Public Infrastructure:
From Crisis to Asset Class

Working Paper

December 4, 2006

By: Rizwan Sheikh

 

I. Introduction

American infrastructure is in crisis. In its latest survey, the ASCE gave national infrastructure a failing grade and says that $5 trillion will be needed over the next five years just to catch up on deferred maintenance. Over that period the national highway trust fund, the historic source of funding for our nations roads, is projected to become insolvent. Add to that the twin problems of urban disinvestment and explosive fringe growth, and the nation’s transportation infrastructure problem can seem overwhelming.

While there is no single solution for fixing our chronically under-funded roads and bridges, one source of optimism is the emergence of infrastructure as an asset class. The global capital markets, overflowing with cash and searching for stable returns, have identified infrastructure as an investment opportunity. This opportunity takes the form of Public Private Partnerships (PPPs) entered into with state and local governments to lease and operate public infrastructure assets.

At best, this development presents an opportunity to close the widening gap in infrastructure funding. At worst, it is a quick fix that will restrict our long term ability to manage both city and economic growth.

As such, it is important to look critically at both the motivations for this rise in privatization and the difficulties that might develop because of it. Only then can we best know how to evaluate which PPPs will be part of the solution to the national crisis and which may stifle growth and make the situation worse.

 

II. Reasons for the Move Toward Privatization

A. Public Sector Motivations

Privatization of infrastructure is appealing to state and local governments because they simply don’t have the money to pay for needed construction and maintenance of vital assets. While these costs can be deferred for a time, under-funding infrastructure will eventually impede both economic growth and overall quality of life. In the past, the federal government made up much of the gap in state and local infrastructure budgets. This, however, is no longer the case. As the federal government has increasingly abdicated its role in funding infrastructure, state and local governments have relied on assortment of bonds to bridge the widening gap.

Recently, another funding opportunity has presented itself. State and local governments have turned to the privatization of infrastructure through Public Private Partnerships. PPPs are particularly attractive for the five following reasons:

Large Up-front Payment - PPP deals provide the opportunity for large up front payments in exchange for long-term operating leases of infrastructure assets such as bridges and toll roads. In effect, the toll revenue over a 75 to 99 year period is monetized into current dollars taking into account the time value of money. This provides state and local politicians the opportunity to access billions of toll revenue at one time. While this money can then be used to build and maintain other infrastructure assets, there usually no restriction on how the money is spent.

More Proceeds - In some cases, PPPs can provide more money than a conventional bond offering. Bonds are priced based on conservative debt coverage ratios. This provides some protection to bond holders by providing less money to the state or local government. In contrast, the equity partner in a PPP assumes the risk that is mitigated by conservative debt coverage ratios. In addition, they are usually more willing to accept more optimistic projections on the future performance of assts. This results in more proceeds for the state or local government.

Flexibility with Proceeds - Both federal funding and bond issues come with an assortment of restrictions on how and when the proceeds from the deal can be spent. These restrictions are in place to protect the long-term interests of the community, but they are often at odds with the short-term desires of state and local officials. PPPs offer those politicians a way of capitalizing the asset and avoiding any such restrictions. Proceeds from PPP deals have been used for everything from paying off debt to creating a “rainy day” fund to paying for annual operating expenses.

Offloading Future Risk - By maintaining and operating its own infrastructure, state and local governments inherently assume operating and capital expenditure risk. By entering into a PPP, that risk is shifted onto the asset’s owner/operator through the concession agreement. Although each agreement is different, owner/operators can be made responsible for maintenance as well as expansion necessitated by changing population and land use patterns.

Fiscal Solvency - PPPs can be a means of leasing an asset to bail a state or local government out of a financial crisis. Instead of declaring bankruptcy or not paying employees, state and local governments can lease their infrastructure assets and use the proceeds to gain better financial footing.

