There's no denying the importance of infrastructure. But the traditional infrastructure model has become problematic. The growing need to repair or replace aging infrastructure in transportation, utilities, telecommunications, and other sectors has soared to record levels in recent years. At the same time, the cost of building materials is skyrocketing, and local, state, and federal governments are faced with declining tax revenues and higher borrowing costs.
Public-private partnerships can help meet our infrastructure needs in today's current environment. The PPP or P3 model can provide a cost-effective alternate way to finance projects and provide for long-term efficiencies over operations and management.
Rapidly rising construction prices, coupled with higher borrowing costs, are causing the costs associated with infrastructure projects to soar. In 2007, the Turner Building Cost Index rose by a staggering 10.6%. In 2007 and 2008, tightening credit markets have made credit both more difficult to obtain and more expensive.
Rising costs can easily waylay infrastructure projects, which usually involve long-term contracts that may not account for changing macro conditions. The public sector generally starts looking at the cost of building a new project years before the project's contracts are put out for bid to the private sector.
Since the costs for materials, such as steel and concrete, have been outpacing inflation, early estimates have not been reflecting actual bids. Governments then struggle to find budgetary and political support - another factor that can lead to project delays. Unfortunately, these delays usually compound the issue that caused the original delay and result in even higher costs.
There is currently a $170 billion annual funding gap for infrastructure projects in the U.S. It is feared that this gap could balloon in the near term as the U.S. economy slows and the public sector begins to experience declining revenue from lower tax collections. At the same time, the U.S. has been coasting when it comes to infrastructure spending.
Japan, for example, has historically spent 10% of its gross domestic product on infrastructure as opposed to the U.S., which spends only 1%. Decades of underinvestment has left the U.S. with a legacy of aging, deteriorating infrastructure and the need for more modern facilities.
The federal, state, and local governments in this country traditionally have financed development of new infrastructure as well as improvements to existing infrastructure with tax dollars, fees, and other public funding. While these sources remain primary, governments are turning increasingly to the private sector for capital in order to finance the country's staggering infrastructure needs.
It's projected that U.S. infrastructure problems could reach crisis proportions in the next 10 years if steps are not taken to attract more private capital to the sector. As the funding gap continues to grow, broader adoption of the P3 model will be necessary to alleviate the growing strain on the public sector and to make certain the U.S. is able to remain competitive on a global basis.
Globally, the public sector is turning more and more to PPPs to build or invest in assets such as toll roads, bridges, and water and waste treatment plants. The P3 solution is more than just an alternative source of funding, it is a way to provide long-term efficiency over operations and management and improve the quality of service to the public. The benefits of private investment need to be better communicated to the various government constituencies. Oftentimes, the dialogue is too focused on the cost of building or financing.
The private sector offers skills and expertise that reduce whole-life costs, accelerate project timelines, improve quality of service, and increase operational efficiency. Historically, projects built under the P3 model have been more on budget and more on time than those under traditional government procurements.
The United Kingdom's National Audit Office conducted a study in 2003 that examined its experience with 66 projects using traditional procurement and 37 based on the public finance initiative model, or PFI, Britain's version of P3s. While 70% of the conventionally procured projects were delivered late and 73% over budget, only 24% and 22% of projects under the PFI model were late or over budget, respectively.
In addition, P3s serve to allocate risk to the party best able to manage it at lowest cost. In many cases, this has relieved public entities of the constraints on infrastructure spending that they face, including budget deficits, public opposition to tax hikes or user fees to finance infrastructure, and mandatory limits or caps on public spending. It has also eliminated competing demands for the allocation of finite public resources.
Virginia and Florida have been leaders in partnering with the private sector on infrastructure projects. The most recent PPP transaction to close in the U.S. was the Capital Beltway, which is saving the government large amounts of money based on design and engineering innovations and is also providing state-of-the-art tolling equipment and tolling practices.
Misaligned expectations between public and private players engaged in P3s are a common problem that can lead to stalled deals. Stalled deals, in turn, often lead to higher costs and greater risk for all parties involved. Particularly in the current environment of rising costs and overall market instability, it's crucial that the public and private sectors are on the same page.
In order to avoid project bottlenecks that result from cost expectations, governments need to enter into dialogue with the private sector early in the process. We recommend the following steps:
* Conducting a robust analysis of the cost components.
* Conducting thorough market research.
* Understanding the costs of certain public policy objectives.
* Considering the demands and timing of other projects in the region.
* Being aware of the market conditions for bonding and performance guarantees.
* Soliciting feedback on construction from bidders throughout the process.
* Revisiting the numbers.
Infrastructure remains an attractive asset class, due to its stable, steady cash flow. Even during the current market downturn, the infrastructure asset class continues to function, albeit at a diminished level. Given the risk profile of typical infrastructure deals versus traditional private-equity transactions, once the markets begin to recover, it's expected that infrastructure will be one of the first asset classes to rebound.
Understanding the costs and the needs on both the public and private side and better communication of the public's rewards for PPPs will provide added certainty to the process and, consequently, stronger political support and more interest from the private sector.
Tim Philpotts is a senior vice president with the transaction advisory services practice of Ernst & Young LLP. He practices in Canada and the U.S. The views expressed are his own and do not necessarily reflect the views of Ernst & Young.