Thursday, 22 March 2012

Private investment in infrastructure: The road to ruin or to the Promised Land?

By Stephen Spratt

Earlier this week David Cameron announced plans to increase private investment in –and management of – Britain’s road network, which will be offered to investors on long-term leases. The hope is that institutions such as China’s sovereign wealth fund (SWF), which are looking for sources of reliable and attractive returns, will be tempted to fill the public funding gap in the UK’s infrastructure sector.

There is nothing wrong with this in principle, but whether it will lead to a better transport network at a lower cost to the taxpayer remains to be seen. This is likely to depend on three questions which have been largely absent from the debate so far:

  1. How will the returns needed to attract private investors be created? Given that SWFs can invest anywhere in the world, these will have to be rather high. Apparently a share of existing vehicle taxation will be ring-fenced to pay investors to maintain roads, perhaps allocated according to the level of road use. Given that maintenance is already funded from general taxation, this will only be cost-effective if the private operators can maintain the network more efficiently than currently happens, after they have taken their returns. For example, the Highways Agency has an annual budget of £1 billion. If investors require a return of 10%, the available pot is immediately £100 million smaller. If the private sector cannot do a better and cheaper job with 90% of the previous budget, the net effect on the public finances will be negative. 
  2. What will be the impact of road pricing and private sector management? To encourage new investment, tolls will be allowed on new roads. Given that potential revenues will be highest where road use is greatest, this provides an incentive to build new roads where the demand is greatest. A day return train fare from Brighton to London during peak times now costs around £50 – more than many low-cost airfares. Tolls on the busiest new roads can also be expected to be very high. While this is sound economics, with prices being used to equate supply with demand, it means that only the relatively wealthy can afford to travel at the most convenient times and on the most popular routes. Across the train network, the cost both to the taxpayer and the travelling public has increased dramatically since privatisation in 1996, a reminder that private sector delivery does not automatically deliver the expected efficiencies. 
  3. What will happen to the less lucrative parts of the network? Assuming maintenance payments for existing roads are linked to the level of use, the private sector would therefore be incentivised to focus on the busiest and most congested areas for both new and existing roads. This makes sense as resources would be diverted to where they are more needed, but becomes potentially problematic if less profitable, yet strategically important routes are neglected. This is precisely why private participation in public goods and services requires robust regulation: commercial and public interests overlap but are not fully aligned.

So, what has all this got to do with development?
Well, private participation in infrastructure has become increasingly important in developing countries, and this looks set to continue. This can produce great results, attracting new investment where it is sorely needed. But the same limitations apply. It is easiest to attract private money into the more commercially viable sectors (e.g. telecoms) than to vitally important but less lucrative areas (e.g. water and sanitation).

Also, while public bodies may be keen to maximise positive development impacts, for example, by ensuring water is made available in remote areas and is affordable for the poor, these can run counter to commercial interests. However, for the private sector, the best way to maximise returns is to charge what the market will bear and to focus on the largest market segments, typically in urban areas. Where there are trade-offs between development and commercial objectives, it is important that the former are not sacrificed to ensure the project is attractive to private investors.

Do commercial and development objectives overlap?
Commercial and development objectives overlap in many areas, but this is less likely where the poorest groups are concerned – this is true in both developed and developing countries. We are only just beginning to understand the conditions under which private investment can deliver better outcomes and cost savings, and where public support mechanisms are needed to ensure social objectives are also realised.

If the poor are to receive good services they can afford, it is often necessary for these commercial interests to be tempered by public intervention (i.e. finance) to ensure access and affordability. Increasing private investment in infrastructure is crucial in both developed and developing countries, but we should not pretend that it will achieve development objectives in all cases.

Good infrastructure is one of the keys to development and a prerequisite for a good quality of life. Similarly, developing a low-carbon infrastructure is a stated objective of countries at all income levels. Working out how to maximise private investment in ways that also maximise social and environmental outcomes – particularly given ongoing fiscal constraints – is a question that deserves far more attention than it currently gets.


