A survey conducted by the Infrastructure Association of Queensland in December 2008 canvassed the views of leading Australian financial services firms including credit insurers, financial intermediaries, equity and debt providers, credit rating agencies and fund managers. The survey was supported by anecdotal evidence and media reports. At the transactional level, large programmed PPP projects encounter difficulties with capital raising exceeding $600 million. Social infrastructure projects with unitary payment arrangements are readily bankable to $500 million and economic infrastructure involving patronage risk is very difficult at any value. An additional difficulty experienced by bidders of projects such as Melbourne's desalination project is the requirement for consortia to arrange parallel financial commitments for their bids. If the financing requirement is $2 billion or more, three bidders will each require commitments from their lenders for that amount. This locks up to $6 billion in debt markets with consequential impacts on market liquidity and the availability of capital for other projects. The survey predicted further volatility in risk margins, debt pricing and equity values. Other specific conclusions included:
1. Evidence of capital rationing with lending ceiling currently in the range $300 (economic infrastructure projects) to $700 million (social infrastructure projects)
2. Higher debt costs
3. Contraction in the debt guarantee market with a reduced number of providers, higher margins and increased transactional scrutiny
4. A lender preference for social infrastructure projects with a revenue stream based on the state payment of a capital or availability charge
5. More exacting credit standards, conservative leveraging and higher debt service coverage ratios
6. High aversion to patronage risk
7. Demise of the initial public offering (IPO) model for new infrastructure projects.30
The survey also pointed to immediate difficulties for project refinancing in present conditions. The mismatch between long-term investments and medium-term finance that is used in Australia requires refinancing of part or all of project debt every 4-7 years.31 Refinancing risk includes the cost of capital and the probability of securing new finance on similar terms. In Europe, Asia and North America, debt is generally structured as long-term project finance which reduces refinancing risk and provides greater certainty with the cost of debt.
The survey respondents were contacted in early May with a request to revise their assessment of existing and future capital market conditions. Three respondents each with international operations suggested that the volatility in the domestic equity market would continue until mid-2010. The remaining respondents indicated no significant change in debt market conditions with the major problem being refinancing of capital-intensive assets that mature in the period 2009-2011. Nearly all of the respondents made the point that infrastructure finance in Australia was a seller's market and that little change was expected in these conditions for several years.
Given the performance benefits of PPPs over traditional procurement methods, the issue now confronting government and markets is to identify alternative funding mechanisms over the medium-term to sustain privately financed infrastructure and preserve the incentive framework that is so fundamental to its success.
State Investment Evaluation
How does the state capitalise its infrastructure investments? As a general rule, the state can finance new investment in one of two ways - by applying taxes or borrowing, that is, via fiscal policy. If the state is to draw capital from existing consolidated revenue, it will do so at the expense of existing appropriations.32
The state generally prices its capital using social time preference - the rate that the state estimates is the price that the community will pay to defer immediate consumption.33 The government's cost of capital (the bond rate) serves as a proxy for social time preference and is used as the discount rate for cost benefit and business case studies and the public sector comparator in some jurisdictions. However, Campbell and Bond argue that this rate is too high and should be reduced for the effects of future growth in wealth and activity, intergenerational equity, uncertainty and diminishing utility. The authors suggest that the utility discount factor substitutes for the social discount rate and at a 10 year bond rate of 4.4% per annum, the social discount rate would be around 1.4% per annum.34
The bond rate as a proxy for social time preference is not a wholly satisfactory approach to measuring state investment. 35 If a state funded project is to fail, taxpayers will be called upon to carry the losses in the form of either further state debt (on which interest is paid and principal repatriated) or new taxes are applied. That is, taxpayers are indemnifying the state against loss and carry the contingent liability for the risk of the undertaking.36 If taxpayers were to apply a risk-adjusted discount rate incorporating a shadow cost of equity, it would be significantly higher than the cost of debt.37 Brealey, Cooper and Habib argue that the social discount rate is the expected rate of return for comparable capital market investments.38 However, the state does not apply this higher discount rate because it sees itself as essentially a risk-free borrower, ie. risk of default is negligible.39 The only break in this circular argument lies with an analysis of the risk attaching to the returns from a particular investment rather than the actual cost of capital.40 Grimsey and Lewis argue that the risks associated with a given undertaking are similar for both private and public investors - the sources of capital and its relative cost has no bearing on how we calculate the project's risk premium.
The risk premium built into a project has two components - systematic and unsystematic risk. Systematic risk is mainly exogenous and outside the control of investors or project managers. Examples of systematic risk include change in government or government policy, business cycles, interest and exchange rate movements. The investor's main tool for measuring systematic risk is the stock exchange. The capital asset pricing model permits comparison of the price and return performance of an individual stock and the market as a whole, an index or other stocks in the market. The co-efficient of variation or beta measures volatility between the selected stocks or indexes, and the market performance serves as a proxy for market-wide or systematic risk albeit an historical indicator with limited forecasting potential.
