Doing Right by the Public: PPPs in High-Speed Rail

» As the retrenchment continues in the American public sector, private-sector investors are likely to play an important role in paying for fast train systems.

California Governor Jerry Brown, a longtime supporter of the development of high-speed rail, has not given up on his state’s plans for an extensive network stretching initially from San Francisco to Los Angeles, and then on to Sacramento and San Diego. Despite cost estimate increases, opposition to the line among residents of some affected areas, and a total loss of new federal funding thanks to anti-investment Congressional Republicans, Mr. Brown has made evident in recent weeks his support for the line.

Construction on a segment in the Central Valley between Merced, Fresno, and Bakersfield is still planned to get under way next year. Funding for that initial link is mostly lined up, thanks to state commitments and federal grants resulting from the stimulus of early 2009.

But because of more detailed projections, the 178-mile first phase of the project is now expected to cost far more than initially envisioned — $10 to $13.9 billion instead of $7.1 billion — and it will need an injection of funds from another source to be constructed. With a promise to the state’s citizens that another demand for California-wide funds will be avoided, few local dollars to contribute, and an utter inability to rely on Washington for practically anything, that means the system will have to find private investors to join in. Whatever the relative merits of allowing private companies to invest in what is fundamentally public infrastructure, California has no other place to turn for the successful completion of its system.

California is not alone; with a depressed economy and few public sector funds available, there is increasing recognition of the importance of engaging private-sector funds in the creation of infrastructure. Illinois Governor Pat Quinn signed a bill this week authorizing public-private partnerships (PPPs) to be used for the creation of infrastructure in his state.

Critics of the California High-Speed Rail Authority have repeatedly argued that the agency would be unable to locate businesses that might be willing to contribute to the system, but international examples suggest that there is significant private sector interest in infrastructure construction. The Authority will release a request for qualifications soon and select a winning bidder in early 2012. But it has yet to clarify the manner in which it would structure its relationship with private companies in terms of financing, construction, and operations.

For precedents, the state should to look at France, which has recently signed two very large deals with private financing and construction conglomerates for the completion of two new extensions of its already large high-speed rail network. They provide two different models for engaging PPPs.

The first is the Bretagne-Pays de la Loire (BPL) high-speed link, which will connect Western France to the existing northern branch of the Atlantique line with 182 km of new tracks between Le Mans and Rennes for a cost of €3.4 billion. The connection will reduce running times from Rennes to Paris by 37 min, making it possible to travel on 320 km/h TGV trains between the cities in less than 1h30 by the time construction is complete in 2016.

The PPP contract here is being mostly funded with public sector sources; RFF, the public infrastructure owner, will contribute €1.4 billion, with state and local governments paying about a billion Euros more. 30% of the costs will be financed by the private sector group Eiffage. These loans will be paid back over twenty years with pre-determined fees from RFF and the government.

Like the Rhônexpress project in Lyon that connects the city center to the airport, this PPP arrangement essentially keeps the operations risks in the hands of the public sector; if ridership comes in under estimates, it will have to scrounge up funds from elsewhere to pay Eiffage its standard due. If ridership is higher than estimates, RFF will make a profit on its investment.

The other much larger project soon to begin construction in France is the Sud-Europe Atlantique line, which will extend the southern branch of the existing Atlantique line 302 km from Tours to Bordeaux. This €7.8 billion program will by 2017 bring Bordeaux within 2h05 of Paris, about an hour faster than today. Ridership to and from that city and Toulouse, planned to be about four hours away from Paris, is expected to rise substantially.

Because of the expected profitability of the line, RFF signed a concession contract earlier this year with a private consortium called LISEA made up of Vinci construction company (33.3%), the Caisse des Dépôts (25.4%), SOJAS investment company (22%), and AXA bank (19.2%). The 50-year contract, which includes construction, operations, and maintenance, is the largest-ever PPP for a high-speed rail construction project in Europe.

