Realizing our infrastructure goals will require the revival of communal interest and compromise
By Manuel H. Lazerov
The magnitude of an ideal infrastructure program envisaged by most everyone could be America’s largest economic initiative over the twenty to thirty years. It is, however, should be more than aspirational, but vital. There is no dispute over the fact that our infrastructure is in terrible shape, and fixing it would make America more competitive internationally. It would boost our productivity, contribute to improving our environment, the quality of our lives, and would contribute to both higher paying jobs and would accelerate economic growth.
The fundamental issue is, how will it be funded? Let’s make it simple. Ask a passerby on the street that question, and they’ll say, “Not by me. I’m already paying my fair share in taxes.” Ask someone running for office, and they’ll say, “I’m all for it. Elect me, and I’ll make sure that someone other than you pay for it.” Can you see where this is going? “I know that we need it, and I’d be happy to use it, but I’m not paying for it.”
The fact is that the $4.5 trillion estimate of the American Society of Civil Engineers to upgrade our roads, bridges, dams, airports, schools, water and waste water treatment plants by 2025 cannot be achieved, simply because as we are delaying decisions to get it done, our infrastructure is deteriorating at an accelerating rate which will absolutely invalidate that very conservative estimate.
The real number, however, is far in excess of the ASCE estimate. Over the years, the ASCE has probably continued to drop that overall number so as not to frighten congress and other public officials into doing nothing. Also, take into consideration that the majority of projects almost never come in on time and under the budgeted number.
If one considers the president’s most recent budget suggestions, there will be much less federal money for economic and social infrastructure. Congress is already struggling with how to maintain existing programs, let alone taking on new ones, like infrastructure. However, in the event of a recession, all of that could go out the window, as public officials “do whatever it takes” to stimulate the economy and to enhancing their prospects for remaining in office.
A Brief History of Infrastructure Development in the United States
How did we get to this point? After World War II, America initiated a national infrastructure program, with the federal government generally paying for 90 percent of the costs, beginning with roads. Local government was expected to pick up the last 10 percent. User fees were supposed to defray the costs. But, the fact is that user fees collected have been generally insufficient to cover the costs of maintenance and repair, and to create reserves for replacement in the future.
Why? Because the public almost always opposes necessary increases, and has shown no hesitancy in voting public officials out of office for adjusting user fees to match actual expenses. So, rates have remained relatively suppressed, rather than reflecting life cycle costs, which is a combination of construction, operations and maintenance costs , and the cost of capital, which costs also happen to increase over time.
Construction costs are only part of the equation. For most infrastructure projects, it has been shown that operations and maintenance is ten times that of the original construction costs. But, then, that was the deal. The government picked up 90 percent of the construction costs, and state and local government assumed the remaining 10 percent, plus operating costs. And, that has been the formula up until this moment.
Is a new paradigm evolving? Well, government at every level claims that they are broke, and the federal government has indicated that it will no longer assume the same role as it has in the past. In fact, it wants to completely reverse the formula, by having state and local government paying for 90 percent all construction costs, with state and local government still paying for all operations and maintenance costs, and the federal government just paying for 10 percent of construction costs. This would represent a massive shift in local government responsibilities.
With state and local governments in arguably worse shape than the federal government, where can the locals be expected to get that kind of money? The federal government’s current position is that state and local governments should sell their existing infrastructure to investors, who would upgrade those assets, and that local governments should raise taxes and user fees to support new bond issues within their own communities. One can expect some legacy programs to be maintained by the federal government, but, realistically, the feds see these programs being phased out over time.
How do public pensions and other obligations fit in here? Not even part of the discussion are rebuilding projects for economic sustainability, adapting projects for climate change and environmental upgrades which must be periodically made, or accounting for state and local pension and benefit liabilities, which according to the Urban Institute amount to $1 trillion to $3-$4 trillion, depending on modeling assumptions.
In order to avoid the necessary annual contributions to pension funds, many jurisdictions have simply predicted higher investment returns than is available in investment grade securities, in order to avoid higher current contributions to fund future pensions. Consequently, many jurisdictions have turned to private equity firms to generate higher returns, and have reduced their tolerance for risk as a trade-off for higher returns, meaning, that they are purchasing lower grade securities with higher rates of interest to greatly improve returns.
It is, however, important to keep in mind that there are inherent risks in lower quality investments. During times of economic stress, those securities drop markedly in value as issuers suspend interest payments, and the value of those securities drop dramatically upon default. Also, there is a liquidity issue, which is when there are insufficient buyers for low rated securities except at very reduced prices. Pension funds always need to keep in mind that retiree benefits will have to be met, and checks will have to be sent out, or benefits reduced.
