- Lennart Baumgärtner
- Oct 8
- 7 min read
Executive summary
Academics widely use the convenient idea of elastic financial markets, where prices are driven exclusively by company fundamentals and never by capital demand or supply. New research confirms what’s been long known in the industry: Markets are highly inelastic (X. Gabaix, R.S.J. Koijen (2021)). Stock and fund prices move with capital flows as well as fundamentals.
Infrastructure assets are particularly inelastic since they are dominated by long-duration funds that are highly constrained in their trading. (Inelasticity is not to be confused with illiquidity in this context. Privately held infrastructure assets are often both inelastic and illiquid) This radically changes how we should value these assets. Regulators and Government must pay close attention to the flows in and out of infrastructure markets if they want to achieve growth and fair outcomes across energy, water and other systemically important sectors.
Idiosyncratic risks are central to infrastructure valuations. In an inelastic market, hedging against idiosyncratic risks is challenging, since hedging activities are expensive and volatility is driven by unobservable market flows. Reflecting idiosyncratic risks in asset valuations is essential to reflect investor realities and company fundamentals.
Political demand for infrastructure could actually lower market valuations. Political ambition drives up the demand for infrastructure equity. However, equity investors require a strong price signal to increase their infrastructure exposure in an inelastic market. This means that the increased political ambition can increase the cost of equity (CoE) across the sector. This can cause market valuations to fall. Governments concerned about this effect should think carefully about how their policies impact equity flows through stock market.
Regulation based on the elastic market hypothesis systematically misprices equity returns. Current regulation relies on the Capital Asset Pricing Model (CAPM), the cornerstone of which is the elastic market hypothesis. In the actual, inelastic market, this creates perverse incentives towards financial engineering and undervalues additional flows in infrastructure equity required to deliver the next generation of sustainable assets.
Elastic vs. inelastic markets
Finance textbooks often begin with an elastic ideal: plentiful arbitrage capital, frictionless rebalancing, and prices that reflect discounted future cash flows and covariance with the market (within CAPM - CAPM requires not just elastic markets but complete markets. On top of elasticity, it assumes the absence of arbitrage opportunities and transaction costs).
In that world, exogenous shifts in demand for or supply of capital are irrelevant because other investors instantly take the other side. For example, if a fund invests £1 extra into the equity market, market valuations do not change since someone else will sell them £1 in shares at fair value. In this world, large parts of corporate finance are irrelevant to valuation since issuance of additional shares do not impact fair values.
Practitioners do not live in that world. They see balance sheets that matter, funding constraints that bite, prices that move when large shareholders buy or sell, and arbitrage opportunities that feed the multi-trillion-pound hedge fund industry. The academic record is slowly catching up with practice: Individual stocks, sectors, and the entire equity market have been shown exhibit strong signs of inelasticity, where the capital flow to and from them strongly impacts their value. Most prominently, Gabaix and Koijen (2021) show that if funds invest £1 additionally into existing US stocks, market valuations increase by £5. Equivalently, if equity markets issue £1 of additional stocks, market valuations drop by £5. Funds are constraint in their equity allocation and require strong price signals to change their exposure. For individual stocks, the eNect is similar though less extreme. £1 additional stocks drive around £1 drop in valuation.
This inelasticity is particularly relevant for infrastructure equity. Both supply and demand of capital is driven by exogenous factors rather than commercial fundamentals. Buyers like pension funds, insurers, and closed-end vehicles operate under substantial concentration, liquidity, and style constraints. Regulator and government priorities (aNordability, decarbonisation, resilience) determine the pace and mix of new projects and asset recycling, which in turn determines how much equity needs to be raised and when. Prices are the joint outcome of capital flows and business fundamentals. Capital flows are the dominant force out of the two.
Infrastructure valuations in inelastic markets
The inelastic market hypothesis poses two challenges to valuing infrastructure assets. Firstly, dividend-based returns and market-based returns are no longer equivalent in a world where market-valuations are driven by capital flow (and dividends are not). Secondly, the common practice of discarding idiosyncratic risks as ‘diversifiable’ is unacceptable since diversification becomes much more costly. In the spirit of a dividend-oriented infrastructure investor, we focus our attention on the latter.
Traditional economic theory, where capital markets are perfectly elastic, tells us that all risks but the market risk can be diversified away. This is known as the Fundamental 4 CAPM requires not just elastic markets but complete markets. On top of elasticity, it assumes the absence of arbitrage opportunities and transaction costs. 8 October 2025 Theorem of Asset Pricing. The Cost of Equity can be calculated from the historical stock market, based on Sharpe’s 1964 CAPM. Here, an asset’s risk only depends on its ‘beta’, estimated as the covariance between its stock return and the market return. (Beta is typically normalised by dividing it with the market variance). In the real, inelastic market, this does not hold. Instead, CAPM overestimates the role of market risks and underestimates the role of idiosyncratic risks.
