The Financing of Transportation Infrastructure

Author: Dr. Jean-Paul Rodrigue

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1. Private Participation in Transport Infrastructure

Transportation infrastructure, like several infrastructure classes, has a significant level of public involvement ranging from direct ownership and management to a regulatory framework that defines operational standards. This is notably the outcome of a tradition where transportation, particularly roads, was seen as a public good not to be subject to market forces and be free of access. A similar trend applied to port and airport infrastructures that were placed under the management of public authorities. Although rail freight has essentially been a private endeavor in the United States, it was significantly regulated by the Interstate Commerce Commission in terms of fares and level of service. Rail terminals are mostly managed by private rail operators while the warehousing / distribution industry is almost completely private. Like many civil engineering sectors, the private sector can be involved in transportation project delivery, which can include design and construction, project management such as maintenance and operations and project financing, namely raising capital.

The trend towards greater private involvement in the transportation sector initially started with the privatization (or deregulation) in the 1980s of existing transportation firms. New relationships started to be established with financial institutions since public funding and subsidies were substantially reduced and new competitors entered the market. Then, many transportation firms were able to expand through mergers and acquisitions into new networks and markets. Some, particularly in the maritime and terminal operation sectors, became large multinational enterprises controlling substantial assets and revenues. As the freight transport sector became increasingly efficient and profitable it received the attention of large equity firms in search of returns on capital investment. The acquisition costs of intermodal terminals, particularly port facilities, has substantially increased in recent years as large equity firms are competing to acquire facilities with secure traffic (and thus low risks). A new wave of mergers and acquisitions took place at the global and national levels as equity firms see terminals as an asset class with different forms of value:

• Asset (intrinsic value). Globalization and the growth of international trade have made many terminal assets more valuable since they are key elements in establishing and maintaining global supply chains. Terminals occupy premium locations conferring accessibility to either maritime, rail or road transport systems. These locations, such as waterfronts, are rare and cannot easily (if at all) be substituted for other locations. Traffic growth is commonly linked with valuation growth of a transport infrastructure since the same amount of land generates a higher income. Thus, terminals and some transport infrastructure are seen as fairly liquid assets with an anticipation that they will gain in value.
• Source of income (operational value). In addition to be an asset, intermodal terminals also guarantee a source of income linked with the traffic volume they handle. They have a constant revenue stream with a fairly limited seasonality (unlike many bulk terminals), which make terminals particularly attractive in light of substantial traffic growth that most terminal facilities have experienced. Traffic growth expectations result in income growth expectations.
• Diversification (risk mitigation value). Intermodal terminals offer a form of functional and geographical asset diversification for a holding company and help lower risks. Terminals represent an asset class on their own. They also offer a potential of geographical diversification as holding terminals at different locations help mitigate risks linked with a specific regional or national market. Financial problems related to the residential real estate sector are likely to incite many holding companies to diversify their assets, even outside the United States.

2. Causes and Forms of Public Divesture

Facing the growing inability of governments to manage and fund transport infrastructure, the last decades has seen deregulation and more active private participation. Many factors have placed pressures on public officials to consider the privatization of transport infrastructure, including terminals:

