With the long-term lease of Virginia's Pocahontas Parkway bringing such transactions to three, and similar deals being contemplated in Houston, Illinois, and New Jersey, critics of this form of privatization have been questioning the wisdom of leasing existing toll roads. Since many of their points would apply to PPP projects for new toll roads or toll lanes as well, we need to assess the critics' points.
A recent critical review of the Chicago Skyway, by NW Financial Group, LLC, is fairly typical. It makes four main criticisms, as follows:
- The toll rates in the out years will be ridiculously high;
- The return on equity is outrageous;
- These deals divert money away from needed transportation investment into the pockets of investors; and
- The same economic value could have been generated by a public-sector re-financing.
Analyst Dennis Enright projects future toll rates, based on the concession agreement's three alternative caps on annual increases. He calls the resulting table the "likely dollar toll results," and his scariest number is an $1,800 toll in the 99th year of the lease. What's wrong with this picture?
What Enright completely ignores is a concept out of Economics 101 called "elasticity of demand." Just because the ceilings in the agreement permit a toll of $X says nothing about whether anyone—let alone a revenue-maximizing fraction of potential customers—would be willing to pay that toll. In fact, the Chicago Skyway faces significant free competition, and the concession agreement contains no non-compete clause. The Cintra/Macquarie consortium is entirely at risk for traffic and revenue.
In such circumstances, the only reason to include price caps in the concession agreement is for political cover. Competition in the highway market would suffice quite nicely to keep the Skyway toll rates at reasonable levels in the absence of any price caps. For supporting evidence, just look at nearby Detroit. Both the Ambassador Bridge and the Detroit-Windsor Tunnel are investor-owned (and always have been). Yet neither is subject to any price caps. Yet we don't see $100 or $500 tolls being charged to cross the Detroit River!
The same principle is true for HOT lanes and Express Toll Lanes being added to congested freeways. The free competition is right alongside the toll lanes, and in these cases any sort of price cap would be not merely unneeded but positively harmful. Value-priced lanes can only do their job of keeping traffic flow uncongested if their pricing is left free to balance demand with capacity. A concession agreement can set conditions such as specifying the level of service (e.g., LOS C) or the amount of capacity to be reserved for buses. But it should not constrain the pricing in any way.
What about return on equity? Under Enright's ridiculous toll rate and revenue assumptions, the maximum post-refinancing return on equity would be 17.4%. To be sure, that's pretty high for an existing facility, even though it does face traffic and revenue risks and large potential future capital costs. But if you look at the returns based on the more likely (CPI-based) toll increases, they are mostly in the 9-12% range. Whether that is "reasonable" depends on whether that is a high enough return to attract capital to toll roads as opposed to other kinds of long-lived infrastructure. My impression is that this is in the right ballpark.
Then there is the concern that such leases rob the transportation system of funding that otherwise would have gone into much-needed investment. In the case of the Skyway, attorney John Schmidt, who advised the City on the lease, points out that any excess revenues from the Skyway (prior to the lease) went into the general fund, just as did the concession fee. And I will point out that the far superior (in my view) Indiana Toll Road lease does devote the entire $3.8 billion lease proceeds to investing in the governor's Major Moves highway modernization program (which otherwise would have been under-funded by half).
But perhaps the most superficially appealing point is the last one: If there is so much value locked up in an existing toll road, why shouldn't the government re-finance the road and reap the benefits instead of investors? The Achilles heel of this contention is the completely unrealistic assumption that the public sector could keep toll rates at market levels over 50 or 75 or 99 years, thereby creating the value in the first place. Both political theory and real-world experience argue otherwise. The Indiana Toll Road had not increased its tolls for more than 20 years. The Skyway had gone without a toll rate increase for 12 years. Given the reality of inflation over these years, that means the real toll rates had been decreasing all those years.
John Schmidt puts the point nicely: "One of the things that happens in a privatization transaction is a shift of control to a non-political entity that is capable of behaving over time in an economically rational mannerï¿½and that opens up financial possibilities that depend on the financial markets' recognition of that reality."
Today, at the dawn of the use of long-term concessions for toll road operations in this country, it is easy to get hung up on the somewhat arbitrary distinction between existing and new toll facilities. But over a 50+ year concession term, major capital investment in expansion and rebuilding is highly likely, regardless of whether investor ownership was involved at the project's birth or only came along later. It's crucial that we have a robust market for financing the expansion and modernization of U.S. highway infrastructure. Therefore, we need to get the principles right in these initial, pioneering transactions.
Robert W. Poole Jr. is director of transportation studies and founder of the Reason Foundation.