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10 Myths and Facts on Transportation PPPs

Leonard Gilroy
May 31, 2011

Given the recent wave of new infrastructure public-private partnership (PPP) enabling legislation proposed or enacted in several states—including Ohio, Illinois, New York, and Texas—it's useful to reflect on some of the myths and facts regarding PPPs that have arisen in earlier policy discussions in other states. Despite the fact that over half of the states now have some form of enabling legislation, PPPs remain a complex subject and one that's easily misunderstood. The following myths and facts synthesize some of Reason Foundation's earlier writings on PPPs, with updates where appropriate.

Myth 1: PPPs involve the "sale" of roads to private interests

Fact: PPPs do not involve the sale of any facilities. Some partnerships involve short-term contracts to design, build, and possibly finance a road or bridge. The most robust form—the long-term toll concession—still involves only a long-term lease, not a sale. The government remains the owner at all times, with the private sector partner carrying out only the tasks spelled out within the concession agreement and according to the terms set by the state. Done properly, these deals are truly partnerships, in which the state does what it does best (right of way, environmental permitting, policymaking, contract monitoring and enforcement, etc.) and the concession company does what it does best (design, finance, construction, operation, marketing, customer service, etc.).

Myth 2: Private toll road operators can charge unlimited tolls in PPP deals

Fact: There are concerns that PPPs deals will lead to sky-high toll rates in future years, leaving the impression that tolls are uncontrolled. However, this is not the case. Most concession agreements to date have incorporated annual caps on the amount that toll rates can be increased, using various inflation indices.

Put simply, future toll rates are a policy decision and are determined by state officials upfront before a concession agreement is signed. In fact, those pre-determined toll rate caps are generally established very early in the procurement process, as they are a critical input to potential bidders' financial models.

It is important to note that those caps are ceilings; the actual rates a company will charge depend on market conditions. Before entering into any toll road project, a company (or a toll agency) undertakes detailed and costly traffic and revenue studies. A major goal of such studies is to determine how many vehicles would use the toll road at what price; too high a toll rate means fewer choose to use the toll road, which generally means lower total revenue. So the toll road must select the rate that maximizes total revenue. That rate may well be lower than the caps provided in the concession agreement.

There are some cases, such as high-occupancy toll (HOT) lanes or express toll lanes, where the main purpose of value-priced tolling is to manage traffic flow. In those cases, pre-defined limits on toll rates defeat the purpose. Those rates must be allowed to vary, as needed, to keep traffic flowing freely at the performance level specified. When such value-priced lanes are operated under a concession agreement, instead of limiting the toll rates, the agreement should limit the rate of return the company is allowed to make, with any surplus revenues going into a state highway or transportation fund. That is how California's original pilot program for long-term concessions dealt with the issue, and similar deals have been done in Texas, Florida and Virginia.

Myth 3: Government loses control of public assets in PPP deals

Fact: One of the prevalent myths about PPPs is that somehow government would be "losing control" of the asset as part of the deal. This really involves a fundamental misunderstanding of the nature of PPPs-namely, that their entire legal foundation is a strong, performance-based contract that spells out all of the responsibilities and performance expectations that the government partner will require of the contractor. And the failure to meet any of thousands of performance standards specified in the contract exposes the contractor to financial penalties, and in the worst-case scenario, termination of the contract (with government keeping any upfront payment the contractor may have paid).

PPP contracts are often several hundred pages long and may incorporate a number of other documents (e.g., detailed performance standards) by reference. The public interest is protected by incorporating enforceable, detailed provisions and requirements into the contract to cover such things as:

So government never loses control—in fact, it can actually gain more control of outcomes—in well-crafted PPP arrangements. For example, state officials in Indiana have testified that they were able to require higher standards of performance from the concessionaire operating the Indiana Toll Road than the state itself could even provide, precisely because they specified the standards they wanted in the contract and can now hold the concessionaire financially accountable for meeting them.

Myth 4: The timing is bad for infrastructure investment, given the sluggish post-recession economic conditions

Fact: In the wake of the fall 2008 financial crisis, some observers have wondered whether the turmoil on the financial markets would dampen private investors' enthusiasm for PPPs and infrastructure asset leases. Broadly speaking, the answer is no.

There is a general consensus in the finance community that infrastructure remains an attractive investment, and PPP projects have continued to advance in both the United States and globally over the last three years. Despite economic ups and downs, people are still going to drive, fly and consume goods. That means roads, airports, water systems and other types of brick and mortar assets remain good investment prospects over the long term.

There is strong evidence that the major providers of equity-infrastructure investment funds, insurance companies, and pension funds-continue to be interested in infrastructure. As discussed in Reason Foundation's Annual Privatization Report 2010, Probitas Research reported in mid-2010 that $10 billion had been raised by infrastructure investment funds in the first half of 2010, only slightly less than the total for all of 2009. And a mid-2010 J.P. Morgan survey found that North American institutional investors expected to see the infrastructure category experience the largest percentage increase in portfolio allocations, going from 4.3% to 5.7% over the next several years.