LISEA will contribute €3.8 billion to the project, with the remainder of costs being financed by the public sector, from local, region, national, and European sources. Much of the private funding will come from low-interest, long-term loans that will be repaid through charges on TGVs and other trains using the line, which will eventually be passed on to the ticket-paying passenger. The public sector funds are grants, so about half the line’s construction cost is expected to be paid back through ridership over the course of fifty years.

Unlike the BPL line, which limited risks of operational profitability and line ridership to the public sector, in this case the private investors will be responsible if initial estimates fall short.

If it wasn’t clear, the business case for Sud-Europe Atlantique line, like that for the California High-Speed Rail Authority, assumes operational profitability. Considering that the international record shows that high-speed rail systems have little difficulty achieving self-support, these are not unsound predictions. In both cases, the advantage of acquiring private-sector support for the project is delaying public investment and using future revenues to pay back construction costs. Each approach has its advantages, especially in terms of where risk is directed.

It would be a mistake to conclude from these examples that private-sector involvement will save any significant money over the long-term. Fundamentally, the creation of PPPs to fund projects such as California High-Speed Rail does not mean that the public at large will end up being responsible for a smaller percentage of overall costs. Indeed, the U.S. Department of Transportation’s Office of Inspector General released an under-recognized report last month that expounded on this fact significantly.

By considering a series of PPP highway projects in the U.S. and abroad, the study noted that they “have a higher cost of capital than traditional public financing… [and] involve equity investors who own stakes in the projects, share in the profits, and expect to earn higher rates of return for the risk they undertake,” in addition to having to pay taxes public projects do not have to pay. Even if PPPs have lower design and construction costs, may be able to more effectively increase tolls, decrease percentage of evading users, and take more advantage of concessions*, they are usually not able to offset the higher costs resulting from the formerly noted issues.

Some states like Illinois and Indiana have “made” billions by leasing off highways to private investors for billions for fifty years or more, but the report argues that “the funds paid upfront to the public sector under a PPP are paid in exchange for future revenues, often in the form of tolls.”

In other words, while the taxpayer may appear to be getting a discount now by having a business group pay for infrastructure, users of that same infrastructure will inevitably have to face the costs of future tolls. In the case of high-speed rail, replacing public sector investment during the construction phase with privately financiers using loans means higher ticket prices in the future to pay back a portion of the costs of construction. There is no free lunch.

The question is whether benefits of a transportation investment advantage the entire public or whether they are reserved to the specific people who take direct use of it. Transportation economists are convinced of the value of user fees, which assume that it is inefficient to carry out redistribution through indirect means, and for them, it makes perfect sense to charge users the full cost of not only the operation but also the construction of the infrastructure they are using. (Many economists would also argue that high-speed rail projects have significant positive externalities like pollution reduction and land use prioritization attached to them that demand direct grants from the government to cover some costs.) This user-fee approach is the method being used in the financing systems of the PPPs discussed here.

Others, however, would argue that the benefits of infrastructure like high-speed rail are economy-wide and that they should be paid for not only by users but by all members of the population through taxes. If we take this side of the argument, it becomes less clear that the best value for the society is to divert most costs to users. A grant-based system assumes that benefits of a transportation investment are felt by people throughout a country (such as through economic growth) and therefore just charging the riders for the costs of capital investments would be inappropriate.

Encouraging private investment in the California high-speed system now may make it more feasible to envision its construction in the short-to-medium-term. Delaying using future public sector revenues to pay for a project today is the basis of much long-term investment, so there is nothing particularly out of the norm about this idea. But the use of such investment will realistically mean a future of higher ticket prices resulting from the need to pay off the bonds taken out for the project’s completion.

Nor is the involvement of private-sector groups in a public-sector project risk-free. In fact, the devastating example of the United Kingdom’s High-Speed 1 line, connecting London to the Channel Tunnel, suggests that any decision to incorporate private investors in public infrastructure should be approached with skepticism — even trepidation.

