Public Utility Regulation for Toll Roads?
Concession-based regulation, not PUC-style regulation, would encouraging needed private sector transportation investment
By Robert Poole

As reported elsewhere in this issue, Rep. Peter DeFazio (D, OR) surprised most attendees at the recent ARTBA Public-Private Ventures conference with his endorsement of toll concessions for new highway capacity. This was, indeed, a welcome change from the overt hostility shown last year by DeFazio and his colleague James Oberstar (D, MN), the two most powerful House players in shaping next year's legislation to reauthorize the federal surface transportation program.

DeFazio related that on a recent trip to Europe he visited concession projects in France and Spain, mentioning both a new rail project in Barcelona and the spectacular Millau Viaduct in France. He then noted that such PPP transportation projects in Europe are regulated as public utilities, and suggested that with that sort of model in the United States, he could see PPPs as a way to enhance transportation capacity, addressing at least some of the large shortfall in transportation investment. And during the question-and-answer period, he clarified that he was not calling for a federal regulatory agency for PPP projects, but rather for some criteria that states would have to enforce on PPPs, with oversight from U.S. DOT.

While I'm glad to see DeFazio moving in a more positive direction on this issue, let me issue some strong words of caution-and a mea culpa. For several years, I've been trying to explain the paradigm shift that's under way regarding PPP toll roads as "extending the investor-owned utility model to transportation infrastructure." Drawing on prior thinking by people like Gabriel Roth and Steve Lockwood, I explain that the highway system has many similarities to other network utilities, such as electricity, telecoms, and pipelines. For the most part, these other network utilities have historically been developed using private capital and private-sector expertise. But because they often have some elements of monopoly and a strong element of public interest, they have generally come under some form of regulatory oversight.

Compared with state-owned electric, telecom, and other utilities in most of the rest of the world (until the global privatization in the 1990s), our investor-owned utilities were the best in the world, which is why nearly every first-world country has now privatized these systems. But there is also a huge literature in economics about the drawbacks of traditional regulation of both prices and rates of return via state utility commissions. So when we come to a new industry that's making the transition from state-owned to investor-owned, it's appropriate to ask whether the traditional form of public utility regulation is the best way forward. In my view, it's clearly not.

Let's start by asking the question: What is the purpose of regulating a network utility, such as investor-owned toll roads? Presumably, it is to protect customers and the broad public interest against monopolistic exploitation. In other network utilities (especially telecoms), in recent years we've come to see that competition can substitute for regulation. And the very fact that most toll roads are subject to competition is what gives rise to investor demands for some degree of protection, via non-compete or compensation provisions (a topic for another column). Nevertheless, as a political realist, I don't expect that we will see robust development of toll concessions without some degree of regulatory oversight.

There are two basic alternatives for regulating network utilities, such as toll roads. One is traditional public utility commission (PUC) regulation, in which the company's charges are set for a few years at a time, via periodic rate hearings, and those rates must be justified in terms of providing scope for a "reasonable" return on investment. The other alternative is contractual: to embed regulatory provisions such as the toll regime and other performance requirements into the long-term franchise or concession agreement itself, with ongoing oversight by the transportation agency.

Two factors that are critically important in assessing these alternatives are politicization and pricing. One of the major benefits of PPP toll roads is the de-politicization of decisions about toll rates. Prior to the lease of the Indiana Toll Road, its toll rates had not been increased for 19 years. Under the traditional approach followed in most states until very recently, toll increases for public-sector toll roads were invariably political issues, leading to much populist grand-standing and generally putting off toll increases for so long that when the need for more revenue became overwhelming, the eventual increase was enormous.

In the recent wave of U.S. toll concession projects, only one-the Dulles Greenway-has been subjected to PUC-type regulation. And sure enough, when that still unprofitable toll road went to the Virginia utility regulator last year for a rate increase, the issue turned into a political circus, with populist objections from politicians with no standing whatsoever (most notably, the Republican congressman from the area, Rep. Frank Wolf). In that particular case, the outcome was a seven-year shift to price-cap regulation, but leaving the question of how tolls might be adjusted between 2020 and 2056 undecided.

Some of us warned against PUC-type regulation at the time Virginia passed the 1988 legislation under which the Greenway was developed, because politicization of the toll-setting process creates enormous risk and uncertainty-and that deters investment. Virginia's subsequent (highly successful) Public Private Transportation Act, passed in 1995, provides for concession-based regulation instead. That is the model that has been followed in all other states with successful transportation PPP legislation.

Besides politicization, the other key issue is pricing-specifically congestion pricing or value pricing. For projects whose purpose is to relieve congestion, primarily in urban areas, even the kinds of annual price-increase caps used in concession-based regulation are unworkable. The whole point of congestion pricing is to let the price rise to whatever level is necessary to control traffic flow to the desired uncongested level of service. More than a decade worth of empirical evidence from California's 91 Express Lanes and I-15 HOT lanes show how powerful this tool is. And it would have been impossible under either PUC-type regulation or price-caps embedded in a concession agreement.

For that reason, when Caltrans crafted the AB 680 legislation that led to both 91 Express and the new SR 125 toll road concessions, way back in 1989, they invented a variation of concession-based regulation. Instead of controlling toll rates, the control would be on the overall rate of return the toll road company could earn during the term of the concession. Because toll projects vary considerably in risk, Caltrans made the decision to hire outside expertise to develop a return on investment (ROI) ceiling for each project. And the law provided that any net revenues earned in excess of that ceiling would be transferred to the state's highway fund, for use on other projects.

For rural, long-distance toll roads, the private sector has accepted concession-based regulation with annual price caps on toll increases. But for urban congestion-relief projects, while concession-based regulation is clearly the way to go, it cannot be based on price caps. That leaves the more difficult alternative of ROI ceilings as the only way to go.

The task for advocates of toll concessions is to educate elected officials that while toll roads are, indeed, a new form of investor-owned network utility, that does not mean we should impose traditional PUC-type regulation. Concession-based regulation, tailored to the type of project, can protect the public interest while not discouraging much-needed private investment in our highway system.

Robert Poole is director of transportation at Reason Foundation. An archive of Poole's work is available here and Reason's transportation research and commentary is here.

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