CAPM overestimates market risks for future cash flows in an inelastic market since beta (covariance) is driven by capital flows more than the actual cash flow uncertainty. If an investor increases their exposure to UK equities, all UK stock prices increase, leading to an increased covariance between individual UK stocks and UK market indices (like the FTSE100). Yet the underlying cash flows of a company are not impacted – capital flows do not pose a risk. Some research suggests that endogenous capital flows account for up to 80% of stock market volatility. (J-P. Bouchaud (2022)) This overestimation is particularly pronounced in infrastructure assets with few comparators since this increases inelasticity. Funds are more constraint in trading their stocks and they tend to be overrepresented in sectorspecific ETFs.
CAPM underestimates idiosyncratic risks for future cash flows in an inelastic market because diversification is costly. If an investor buys a stock as a hedge, that raises its price, they buy it at a premium. If they sell the stock at a later stage, that lowers its price, such that they will sell at a discount. The difference between premium and discount is the cost of the hedge. (There are more issues with the diversification assumption of CAPM which we have addressed in other articles in more depth) Depending on the exact costs, investors will be better oN without the hedge. Either way, they want to limit idiosyncratic risks if that lowers their costs. For asset valuation, the consequence is that idiosyncratic risks warrant explicit premia in the CoE.
Equity volatility is not the same thing as fundamental risk. Treating it as if it were leads to return expectations that are too low where idiosyncratic execution risk is high, and too high where high betas reflect macro-sensitive comparators rather than project realities.
Regulation in an inelastic world
Infrastructure policy and regulation heavily rely on the elastic market hypothesis, particularly in the UK. CAPM is used to set the allowed return for investors.
That assumption embeds three problems. It discards the asset-specific, nondiversifiable risks that investors carry; it understates the role of balance sheets in shaping outcomes; and it overlooks the impact of policy-driven equity issuance on valuations. When large programmes expand the supply of infrastructure equity—Net Zero pipelines, water quality mandates, grid expansion—the market must absorb that issuance. In an inelastic setting, valuations are pushed down and the CoE rises. If regulation does not acknowledge this, it will repeatedly set allowed returns below the level required to attract marginal equity, slowing delivery or shifting the burden to the debt market.
A better anchor is the risk investors actually assume. Start from the fair value of cash flows and add clearly identified premia for risks: construction and delivery, permitting and political timing, technology and obsolescence, counterparty credit, policy stability. Make balance-sheet resilience part of the return conversation rather than an afterthought: refinancing risk, interest-rate exposure, and liquidity buffers have social value in essential services and should be recognised in incentives and returns. A bottomup framework, like the Vallorii Price of Risk model, lets regulators explain, contest, and update those premia transparently as risks are mitigated.
Two live examples of this are the CoE of Heathrow and the offshore wind CfDs. Applying CAPM to Heathrow comparator airports yields 8.87% CoE, staggeringly high for an airport that is considered a monopoly. The reason for this is inflated market betas – airports tend to be closely tied to GDP overrepresented in transport-specific index funds. Applying VAPRI to understand granular risk drivers lowers CoE to 7.0-8.5%. Offshore wind CfDs, however, are subject to more recent political risks underrepresented in historical stock price volatility. As a result, VAPRI’s CoE is 9.7-10.6% for new assets, significantly higher than CAPM-based 6%.
Using flows deliberately
In an inelastic market, the actors who shape flows also shape market valuations. Corporate actions—issuance, buybacks, dividend policy, and asset recycling—change the float and the investor base. Public policy can do the same at scale. Co-investment vehicles, targeted equity participation, or tax designs that reward long holding periods reduce turnover and deepen the pool of natural holders. Sequencing of public and private capital raises matters: clustering large equity calls in thin windows needlessly depresses valuations; staging them alongside supportive measures can lower the CoE without compromising prudence. Last-resort measures such as trading bans are politically challenging but not unlikely in the case of a bond market crash or aNordability crisis.
None of this implies micromanaging markets. It means acknowledging that supply must rise because society needs more grid, cleaner water, resilient transport. The path of that supply and the design of the investor invitation will affect the price we all pay.
With many thanks to Robert Ritz and Cameron Hepburn for their helpful comments.
X. Gabaix, R.S.J. Koijen (2021). In search of the origins of financial fluctuations: the inelastic market hypothesis. NBER Working Paper 28967.
J-P. Bouchaud (2022). The Inelastic Market Hypothesis: A Microstructural Interpretation. Preprint.