Thursday, October 20, 2005

The first five years of the twenty first century have, I think seen two broad developments of key relevance to the future of transport sector public private partnerships.

First, urgency has been added to the transport agenda for many European nation states – and for the broader European community as a whole.

This has resulted from the impact of globalisation, the consequences and possibilities of enlargement, and ever greater social mobility within and across national and regional boundaries;   continuation of economic growth leading to greater congestion, on land, at ports and in the skies has also led to heightened environmental concern.

The second broad development evident is increased dynamism in the way the private sector organises itself to finance, construct and service transport projects.

This dynamism – responding to the projects and investment opportunities promoted by public authorities – is not only creating new project development capacity but also tapping capital markets in more varied forms.

It is seeing the growth of new types of enterprise and funding structures targeted to infrastructure investment – an asset category that is itself assuming greater prominence within broader investment markets.  

The positive possibilities opened up these trends should, I believe, be of great interest to policy makers charged with delivering transport improvements, but also to those charged with responding to broader questions concerning savings and pension policy, and regional economic development.

Against this backdrop, Public Private Partnerships have a place as one tool in the government toolbox.

Experience to date suggests that this tool can be exceptionally useful and effective for some tasks, but is useless and even counterproductive for other types of job – 
and at other points on today’s agenda we will be discussing the boundaries between these two categories.

The point I wish to focus on here is a narrower one:  in seeking to develop PPP programmes that deliver long term value for money to taxpayers and the communities they serve, governments and their public agencies now need to consider how to render themselves as competitive as possible in an evolving international market.

Essentially appropriately structured PPPs will deliver value for money because they have two key attributes:

• they de-risk taxpayer exposure to the construction phase of major transport improvements 

• and they link private profit to long run social benefits,

so, in combination preventing the contract dispute, and cut-and-run interaction of private and public sectors that has too often generated expensively created infrastructure that persistently underperforms or dramatically deteriorates in service.

This is important because the last half century provided more than ample evidence that the governments of our liberal democracies have generally struggled badly with long term capital planning for infrastructure - and that in transport in particular the implementation phases of investment strategies have far too often been littered with major cost overruns.

These in turn, have provoked further stop-start reactions that carry with them their own damaging costs, not least the costs of benefits foregone as delivery of transport investment priorities long identified are indefinitely delayed. 

Indeed at the European level we are in that situation today in relation to many key elements of the Ten T programme – where clarity of vision has repeatedly given way to highly uncertain forward progress, then subsequent inaction.

The most comprehensive analysis available on capital cost overruns in transport across the OECD is that found in the work of Brent Flyborg and his colleagues at Aalborg University, originally published in the Journal of the American Planning Association in 2002, since extended in a variety of publications.

This study examined 258 projects worth over Euro 140 billion in 1995 prices and found that, on average for all types of major transport project, cost escalation between the original public sector decision to proceed and the serviced infrastructure coming into use was 28%.

As we were discussing in one of the workshops yesterday rail investment fared particularly badly with an average 45% cost overrun, tunnels and bridges were found to have escalated by 34% on average, and roads by 20%.

What lies behind this calamitous history of cost escalation?

Flyborg and his colleagues place particular emphasis on the duplicity of project champions, whether in the public or private spheres, citing the persistent tendencies to underestimate costs, ignore risks and overestimate benefits as being driven by sectional self interest. This is seen as leading to a generalised conspiracy of optimism on the part of project promoters, politicians and administrators who, they observe, are rarely still around to answer for the long term consequences of ill judged investment decisions that fritter away scarce resources.

While this academic viewpoint is seductive, I myself take a slightly less cynical approach – and one that is supported by the emerging track record of Transport PPPs.  

Within PPPs of course construction cost and delay risk for major investments are generally transferred to the private sector – effectively to the equity investment put at risk within the project finance structure.

It is this equity that is the essential platform for the private sector to be able to assume those risks that can be cost effectively transferred from the public sector balance sheet.

The processes that lead to commitment of project debt and equity involve extensive scrutiny of multiple risks being carried out by a complex chain of financiers, investors and contractors backed by technical expertise directed to an overriding objective – generation of a robust, sustainable and deliverable project.

And the formation of the contractual arrangements that bind these players together, and which seek to mitigate and distribute key risks between them, forces key decisions to be taken in both a detailed and a timely fashion – they concentrate scrutiny on the realism behind plans to achieve the outputs required, not the political and administrative processes that tend to predominate when a public authority or government department is variously promoter, regulator, financier and delivery agent.

Consequentially project financing will, as the record now shows, generally lead to far more effective management of these risks in the implementation phase.

This is not to say that occasional conspiracies of optimism don’t exist in private consortia and or that risks aren’t ever overlooked or underestimated by PPP bidders and promoters – and here amongst others the UK light rail market of the last ten years can provide a cautionary tale – but the key point is where they do occur the public sector client is effectively insulated from their considerable consequences.  

As we know the last quarter of the twentieth century, produced many engineering triumphs which were public expenditure disasters and a few prominent privately financed engineering marvels that were disastrous for private investors.