A report from the Public Interest Research Group, also released this summer**, established a number of valuable principles for PPPs that are useful to consider in evaluating whether or not to include private groups in the funding process for a high-speed rail line. These suggestions include aligning “private sector incentives with public sector goals,” only pursuing PPPs “where ample competition exists,” ensuring “clear public accountability,” retaining public control over system decisions, limiting lengths of contracts, and guaranteeing transparency in the contracting process.

In addition to considering the French examples for PPP contract models, these are helpful suggestions that should be taken to heart by the California High-Speed Rail Authority as it develops its plan to bring fast train service to the state.

* Many of these fiscal advantages may (or may not) stem from the ability of private sector groups to avoid paying workers living wages, comply with minority workforce inclusion programs, fulfill expectations expressed by the public in the democratic system, and so on.

** For the sake of full disclosure, I served as a reviewer for the PIRG report.

30 Comments | Leave a Reply »
  • Danny

    Are you sure you understand the difference between a cost of capital and a cost?

    Hypothetical example to illuminate the difference. Lets say the government wants a maglev PRT system for its citizens. Lets also say that the present value of the lending costs are $10 billion for the government to build it, and $100 trillion for the private sector to build it. Big difference right?

    But what if the present value of construction costs and operation costs and maintenance costs are $100 trillion for the government, and $1 trillion for the private sector? By going with the private sector, the project still comes in with a $9 billion advantage, despite its obvious disadvantage in cost of capital.

    The DOT report actually explains this concept well using real world numbers instead of a silly hypothetical, but it appears the real world numbers weren’t interesting enough to make you pay attention to them.

    Furthermore, the DOT report confirms that the cost of taxes is as significant as higher risk premiums in causing a higher cost of capital. In other words, the government is the cause of much of the the higher costs…and also the beneficiary of those higher costs.

    I would argue that a significant portion of the risk premium (the actual portion that can be ascribed to the private market) could be due to the private market’s skepticism of government involvement…given their penchant for subsidizing competition (the entire interstate system), condemning and seizing private property (google “Columbia University + Eminent Domain”), raising property tax rates disproportionately on businesses that can’t move their business elsewhere (ask the freight railroads about it), and intervening in bankruptcy proceedings at the expense of investors (ask a Chrysler bondholder about it). I know I personally would require a higher return on my investment with those kinds of risks.

    With regard to your assertion that PPPs only be approached where ample competition exists…I agree with you. High Speed Rail offers a truly unique opportunity almost perfectly suited for PPPs.

    The competition (airlines, buses, etc) in the HSR market is so fierce that it regularly affects ridership levels on all sides, even causing the failure and bankruptcy of promising projects that do not plan for it (have you heard of Eurotunnel?). Not a perfectly competitive market, but it is certainly close.

    • Danny

      PS…your spam rules make it difficult to cite sources.

    • Danny

      PPS…forgive the billion/trillion typo in my third paragraph. Hopefully it still makes sense.

    • Nathanael

      Your hypothetical requires unreasonable assumptions, namely that anything constructed by the government is much more expensive than anything constructed by private companies.

      • Quite … where the lower cost of capital to the public sector drops out as a factor is in the operations …

        … but if a private sector franchisee can operate it at a lower gross cost to the public (profit included), then franchise out the operation. Straightforward and a “public private partnership” that lines up the cost of capital.

      • Danny

        A hypothetical is by necessity an unrealistic argument. The data itself is far less important than what the data conveys. It allows you to use extremes in data to show simple relationships.

        The hypothetical I presented is just as valid if I phrased it this way:
        Public project: lending costs 2 million, construction/operation/maintenance costs 50 million
        Private project: lending costs 4 million, construction/operation/maintenance costs 45 million.

        But just so you know how completely realistic the idea is, read the DOT report. It is far more realistic than not.

        In fact, even though the DOT considers higher costs of capital to be the rule for PPPs, they treat PPPs where total costs are higher than purely public projects as exceptions to the rule.

