by Geoff Seeff
The recent announcement by the Transport Minister that the Government would be dropping the Ryrie rules and taking steps to encourage private-sector-led transport infrastructure projects — notably private roads and light railway schemes — marks an interesting change of attitude, and should be welcome news indeed. For prospective developers and contractors who have been frustrated by the planning, legal and financial constraints on such developments, this should bring real additional business opportunities. For the long-suffering consumer there is now a prospect of the supply of facilities matching the ever-increasing demand for them. But is such optimism justified?
At this stage the announcement has been couched in the vaguest terms, with a promise of a more detailed paper later in the year. However, unless some fairly radical measures are taken — most especially to allow for a longer-term view in the way that any public-sector contributions to a project are assessed and awarded — private-sector initiatives of substance may be no more likely to come forward than at present.
The current position
There is no doubt that, hitherto, the Government’s attitude to offering financial support for private-sector projects that constitute or involve a substantial element of infrastructure has been highly ambivalent. On the one hand Government has consistently sought to minimise public-sector investment after exhorting the business community to take on a greater share of community responsibilities, so we would expect financial support as a principal plank of such a policy. On the other hand, a monetarist government and its advisers has never seen any real difference between a public or private investment on non-revenue-earning assets with regard to its impact on inflation, and so will seek to impose strict conditions on how and when such investment may be undertaken.
Thus, incredible as it may appear, Government has no specific power to enable it to award financial support to private-sector-led infrastructure projects and has not even given itself this power in respect of the newly privatised utilities. It can, of course, award grants to public-sector-led schemes in which the private sector has a non-controlling interest, under section 56 of the Transport Act, for example. Further, it can pass an enabling Bill for an identified project, as it did for an earlier incarnation of the Channel Tunnel project. However, this is rarely done as it tends to be cumbersome.
Other than this, if it wishes to support a project it can do so only by utilising discretionary grant regimes which were primarily intended for other purposes. These include the regimes of selective assistance and regional selective assistance, city grant and derelict land grant and direct contribution to infrastructure, in whole or part to service commercial projects, by agencies such as urban development corporations. In certain circumstances it can draw on ERDF, normally when there is already public-sector input, although there are proposals in hand to allow for direct application by the private sector. The use of tax incentives, as in enterprise zones, has limited effectiveness in respect of these types of project.
The problem is that these grant regimes have been established essentially to support commercial projects and are predicated on facilities achieving a high degree of utilisation, maximisation of revenue and costs incurred being wholly or exclusively necessary to bring about the project and/or create a source of revenue. Accordingly, the returns sought (value for money, “VFM”) for any public-sector contribution in terms of investment gearing and non-user benefits (user benefits being recouped through an appropriate pricing mechanism) are assessed for their immediate or short-term impact. Schemes that provide capacity for the future or incorporate a significant element of non-revenue-earning features (which, of course, characterises infrastructure projects) are generaly viewed as low priority.
In any given set of economic circumstances, and for each of the various different types of infrastructure project, there is obviously a considerable range of capacities and features for which provision could be made. Not surprisingly, the process of working up a project by a developer in conjunction with the public sector can be extremely complex, in that a considerable volume of detailed economic and financial analysis will be required to prove the need for support, and confusing, in that there is no certainty as to what is likely to be regarded as satisfactory VFM. A not infrequent complaint from project developers is that the rules for computation of assistance and evaluation of benefits seem to be devised as each new scheme is presented. The following four areas serve as examples of where the policy queries arise.
Forecasts of demand
To what extent should the facility accommodate long-term demand as opposed to that which can be more readily forecast in the short to medium term? How much reliance can be placed on forecasts of demand for proposed facilities and projected income, particularly when it may be building up over an extended period? How much time and energy should be put into trying to forecast and value non-user benefits such as less congestion and fewer highway accidents if they can be anticipated?
Developers and their consultants can and do produce demand models by the dozen, but there always exists a level of uncertainty — and on very large projects particularly there is a sizeable difference between what the project developer and its bankers feel they will be able to support and what the public sector could support vis a vis benefits and VFM. On the assumption that the demand estimates are not contrived, the question arises as to who will plug the gap and bear the risk — the private sector, which has to answer to shareholders and financiers, or the public sector, which has not only to answer to the public at large but has also to decide between alternative projects and which ultimately is going to produce the higher level of output.
Balance of infrastructure to commercial facilities
A particular aspect of the maximisation of revenue in commercial schemes is the relation of infrastructure or non-revenue-earning facilities to the productive/revenue-producing element of the project. The higher the proportion of infrastructure, the higher the grant requirement and the lower the VFM offered by the project.
The problem with very large projects is the extent to which it may be defined at the time of application. Ideally, from the grant-aiding authority’s point of view, site layouts, designs and income potential should be clear from the start. In practice — and for a whole host of commercial reasons — project developers wish to keep their options as open as possible and, for example, may wish to complete only a proportion of the proposed facilities and review achieved demand before finalising the nature and design of further facilities. Phased development brings a number of difficulties to the grant-aiding authority because infrastructure costs will be incurred in advance of an, as yet, undefined end use or income may not be maximised for an, as yet undefined, extended period, while ultimate benefits become more speculative. Again, we are left with the question of who will take the risk.
