In the following piece, we discuss ways to address the global infrastructure gap. The jumping-off point for our analysis is the observation from 39 percent of our Future of Infrastructure survey respondents that a lack of public funding is the key reason that civil infrastructure is failing to keep pace with society’s demands. With massive infrastructure needs around the world, and against a reality of constrained public-sector budgets, bold leadership is needed to prioritize assertive public policy, harness private capital, and bring innovation to infrastructure funding and project delivery. While many of our observations and recommendations apply globally, much of the focus in this article pertains to the United States.

The infrastructure gap

The need for substantial investment in infrastructure has been well documented, with the McKinsey Global Institute estimating that US$3.3 trillion must be spent annually through 2030¹ just to support expected global rates of growth. Most countries are not investing nearly enough, with an annual global shortfall of US$350 billion². The American Society of Civil Engineers (ASCE) estimates that if the 10-year U.S. infrastructure gap of US$2 trillion is not addressed, it will cost US$3.9 trillion in GDP by 2025.³ This shortfall affects everyday life – each year, two trillion gallons of drinking water are lost to water-main leaks⁴ while 5.5 billion hours are lost to traffic congestion.⁵ Americans could soon experience “Thanksgiving-peak” transit volumes at 24 of the 30 largest airports at least once a week.⁶ Failure to invest in infrastructure is not just costly; it also impacts personal safety. Almost 10 percent of the bridges over which Americans drive – about 56,000 in total – are structurally deficient, as are 15,500 dams (17% of the total).⁷ The infrastructure gap is exacerbated by factors such as climate and technological change.

Constraints on public-sector budgets

Public-sector budgets across the developed world are strained. U.S. state and municipal governments face unfunded pension liabilities of more than US$1.6 trillion,¹⁰ diverting tax revenues away from infrastructure development and maintenance. Moreover, the U.S. municipal bond market, which has funded much public-sector infrastructure, is facing headwinds as lower tax rates and persistently low interest rates make these bonds much less attractive to investors.¹¹ It is noteworthy that municipal bonds are inefficient for tax-exempt investors, the largest pools of long-term capital, and they cannot be used to fund infrastructure developed by private-sector interests.¹²

Private capital is drawn to infrastructure, but with caveats

A relatively recent development in the financing of infrastructure is the significant and growing private-sector capital that has been drawn to these assets. Infrastructure investments are well suited to the portfolios of the world’s largest and most patient pools of investment capital – the balance sheets of pension plans, life insurance companies, and sovereign wealth funds. Cash flows from infrastructure assets are reasonably predictable, of long duration, somewhat indexed to inflation, and relatively uncorrelated with public equity markets, all of which makes them a good match for the liabilities of life insurers and pension plans, and for the permanent capital of sovereign funds. For an indication of the possible magnitude of capital that could be directed to infrastructure investing, it is worth noting that U.S. public pension plans, corporate pension plans and life insurers hold assets of US$4.2 trillion,¹³ US$1.5 trillion,¹⁴ and US$6.8 trillion,¹⁵ respectively, while sovereign funds globally hold assets of US$7.4 trillion.¹⁶ Allocations of five percent of the portfolios of these asset pools to infrastructure would equate to close to US$1 trillion, with upside from non-U.S. pension plans and insurers, and from higher allocations.

Investment management firms helped catalyze the infrastructure allocations of institutional investors and have responded to the growth in such allocations with more and ever-larger funds. At the end of the first quarter of 2017, total assets under management by private infrastructure funds were US$426 billion.²⁰ This will likely increase substantially, driven by both supply and demand factors. On the supply side, several US$10 billion-plus funds have been raised or are presently being marketed, while on the demand side, 53 percent of institutional investors surveyed plan to increase their allocations to the asset class.²¹

Is this growing pool of private capital effectively addressing the financing needs for global infrastructure? We believe that the answer to this question is, at best, equivocal. In an industry-wide survey, investment managers’ primary concerns were found to be transaction valuations (expressed by 53% of those surveyed) and deal flow (32%).²⁴ Exacerbating these concerns is the growing accumulation of capital committed to funds but not yet invested (dry powder), which has grown to US$151 billion²⁵ and can be expected to increase as the trend of mega funds continues.²⁶

Why this disconnect between capital and investment opportunities? While there is strong interest among investors in cash-flow-generating operating assets, private capital is very cautious about investing in assets without in-place revenues and in greenfield assets.²⁷

There are no silver bullet solutions. And, given the stakes, inaction is not an option in addressing global need. What is required is a combination of approaches aligned behind a strong vision, transparency, innovation, a conducive regulatory and permitting environment, and willing partners – across borders, governments and industries – that can rise above complicating factors and build trust that leads to confidence in proceeding.

