Public infrastructure 101 – Part 1

I read a headline in the Australian newspaper yesterday (March 19) – Nation building funding crisis as private sector fails to find cash. What? Nation building requires significant budget deficits. When was it dependent on the private sector having to trump up cash? I soon recalled that we have been living in the Public Private Partnership (PPP) era where governments have relinquished their responsibilities to build essential public infrastructure that not only supports a sense of public good but also underpins the prosperity of the private market economy. Its that time again. Time to debrief.

The journalists (Adele Ferguson and Jennifer Hewett) were arguing that

The Rudd Government’s ambitious plans for major economic infrastructure projects are in crisis because of a lack of available financing from the private sector …

The global credit crunch has crippled the ability of the private sector to co-invest, while the public money available through the Government’s Building Australia Fund has been savagely depleted.

Canberra’s ability to borrow to fill the gap is also severely restricted because of the need to finance its ever-increasing budget deficit and help the states with their own borrowings for infrastructure.

There are so many errors in these few sentences that my head was spinning. Cruelly, they went on:

The Government would have to be prepared to radically lift its own borrowings again if it wanted to short-circuit this problem.

This impasse could indefinitely delay much of the critical infrastructure spending promised by Prime Minister Kevin Rudd to improve the nation’s productivity.

Some commentator from the infamous Royal Bank of Scotland (local branch I assume) was quoted as saying:

… if the funding crisis was not sorted out, the pipeline of infrastructure projects would fall off acliff …

Everyone understands the importance of infrastructure for job creation, stimulating growth and improving efficiencies, but if the states and private sector can’t finance the projects, then it won’t happen.

Excuse me. When did the sovereign government have to rely private sector finance to nation build?

First we have to distinguish between Federal and state governments.

The Federal government, to repeat my familiar theme, is not revenue-constrained. So all the statements above about debt runouts etc are just plain wrong. They are the types of statements that have constrained the Federal government from maintaining a viable, competitive infrastucture in this country. For example, how bad is our broadband infrastructure? So the Federal government can build or buy what it likes if there are resources available in the economy to be bought. It is hard to mount an argument that there are not (increasingly) such resources. It becomes a matter of political commitment. That is the only constraint on the Federal government – if they voluntarily choose to keep interest rates at whatever they are (hence have to issue debt to drain the excess reserves resulting from the deficits) and they also have some voluntary limits on debt ratios, then the nation will not be “built”. But these are just voluntary constraints. They are not necessitated by any intrinsic financial constraints on its capacity to spend and buy whatever is for sale.

The State government is more like a household because it is not sovereign in the currency and has to “finance” its spending. That spending it cannot cover in taxation has to be covered with debt-issuance. But it is quite different to a household in another sense – it has a huge tax dragnet to draw upon and the likelihood of it becoming insolvent is low. That is why it can borrow to fund net spending (deficits) at much lower rates than the private sector. With the household sector now looking for safe havens to save outside of the creaky share markets, riskless public bond issues should be very attractive.

Some private lobbyist from Infrastructure Partnerships Australia also tried to claim yesterday that the task to rebuild the infrastructure was beyond the financial “capacity of the public sector alone.” What? This claim is totally spurious. The private sector might have to be involved in the construction of the infrastructure given the years of privatisation has destroyed the public capital works capacity. But there is no financial reason why the public sector (at the Federal level) cannot fund all the projects currently being identified as worthy.

Further, the Commonwealth’s guarantee of the private banks has distorted, to some extent the attractiveness of state government debt. The bank debt (AAA rated because of the government guarantee) is now very attractive and has given them the imprimatur to borrow billions from foreign creditors. The simple solution to this is for the Commonwealth to simply guarantee the state government debt within sensible guidelines. Pretty simple. The only thing stopping this will be the politics (voluntary constraint).

Then the Moody’s rating agency claimed that “financing new PPP projects will be a significant challenge in the immediately foreseeable future.” Maybe that is true which is why PPP projects are and always have been false economy.

The PPP debriefing

If you are interested in a more detailed analysis that I wrote with some colleagues on the failure of privatisation and PPPs then I invite you to read our Creating effective local labour markets: a new framework for regional employment policy Report, which was released late last year. The following is an excerpt from it on PPPs.

Government procurement has undergone considerable reform over the last 20 years and PPPs are increasingly becoming the norm for social and economic infrastructure delivery. PPP projects in Australia have been estimated to have reached a total of $20 billion (Joint Select Committee on the Cross City Tunnel, 2006). The term PPP covers a wide variety of collaborations between the public and private sector. A familiar model that has been used frequently in Australia since the early 1980s involves provision of infrastructure such as toll roads which is argued to provide infrastructure more quickly than by public provision which is subject to government-imposed budget constraints. This arrangement ultimately transfers the cost of infrastructure to users with associated negative distributional impacts.

PPPs offer the government and society a hybrid model for public investment in infrastructure and services. PPPs seek to harness the benefits of a competitive market as well as private sector expertise and innovation. In theory, the involvement of the private sector allows the public sector to transfer the risk associated with delivery, obtain “value for money”, and allows increased provision of public infrastructure compared to traditional public sector provision. The PPP literature maintains that access to services and utilities remains equitable and that positive benefits associated with the asset continue to flow onto society. In practice however, there may be major deficiencies in accountability and private acceptance of risk.

Prominent examples of public private partnerships are found in the Joondalup Health Campus in Western Australia (see below), the Casey Hospital in Victoria and the New South Wales Government “New Schools Projects” for new schools financed, built, owned and maintained by the private sector and handed back at the expiry of the 30 year contract.