The reasonableness of cost estimates
While it may be thought axiomatic that estimates of the project costs, land reclamation, construction, professional fees and financing charges should be reasonable, in conditions of uncertainty, in which most infrastructure projects are to be found, there is often a wide range of interpretations as to what is or is not reasonable. A project developer may need to undertake a considerable amount of research to be able to ascertain ground conditions, for example, and this may necessitate the outlay of what can amount to substantial expenditure before it is known whether support is likely to be forthcoming. In a situation where grant aid is not required, the developer may be in a position to take the chance without the necessity for detailed survey — but once government funds are involved more than “gut feel” is required. Therein lies the difficulty.
Risk and rate of return
Reasonableness or otherwise of the rate of return can be judged in relation to the project developer’s opportunities and market, and in the light of assessed risks and the sensitivity of forecasts.
The difficulty here is that there is no real market to guide either the public or private sector on what return it is reasonable to expect from an infrastructure project and what might constitute a reasonable measure of risk. The rates of return used by Government to evaluate its own projects come nowhere near to acceptable commercial levels, while it has to be remembered that the higher the rate of return applied to the income stream, the lower the capital value and the higher the project deficiency, possibly bringing the project out of supportable range on VFM grounds.
Clawback
One of the methods that it is often believed will deal with the problems discussed is clawback — a mechanism that allows the grant-aiding authority to obtain repayment of the grant out of the developer’s additional income if the project performs better than expectations at the time of the application. There are a number of different types of clawback based on both annual income and capital values or cost savings, and quite obviously the use of such a mechanism permits the developer to finance the project with a lower level of forecast demand and prices or to live with uncertainties in costs and other types of risk. Clawback provisions do not seek to recover the full excess, but leave a margin so that the developer remains motivated to achieve the highest level of income possible through good promotion and general management. They are not designed to give Government an equity interest, and so clawback is restricted to the value of grant paid.
Thus when there is a gap between requirement and what can be supported, applicants invariably say to Government, “Fund the difference and we will offer clawback arrangements — even 100% if you want”. Unfortunately, life is not as easy as that — grant cannot be awarded on the basis that clawback is bound to come into operation and therefore the “real” outlay to Government will be correspondingly less, while the “real” VFM will eventually be satisfactory. To begin with, forecasts of revenues and costs must be fair and based on best estimates and, in the first instance, it must be assumed that clawback will not actually be achieved. Treasury, in particular, is concerned with VFM based on maximum exposure — not with what might be if things go better than expectations.
Further, clawback cannot be used as an excuse for the Government to assume normal commercial risks, and to allow it to do so would be to encourage developers to arrange their estimates to their own advantages. Similar arguments apply to loans and guarantees, ie in effect, the reverse of clawback. There, again, maximum exposure rather than net grant equivalent, taking into account repayments, is used to assess VFM.
Recommendations on measures to be taken
So what can be done to bring forward infrastructure projects from the private sector? With so much needing to be tackled it can be to no one’s advantage if both the private and public sectors stand back and eschew the risks.
There are two things that a private-sector developer can do in the context of a given project:
(a) Examine the possibilities for associated commercial development, whether property or complementary facility. These would increase the benefits and minimise the grant requirement by sharing the costs among more end-use projects, and trapping the, it is to be hoped, increasing value in land and other economic activities affected by the project. The project developer does not necessarily have to carry out this work directly, but put in hand mechanisms for bringing in the additional investment. In this, provided the project was seen as potentially beneficial, one would normally be able to count on the co-operation of government departments in the facilitating of procedural matters that have to be addressed, such as planning and land acquisition.
(b) Ensure that the project proposal demonstrates a good economic and commercial case (ie is sensible from a commercial point of view and that there is some benefit to the public at large), do the necessary research and identify what information is still required to make a commercial decision. Regard Government in the same light as a prudent investor or banker, and present a proposal clearly and comprehensively.
Ideally, the project should be discussed informally at different stages as it is being worked up and before it becomes crystallised into a formal application by which time it is too late to change its principles.
Now my suggestions as to what the Government should do!
(a) It should establish special powers to fund private-sector infrastructure projects. In so doing it should:
(i) Establish a fund for both grants and soft loans. Loans as a concept have always been unpopular with the Treasury because they imply the taking of security, involve monitoring and require administrators. However, despite the cost of administration, the money would at least for the most part come back into the system.
(ii) Clarify the rules under which support will be awarded and the corporate structures and financial instruments that will be permitted. (A NEDO working party is presently examining this issue.) In particular it should:
- encourage joint venture arrangements (with equity sharing, profits would come back into the system);
- define the computation rules for commercial input;
- identify the benefits sought and how they should be evaluated;
- consider the use of reverse clawback in the form of guarantees of a type that ensure there is sufficient leverage on the private-sector developer to try to ensure that they are not called.
(b) Perhaps following on from the above — and with an ever-watchful eye on public accountability — the Government should be prepared to recognise the risk for the private sector and take a longer view of the project’s positive benefits and perhaps of the disadvantages if the project does not proceed. Sometimes some of these projects are articles of faith — despite expert opinion we cannot forecast accurately what will happen when the facilities are installed.
However, while one imagines there are high-powered teams of economists compiling complex multipliers to recognise the catalytic impact of any investment on the VFM indicators, I understand this is far from reality, and indicators such as leverage ratio, with its much-publicised target of 1:4, are simply achieved averages of direct investment. If important decisions are going to be made on the basis of VFM indicators, I would suggest that a good deal more research needs to be undertaken into these measurements to ensure that they do take account of social values and future requirements. We are otherwise suffering from “mass myopia” and guilty of making no effort to correct it — with awful consequences for our children and subsequent generations.