In this spirit, we now turn to four approaches that taken together can be helpful in reducing the infrastructure gap.

1/ PUBLIC-PRIVATE PARTNERSHIPS

Public-private partnerships (P3s) are an effective way of transferring life-cycle costs of infrastructure off public-sector budgets and simultaneously create investable assets for the private sector. We expect that the P3 market – which is quite evolved in countries such as the U.K., Australia, and Canada – will deepen in the U.S. as concession terms become standardized and as valuation transparency is enhanced from higher transaction volumes.²⁸

P3s have demonstrated their value in projects around the world. Private investment in infrastructure, in partnership with the public sector, can motivate accountability in the delivery of critical assets, stretch public dollars and help local, state and national governments deliver highways, bridges, ports, airports and other infrastructure faster and cheaper, and ensure that they are properly maintained.²⁹

2/ A REGIONAL APPROACH TO INFRASTRUCTURE

The realities of a federal system, the inefficiencies of completely devolving decision making and financing to the state and local level, and the reality that infrastructure is not artificially bounded by state lines (think port and airport systems, roads, rails and waterways), all suggest that infrastructure could be tackled on a regional basis. This is especially true as urbanization transforms many of our global cities into mega-regions, requiring broad and interconnected infrastructure systems. Today, 55 percent³¹ of the world’s population lives in cities; that is projected to increase to 66 percent by 2050.³²

Regional infrastructure authorities

The U.S. has numerous authorities that operate – and have been responsible for developing – significant portions of the nation’s infrastructure. Among the advantages of these bodies is that they take a long-term and expansive view of infrastructure needs. For example, the Port Authority of New York and New Jersey used revenues from bridge and tunnel tolls to help fund development of nascent airports in the New York area.³³ Its scale allowed it to negotiate equitable terms with airlines. Similarly, the Tennessee Valley Authority – whose service area covers portions of seven states – has invested significantly in infrastructure (power generation and environmental systems), while also spurring regional economic development. We believe that these and similar bodies should remain a core component of national infrastructure policies.

Regional P3 centers

Governments seeking to advance P3s in a programmatic manner might adopt the successful model of infrastructure offices, such as the U.K.’s Infrastructure and Projects Authority and Canada’s Infrastructure Ontario and Partnerships BC. The role of these centers is, among other things, to spur P3 activity through encouraging enabling legislation, prioritizing projects, and interfacing between procurement agencies and private capital sources.

We recommend a regional approach to P3 centers for several reasons. A highly centralized model is not realistic in light of the federalized system of decision making in the U.S. At the same time, it is not realistic or efficient to replicate P3 centers in 50 states. Regional centers would standardize legislation and concession terms (in the absence of standardization, private capital would be disincentivized, from having to “reinvent the wheel" on each new transaction). Additionally, regional centers could act as advocates with all stakeholders – procurement agencies, legislatures, the public, and private capital. There is an important role for the federal government to support these centers. It could partially fund their budgets, deploy specialists (perhaps rotating out of private sector), and help with standardization of enabling legislation and concession agreements.³⁴

3/ BETTER MODELS FOR FUNDING OF INFRASTRUCTURE

Whether financed by public or private capital, there is much that can be done to enhance funding models for infrastructure assets.

Generate sustainable revenues through fair-usage charges

Many infrastructure assets, particularly in the transportation and water/waste sectors, are subsidized or free to users. This is not uniformly sustainable and so we recommend a reality where, in the words of the ASCE, users “pay … rates and fees that reflect the true cost of using, maintaining, and improving … infrastructure.³⁵ There are numerous examples where this reality has been recognized. New Jersey is considering a US$0.90 surcharge on New York-bound trips to fund its portion of the Gateway rail tunnel expanding links between the two states.³⁶ Israel – much of which is desert – has sustainable water resources, in part because water is priced at market rates to all users.³⁷ Airports – particularly in the U.S. – have argued for removal of caps on passenger facility charges, as these are a necessary source of funding for infrastructure improvements.³⁸ Of course, usage charges are not realistic for all assets, most notably in the case of rural transportation systems. In these cases, tax revenue will generally need to cover capital expenditures as well as operation and maintenance. That said, in the absence of market controls, these assets would need to be prioritized very carefully to avoid white elephant projects, such as the US$400 million Ketchikan, Alaska “bridge to nowhere.”³⁹