It makes sense that investors are looking beyond the immediate market conditions to the long-term view, as they are investing in long-term transactions and basing their bids on future traffic and revenue forecasts extending several decades out, not on what is happening now.

Further, given that interest rates are at near-historic lows, a strong argument could be made that the best time to pursue private sector infrastructure financing is now, given that any future rise in interest rates will make debt more expensive. Interest rates are not getting any lower, so there's no benefit in waiting. Locking in at current rates now would allow the state to capture more value from its PPP projects, avoiding the higher costs and lower values likely in the future when interest rates inevitably rise again.

The proof is in the pudding though, and perhaps the most significant indicator of PPP market conditions is that several high-dollar PPP deals have reached commercial and/or financial close since 2008, including:

Myth 5: PPP deals include "non-compete clauses" that prevent state and local officials from building nearby, competing roads

Fact: Whether public or privately-owned, bond investors are very unlikely to buy bonds for assets with unregulated competition from entities with the power to tax and build competing facilities. Contractual clauses designed to protect toll road operators from the construction of new, parallel "free" roads have evolved over the years.

The approach has changed from an outright ban on competing facilities to a wider definition of what the state may build—generally, everything in its current long-range transportation plan—without compensating the toll road developer/operator. And for new roadways the state builds that are not in its existing plan and which do fall within a narrowly-defined competition zone, the current approach is to spell out a compensation formula.

The idea is to achieve a balance between, on one hand, limiting the risk to toll road finance providers (of potentially unlimited competition from taxpayer-provided "free" roads) and, on the other hand, the public interest. All of Texas' PPP concessions to date have utilized this approach, as will any future projects under Arizona's 2009 PPP enabling legislation.

Two long-term lease transactions provide a useful illustration. For the Chicago Skyway concession, there were no protections for the private-sector lessee. Given that the roadway is located in a highly-developed area of Chicago, it is highly unlikely that any competing, parallel freeways will be developed in the future.

In the case of the Indiana Toll Road lease, the concession agreement set up a narrow competition zone alongside the toll road. The state may add short, limited-access parallel roads (e.g., local freeways), but if it builds a long-distance, freeway / expressway-standard road greater than 20 miles long within a 10-mile competition zone, there's a formula for compensating the private sector for lost toll revenue if the concessionaire can prove the new road is causing a financial loss. However, it should be noted that has not been a constraint on road building more generally, as the state is investing hundreds of millions of dollars from the proceeds of the lease transaction into new and expanded transportation infrastructure in the counties traversed by the Indiana Toll Road. In other words, the competing facilities provisions in the lease agreement are not preventing the state from making needed transportation investment.

Myth 6: PPPs involve selling our roads to foreign companies

Fact: A common, but often misunderstood, concern about any PPP is the potential that a foreign company will become the state's partner in operating a toll road, bridge or mass transit system. The potential is high that a foreign company might win the bid, and the reason is simple: because foreign companies have the most experience with PPPs. Countries like Australia, New Zealand, the United Kingdom, France, Italy, and Spain have utilized PPPs for years. Therefore, it is not surprising that the private-sector role in the provision of transportation services is more developed and mature outside of the United States.

In the early years of U.S. adaptation of the PPP concession model, states want to deal with firms that have extensive experience as toll road providers. The simple fact is that this is a nascent industry in the United States, because we have used only public-sector agencies to build and operate toll roads. Meanwhile, European and Australian companies have decades of experience as world-class toll road providers. Thus, a responsible state government, wanting to ensure that the toll road is in experienced, professional hands, will weight prior experience very heavily in its selection criteria.

However, a domestic market is rapidly emerging in America. U.S.-based investment firms like Goldman Sachs, Morgan Stanley, and JPMorgan Chase have created their own infrastructure investment funds, as have many of their international peers.

In addition, U.S. union pensions are attracted to investing in infrastructure because those investments create jobs for union members. Unions have already contributed to investment funds run by firms like the Australia-based Macquarie, blurring the line between foreign and domestic interests. Further, in 2009 the Dallas Police and Fire Pension System became the first public pension fund to serve as a direct equity partner with a private concessionaire in two concession megaprojects in the Dallas area valued at over $6 billion total.

Regardless, it would be unwise to ignore international operators—and their experience and expertise—simply because they are foreign. Taxpayers should not be too concerned if a foreign company from Australia or Spain (like the consortium currently operating the Indiana Toll Road) wins the bid to build a new, privately-operated highway in their state. First, any potential roads would remain the property of the state, in public ownership. Second, the terms and conditions of the contract would empower the state to seize control of the road should the company violate their contractual agreements. Third, a road is a fixed, nonmoveable asset. It is not as if a foreign company will be able to pack up this asset and ship it overseas. Finally, many foreign companies are part of the pension portfolios of many Americans (including labor unions), so any attempt to limit the participation of international firms in state PPPs would be counterproductive to many workers right here at home.

