, this does not account for spillovers and externalities. Roads, airports, and trains all contribute to delivering products to shops or your doorstep. Indeed, fees can be priced into the cost of deliveries, but it is a myth that just because you do not personally use a service, it is not of value to the wider economy. Transportation methods that you do not use may be the only way to commute for the person who serves your coffee in the morning, or the cleaner at your office, or the teacher at your child’s school.
The federal government takes on costs on behalf of all taxpayers, which they may be unwilling to pay individually. Subsidising clean energy infrastructure via the Inflation Reduction Act is an example of socialising the cost of decarbonisation. Carbon emissions and the climate damage they cause are externalities that are not explicitly priced via US federal tax, but there are many programs to incorporate its pricing into energy markets.
Of course, there are ways to privately fund infrastructure that would address some of these concerns, like taxing carbon emissions. The ‘fast lane’ toll road model mentioned by Black offers free and paid versions of infrastructure, which then price-discriminates based on the value the user places on saving time.
There is a role for private infrastructure, if people are willing to pay and the private sector is willing to fund it. This saves government resources for where they are most needed. Let’s just be clear on what we mean by ‘fair’ when it comes to who is paying for infrastructure, and how much.
What counts as “Energy Transition”?
Imagine it is 1920 or so, and you have raised an “automotive transition” private equity fund[1]. Your investors (Limited Partners, or LPs) are tired of their slow, plodding horses, and want to accelerate the adoption of cars. Ford has been producing the Model T for over a decade, and there are 7.5 million cars on the roads, but there is still perhaps a decade to go before cars become truly dominant. Will you invest in car factories, roads and fuelling stations? Or are you backing the manufacturers of hub cabs, windscreen wipers and hood ornaments?
$1.8 trillion was invested in the “energy transition” in 2023 according to Bloomberg, who include transport electrification and renewable power as the two largest categories (one third each). These investors are paying to install new technology that will change the way we use energy, including the “retail investment” of someone purchasing an electric car.
The portfolio companies of some “energy transition” funds tell a different story.
Blackstone Energy Transition Partners (disclosure: I used to work at Blackstone) announced a deal this month in Europe to buy SEVES, a company that makes the insulation for electricity grids. They have previously invested in Enstall, a solar panel mount manufacturer. These investments have an energy theme but will not necessarily decarbonise energy unless someone invests directly in grid upgrades and solar farms.
To be clear, it is not a problem to invest in these companies. They make strong returns for Blackstone and their LPs (Blackstone’s Energy funds have performed well historically), and robust supply chains are important for any industry. LPs also want an energy transition or climate change product, so much so that Blackstone rebranded the existing “Blackstone Energy Partners,” which still holds gas and coal assets. But investors might be disappointed if their goal is to contribute capital to emissions reduction, and not just suppliers riding the wave of a growing market.
Fund managers sometimes scornfully refer to noble firms like Just Climate, which explicitly invests in technology for sectors where emissions are hard to abate. Why tackle the emissions that are most difficult, when you can pick the low hanging fruit and make the same money? There is also less honour for investors who choose to back renewable projects, because there is relatively low risk, and correspondingly low returns. These deals aren’t deemed as exciting, even if they are more transformational for the power sector.
This matters because LPs may reasonably believe that they are actively contributing to the energy transition by investing in an energy transition fund. This potentially diverts funding away from investing in solar and wind projects, or electric car manufacturing, which would change the energy system faster.
Investors in the early automotive supply chain probably made money as the sector grew, but the transformation primarily happened from backing cars themselves, and the underlying infrastructure that enabled driving. Directly supporting emissions-reduction technologies and their deployment seems like a better use of limited “energy transition” capital than funding the suppliers of small component parts.
