THE USE OF FEDERAL INNOVATIVE FINANCE TECHNIQUES IN PUBLIC-PRIVATE PARTNERSHIPS THE CASE OF THE CAPITAL BELTWAY BY MARTIN J. LUBY

Transcription

1 THE USE OF FEDERAL INNOVATIVE FINANCE TECHNIQUES IN PUBLIC-PRIVATE PARTNERSHIPS THE CASE OF THE CAPITAL BELTWAY BY MARTIN J. LUBY

2 Compared with the rest of the world, the United States has been relatively slow to use public-private partnership arrangements (P3s) in building, financing, and operating infrastructure assets. One reason is U.S. tax policy unlike many countries, the United States allows state and local governments to issue tax-exempt municipal bonds to finance the building of infrastructure assets. This tax exemption enables state and local governments to procure financing at a much lower cost than can be achieved by the private sector, which often uses a more expensive debt and equity financing mix. Because of this financing advantage, state and local governments have a long history of financing, building, and operating infrastructure in the United States,which,some would argue, has provided these governments with a level of operational expertise that is similar to that of the private sector.the question, then, is whether the public sector s seemingly inherent financing cost advantage is enough to offset whatever capital and operational cost efficiencies the private sector brings to the building and managing of infrastructure assets. One way to analyze this question is by comparing the amount of funds the private sector is willing to pay the public sector for the right to finance, construct, and operate toll roads in the United States with the amount that can be raised through conventional municipal bond financing. How much is the future cash flow stream of the asset worth under private versus public provision and financing? QUANTITATIVE, QUALITATIVE; GREENFIELD, BROWNFIELD A number of recent studies mainly covering U.S. surface transportation assets address this type of explicit quantitative analysis. In reality, of course, the policy decision to use a P3 arrangement must also take into account more qualitative factors including control of the asset being lost, appropriate level of consumer surplus for toll users (i.e., the difference between the maximum toll a citizen would be willing to pay versus the actual toll rate), future regional transportation needs, diversion of traffic, and environmental impacts. However, while these qualitative considerations are clearly important,they will likely be considered only if a government The question is whether the public sector s seemingly inherent financing cost advantage is enough to offset whatever capital and operational cost efficiencies the private sector brings to the building and managing of infrastructure assets. can make a case from a quantitative standpoint that private rather than public financing,construction,and provision of an infrastructure asset is more effective. Second, within types of P3 arrangements, one must distinguish between the construction of new roads, often referred to as greenfield projects, and privatization of existing roads, called brownfield projects. In many contemplated greenfield P3s, the private sector designs, finances, constructs, operates, and maintains the new road. In return for a one-time, upfront payment to the government, the private entity receives the right to collect and keep all revenues from the asset over a specified term. In a brownfield project, the road is already built, so the private sector entity only operates and maintains the asset, although maintenance might include significant future capital costs. Like in a greenfield project, the private entity receives the right to collect and keep all revenues from the asset over a specified term in return for a one-time, upfront payment to the government. The level of value the private sector offers, as it relates to risk sharing and cost containment, may be much different for greenfield and brownfield projects. Construction, revenue, operational, and environmental risks are much higher for new roads, and for this reason, P3s can be a better arrangement in greenfield projects (even if the quantitative analysis favors the public sector) because the risksharing arrangement between the public and private sectors is more appropriate. It is not surprising, therefore, that most of the debate (and, thus, most of the written studies) on P3s has been over brownfield projects. It seems that most observers recognize the significant value the public sector can realize in transferring risk to the private sector in greenfield projects, whereas there is still considerable debate about the impact of private sector involvement in brownfield projects. Chicago Skyway and Indiana Toll Road. Given the size and prominence of several recent P3s, including the $1.8 billion Chicago Skyway and $3.8 billion Indiana Toll Road projects, several studies have been commissioned to examine whether it makes sense to enter into such P3 arrangements. Dennis Enright, a prominent critic of P3 brownfield projects as they have been structured to date, analyzed the Chicago June 2009 Government Finance Review 33

