Two rules for infrastructure projects

Governments are currently very keen on infrastructure spending to restart the economy. Though in the midst of a crisis it’s tempting to spend as quickly as possible, rigour in how infrastructure programs are implemented is essential to long-term prosperity.

Two critical elements in analyzing infrastructure projects are often overlooked: the true cost of capital and long-term maintenance expenses.

The most common pitfall in evaluating infrastructure projects is to mistakenly assume their profitability is automatically higher when they are funded at the lower government “risk-free rate.” But this advantage arises only because the government has the unique ability to tax citizens to reimburse lenders if its investment projects end up losing money. This right to expropriate taxpayers’ income and assets allows the project’s risk to be transferred from lenders to taxpayers. If private businesses had the same power, their cost of capital would be lower, too.

But hiding the appropriate risk premia demanded from private-sector developers and subtly transferring risks to taxpayers does not make an investment project less risky or more profitable. The obvious danger in using an inappropriately low government cost of funding is that white elephants — loss-making projects — get approved. At today’s ultra-low government borrowing rate, the worry is that many more such unprofitable public investments will pass this faulty test.

This does not mean government should not finance infrastructure projects — quite the contrary, especially considering today’s difficult private credit environment. But it does mean that projects’ profitability should be established using a cost of capital that includes a suitable risk premium. Making taxpayers assume the investment risk is a political decision that governments can either make or not. But who pays should in no way affect the inherent profitability of public infrastructure projects. Profitable public infrastructure contributes to prosperity; unprofitable investments eventually become a burden to future generations.

Another common valuation trap is to neglect longterm infrastructure maintenance costs. Think of a family buying a fancy new home without factoring-in maintenance. After just a few years, it may have to unload a depreciated asset when the maintenance “deficit” is both urgent and financially unsustainable — not to mention higher for having been postponed. Such households impoverish themselves. A more honest evaluation of long-term cost would have allowed them to build value and wealth.

Mainly because of the electoral cycle this short-sightedness is all too common in analyzing public infrastructure projects. With workers, entrepreneurs and citizens all benefiting from government expenses in the short term, the temptation is strong to finance extravagant projects and overlook their substantial maintenance costs, which after years of neglect and, sometimes, real danger to the infrastructure’s users, are passed on to the next government. The American writer dale Maharidge believes that is more or less what happened following overinvestment in the American road network.

Quebecers who lived for decades with crumbling bridges and overpasses and now are suffering seemingly endless traffic congestion as repair and reconstruction crews catch up are likely to agree.

Public-private partnerships (PPP) would help avoid both these infrastructure pitfalls: private promoters face the real cost of capital and, when accountable for maintenance, have an incentive to include its cost in their bids to deliver infrastructure projects.

unfortunately, the experience necessary for the effective deployment of national infrastructure programs through such partnerships takes years to develop. establishing an adequate governance structure, which currently seems to be lacking in government-financed projects, is particularly critical to their success.

Canada’s experience with PPPS is limited so governments will have to remain highly involved in the funding and management of many major projects. To avoid committing taxpayers’ resources to unprofitable and unrealistic ventures, their decision-making will need to be more disciplined than in the past — though discipline has not been topof-mind over the last four months of unprecedented spending rollouts.

At a time when the private sector is facing considerable investment uncertainty, the economy cannot afford harmful and costly delays due to endless partisan discussions about national priorities. Rather, policy-makers should use the above criteria to identify genuinely profitable public infrastructure projects and prioritize those at the top of the list for prompt approval.

True leadership requires governments to put aside partisanship, establish a rigorous and independent governance framework for approving the most promising projects and, for the sake of the recovery, deploy resources promptly.

Projects’ Profitability should be established using a cost of capital that includes a ... risk Premium.