B. Private Sector Motivations

For the private sector, the rationale for pursuing infrastructure PPPs is much more straight forward. The global market is currently awash in capital looking for stable returns. Real Estate, once a marginal investment for institutional investors, has developed into an accepted asset class with strong negative correlation to stocks and bonds. With the commercial real estate market experiencing historic cap rate compression, investors are now looking for other opportunities. The similarity of infrastructure investments to real estate provides some comfort to would-be investors. As a result, infrastructure has been identified as the next possible investment frontier.

The long term nature of infrastructure investments is particularly appealing to pension funds and insurance companies looking to match long-term obligations. This adds up to a large pool of money clamoring to invest in the nation’s infrastructure. This interest is amplified by the high rates of return earned by first-movers into the space. Those spreads on infrastructure deals should close considerably as more participants enter the market. Even so, the fundamental characteristics of infrastructure deals, namely stable, long-term returns should continue to propel the market and establish infrastructure as a competitive asset class.

 

III. Potential Concerns and Risks

Although PPPs offer an attractive alternative to conventional funding and financing sources, there are a number of concerns, considerations and risks associated with such deals:

Toll Increases - The primary way that private owner/operators generate more income is by raising tolls. Often, it is politically impossible for governments to increase tolls, even when those tolls are not keeping pace with the rate of inflation. Buy including mandatory increases in the concession agreement, private owner/operators increase income without ongoing political oversight and governments can monetize the value of those increases.

Length of Concession Agreement - The problem for the private sector, however, is that it’s inherently difficult to build financial models 75 or 99 years into the future that accurately predict cash flow. This is especially true since there is no real way to quantify the ways that the built environment around the roads will change over that time period.

Sustainability of Public Support - There are numerous examples around the world of governments nationalizing private infrastructure because of a change in public will. In the case of American infrastructure, the implicit assumption seems to be that that sort of thing could never happen here. It is not hard to imagine, however, a political environment where tolls are high and increasing, the owner/operator has recuperated his initial investment, the country is in a recession and the public demands that the asset be nationalized.

Certainly, there are laws that protect against such things. But when the entity you are leasing from is the same entity that writes the laws and is in charge of law enforcement, there is not nearly as much protection as might be imagined.

Some years ago, lenders poured money into developing counties more or less on the principle that nations don’t go bankrupt. While that may be true, we now know that it is possible for them to simply stop paying bills. It is possible that lenders are similar, overly optimistic assumptions about the stability of privatized infrastructure.

Safety and Security - There is a concern that private owner/operators, whose primary focus is profit, will neglect maintenance and create an unsafe environment for users. This concern can be mitigated by writing maintenance standards into the concession agreement with the final punishment being termination of the lease.

Loss of Revenue - An objection sometimes mentioned is that long-term leases of infrastructure take money away from the government because private operators keep toll revenue. This can happen when future revenue is underestimated and the private owner/operator collects more than projections indicated at the close of the deal. While this scenario is certainly possible, the extra reward of higher than expected usage is the reward due equity investors who are assuming greater risk.

Responsible Spending - There is a significant risk that proceeds from a PPP will be used irresponsibly. Unlike with federal funds and other financing methods, there are few controls over how proceeds can be spent.

Projection Uncertainty - Given the long-term nature of infrastructure PPPs, it is inherently difficult to project revenue accurately. As such, the true value of the asset could end up being far higher or lower than the price paid at the deal’s close. If the price paid is too low, there is the risk of the government renegotiating. If, however, the price appears to be too high, the owner/operator risks bankruptcy. In that situation, some form of government bail out may be necessary in order to ensure that the safety and security of the asset are maintained.

 

IV. Privatization’s Impact on Land Use

In addition to the concerns above, the long-term lease of infrastructure can not help but have a dramatic impact on future land use. Put differently, inevitable changes in land use can not help but have a dramatic impact on the viability of PPP deals. It is the two way nature of this interaction that can make these deals simultaneously risky and sustainable.