3 Skyway lease transaction and attempted to determine whether traditional municipal bond financing could have been used to provide the $1.8 billion upfront payment received under the concession. 1 Simulating a conventional municipal bond financing, Enright found that public financing at the same or even greater monetization levels would have been feasible for the Chicago Skyway. In the context of loss of operational control and future cash flows under the P3, Enright argued that conventional upfront municipal financing would have been a better public policy option for the City of Chicago. Enright also examined the $3.8 billion Indiana Toll Road lease transaction using the same framework as his Chicago Skyway study. 2 Similar to the previous study s findings, he determined that conventional municipal bond financing could have provided an upfront financing amount similar to what the P3 provided, without the need to transfer operational control and future revenue growth to the private sector. Pennsylvania Turnpike. A 2008 study of the proposed leasing of the Pennsylvania Turnpike, commissioned by the Democratic Caucus of the Pennsylvania House of Representatives, analyzed three financing alternatives (traditional municipal bond financing by the Pennsylvania Turnpike, full public sector monetization by a public benefit corporation,and a P3 corporate lease) and attempted to determine which alternative made the most financial sense. 3 The authors found that on a present-value basis, the traditional municipal bond financing would provide $26.5 billion in upfront funding to the state, the full public monetization would provide $22.8 billion, and the P3 lease, $14.8 billion. The study provided several conclusions, based on sensitivity analyses and financing structures: 1) given comparable toll schedules and operating expenses, the cost of capital becomes the most significant value driver for the operator of the Turnpike; 2) the other major drivers of value are the length of the concession term, the toll formula, and the assumption regarding the growth in traffic; and 3) value is relatively insensitive to operating and capital costs. The third conclusion could be seen as refuting one of the primary arguments of P3 proponents: namely, that operational and capital efficiencies make these assets more valuable in the hands of the private sector than the public sector. P3 PROPONENTS The Reason Foundation is a major proponent of P3s. Much of this organization s advocacy relies on the traditional argument that the private sector often offers more efficient service delivery of public goods than the public sector can. As it relates to transportation infrastructure, the Reason Foundation and other P3 advocates claim three primary advantages to privatization. They argue that the private sector can: 1) provide better customer service, 2) operate the assets as a real business (including reduced capital and operating costs), and 3) make better investment and financing decisions than governments can. 4 While the Reason Foundation generally concedes that public-sector financing may be less expensive than what the private sector could put together, it contends that this difference is smaller than P3 critics claim and that the operational and capital cost efficiencies the private sector provides overcomes the financing advantage. 5 (See Exhibit 1 for a comparison of the two contrasting perspectives as they relate to the level of upfront funding in a P3 project.) Robert Poole, director of transportation studies for the Reason Foundation, challenges the plausibility of the assumptions P3 critics make regarding conventional municipal bond financing, including the Enright studies. Poole dismisses critics analyses based on the following factors: 1) unrealistically aggressive traffic and revenue forecasts, 2) unrealistic projected toll increases, and 3) inappropriate discount rate. 6 With respect to his first two criticisms, Poole argues that municipal 34 Government Finance Review June 2009

