On July 15, just two weeks before the Department of Transportation Highway Trust Fund was expected to run out of money, the U.S. House of Representatives passed a $10.8 billion short-term fix to extend the fund into May 2015.
Protracted political gridlock is just one of the many challenges burdening public infrastructure in the United States. Underfunding and underinvestment, crippled state and municipal budgets, and delayed maintenance and repair also have contributed to the country’s glaring infrastructure deficit. The American Society of Civil Engineers (ASCE) gave the nation’s major infrastructure industries a D+ in 2013. According to the ASCE, based on current investment trends in public infrastructure, the country will develop a $1.1 trillion gap between projected infrastructure funding and expenses by 2020. To make matters worse, this deficit could widen to $4.7 trillion by 2040.
Lackluster performance in infrastructure-related industries
In response to these challenges, state governments are increasingly experimenting with public-private partnerships (P3) to finance new infrastructure projects or maintain existing assets. To provide context to the operating environment of P3s, IBISWorld analyzed public infrastructure-related industries from a collection of more than 40 reports in domestic construction in its report, Public-Private Partnerships: The Reenergizing of U.S. Infrastructure by Darrlye Ulama. A survey of the nation’s infrastructure-related industries revealed tepid-to-mild fluctuations in revenue during the five years to 2014, confirming the decrepit state of the country’s public infrastructure. For example:
- heavy infrastructure construction, which includes operators that build dams, docks and mass-transit systems, is projected to contract at an average annual rate of 0.1 percent to $44.4 billion;
- road and highway construction is expected to decline an annualized 0.8 percent to about $69.0 billion;
- road and highway maintenance is forecast to decline an average annual 2.6 percent to $13.6 billion;
- water and sewage line construction is expected to grow a modest 0.4 percent to $45.4 billion; and
- bridge and elevated highway construction is anticipated to expand an annualized 2.8 percent to $20.5 billion.
Each of these industries has specific demand drivers that determine industry performance, ranging from the value of utilities construction to the price of inputs, such as cement. However, because these industries provide public goods, government funding, particularly at the state and municipal levels, is a strong indicator of industry performance. IBISWorld estimates that local and state government investment will decline an annualized 3.4 percent in the five years to 2014. Because local governments are responsible for nearly three-quarters of infrastructure investment, chronic declines in state and municipal spending bode ill for the nation’s infrastructure network. P3s offer new opportunities for greater private sector involvement in the delivery of much-needed public services.
Potential benefits and pitfalls of P3 financing
The value of P3s is multifaceted.
- The involvement of a private partner could expand the financial capacity of a given project through capital injection, equity contributions and commercial loans, thereby mitigating the public sector’s financial burden. Increased financing is particularly helpful for infrastructure projects that require significant upfront costs that many local governments are unable to meet.
- Because private partners are market driven, P3s can allow for improved project management, as well as on-time and on-budget delivery.
- The varying degree of public-private involvement can maximize risk allocation between public agencies and private firms. Risks can range from economic/financial, such as cost overruns or price risks, to operational, such as supply-demand balances. A private firm that incurs sizable risk usually will seek compensation in the form of a risk premium, an additional return in exchange for taking on greater risk.
- Other benefits include taking advantage of private sector skills and specialties and encouraging the public sector to focus on output and early delivery. Consequently, greater P3 activity in infrastructure industries, particularly in those that depend heavily on government funding, could lead to more pronounced revenue growth in the five years leading up to 2019.
Efficiency gains from P3 financing can result in lower overall costs. The National Council for Public-Private Partnerships (NCPPP) estimates cost savings between 7 percent and 10 percent during the lifetime of an average P3 project. In 2014, IBISWorld estimates that the average industry profit margin will account for 3.1 percent of revenue in the road and highway construction industry and 6.4 percent of revenue for the bridge and elevated highway industry. Typically, large operators in these industries command higher profit margins and push out smaller companies due to their wider resources and financial capacity. Nevertheless, if used properly, P3s can potentially bolster average profit margins for these and other infrastructure-related industries in the future. Although larger operators likely will continue to dominate the market, greater demand for P3 contracts could encourage more operators to enter these industries, in turn heightening competition.
A variety of challenges accompany P3s. Even with sound risk allocation, P3s are not immune to financial loss. Project mismanagement or design flaws can lead to undesirable outcomes or even private partner default. For example, a 1997 concession granted by the Port Authority of New York and New Jersey to replace JFK International Airport’s Terminal 4 required a renegotiation due to $100 million in cost overruns and lower revenue after the Sept. 11 attacks. Renegotiation and refinancing can be costly, draining public resources for administrative and legal fees. Additionally, P3s assume a loss of management control by the public sector, even if the government is wholly accountable for the project. Lastly, the difficulty of assessing the value of public assets and resources could lead to an undervaluing of such assets over the lifetime of a P3 contract.
If current projects prove successful, P3s can play a pivotal role in jump-starting the country’s infrastructure. However, to realize their benefits, the public sector must lead the charge. In addition to creating necessary legislative and policy frameworks, states must first develop deal structures and public-sector comparator models to encourage the creation of a more robust P3 market. Public agencies also must carefully consider projects that are viable for P3 financing. Typically, P3 projects are larger, more complex and have strong public support and a secure revenue base. Choosing the appropriate P3 scheme and private partner is critical to minimizing project risks and achieving gains.
Once a P3 marketplace is active, governments can experiment with more sophisticated models and move into other public service industries. Previous experience with P3s can be leveraged and governments can create P3 agencies to develop and test new delivery models. Additionally, the United States can learn from countries with more mature P3 markets. For example, the United Kingdom, considered the pioneer of the partnership model, deploys P3s in sectors including education and defense. In Australia, P3 projects have expanded to water and information technology. With their tremendous potential, P3s are innovative tools that sub-national governments can use to ameliorate the growing infrastructure gap in the United States.