How and when to use private money in infrastructure projects

WHEN the Indiana Toll Road was opened in 1956, there were eight pairs of travel plazas, or rest stops, along the 156-mile (250km) stretch linking Chicago to Ohio and points eastward. As cars became faster and less thirsty, travellers had less reason to stop regularly for petrol or snacks. Three of the travel plazas closed in the 1970s. Restaurants shuttered, even if offered free rent. The remaining plazas, dwindling in number, fell into disrepair. The abiding memory some road users had of Indiana was of grubby toilets along the toll road.

Those rest-stops are at last getting a makeover. IFM, an Australian infrastructure fund, is investing $34m in the toll-road’s plazas, part of a $200m-plus upgrade. Half of the road’s length, with 57 bridges, is being resurfaced, using a treatment known as “crack-and-feed”, which lasts longer than simply patching the top. IFM, which acquired a 66-year lease on the road in a $5.8bn deal in 2015, says a private-sector operator has the right incentives to invest for the long term. Fewer tyre blowouts mean less gridlock, more road users and more revenue.

Politicians across the spectrum agree on the need to upgrade America’s crumbling roads and bridges. President Donald Trump has promised a $1trn infrastructure package. His commerce secretary, Wilbur Ross, is keen to involve the private sector. His vice-president, Mike Pence, was governor of Indiana when the toll-road upgrade was announced. It was not a smooth ride. The 2006 legislation to sell the road barely passed: concerns had been raised that a private owner would cut corners on maintenance and service. Then a plan to levy tolls on a new road built with the privatisation proceeds failed. The debt-heavy consortium which first acquired the Indiana toll road went bust (IFM subsequently bought it). The tale shows the promise of private-public partnership, or PPP, in infrastructure—but also the perils.

Linking public-sector need with private-sector capital ought to be a perfect match. Around $2.5trn is spent worldwide each year on roads, railways, ports, sewers, telecoms systems and other infrastructure, but that is still short of the roughly $3.3trn required each year from now until 2030, according to McKinsey Global Institute, a think-tank. The average national shortfall is 0.4% of GDP (see chart). When public finances start to creak, capital spending is often the first thing to go.

Meanwhile, the pitiful yields on government bonds, plus longer lifespans, mean pension funds are desperate for fairly safe assets that offer a stable, inflation-plus return to provide the income they have promised to the retired. The steady, fee-based revenue generated by airports, toll roads, seaports and utilities seems ideal. Asset managers, such as the Ontario Teachers Pension Fund, have built up know-how in infrastructure investment. Others put money to work through specialist fund managers, such as IFM. These have raised more than $260bn over the past decade, including $47bn last year (see chart).

PPP thus promises to deal with a host of shortages: of infrastructure; of fiscal space; of long-lived and safe securities; and of aggregate demand and jobs. If it is done correctly, the public users of infrastructure gain from the innovation and efficiency of private-sector firms. But the shortish history of PPP is littered with examples where private provision did not live up to its promises. Problems fall broadly into three categories: the behavioural barriers that turn off consumers; political interests that often turn projects sour; and the difficulty of finding financial and incentive structures that align the interests of all parties.

Start with public opposition. Anxieties about privatising essential services are present in all countries but tellingly are not always consistent. Britain seems fairly relaxed about private water companies but is cool on privately run toll roads. In contrast, private toll roads are a feature of Australian life but water privatisation remains controversial. A lot depends on what the public has become used to. It is typically more comfortable with the private ownership of telecoms and electricity assets, which is established, than with highways. Yet cable and power networks are at least as critical as roads, perhaps more so.

Whatever the logic, a touchy public makes for jumpy politicians. A change of administration can often kill a project or drain public support for it. For instance, last year legislators in North Carolina voted down a PPP toll-road project agreed in 2014. It is now under independent review. The East-West link, a PPP toll way in Melbourne, Australia, was cancelled after public opposition. Politicians’ desire for quick results is also at odds with the detailed preparation and long gestation period needed for good infrastructure projects. “Everyone wants to cut the ribbon,” says Kyle Mangini of IFM. “But the political cycle is four to five years while the infrastructure cycle is five to ten years.” Public support for private infrastructure can, however, be built up. Industry experts rave about the “Australian model”, for instance, in which proceeds from privatisations of ports and roads go towards new hospitals, schools and so on.

That leaves the third substantial difficulty, of getting the financial structure of PPP deals right, so that taxpayers, politicians, banks and fund managers are all content. The first need is to work out whether, and how, private capital will provide benefits that public finance cannot. Too often, the main reason for a government to bring in private capital is a bad one: to follow fiscal rules that cap public borrowing or debt. “If the starting-point is to keep a commitment off the public-sector balance-sheet, it’s hard to negotiate a good deal,” says Andy Rose of the Global Infrastructure Investor Association.

The right way is to allocate risk where it can best be managed. Governments can borrow cheaply. The cost of private capital is higher. Commercial incentives often make private companies better at pushing construction and operating costs down while keeping users happy with the service. PPP typically works best when there is a stream of revenue from fees, road tolls, airport charges or utility bills. It works less well where returns need to be enhanced by a public subsidy, the terms of which are liable to change. And it works badly wherever there are risks that private capital cannot gauge or reasonably bear, such as cost overruns due to delays in regulatory clearance or to “tail risks” which the state simply cannot lay off, such as nuclear decommissioning. Politicians might see PPP as a way of pushing all risks onto private contractors. But the wise ones shun such deals.

There is a spectrum of procurement options. At one end are projects financed from taxes. For instance, last year Los Angeles voted to raise its local sales tax by 0.5% to pay for infrastructure. At the other end are private projects, such as London Gateway, a deepwater port on the Thames built by DP World, a Dubai-based port operator. In between lie privatised utilities that are subject to public regulation; or concessions where a private operator is asked to build, say, a hospital or airport terminal and then operate or manage it for a fixed period in return for the revenue it generates or an agreed fee. Crossrail, a massive project in London (pictured on previous page), is an example of another sort of hybrid, where the asset is built by the private sector, but ownership remains public (see box). The right procurement model depends on the individual project, says Mr Rose. Ultimately, however, the taxpayer pays, whether in taxes, fares, tolls or bills.

The PPP model, though more established in Australia, Britain and Canada, is slowly gaining adherents in America. One example is the new terminal at La Guardia airport in New York. Will Mr Trump’s infrastructure plans give PPP a big push? The only specific detail that seems to be agreed on is a tax credit for equity investors. But a shortfall of private capital is not the main bottleneck, says the head of the PPP infrastructure business at a big construction firm. Rather, pots of money are chasing a paucity of projects that are ready and fit for private-sector participation.

A lot of groundwork, such as environmental studies and detailed risk-assessments, are needed before a private company will bid on a project. One reason Canada and Australia have a good record on infrastructure is that they have agencies dedicated to grooming projects. It is far harder to get projects going in America, where contractors must deal with a plethora of regulators in different departments, both federal and local. Streamlining planning and permits is painstaking work. Does Mr Trump have the patience for it?

Correction (April 21st): A previous version of this article said that the Ottawa Teachers Pension Fund invests in infrastructure. It is in fact the Ontario Teachers Pension Fund that does this. Apologies.