4 Exhibit 1: Privatization Perspectives on Brownfield Projects P3 Proponents P3 Critics What Type of Financing P3 proponents agree that the tax-exempt P3 critics see conventional municipal bond Will Provide the Largest bond borrowing cost is likely to be less than financing as preferable to P3 arrangements Upfront Payment to the weighted average cost of capital incurred in most cases.the buyer s cost of capital is the Government? by a private firm. However, they argue, the the dominant valuation driver, according to public sector borrowing cost does not take this argument; the entity that has the lowest into account the risk premium associated cost of capital will be able to raise the largest with project-associated risks such as cost amount of upfront money.the tax-exempt overruns. In addition, a P3 might be able to benefit afforded to state and local governments raise more money than the public sector ensures that the public sector will be the because tax-exempt bond investors, worried winning bidder. Unlike the rest of the world, that future elected officials might intervene in the United States has a massive debt market toll rate schedules and might demand a higher that provides tax-exempt benefits to bondrisk premium than normal, which would be holders. Moreover, there is no shortage of reflected in the bond borrowing cost. In capital to fund these transactions like there addition, the gap between public and private is in the rest of the world. P3 critics also argue cost of capital is narrowing, and greater use that the transaction costs and monitoring costs of creative financing models such as private going forward need to be added into the P3 activity bonds is likely to further reduce this decision matrix, and that doing so further tips gap, P3 advocates say. the balance in favor of tax-exempt financing. bond investors and credit rating agencies would be dubious of both the public sector s will and ability to raise tolls at the pace contemplated under a P3 arrangement.poole concludes that the public sector would not be able to raise as much upfront funding as the private sector could, based on the assumption that governments would not raise tolls as much and as often as a P3 would,and that bond investors and credit rating agencies would tend to favor conservative, investment-grade types of revenue projections. Poole also argues that the use of Transportation Infrastructure Finance Innovation Act (TIFIA) loans (i.e., direct loans from the Federal Department of Transportation) and the issuance of tax-exempt private activity bonds by private entities can significantly decrease the public sector s financing benefit over the public sector. THE CAPITAL BELTWAY PROJECT The Capital Beltway public-private partnership between the Virginia Department of Transportation (VDOT) and its private partners is, in many ways, a landmark surface transportation project.it includes the largest private-sector equity investment in a U.S. new-build toll road public-private partnership. The Capital Beltway project is also the first U.S.surface transportation project to use tax-exempt private activity bonds (PABs) and the first to use U.S. Department of Transportation TIFIA funds and PABs in one financing. 7 The significance of such a novel government-assisted private-sector financing structure is the reduced cost of capital for the private sector partner. The $1.4 billion Capital Beltway project involved the VDOT granting its private-sector partner the right to design, construct, finance, and operate high occupancy toll (HOT) lanes on the Capital Beltway on I-495 in Virginia. 8 The Capital Beltway HOT lanes project aims to bring congestion relief to Northern Virginia through the construction of 14 miles of electronically tolled Hot Lanes, adding two new lanes in each direction. This will increase the total number of lanes from eight to 12. HOT lanes are tolled lanes that operate alongside existing highway lanes (see Exhibit 2). Buses, carpools, and emergency vehicles can access the HOT lanes for free, and drivers with fewer than three occupants can choose to pay to use the HOT lanes. Simple supply and demand principles combine with advanced traffic management technology to ensure both the HOT lanes and the adjacent regular lanes operate at maximum efficiency.when traffic is light, toll prices are low.when congestion increases, toll prices go up to regulate the number of drivers wanting to enter lanes. In financing the Capital Beltway project,vdot s private partner relied on two innovative, federally sponsored finance options,pabs and TIFIA funds. 9 The PAB issuance was authorized under the recent federal transportation-funding bill, SAFETEA-LU, which permitted the U.S. Department of June 2009 Government Finance Review 35

