Transportation agencies need to be prepared before inviting private investment in infrastructure.
Last month President Trump released his plan to “rebuild our Nation’s crumbling infrastructure.” While it is not uncommon to hear hyperbole from the President, in this case, crumbling isn’t too much of a stretch. The American Society of Civil Engineers (ASCE) gave the nation’s infrastructure a failing grade of “D+” in its latest report card.
Instead of emphasizing direct federal investment in infrastructure, the President’s plan would fund incentives to encourage state and local governments, and the private sector, to invest. Two aspects of the plan would encourage state and local governments to strike deals with private investors. Figuring out how to structure agreements, is up to these entities.
First, the plan proposes to distribute $100 billion in grants to state and local governments for projects that will be selected on a competitive basis. Analysts believe the proposed selection criteria emphasize outside funding in a way that favors the private sector. Second, the plan would expand the private sector’s use of tax-exempt bonds known as private activity bonds. This would make it cheaper for private sector companies to borrow money for publicly-oriented projects, again making the private sector a more attractive partner.
Thrusting the private sector into public infrastructure building is controversial. Proponents say private funding will speed up project development and lower costs. They highlight successes in Australia, Britain and Canada. Skeptics, on the other hand, point to the misalignment between public and private objectives. For example, a privately developed toll road in southern California included a non-compete clause that prevented the government from developing public transit projects along the corridor. The government eventually bought out the private owner to allow the public transit projects to proceed.
Yet, apart from a few literal examples, including the Goethals bridge between New Jersey and New York, symbolic bridge building between public and private investment in US transportation infrastructure is still rare. These partnerships, commonly referred to as public-private partnerships, accounted for less than one percent of total spending in 2013. The Trump infrastructure plan could significantly change this.
What should state and local governments do to prepare for the opportunities and challenges that possible public-private partnerships will bring? For one, they can take a look at electricity, where the private sector has long been the dominant source of investment in publicly needed infrastructure.
Higher Risks and Higher Returns
Electric utilities aren’t a perfect analogy, but they raise some of the key challenges that are inherent to having private companies make investments for the public good. One of the toughest challenges is how to share risks and rewards between private investors and the public.
Utilities regulators accomplish this through rate of return regulation, whereby the regulator explicitly sets a return that a utility’s investors receive. State government might use other approaches when negotiating a public-private partnership, but will still need to confront how to appropriately reward private investors.
Electric utility investors receive attractive returns by some measures. Data collected by S&P Global Market Intelligence show the median return on capital authorized by state utility regulators in 2017 was 7.8%. That is more than 5% greater than the return received by holders of 10-year government treasury bonds. Of course it is not static, but over the last 15 years the spread between median authorized returns for utilities and 10-year government yields has fluctuated between 4 and 6%.
The 7.8% rate of return authorized in 2017 is actually based on two components, the return on debt and the return on equity. The return on debt is quite similar to the government yield rate, but the median return on equity was much higher – 9.6% in 2017. Not a bad deal.
Generating a Good Return for the Public
The large gap between private returns on equity and government yields in electricity gives rise to the argument that the public is getting ripped off by private companies. It’s argued that the government should undertake investments itself because government can borrow money for less.
However, comparing rates of return doesn’t tell the whole story. When the government fully funds an infrastructure project, taxpayers-at-large are left with an array of risks – cost overruns, delays, unexpected maintenance. These potential costs may not be explicitly recognized at the time an investment decision is made, but should be.
Arriving at an appropriate rate of return requires a careful, and difficult, balancing of risks and rewards. Set returns too low, and private investors don’t invest. Set it too high, and private investors walk away with excess profits. Getting this task right is something utility regulators have struggled with for over a century. Debates over the best rate of return estimation method rage on in regulatory commissions and the courts. Every rate of return regulatory proceeding is a battle between dueling expert witnesses. Commissions struggle to maintain the expertise necessary to challenge arguments put forward by profit-motivated utilities.
The Trump infrastructure plan is encouraging state and local transportation agencies to enter this morass. Perhaps the opportunities are worth the struggle, but if state and local transportation agencies are going to invite the private sector to enter the transportation sector in a big way, they need to be prepared. Agencies will need to increase their proficiency in risk assessment, finance and negotiations before going head-to-head with private investors. Otherwise the nation’s crumbling infrastructure could be replaced by crumbling public finances.