Infrastructure Studies

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The problem with airports…are they viable or just necessary

It is argued that efficient airports are a necessary ingredient to economic well-being.

Airports, however, are not viable on the basis of their aviation revenue alone and depend on income from car parking, retailing and hospitality to create sufficient income and profit to justify the capital expenditure required to build and maintain them. Even so the margins are small.

For example it may be that new airports cost more to build than their own economic value can justify. The balance, however, should be filled by the economic benefit they project onto the economy in general.

However, the private sector will not fund a non-viable entity, which leaves the state to finance the difference and at the current time many states are disinclined to provide this funding which could leave many developments unable to get off the ground.

Is the Keynesian multiplier a reliable measure of desirability

Projects such as the HS2 railway in the UK continue to base their macro economic desirability on the Keynesian multiplier but is this measure robust?

For example a combination of potential cost overruns and leakage of expenditure into external economies implies that the domestic multiplier may be less than that calculated.

In the case of HS2 the multiple (varying from report to report) is 1.5 to 2 times the estimated expenditure of £32bn. Negative variations could easily reduce this multiple to +/- 1.

The multiplier was introduced in the 1930’s as a simple way of illustrating the extent to which aggregate demand increased in response to capital spending by government. This was an era of more insular economies and infrastructure projects were then more labour intensive than today.

In the era of mechanisation and globalisation are policy makers deluding themselves that this simple measure of infrastructure expenditure impact remains positive and is there a better alternative?

Infrastructure spend to 2030. Is there enough money?

Throughout the world, governments in indebted countries have seized the idea that investment in infrastructure is the single most effective policy option available to them to stimulate their economies. Developing countries are engaged in similar activity in order to build a firm base from which they can develop.

On an aggregate basis there is concern that demand for funds exceeds the global supply by a significant margin and that only the most credit-worthy states will be able to attract private sector finance. 

This may be a key structural issue that will determine the way in which the balance of the global economy will be reshaped over the next 20 years. 

Recessions are transformative events. Economic theorists argue that the virtue of recessions is that they recycle a significant fraction of assets simultaneously, enabling a dysfunctional economic balance to be replaced by a new structure.

Survival is vital, but the precise way in which you emerge is key to subsequent prosperity and this is true for states and companies.

The received wisdom, most closely associated with John Maynard Keynes in the 1930’s, is that in recession a government should borrow to finance major public works projects in order to stimulate investment and employment. The marginal debt can be repaid when the economy is buoyant and tax revenues increase.

The adoption of this Keynesian solution has become so widespread that the global aggregate proposed expenditure on state sponsored infrastructure projects is estimated to be UD$ 50tn[1] over the 17 years to 2030.

If this proposed expenditure was distributed evenly across the period it would absorb around 4%1 of global GDP.

If the distribution of expenditure is skewed toward the short term, which is likely, it could exceed 6% of GDP during the initial period.

Compare this data with the fact that the USA expenditure on infrastructure has fallen to 2.4% of GDP, whereas India and China spend around 9% of GDP.

In the 10 years to 2010, global credit expanded from US$57tn to US$109tn and must grow to US$210tn by 2020 if the ratio of credit to global GDP is to be preserved.[2]

But the principal features of the current recession are that many states are already over -leveraged and need to reduce their national debt at the time when, according to Keynes, they should borrow to invest. The natural alternative is to turn to private sector funding under some variant of the established PPP structure.

The second key feature of the recession is that the banking sector has been damaged severely and is not in a position to provide the volume of debt that would traditionally been used to fund PPP projects.

Given the constraints in banking and the need for it to expand credit to underpin the growth of world trade it is unlikely that it will be able to provide the debt funding required to support the projected global infrastructure expenditure.

So if the unprecedented demand for infrastructure cannot be funded by sovereign debt or by the banking sector, what is to happen?

The easy answer is to believe that the private sector will fill the gap.

The value of assets globally held in institutional funds is estimated to be US$65tn and these institutions seem unlikely to invest more than 6% (US$ 4tn) in infrastructure as part of a balanced portfolio.