  • Chris

    The tax impact on the cost of capital is certainly real (though longer term we should question the practice of favoring municipal bonds with tax exemptions as a dubious capital allocation policy). However, the point about equity investors seems confused – for public projects, the public serves as an equity investor. It’s not clear that why the state would demand an equity return significantly different from a private entity that primarily is investing on behalf of pension funds, endowments, and other very long-term investors. If the state is indeed making very low-return equity investments, we should ask ourselves why it’s investing our money so poorly – we’d maybe be better off sticking that cash in a broad equity index fund.

    • AFAIR, the federal income deduction is more constitutional than chosen for a policy impact ~ as municipalities derive their power from the state, and “the power to tax is the power to destroy”, the federal government not taxing municipal and state bond income is federalist separation of powers.

      • Chris

        This was true at one point, but the Supremes changed tack on that one 20 or more years ago. The tax protection for municipal bonds is purely statutory, under current law.

  • Florez

    California Treasurer Bill Lockyer, the California politician responsible for selling these CAHSR bonds, said on March 14, 2011 to an LA news reporter that no one is interested in buying CA HSR bonds because the CAHSR is more interested in issuing bad PR, rather than coming up with a sound business plan. Until there is a sound business plan, or even a half-baked one, then no one will invest in this stinker of a project. Interviewer asks: “so are investors saying we’re interested, but it doesn’t look like you guys [CAHSR Authority] know what you’re doing” & Lockyer responds: “that’s what they’re saying”; Interviewer: “what do you think?” & Lockyer responds: “well, I think the same thing.” Lockyer also says “we don’t have a [business] plan that makes sense” and “I don’t think the State of California can sell these bonds”, and even though voters authorized the bonds, the bonds don’t need to be sold and the project can be cancelled in 2011 or 2012 – see interview here:
    http://www.nbclosangeles.com/on-air/as-seen-on/NewsConference___California_Treasurer_Bill_Lockyer__Part_3_Los_Angeles-117841823.html

    • Glen

      Reason Troll you are all over the web with the same copy post in every article on line about California HSR…to bad It will be built now find another purpose for your time

  • Chris

    Better to have a HSR system built via PPP than to have no HSR system, which is what we’d get otherwise.

    Even if the government could afford to build a HSR system without any private-sector involvement, having a PPP frees up taxpayer dollars to be used for additional projects.

    • Adirondacker12800

      Frees up taxpayer dollars to go to the profits of the PPP. Those people buying tickets are taxpayers.

      • Chris

        Then again the stakeholders in the PPP are taxpayers as well, one way or another, just as the ticketbuyers are.

      • Chris

        Say you have $100 in tax dollars available and $500 of infrastructure needs, divided into 4 projects costing $100 and 2 projects costing $50.

        If you invest only tax dollars, you can pay for just 1 $100 project or 2 $50 projects.

        If you attract private investors’ funds, you can pay for many more projects- say, 1/2 of 2 $100 projects, with tax dollars, using PPP financing for the rest of those projects, or perhaps more.

        There was a private highway built in Greenville, SC- it was a complete disaster, and the private investors lost their shirts. The government funds that would have been wasted on that were instead used for other highway projects.

  • Bucheyeman

    Looking at it one way, PPPs are not necessarily a cure-all. Looking at it another way,if the choice absolutely, positively HAS to be between that and nothing at all, then by all means do the PPP. It’s just that whatever means is used to finance and/or build anything needs to be done just right and those who have any stake in it at all, be they public or private, absolutely, positively need to get every last thing about just right and nothing short of it.

  • nick

    Hold bids to let Google/Comcast/Qwest/ (and others) put fat fiber optic lines in conduits buried under the HSR ROW – for a price. Ask for lump sum payments for 20 year rights of use and autonomous third party licensing authority. The ROW will be valuable for pipeline and transmission uses too. Sell some sticks in that bundle to raise some dough.

    • Danny

      We already had a dot-com bubble that gave us transcontinental fiber optic links to every major city at the expense of irrational people. There isn’t really any major value to more intercity fiber optic cable.

      The only markets where there would still be value in doing the fiber-optic bundling would be in the intracity market. And public transportation officials would be wise to consider it, considering the rapidly falling costs of GPON technology.