Due to our inefficient national constitution, state and local governments have to deliver most of the essential services but face constant revenue issues. There is a real case for realigning spending and taxing responsibilities to allow the federal sphere more influence. This is clearly preferable given that the Federal government does not have a financial constraint. If the Federal Government took over the responsibility for infrastructure provision much of the PPP debate would become irrelevant inasmuch as it is based on the revenue constraints faced by state governments in the face of their responsibilities.

However, in saying that, the debate when focused at the state level is based on false premises. There is no economic logic that state government borrowing is bad. The argument that a state government has to run a surplus to maintain an AAA rating is nonsensical in the context of a ideologically-driven unwillingness to use that rating to borrow on favourable terms which maximise social advantage. There is nothing efficient about surpluses that both accompany the run-down of social infrastructure and the higher cost provision of essential infrastructure and services.

The role of government is to maximise social welfare rather than maximising private welfare. When we discuss the efficiency of a particular activity within the context of resource allocation we should always focus on the maximisation of net social benefits rather than the maximisation of net private benefits. Generally, PPPs have failed to meet this performance benchmark and typically compromise social interests in favour of private interests. Government should use its fiscal power to: (a) ensure full employment; and (b) to maintain high quality public infrastructure. In relation to this second role, governments face two questions: (a) What is the best way to provide for the rising demand for best practice public infrastructure?; and (b) What is the best way to gather the resources necessary to guarantee this provision?

There is a strong economic case for Government to provide public infrastructure because of market failure considerations – the existence of public goods, externalities and such does not support sufficient private returns from user charges to ensure the private provider will remain profitable. The classic case is of the railway system. Further, the presence of natural monopolies will generate excessive prices and returns should a private supplier be present. Finally, public infrastructure services typically generate benefits across time and beyond the immediate users (schools, hospitals, sewage, etc.) which means that it is not an excludable good and therefore not appropriate for private provision.

Public infrastructure investment also promotes productivity and economic growth. It provides a fundamental training ground for skilled labour (for example, a national apprenticeship capacity), and, beyond its economic contribution, public infrastructure provides a social fabric and hence social benefits.

Key steps in a PPP

A PPP is a contractual partnership between the public sector and the private sector to finance, construct and / or operate projects which would normally be the responsibility of the public sector.

Key steps involved are:

• Private partner invests in public infrastructure;
• Contract extends to operation of the facility – usually with bundled services; and
• Government pays annual fees for capital and services which include risk premium, private profit margin.

There are various forms of PPPs used, the most popular being:

• Design, construct and maintain (DCM)
• Build, operate and transfer (BOOT)

The issue of how much service delivery should government retain usually results in the government being reduced to policy development, and brokerage and management of contracts with private service delivery partners. Given that these arrangements oversee the development of key public infrastructure the responsibilities vested in private financiers and developers is disproportional to their ability to gauge the public interest.

The proponents of PPP arrangements argue that they offer value for money which in the literature is an efficiency concept entailing: (a) Lower construction costs; (b) Lower operating costs; and (c) Higher quality services. The evidence from Australia and the UK is mixed but generally does not support these alleged advantages across education, health and other sectors. We consider a specific case study further on in this sub-section.

The financing myth – who ultimately carries the risk?

The standard attack on PPPs has been somewhat misleading. The argument goes that the private sector has to price its debt in the market whereas public debt prices at the long-term bond rate. Given that there is typically a 3-5 per cent difference between private and public funds, the PPP can never be cheaper unless services (employment) are cut dramatically or construction quality reduced.

However, we have to recognise that the difference in borrowing rates reflects project risk and lower public rate implies that government will rescue a failing project via drawing on consolidated revenue. Therefore the PPP is constructed by its proponents as an efficient transfer of risks from public to private and the critics are dismissed as being ignorant of this “risk transfer” argument. The gains are alleged to arise from the private sector being better able to manage risk – largely because they have a higher incentive to do so – private profit.

The real problem with the PPPs in this regard is that is a falsehood that the risk shifts from the public to the private sector. Who ultimately bears the risk? The risk premium in private financing is based on the fact that a private entity can become bankrupt with its product and service exiting the market. With an essential public service it is a fantasy to say that the PPP contract transfers risk to the private sector. If the private partner defaults, the public always has to pick up the pieces. There is no real risk transferred.

There is substantial empirical evidence, particularly from the UK that shows that PPP partners in the private sector profiteer from the “risk” transfer component built into the contract payments. The private provider aims to minimise financing costs over the life of the contract by early repayment and refinancing existing loans at lower interest rates. The risks are typically high in construction phases and drop to near zero once service operations begin.

The private partner reduces costs by refinancing at lower rates once construction is completed. The private partner captures these gains at the expense of the social good. The PPP contract may be able to prevent this from happening but then it reduces the incentive of the profit-seeking private provider to enter the contract.

The problem is that the concept of making private profit on public infrastructure is in our viewed a flawed one. Why should the public payments include a profit margin? Is ownership or management the key to sound project outcomes? This is a rehearsal of the privatisation debate which failed to show ownership mattered.

Conclusion

There are many other issues that should warn us off PPPs. Issues such as contract monitoring problems which have been found by researchers to be profound; the problem of who is responsible for the type and direction of public infrastructure planning etc – so as to avoid disasters such as the Sydney Airport development consuming local communities and their localised commerce. We cover many of these issues in the Report I referred to above.