This history should caution us against embracing panaceas, but it is also now sufficiently rich to lead us towards some general lessons, and of sufficient length for us to be able to discern key trends that policy makers should be aware of and seek to harness.

For example, it has often been observed that at the fundamental root of both categories of failure has been a failure to evaluate and manage whole life costs and benefits – to adequately bind together the process of asset creation and asset use for service delivery and this leads us to the second inherent strength that should recommend adoption of the PPP mechanism where other surrounding pre-conditions, related to project size and the potential for clear definition of public and private sector roles and responsibilities, render it a possible approach.   

Correctly structured PPPs will link private sector investment returns to long run, sustainable performance – and these returns are attractive to the wider market precisely because of their usually robust nature once the riskiest stages of project implementation have been successfully negotiated.

It is this fundamental feature that is underpinning the emergence of infrastructure investment as a more prominent and distinct asset class – a trend that can be discerned if one looks at the evolution of the UK’s PFI market over the last decade. Here some 50 billion of capital investment in transport and social infrastructure has been procured, with perhaps a total of 5-6 billion of project equity deployed by the original sponsors, a mixture of contractors, operators and third party specialist investors.

As the number of operational projects has risen, a secondary market has evolved, offering opportunities for project developers to recycle equity, taking advantage of the value uplift created by successfully negotiating the construction and early service period phases. The purchasers of these interests in a UK context have to date in the main been dedicated secondary funds, often drawing on institutional support – particularly from among those who are seeking steady yield from assets that can be matched to long run liabilities, such as pension obligations.

As the number of operational projects has risen, pension and life fund interest in direct investment has also increased both nationally and internationally, and this has been mirrored in jurisdictions as diverse as the Australia, Canada and the USA by the formation of listed and unlisted vehicles attracting the interest of high net worth and retail investors. 

In some cases single infrastructure assets have been listed on local exchanges, a trend bringing about new possibilities for individuals to invest in their own communities and the transport improvements that serve them. In a recent example some 38% of initial investors in an as yet to be constructed urban tollway were domiciled in the immediate vicinity of the transport corridor concerned. 

These trends – which are also reducing the relative cost of capital that can be harnessed to create public realm transport assets - seem set to endure. And they are ones that both finance ministries and transport ministries should in my view seek to analyse, facilitate and exploit.

So to return to the overarching question – in order to harness these trends to maximum effect – how should governments render themselves competitive in a market that is becoming both more diverse and more international?

A key point is that PPP investment should be clearly articulated and communicated to the market as one part of the overall transport investment strategy being pursued in the national interest. As such it must take its place within overall public sector financial planning – particularly because infrastructure involving ongoing availability or volume based payments from the public sector – in other words not fully remunerated through exposure to patronage risk or direct user payments – can lock in significant obligations over the longer term. This is the flip side of the coin that ensures that private investment will also deliver maintenance and operation to a consistent standard over the full life of any concession. And as we can observe in certain situations a failure to adequately appraise these future payments in the overall context of public expenditure can necessitate potentially painful and difficult restructuring of entire programmes midway.

Governments should be both proactive in promoting the potential benefits of PPP programmes to the community and in ensuring thorough transparency in relation to the relative costs and benefits off PPP versus the alternatives. There are no prizes for lack of transparency in this game – quite the reverse.

In order to do this it is essential that governments have adequate in-house skills and sufficient resources to both control their advisers and to accurately and comprehensively analyse the relative costs and benefits of alternative procurement routes. Advisory resources are not enough – for far too often over reliance on external short term resource will mean that the procurement process is over-extended to the benefit of those in receipt of transaction fees,  and inefficient because retained knowledge is not built up to enable effectiveness as a client over the longer term.

What is clear from recent European experience is that governments who resource and implement procurement programmes that are perceived by the market to be efficient, well supported politically and adequately communicated to the wider community will be rewarded by a depth of competitive interest that will deliver value for money and a highly competitive cost of capital. .  Where market programmes are perceived to be soundly based, international players are also likely to combine with local companies to create local capacity so enhancing local economic development.

Conversely, those that tolerate tick box or artificially bureaucratic protectionist procurement practices or pursue blanket risk transfer in the mistaken belief that the most aggressive deal is in the long term public interest, are likely to find that  competition is burnt off.

As to how far governments should follow precedent, it is true that in the development of PPP programmes precedent is useful, and standardisation of terms and processes has a part to play – but not to the exclusion of innovation and the tailoring of concessions to meet local circumstances.   Already we see for example a spectrum of effective procurement approaches from those such as Italy or indeed the USA where the concepts of the project promoter and the unsolicited proposal potentially triggering a competitive procurement process offer different approaches to those that have pursued in places such as the UK and Scandanavia.  No model is perfect, and my own company’s experience elsewhere in Europe suggests that the UK for example can learn from others when it comes to optimising the efficiency of procurement processes and minimising public and private sector bid costs.    

What is clear however is that the PPP Transport track record is now sufficiently developed for governments to be able to use this tool with greater dexterity and a higher degree of confidence. Continual sharing of best practice can assist in ensuring that at both the political and the administrative level both the will and the skill are put in place for this to happen – and at the broader European level this will be invaluable if we are to be able to meet current transport sector challenges in a timely fashion.