      In the intercity markets, you might have some luck with natural gas providers, but I don’t know if there are safety or regulatory issues with that.

      • Tim E

        I wonder if their is a market for power transmission? Actually wondered if Warren Buffet would consider it as has he owns two ROW’s outright. One going across northern US – BNSF Seattle to Chicago (think a lot of wind power in the middle) and the other across the southern US – BNSF LA to Chicago transcon (think lot of solar energy on one end and a lot of wind on the other end)

        have to agree on the fiber optic part, most builders have lost their shirts and most of the cables laid in the US are way underutilized. I believe I read a Wall Street Jounal not to long ago that the last two big players in the market were talking a merger just to stay afloat.

        • Nathanael

          Matt Rose of BNSF has already discussed this possibility, but apparently has not found a powerline company to partner with.

          The urban railroads of the old era would just have founded their own power companies — that was made illegal in IIRC the Public Utility Holding Company Act (?), helping drive a number of them bankrupt, but it’s legal again now.

  • Tim E

    Actually, Dissappointed in Gov Brown since moving out here last year when it comes to HSR and its role in the state’s transportation network. As far as my opinion goes, this guy has not put any political capital into it nor will he from what I see and read, which isn’t much. A shame considering that California has the population, the urban centers with ideal distances (competitive with air travel but sees ever increasing continental and international flights) and an unique opportunity to build a big chunk of it in the flat CV. As noted in the occassional editorial, the state is going to see a big bill for all the above, more roads, bridges, runways and gates any way they look at. Gov Brown needs to be at the bully pulpit and get that message across, we either build a new runway into the Bay, double the size of the freeways or start building HSR.

    But the first and foremost thing that Brown needs to do is reorganize the commission and fold it into Caltrans. Being in Caltrans will not dimish its ability to seek a PPP venture and will do a lot to get the process in the realm of accountability as it desperately needs. the current structure using a boat load or should say a train full of consultants has been an utter failure.

    My fear, this opportunity is already leaving the station and worse yet, LaHood might not be able to redirect the funds where NEC and/or the Midwest would have the dollars working in short order on a range of rail projects already laid out. These funds could very much be used to rebuild Mississippi/Missouri levees next spring if the House gets its way.

  • Public risk and private profits?

    What could go wrong!

  • Nathanael

    Regarding PPPs for existing toll roads and the like:

    A lot of people have suggested that the primary reason for these is so that politicians can let the private company do the “dirty work” of raising tolls (etc), rather than have the politicians being blamed for fare increases which really should have been done a long time ago anyway.

    PPPs do work for this purpose. For what it’s worth.

    • Danny

      It doesn’t really work that way very often. Remember, the New York City subway companies wanted to raise fares after decades of inflation, but it was politicians that prevented them from doing so…buying votes by ensuring that the nickel fare continued.

      • FG

        That’s exactly what happened with both the Chicago Skyway and Indiana Toll Road, however (and I suppose, with the Chicago Parking Meter debacle as well).

        • Nathanael

          Those are the three examples I am thinking of. Yep, all three were essentially for the purpose of letting “somebody else” raise fares.

          In NYC, Mayor Hylan wanted to take over the subways… so different politics going on.

          • Well, in the case of the first two, the assets were also severely overvalued. Indiana sold its Toll Road for about twice what it’s worth now.

            In the case of the last one, it was a bad attempt to get someone else to raise fares; all it’s doing is making it harder for neighborhoods to remove parking spots.

            • FG

              Several aldermen specifically said they voted for it so that someone else would get the blame for raising parking rates, whether that’s good or bad is a different question.

  • Ocean Railroader

    I only wish that I betted money that the Califroinia High Speed Rail system won’t get built it looks like it’s going to die the same way the Florida High Speed Rail system did.

    If I where a privet company and I dealt with the same things they did on the Florida High Speed Rail system I wouldn’t even talk about any deals with Califorinia in that it is not going to be built.

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