5 Exhibit 2: High Occupancy Toll Lanes Shoulders Shoulder Shoulder Regilar Lanes HOT Lanes HOT Lanes Regular Lanes Source: Capital Beltway Hot Lanes,Transurban Group, December Transportation to allocate up to $15 billion in PABs between qualified highway and surface freight transfer facilities. PABs retain their tax-exempt status despite a greater level of private involvement than is ordinarily allowed for these types of bonds.this allows public-private partnerships to obtain lower financing rates, eliminating one barrier to private sector participation in transportation finance. The TIFIA program, as reauthorized under the Safe, Accountable, Flexible, Efficient Transportation Equity Act, provides federal credit assistance to nationally or regionally significant surface transportation projects, including highway, transit, and rail. The program is designed to fill market gaps and leverage substantial private co-investment by providing projects with supplemental or subordinate debt at low-interest rates.the U.S. Department of Transportation expected that applicants for PAB authority would, like in the Capital Beltway project,also apply for TIFIA credit assistance. Thus, TIFIA applicants that might previously have needed to consider senior-lien taxable financing could now combine the benefits of senior-lien tax-exempt financing with subordinate TIFIA debt. In financing the $1.4 billion project in June 2008,VDOT s private partner relied on $589 million of PABs and approximately $525 million in TIFIA funds, with the rest of the project funded by private The difference in the cost of capital for the public and private sectors may not be as pronounced as it once was due to the use of innovative finance tools like PABs and TIFIA loans. equity. The 40-year tax-exempt PABs are costing the private entity 4.97 percent, while the TIFIA funds were borrowed at an interest rate of 4.45 percent. As such, the weighted average cost of capital of both PABs and TIFIA loans for the project is 4.71 percent. 10 This debt cost of capital is likely much lower than what this private-sector entity could have procured in the corporate bond market at the same time.in June 2008,20-year BAA-rated corporate debt was being sold in the low-to-mid-7 percent range. CONCLUSIONS The significance of the private entity s reduced borrowing cost directly relates to the current debate between private financing and conventional municipal bond financing in funding large-scale surface transportation projects.that is,critics of public-private partnerships often cite the public sector s historical ability to raise funds through the tax-exempt municipal bond market much more cheaply than the private sector can through the taxable debt and equity markets. This cost of capital advantage (as well as the public sector s long history of designing, managing, and building the nation s infrastructure in the United States) is cited as one of the primary reasons why the public sector can design, construct, finance, and operate U.S.infrastructure more efficaciously than the private sector. However, as demonstrated in the financing of the Capital 36 Government Finance Review June 2009

6 Beltway project, this cost of capital difference between the public and private sectors may not be as pronounced as it once was due to the use of innovative finance tools like PABs and TIFIA loans.thus, the narrowing cost of capital spread in concert with two other factors favoring the use of publicprivate partnerships namely, the operational and capital cost efficiencies offered by the private sector and the ability to allocate risk properly between the public and private sectors in a P3 provides ample evidence that state and local governments should continue to seriously consider P3 arrangements in their attempts to provide sufficient and timely funding for maintaining and developing surface transportation infrastructure. Notes 1. Dennis Enright, The Chicago Skyway Sale: An Analytical Review, Northwest Financial Group LLC, May Dennis Enright, Then There Were Two: Indiana Toll Road vs. Chicago Skyway, Northwest Financial Group LLC, November Gary Gray, Patrick Cusatis, and John Foote, An Analysis of Financial and Strategic Alternatives for the Pennsylvania Turnpike, study commissioned by Democratic Caucus of the Pennsylvania House of Representatives, February Peter Samuel, Should States Sell Their Toll Roads?, Reason Foundation, May Robert Poole, Tolling and Public-Private Partnerships in Texas: Separating Myth from Fact, Reason Foundation, May Ibid. 7. Capital Beltway Hot Lanes,Transurban Group, December Ibid. 9. Toll Roads News, Transurban closes on senior debt at 4.97% for DC Capital Beltway HOT Lanes, June 18, Ibid. MARTIN J. LUBY is a senior vice president in the Chicago office of Scott Balice Strategies, an independent financial advisory firm serving state and local governments. He is also a doctoral student in public affairs at Indiana University s School of Public and Environmental Affairs, concentrating his studies on public finance and public management. His current research includes municipal finance and state and local tax policy. Luby s primary focus at Scott Balice has been financial strategy assignments, including modeling and structuring capital finance programs, pricing bond and derivative transactions, and authoring debt and swap policies. His clients have included the Illinois Tollway, Illinois Sports Facilities Authority, State of Illinois, Chicago Transit Authority and the City of Chicago. Prior to joining Scott Balice Strategies, Luby was a public finance analyst at Bear Stearns and Chapman and Cutler. Why Become a CPFO? Financial Reporting and at the annual GFOA conference. Vivian McGettigan, MBA, CPA, CPFO, Director of Finance for Fauquier County and Public Schools Government Finance Officers Association June 2009 Government Finance Review 37