Furthermore, it is important to remember that even deals that involve 100 percent non-U.S. companies are very good for our economy. Attracting billions of dollars in global capital (and expertise) to modernize vital highway infrastructure is a large net gain for this country. Rather than investments and jobs going overseas; foreign entities are willing to invest their money domestically, creating jobs here in the United States. The further build-out and investment in our transportation infrastructure only makes the U.S. more competitive in the global marketplace. And we should not forget that U.S. subsidiaries of international firms tend to do the majority of their hiring locally, so fears of "importing foreign workers" are unjustified.

In effect, foreign investment in our nation's infrastructure represents the reverse of outsourcing—it's more properly viewed as "insourcing." The opportunity to "insource" significant amounts of foreign investment into a state should be embraced rather than avoided.

Myth 7: Governments give private companies the authority to take private property through eminent domain in transportation PPP deals.

Fact: There is understandable concern that toll road PPP might lead to private companies acquiring the power to condemn land for right of way. None of the over two dozen state PPP enabling acts has delegated any such power to private partner companies. The eminent domain power is always reserved by the state, in its traditional role of acquiring rights of way for public-use infrastructure.

Myth 8: Government ends up holding the bag if a PPP project goes bankrupt and fails

Fact: In the event of a corporate bankruptcy on the part of a private sector investor-operator, the asset would revert to the project lenders who, with permission from the state, would select a new operator. The lenders have strong financial incentives to continue to properly operate and maintain the road, lest they risk losing the value of their investment. It should also be noted that if the concessionaire needs to sell, get out of, or modify the contract for any reason during the lease term, final approval would rest with the state.

Myth 9: PPPs should be avoided because they commit future generations when policymakers today cannot predict what the needs will be

Fact: State governments regularly make commitments that impact taxpayers for longer than 50 years. Bonding for infrastructure and changing pension benefits are two examples. Because the capital costs for major infrastructure projects are so high, it is necessary to finance them over long periods of time.

But PPPs are not designed to be inflexible and static. It is entirely possible that changing circumstances will require revisions to a PPP, and that is why all concession agreements have detailed provisions to permit changes during their term. Concession agreements have detailed provisions for negotiating and arbitrating disputes, and employing independent parties to make fair financial estimates. The only limit to changes in the terms of the concession is normally that neither side should be disadvantaged financially by the changes.

Policymakers should also remember that along with long-term commitments come long-term benefits. In this case, using PPPs to deliver new transportation infrastructure that otherwise might lack realistic prospects for financing not only enhances the mobility of current and future generations, but it also benefits the state economy in the long run as well.

Myth 10: A backlash after the Indiana Toll Road lease prompted Indiana policymakers to reject more PPPs

Fact: The $3.8 billion lease of the Indiana Toll Road in 2006 represented a paradigm shift in infrastructure finance in the Hoosier State, and some policymakers and taxpayers expressed skepticism or "buyer's remorse" in the immediate aftermath of the deal. However, the more time that passes, the more comfortable that Indiana has become with the PPP concept.

Simply put, the "sky did not fall," and as the benefits of the Indiana Toll Road lease continue to mount—e.g., the ability to pour billions into statewide transportation investment that otherwise would not have had funding, modernization of the Indiana Toll Road itself, and more—officials are increasingly recognizing the important role PPPs can play in keeping the economy moving.

The evidence is abundant. In 2009, both Indiana and Illinois enacted enabling legislation to permit the use of a PPP to develop the proposed Illiana Expressway toll road, a $1 billion project connecting I-65 in Indiana to I-57 in Illinois. That same year, Indiana policymakers approved using a PPP for a $4.1 billion joint effort with Kentucky to develop two new toll bridges across the Ohio River in Louisville; they also authorized the formation of a bi-state commission with Kentucky for the Ohio River Bridges project.

And earlier this year, Indiana legislature passed legislation granting the Governor broad authority to pursue additional transportation PPPs, as opposed to its previous stance of authorizing only specific projects. In essence, Indiana policymakers have broadened the scope of the state's PPP authority the more they've become familiar with this policy tool. Given such demonstrable support for PPPs after the Indiana Toll Road lease, the reality is that Hoosier State policymakers are increasingly embracing PPPs, not rejecting them.

Leonard Gilroy is director of government reform at Reason Foundation.

[Note: Portions of this article were adapted from earlier Reason Foundation publications, including December 2009 testimony to the Pennsylvania House Republican Policy Committee, the Annual Privatization Report 2010, our 2007 FAQ on building new roads through PPPs, and several other documents listed here.]


Leonard Gilroy is Director of Government Reform


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