Taxing the rich: private equity carried interest tax changes in the UK
The humble private equity investor is compensated in myriad ways. She earns a base salary, as is tradition for most office jobs. She receives a year-end bonus, in part based on performance and in part a reward for sticking it out for another gruelling year. She receives some stock in the company[2]. She attends all-expenses-paid glamourous retreats to Monaco and Miami with her colleagues. She enjoys the kudos of her peers for working in private equity, if they care about that sort of thing. And the pièce de résistance: she receives carried interest (‘carry’). Labour is coming for carried interest tax in the next UK election, and some private equity professionals are upset about it.
ESG investing plays a role in promoting social good, however taxes levied by government are the ultimate way to redistribute income. Indeed, a recent Harvard study found that many of the ESG businesses favoured by investors appear to be underpaying taxes. How we tax high-income earners is important for this reason.
PE investors (‘general partners’ or GPs) do not invest their own money. They raise funds from ‘limited partners’ (LPs) and buy companies on their behalf. For the privilege of finding good deals for LPs, GPs charge fees and carried interest. The classic model was a ‘2 and 20’ model, charging 2% of fees per year on funds under management, and 20% “carry”.
Carry is another name for a profit share in the proceeds of a deal. In simplified terms, if the GP buys a company for £100 million and later sells it for £200 million, they get to keep £20 million: 20% of the £100 million profit. This is in addition to the fees they collect for managing this asset for several years.
These profits are distributed among the employees of the funds and can be lucrative. In 2022, 3,000 people in the UK declared carried interest payments worth £5 billion (£1.7 million apiece).
Carry is currently taxed as a capital gain, at 28%. In the UK, the highest income tax rate is 45%, kicking in for earnings over ~£125,000, plus a couple of percentage points of National Insurance (similar to Social Security). It’s not clear why carry is taxed as a capital gain, as it is not based on owning any stake in an asset but rather on the profits gained for someone else.
Labour is proposing to close this loophole, and rightly so. PE professionals pay the income tax rate for salaries, bonuses, and even health benefits. Indeed, my carried interest payments at a PE fund were taxed as income, because the fund was designed to hold assets indefinitely (i.e. without an asset sale) and they still compensated staff with ‘carry’ for value creation.
Rachel Reeves has thrown a bone to PE investors, however, by suggesting that if they have skin in the game, i.e. invest their own money in deals, then they can receive carried interest. This loophole seems unwise if the intent is to make the tax system fairer.
Many GPs put their own money into their funds already, partly to signal to their LPs that they believe in their investment product. This amount is typically small – 1-2% or less – and in no way tied to the carry incentive they receive. In addition to their carry, the GP receives their portion of the profits from invested capital like the other LPs. Staff can also invest ‘side-by-side’ on deals.
It is reasonable that profits from investing your own money should be taxed as capital gains. However, it is not clear why putting up, say, 1% of the total funds should entitle you to pay discounted capital gains tax rates on your 20% profit share, versus taxing it like a performance bonus.
One reason to advocate for this tax system is to keep finance jobs in London. Tax rates in the UK are already elevated, and this would be a heavy hit to the high earners who might take their talents to other countries. The UK only last year removed a cap on banker bonuses to boost London’s financial services industry, originally implemented as part of an EU-wide restriction to disincentivise risk-taking at banks. This tax change would be a blow to a small number of people, but have wider effects on the investment landscape in the UK, including ESG investors.
Taxing carried interest as income appears to be the right move, however, and we shouldn’t make exceptions for GPs who invest their own money in their funds. They profit from their direct investment like other LPs, and make a performance fee on top. If we need something to sweeten the deal for private equity investors beyond the large sums they already make, the top marginal tax rate could be lowered as an alternative. This would be more equitable, applying to all forms of income and not just carry, and apply to sectors beyond finance.
[1] PE firms didn’t really exist then in the same way, but hopefully you get the analogy
[2] Which may be paid (‘vest’) over time
I am very new to the workings of ESG, and investing for that matter. Just started being interested recently (as a hobby).Your posts have been educational, to say the least.