• Fiscal problems. The level of government expenses in a variety of social welfare practices is a growing burden on public finances, leaving limited options but divesture. Current fiscal trends clearly underline that all levels of governments have limited if any margin and that accumulated deficits have led to unsustainable debt levels. Since transport infrastructures are assets of substantial value, they are commonly a target for privatization. This is also known as “monetization” where a government seeks a large lump sum by selling or leasing an infrastructure for budgetary relief.
• High operating costs. Mainly due to managerial and labor costs issues, the operating costs of public transport infrastructure, including maintenance, tend to be higher than their private counterparts. Private interests tend to have a better control of technical and financial risks, are able to meet construction and operational guidelines as well as providing a higher quality of services to users. If publicly owned, any operating deficits must be covered by public funds, namely through cross-subsidies. Otherwise, users would be paying a higher cost than a privately managed system. This does not provide much incentives for publicly operated transport systems to improve their operating costs as inefficiencies are essentially subsidized by public funds. High operating costs are thus a significant incentive to privatize.
• Cross-subsidies. Several transport infrastructures are subsidized by revenues from other streams since their operating costs cannot be compensated by existing revenue. For instance, public transport systems are subsidized in part by revenues coming from fuel taxes or tolls. Privatization can thus be a strategy to end cross-subsidizing by taping private capital markets instead of relying on public debt. The subsidies can either be reallocated to fund other projects (or pay existing debt) or removed altogether, thus reducing taxation levels.
• Equalization. Since public investments are often a political process facing pressures from different constituents to receive their “fair share”, many investments come with “strings attached” in terms of budget allocation. An infrastructure investment in one region must often be compensated with a comparable investment in another region or project, even if this investment may not be necessary. This tends to significantly increase the general cost of public infrastructure investments, particularly if equalization creates non-revenue generating projects. Thus, privatization removes the equalization process for capital allocation as private enterprises are less bound to such a forced and often wasteful redistribution.

One of the core goals of privatization concerns the derived efficiency gains compared to the transaction costs of the process. Efficiency gains involve a higher output level with the same or fewer input units, implying a more productive use of the infrastructure. Transaction costs are the costs related to the exchange (from public to private ownership) and could involve various buyouts, such as compensations for existing public workers. For public infrastructure, they tend to be very high and involve delays due to the regulatory changes of the transaction.

3. Privatization and Financing Models

Once privatization is considered, an important issue concerns which form it will take. There are several options ranging from a complete sale of the infrastructure to a management contract where the public sector retains ownership and a share of the revenues. Three forms of privatization are particularly dominant:

• Sale or concession agreement (lease) of existing facilities. Divesture is part of a political agenda which began with deregulation. As discussed before, budget relief is sought because of mismanagement; the public sector is essentially forced to sell or lease some of its infrastructures. For a sale, the infrastructure is transferred on a freehold basis with the requirement that it will be used for its initial purpose (unless another agreement was negotiated). For a concession agreement, it commonly takes the form of a long term lease with the requirement that the concessionaire maintains, upgrade and build infrastructure and equipment.
• Concessions for new projects. Tap new sources of capital outside conventional public funding. It can take place in the context of fiscal restraints or as a way to experiment with a more limited form of privatization since existing assets remain untouched. It also confers the advantage of getting the latest technical and managerial expertise for the infrastructure project.
• Management contract. While ownership remains public, management is given to a private operator, commonly through a bidding process. This strategy has been particularly popular in the terminal operation business as many rail and maritime terminals are managed by private operators who do not own the facilities but have long term leases. The outcome commonly involves efficiency improvements.

Concessions are a simple and fair strategy involving a bidding process, which underlines the importance to have it take place in a transparent and open way. This is particularly relevant in the current context as retirement funds, sovereign wealth funds, investment banks and other financial institutions are increasingly involved in the funding of transportation infrastructure. A lack of transparency can be perceived negatively by the general public and can transform a simple transaction into a complex political process. Since some concessions are set over long time periods (50-75 years), they bring the issue of changing market conditions that may force a renegotiation of the contract. It is next to impossible to foresee long term market changes and traffic levels, so a provision for renegotiation should be provided. Again, this renegotiation can be subject to controversy and public debate, particularly if performed in an un-transparent manner.

Due to their nature and function, several other forms of privatization can be established for intermodal freight terminals. Considering that intermodal terminals have an intensive use of equipment, leasing agreements are an important dimension of privatization and of the strategies of existing private infrastructure operators.