Consequently, if the normal annual global average expenditure in infrastructure was 4% of GDP but over the next five years this increases to 6% of GDP, then the marginal increase equals US$1.4tn pa, which cannot be funded through credit growth.

Were this marginal increase to be funded from institutional funds over the next five years, it would represent US$7tn or an additional 11% of the sectors assets in real terms.

Our estimate is that at least 20% of the proposed expenditure of US$50tn is not fundable.

If debt-to-equity ratios are also modified to reduce leverage, we estimate that the non-fundable proportion may rise to 30% or US$15tn.

This data makes no allowance for the observed trend that infrastructure projects can exceed their original budget by 30% to 80% and therefore those projects that do proceed will need to secure this ‘contingency’ funding. This implies that, to accommodate the low level of probable overspend, only US$25tn or 50% of the proposed expenditure on infrastructure may be able to commence.

Demand pressure will cause the cost of infrastructure finance to increase and only projects proposed by the most credit-worthy states and those offering the highest investment returns will absorb the limited funds available.

We believe that these projects will need to generate a minimum IRR to equity of 15-20%.

Funds will flow to countries offering the lowest credit risk and it is conceivable that wealthy nations may absorb the entire volume of funds available globally for the infrastructure asset class, mitigated only by the balancing of geopolitical risk. Such distortions may not necessarily increase the availability of finance to projects considered to occupy a higher risk category and where funds are available, they may not be priced at margins that projects can support. Capital markets will be concerned with the problem of deciding which projects to support.

The consequence of rationing funding for infrastructure projects will, if Keynes’ thesis is correct about this being the prime mover of economic recovery, be to reshape global economic topography to benefit those nations that are financially wealthy but asset-poor and disadvantage those nations that are asset rich but financially challenged. Developing nations that are both financially and asset-poor will find the acquisition of finance to be extremely difficult.

References:

[1] OECD

Thanks to our Founders’ Community member Best Dog Crates and Beds for sponsoring this research. Without their contributions, this would not be possible.

Dark Risk in complex infrastructure projects

Mega projects contain identifiable risks based on the performance of previous projects but unexpected problems seem to often emerge close to key dates with the stereotypical contemporary example being Berlin Brandenburg Airport that experienced major systems failure one month before its scheduled opening leading to a 24 month delay.

How can new projects address this type of obscure risk that frequently arises to disable their development programme or has their complexity exceeded the threshold of reliability of our current control methodologies?

Do large complex infrastructure projects always contain this ‘dark risk’ that is seemingly invisible to ordinary management techniques but which routinely delays projects toward the end of their construction phase? Has our technological hubris progressed faster than our programme management capability?

Our research into systemic risk within complex projects is starting to reveal a picture of how the separate entities within complex projects can interact in a detrimental manner and in a way not dissimilar to a financial market collapse.

We believe that the ability to model this interaction will shed new insights into what happens at the end of these projects and how this Dark Risk may be better understood and managed. The Institute intends to research and publish a number of papers on this subject, leading up to the publication of a book on the nature of Dark Risk in infrastructure projects.

The Modern Mega Project: Can PPP Deliver?

Introduction

Modern mega projects are huge and intricate undertakings which represent the application of our best engineering and technology on the largest of scales. However, with these great endeavours come equally great risks and frustrations and despite decades of projects being delivered late and over- budget (Van Marrewijk et al. 2008), we seem incapable of improving their delivery.

In the early 1990s, several governments thought that the private sector offered a solution to these problems, as well as a new source of capital for major infrastructure works. The Public Private Partnership (PPP) model became the international methodology of choice for funding, risk transfer, building and operating large scale infrastructure.

Our research, however, indicates that during 20 years’ experience, PPPs did not deliver the solution they promised. PPP mega projects globally continue to complete late and over-budget because the causes of these problems have not been addressed and, in a more complex world, the inflexibility of the PPP structure creates additional challenges.

…more to come soon