Unsystematic risk describes the idiosyncratic characteristics of a project; it is generally endogenous in nature and will differ between projects. It can be eliminated by diversification and is recognised in the public sector comparator calculations for Partnerships Victoria projects.41 In Britain, the public sector comparator is no longer used for PPP projects and when it is applied, there is no recognition of market or project risk.42 Why are discount rates important? The risk weighted lifecycle costed model of traditional procurement (the public sector comparator or PSC) is determined using discounted cash flow analysis and the discount rate is central to the valuation of future cash flows - positive and negative.43 The PSC is used to compare private bids with the public sector comparator and provides the quantitative component of the value for money test. Value for money measures the entire procurement option and if the private bid is lower than the PSC, the cost of capital is not a decisive factor. It is the total value for money outcome that drives a successful private bid. There is no evidence to suggest that the cost of capital per se is a decisive influence in the state's selection of the better method of procurement for a particular project. 44
Two other matters which are not readily identified in the literature but which nevertheless are of importance to the state's investment decision. Firstly, when should the state invest? It is argued that the state should invest in infrastructure when the social rate of return exceeds the cost of capital.45 A difficulty here is identifying economic benefits for public goods and placing a value on social benefits.46 For example, a survey of cost benefit studies for infrastructure investments in developed economies found that eatest social returns was derived from investments in land transport and communications with destination freight rail the best performer.47 At the bottom of the list were social infrastructure projects including new schools and hospitals and, dams and water resources. The dilemma is one faced by the state every day and the state's selection of priorities is generally based on policy considerations and the broader public interest informed by underlying economics.48
Second, how relevant to the state's investment decision is management efficiency? In the United Kingdom, the PSC for the authority operating assets used by London Underground was viewed by the National Audit Office as an inefficient manager and confirmed the view of advisers that the PSC should include an adjustment for an inefficiency premium.49
Capital productivity and operational efficiencies are major issues to be addressed by policy-makers and regulators if we are to improve the performance of Australia's strategic infrastructure. This will require further research that examines comparative efficiency of supply chains at the industry level and operational performances in both the public and private sectors at the enterprise level.
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30 Regan 2008a.
31 ConnectEast 2004; River City Motorway 2006; BrisConnections 2008.
32 Projects submitted to Infrastructure Australia in 2008 for purposes of prioritisation were required to meet qualifying criteria (Infrastructure Australia 2008). However, the projects announced by the Commonwealth Government in May 2009 were determined in cabinet. The allocation to the states and territories (on a per capita basis) broadly corresponded with state population distribution.
33 Campbell and Brown 2003, p. 221-237.
34 See also Campbell and Bond (1997). The authors employ a labour supply incorporating average and marginal tax rates. The model tests the effect on the supply of labour of a 1% increase in marginal tax rates - the changes in tax revenues and deadweight loss are used to estimate the marginal cost of public funds in Australia.
35 H.M Treasury 2003 (the Green Book).
36 Grimsey and Lewis 2004, p. 133.
37 Klein 1997. This approach was adopted by Commonwealth business units in 1998 (Commonwealth Competitive Neutrality Complaints Office 1998).
38 Brealey, Cooper and Habib 1997.
39 The risk of default has a low probability provided the country has a superior credit rating. However, in conditions of economic stress, national fiscal management may deteriorate and national sovereign ratings quickly revised. An adverse revision of a state's credit rating may increase the cost of servicing all state debt and impose significant current and future burdens on taxpayers and public borrowings.
40 Flemming and Mayer 1997; Anderson, Finn and Peterson 1996.
41 PV 2003.
42 HM Treasury 2003; Infrastructure Australia 2008c.
43 In discounted cash flow forecasts, low discount rates operate to increase the value of deferred cash flows whilst high discount rates have the opposite effect. A given set of cash flows with a low discount rate will disclose a higher internal rate of return than it will with a higher discount rate.
44 Lower cost of capital improves the value of private bids. For social infrastructure using an availability payment structure, a reduction in capital costs would be reflected in a lower unitary charge (McKenzie 2008). However, a criticism of PPPs is that the state pays excessively for the services it contracts to buy because the private operation requires a return on its investment and its cost of capital is higher than that of the state. Notwithstanding the validity of this argument, value for money relies on more than the cost of capital. The tender process effectively has the state as a competing bidder with its public sector comparator. If private bids are lower than the comparator, the state delivery option is more costly. In the bid evaluation process, the state will not have access to the innovation, technology, incentives or efficiencies available to private consortia and the collective effect of these benefits is to outweigh the disadvantage of a higher private cost of capital and the requirements for private investors to make a market return.
45 Smith 1995 cited in PC 2009, pp 55-56.
46 Most economic and social infrastructures are public goods. Public goods are provided by the state from revenues for the benefit of the community as a whole and include items such as public roads, street lighting, nature reserves and lighthouses. Public goods do not generate revenue sufficient to meet their cost and are therefore the responsibility of the state because the market has no interest in their provision.
47 Regan 2007.
48 Such as fiscal stimulus during a recession. Affuso, Masson and Newbery 2003.
49 The reasons for the inefficiency may reside in the system of public administration of the authority, budget cut-backs, program suspension or curtailment of maintenance work (NAO 2000, pp. 3, 5, 8).