4. Limitations of Private Capital

Although a level of privatization is commonly perceived as a desirable outcome for the efficient use and operation of transportation infrastructures, privatization comes with limitations. In some instances privatization can be unsuccessful. The main reasons are linked with the private contractor unable to honor the commitments (which is rare) or the new cost structure is perceived to be unfair by users since the privatized infrastructure now offers market pricing (more common). If customers are used to low and subsidized costs they will not well respond to market prices, particularly if they are not introduced in an incremental manner. Although private initiatives commonly result in efficiency gains, private capital involves many limitations concerning capital costs and the issue of domestic versus foreign capital:

• Capital costs. Nominal costs for private capital are often higher than for public debt, since the later is guaranteed by the full faith in the credit of the state. This can create a moral hazard as the capital costs and their risks are transferred to the public in terms of guarantees to cover operating costs (cross-subsidy) or bail-outs in case of default. This process is very common in a variety of public enterprises which is spite of acute losses operate on the assumption that their financial shortfalls will be covered by the state. Thus, depending on the size and capitalization of a transport operator, capital costs can be higher than for a public counterpart.
• Domestic vs. foreign finance. Local private capital markets can be very limited, particularly in developing countries. Transportation assets are also so substantial that they are only accessible to the largest equity firms. Modern transportation infrastructure projects are easily beyond the range of local and regional governments. Finance can thus be tapped from foreign markets. Even in the United States, terminal assets are mainly accessible only to a few large equity firms, many of which are foreign owned. This can be controversial as the case of Dubai Ports World purchasing the port terminal assets of P&O in 2006 demonstrated. Because of political pressures DPW was forced to sell the American port assets of the transaction to the AIG holding company. Fluctuations in exchange rates can also be a significant risk factor, but if a currency is undervalued (debased), investments can pour in to take advantage of the discount to capture valuable and revenue generating assets.

5. Private - Public Partnerships

Public - private partnerships (PPP) are contractual agreements between a public agency (federal, state or municipal) and a private sector entity that allow for the design, building, operation or financing of transport infrastructure (FHWA, 2007). They thus confer a wide range of options in terms of capital allocation and respective levels of participation. They can simply cover the standard design / build contracting process common in many road projects or involve innovative approaches where a private operator takes charge of the construction and management of a transport infrastructure over a long term concession. This business model has been in use for centuries, particularly in the public utilities sector.

PPP take place in situations where stakeholders alone cannot clearly evaluate the respective advantages of the investment and find it too risky to finance. The public sector thus helps leveraging the position of the private sector, which commonly results in a better allocation of resources than if they would have done so independently. While the public perception tends to relate PPP to toll roads, the reality places these initiatives in every segment of the transportation industry from modes to terminals. PPP take a particular dimension in the freight sector as freight transportation is much the realm of the private sector with public interests mainly covering the regulatory framework. The most significant infrastructure assets are related to freight transport terminals, particularly ports and rail, a reason why they are dominantly owned or operated by large private interests, which makes public involvement problematic. There is thus a conventional approach to PPP which is gradually been supplemented by an emerging framework where private entities are taking a higher level of responsibility, so the term private - public partnerships appears increasingly more appropriate.

However, like most initiatives where governments are involved, there are unintended consequences, implying a difference between the expected and the real outcomes. The two most prominent unintended consequences of a PPP involve undermining innovation and risk:

• Innovations. Since a PPP results in less competition as the private company is securing an intrinsic monopoly, there are limited incentives to innovate, particularly for the purpose of reducing operating costs. Innovations, such as new management methods and new infrastructures, may also be impaired by regulations and conditions related to the contract. Therefore, as long as the contract remain effective, inertia (status quo) will endure, which means that long term contracts can become factors delaying innovation. It can also be expected that investment capital commonly the outcome of the accumulation of profits would come from the public sector. Since governments often put maximum profits clauses in contracts (windfall profits), there are limited incentives to use innovations to increase productivity and profits above the arbitrary threshold.
• Risk. Strategies involved in the exploration of new market opportunities, such as new services for customers, are common business practices and always involve a level of risk. While a PPP may reduce several risk factors because of the implicit public support, both from a financial and regulatory perspective (the government retains its potential to tax and coerce to achieve its goals), the abatement of risks also has unintended consequences. The goal becomes compliance to government policies at the expense of focusing on new opportunities and mitigating the associated risk. Thus, the rewards of risk taking are essentially removed. This can be seen as a reverse form of moral hazard where a government guarantee undermines the risk taking behavior of private enterprises.