It is in the interest of both governments and owner/operators to adapt to changing usage patters, and in the end, it is that similar goal that might make it possible to renegotiate and adapt agreements that are no longer in anyone’s best interest. If that kind of flexibility is not realized in the years to come, then the move toward privatization of transportation infrastructure could very possibly stifle the growth of our cities.

A little over 100 years ago canals were the main method of freight transportation and individuals traveled via horse on dirt roads. Taken in that context, the idea that we can predict what people will be traveling in, much less where they will be traveling to and from in 99 years seems suspect at best.

In addition to large societal trends, there are specific and immediate land use issues that must be accounted for in most deals. Using the Chicago Skyway deal as an example, John Foote said in testimony to congress, “The city abdicated the control of a major transportation artery and along with it the ability to manage the regional transportation network in a coordinated fashion.” This is an example of how governments may be hamstrung by concession agreements that limit their flexibility to adapt to changing usage patterns over the region as a whole. The economic and social impacts might not be immediately apparent, but over time, and in conjunction with other such privatized regional roads, the results could be devastating.

 

V. How and When Privatization Makes Sense

When considering how and when infrastructure PPPs make sense, it is important to think of them as more of a marriage than as a business deal. When bonds are issued for infrastructure, the deal is made and the government is responsible for timely payment. That’s all. In contract, a PPP is a long-term relationship between two parties. Because of the level of mutual dependency over such a long period of time, there is no doubt that circumstance will change. The single true test of a PPP arrangement is the way in which it can adapt to the changing environment.

Unfortunately, concession agreements and other similar contracts are inherently bad at retaining flexibility over time. Taking the metaphor of marriage, and perhaps stretching it a little too far, it would be like drawing up a prenuptial agreement that is supposed to govern how both parties are to act in every circumstance over the course of a 99 year marriage.

Despite the potential problems, however, there is no doubt that the privatization of infrastructure will continue. The reasons explored above are simply too compelling to think that the trend will reverse. Therefore, it is important to differentiate between deals that do a good job of mitigating the inherent difficulties in infrastructure privatization and those that do not.

For the government, “Improving the mobility of our citizens should be the overriding goal” of privatizing infrastructure.  For the private sector, the goal is to make money. Having said that, it is in the private sector’s interest to structure win-win deals where profits are tied to responsible land use. This will make the deals more sustainable and profitable for everyone involved.

 

VI. PPP Scorecard

In order to differentiate between good and bad Public Private Partnerships, it is helpful to look at individual deal from six different perspectives. These six perspectives combine to form a PPP scorecard.  Deal participants can use this scorecard to measure the long-term value to the community, financial viability and sustainability of the partnership.

1. Proceeds Reinvested in Region’s Infrastructure

It is important that proceeds are reinvested in regional infrastructure as opposed to being used for other purposes. Buy devoting proceeds to non infrastructure uses, state and local problems are only exacerbating the infrastructure crisis.

2. Rational Toll Increases

A key component of most PPPs is the owner/operator’s ability to raise tolls. It is important that this right is explicitly regulated and that it does not place undo burden on users.

3. Regionally Integrated Toll Policy

It is important that proceeds are reinvested in regional infrastructure as opposed to being used for other purposes. Buy devoting proceeds to non infrastructure uses, state and local problems are only exacerbating the infrastructure crisis.

4. Accountability of Non-cash Costs

It is important that proceeds are reinvested in regional infrastructure as opposed to being used for other purposes. Buy devoting proceeds to non infrastructure uses, state and local problems are only exacerbating the infrastructure crisis.

5. Concession Agreement Flexibility

It is important that proceeds are reinvested in regional infrastructure as opposed to being used for other purposes. Buy devoting proceeds to non infrastructure uses, state and local problems are only exacerbating the infrastructure crisis.

6. Maintenance Oversight

It is important that proceeds are reinvested in regional infrastructure as opposed to being used for other purposes. Buy devoting proceeds to non infrastructure uses, state and local problems are only exacerbating the infrastructure crisis.