This is not an inconsequential concern, since most public pension funds are very underfunded already, many in the billions of dollars, which in times of economic stress will impact their ability to borrow.
Alternatives for Finding the Money, and Some Predictions
As a general rule, those jurisdictions which have excellent credit will likely develop projects by continuing to borrow the money outright and keeping projects on their own balance sheets, assuming all of the risk for construction and ownership themselves. They are not likely candidates for entering into Public-Private Partnerships (P3’s). This is the way in which they have always developed projects, and they are not about to change, despite the logic that they could do many more projects than they might otherwise do, especially highly complex ones.
There is one qualifier, which is, if the economy and tax revenues were to decline significantly, that might alter their way of doing business.
Private investment in public infrastructure
There are institutional investors which are willing to fund public infrastructure projects. But very little has been invested, compared to the need. The reasons for that have to do with a number of factors.
First, there has been a great deal of resistance to the idea of private investment in public infrastructure. Recently, there has been a growing public antipathy, where the perception is that they being ripped off anytime that concessionaires, i.e. infrastructure investors, are involved. Then fact is, resentment runs even deeper than that, which is that concessionaires wi earn undeserved profits, and that government is the better alternative, since it can be pressured into maintaining rates below life cycle costs. This just constitutes passing along higher deferred maintenance to the next generation, which is what we have been doing for decades.
Second, public officials are often resistant to investor involvement. Concessionaires who undertake development responsibilities build, finance, operate and maintain a project for a specific period of time, turning over the property to the jurisdiction at the expiration of the concession, which can run to 20 years or more.
Under this arrangement, a jurisdiction has an opportunity to transfer many of the development and operating risks to the concessionaire. In the process of turning over the project after the expiration of the concession, they also have to ensure condition of the property is in good shape, less normal wear and tear.
The opportunity for many concession agreements lies in the fact that they can get money more easily and create financing terms which may be superior to what jurisdictions with less than stellar credit may be able to achieve on their own. And, as previously mentioned a great deal risk can be shifted in the process as well. Concessionaires’ experience with very complex projects is also an advantage.
Public officials, however, view this very differently. Their resistance is often heavily “territorial”. By this, we mean that when concessionaires enter into concession agreements, they usually use the design-build model, where they accept all responsibility for any design flaws and provide a guaranteed maximum price contract. Sounds good, so why the resistance?
Because, it’s the concessionaire who picks the designer, the engineer, the contractor, and the suppliers. Long term, this may be disruptive to existing relationships, which make public officials feel marginalized. Newer agreements “normalize” those responsibilities, wherein both the concessionaire and the public officials participate in the selections. It’s important to note, with control comes risk, and the more control that public officials have, the more construction, design, and operating risk they retain on their respective books.
Overcoming that Resistance and Predictions
At some point in the future there will be a recession. When that occurs, the redevelopment and expansion of our infrastructure will be a much easier sell to the public.
The question is what’s going to change the public resistance in paying realistic user fees? The Democrats want government control and taxes to help defray the costs. The Republicans claim to want greater private investment in public assets, and no increase in taxes. Then there’s the sentiments of public officials and taxpayers to take into consideration.
What could change that? There’s a default position on which everyone could agree. In the event of a business turndown, the federal government could reverse its current fiscal formula for providing financial assistance to the state and local governments. It could go back to its 90 percent participation for construction.
Why would they do that? Several reasons. The Fed can print money and maybe think about raising taxes at some distant point in the future. Second, they can do it much faster and easier than can local government. And, third, they can kick all of that deficit spending down the road ‘til the cows come home. No tax increases, but more tax revenues. Continued suppressed user rates. Jobs, jobs, jobs. Economic stimulus. And, most importantly, no pain, except to future generations which will have to deal with the doubling of our debt from where it is now.
What about getting more private money into the equation? It’ll be modest, because federal funding is “less expensive”, because user rates will be predictably suppressed. And, when jurisdictions cannot secure federal funding, then they will simply do without, other than projects which do not rely on public financing, which is where concessionaires can play a role.
To realize our goals will require the revival of communal interests and compromise. Optimistically, I believe that some of the less desirable solutions in getting this done are very likely.
Manuel H. Lazerov is President of Infrastructure Financial, Inc. He may be reached at www.infrastructurefinancial.org