Ricardo Santos said...

Interesting post, Stephen.
It would maybe the wise the UK to look at the "bailot countries", in particular Portugal. The question you put "how will the returns needed (...) be created", was a core part of very badly conceived business plans that secured high return / low risk arrangements to the private partners. Without serious supervision, this Private-Public Partnerships became ways to hide current public deficts to the detriment of future generations (and governments). In Portugal they are an intrinsic part of the unsustainable public debt that forced the country into the bailout.

Stephen Spratt said...

Thanks Ricardo.

A similar thing happened in the UK with private finance initiatives (PFIs), which had the effect of reducing the stock of official public debt. As pointed out in last year’s select committee reports, they often ended up being a bad deal for the taxpayer as well. This need not be the case, however. In the UK at the present time, the government can borrow at extremely low levels of interest, as it is still seen as something as a safe haven. Where the government can borrow at, say, 2% it does not appear to make a lot of sense to generate a 10% return for the private sector to take over public sector activities.

The situation in countries where borrowing costs are higher may be different. Here, it can be the case that private investors can raise funds more cheaply than the government, particularly where a bilateral or multilateral development finance institution (DFI) participates in the deal, bringing some political insurance. On purely economic grounds, it can be cheaper to finance infrastructure through the private sector in these instances.

This says nothing about whether the public or private sector is likely to run the project more efficiently of course: if public borrowing costs are much lower (as in the UK) the private sector needs to perform heroically for it to make economic sense; if public and private costs are equal the private sector still needs to perform better, as it needs to earn a return; if the private sector can borrow more cheaply than the government, however, there is – potentially – a more straightforward economic case.

Ricardo Santos said...

Thanks Stephen,
You make a good point. However, I'm not sure that the only item of a cost-benefit analysis is the financial cost differential.
There are sound economic reasons why private economic actors do not, on their own accord, enter in some economic activities. If, given its own technology, a firm finds other productive investments to generate more earnings than a particular one, let’s say, the provision of a public service or managing the access to a particular infrastructure (for example an highway, again very typical of the Portuguese case, or a particular railway), the opportunity cost is enough for it not to chose the latter. That happens despite of the financial costs of investment. In fact, the fundamentals of any investment in a country where the government fails to generate enough predictable income to pay a lower interest rate than any firm operating in it should imply that the firm itself should not be able to finance itself at a lower interest rate when investing in public services in partnership with said government. By assuring to a private investor a rate of return that is not fundamentally supported by the provision of the service, the PPP arrangement seriously distorts the incentives, even if the assured rate of return is below the interest rate the government would have to pay in the international market. So, the criteria must be not to imprint into the PPP agreement an expected rate of return for the private partner above the one the economic activity to be performed can afford to. That alone would prevent a fair amount of PPP to ever see the light of day.
It may be the case, however, that we are talking about local or national natural monopolies. That is in fact the case of many of these public investments. In that case, the PPP may allow the firm to reach pretty high return rates, by capturing rents but economic theory says that the second-best rule is the one that should apply, which, again forestalls particularly interesting rates of return. Here a PPP is possible but has to be managed by the government with a degree of technical control, transparency and accountability towards the electorate that is, in itself, quite problematic given the governance fragilities of many countries (and we don’t need to look that far to see how business is prone to influence policies through strategic donations, just to avoid the finger pointing exercise to the usual suspects).
In summary, there are good reasons why private actors should not enter certain economic activities, in the very least without the previous assurance of a strong and effective regulatory apparatus: they either are unable to produce enough profit or they are prone to generate monopoly rents. These must be also taken into account when thinking about PPPs, not only differences in the financial cost of the initial investment, I would suggest.

Arman Dalton said...

Private investments help public infrastructure for expansion and in turn stimulate productivity. There should be clear definitions based on amount of extensible aid they are contributing.

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