Creatively utilize value-capture techniques

Land and property values increase – sometimes dramatically – when they benefit from adjacent infrastructure. Value capture leverages the increase in real estate valuation to fund infrastructure development. One approach to value capture, used extensively to finance expansion of Hong Kong’s mass transit system, is called “Rail plus Property.”⁴⁰ Hong Kong grants MTR, the private-sector transit operator, development rights above new stations. MTR uses its profits from newly developed real estate to fund expansion and maintenance of rail lines, allowing the city government to avoid taking on infrastructure development costs. The approach works because of Hong Kong’s extremely high density and land values and can be adopted by other densifying cities. More generally, transit systems can generate revenues from development of mixed-use real estate at transit nodes. Another approach to value capture is tax increment financing which finances new infrastructure from tax revenues that it generates. The extension of New York’s subway system to the Hudson Yards district was financed using debt that will be repaid with property tax revenues from to-be-developed real estate in the district.⁴¹

Ensure dedicated and robust state and local sources of funding

A peculiarity of the U.S. federal system as it pertains to publicly owned infrastructure⁴² is that it is not uncommon for the federal government to fund upfront capital expenditures and for state and local governments to fund operation and maintenance.⁴³ Stressed state and local budgets inevitably lead to maintenance backlogs, which is why it is of prime importance that local sources of maintenance funding be developed from tax revenues and ring fenced, protecting them from being diverted to other budgetary needs.

Modernize the gas tax

The U.S. Highway Trust Fund, which finances most federal government spending for highways and mass transit, is funded primarily from gasoline taxes. The fund has effectively operated in deficit since 2008 because the tax per gallon of gasoline has not changed since 1993 and because it did not anticipate the significantly higher fuel efficiency of modern motor vehicles – not to mention the absence of revenues from electric vehicles.⁴⁴ Because wear and tear on roads is correlated much more closely to mileage driven than to gasoline usage, the fund could be stabilized using a mileage-based revenue source that accounts for both gasoline-powered and electric vehicles.

4/ ENCOURAGING GREENFIELD DEVELOPMENT

Development of new infrastructure requires substantial capital and entails significant risks. We propose several approaches to address these challenges.

Government-subsidized construction financing

As in many other countries, the U.S. has governmental programs that subsidize financing for infrastructure development. We believe that budgets for these programs should be expanded, as they are an effective way of providing leverage to federal funds, from private capital and state or local public capital, in the development and maintenance of infrastructure.

Asset recycling

An effective way to leverage public capital in a resource-constrained environment is to fund new infrastructure via “asset recycling,” whereby proceeds from the lease of existing assets are redeployed in the development of new infrastructure.⁴⁵

Mitigate risks for private investors

Private capital is generally unwilling to invest in greenfield development because of the difficulties in accurately budgeting development costs and timelines, and forecasting future revenues in the absence of operating history. These concerns are heightened by well-publicized examples of projects going awry, such as Berlin Brandenburg Airport, which is expected to open almost a decade late and €4.5 billion over budget.⁴⁶ These risks can be mitigated by inclusion of the right partner in the development and operating consortium. Private-sector investors will typically not take volume risk, which is why greenfield P3 concessions usually incorporate availability payment structures, whereby the private-sector partner receives a flat fee and the public sector absorbs volume risk. Another consideration in new developments is political uncertainty – this is generally remediated by active stakeholder engagement⁴⁷ and by utilization of political risk insurance.

Reforming regulatory and permitting practices

Predictable regulatory guidelines and efficient permitting processes can be helpful in driving private investment into infrastructure. In countries around the world, there are many cases of multi-year delays in project approvals because of inter-jurisdictional conflicts and changing environmental approval standards. Policies set by one administration or legislature can fall away with the next, creating uncertainty.

Conclusion

As we have argued, there are practical steps that can be taken right now by participants in the infrastructure market, as well as public policy initiatives that we actively support. In future articles we expect to expand our scope beyond the U.S.