Analysis of the Explicit and Implicit Costs of Financing Alternatives

what the argument against PPP and privately funded infrastructure development is.

The argument suggests that it does not make sense to establish PPPs in well-performing economies, such as Finland, because governments typically have an excellent credit rating, and their cost of borrowing is often very closely the benchmark of financial markets, i.e. the risk-free rate of interest. Whereas the cost of borrowing, and especially the cost of equity of a separate legal entity will certainly be subject to a risk premium over and above the risk-free rate, because it is practically impossible to isolate an individual venture from all sorts of risk (e.g. commercial, technological, natural). In other words, PPP is a poor alternative to procuring infrastructure in well-performing economies.

The reverse is true for developing countries with poor national credit ratings and tight budgets. The cost of borrowing on a project basis can provide more leverage and a significantly lower cost of borrowing, leading to a lower WACC, because the project’s viability is evaluated as a separate economic entity, with greater independence from the respective economic, political, legal conditions and many other variables, which are typically unfavorable (but which are nevertheless factored into the analysis).

5.3 Analysis of the Explicit and Implicit Costs of Financing

takes into account only the explicit costs of debt service. To quantify the implicit costs we can calculate the opportunity cost and subtract from that the explicit costs of debt service in what follows.¹³¹

To review, opportunity cost is the value of the best alternative use of the resources, in this case pure capital. Basically, there is an infinite variety of alternatives that the financial resources could be put to, but it is not possible or meaningful to consider the whole universe of alternatives, if we assume that a government has determined that a certain infrastructure asset would be beneficial from a social welfare viewpoint. However, one obvious alternative that should not be overlooked in this context is pure, financial investment, which represents a relevant comparable, alternative course of action the government could follow.

In other words, the government could choose to use the resources I for investing in an efficient portfolio of risky assets with an expected rate of return r_p in the financial markets. The government, in essence, would function like any bank, taking in funds amounting to D = I, for which it pays an interest rate r_f,, and subsequently investing these in an efficient portfolio of assets that generate an expected rate of return r_p > r_f. The government would thus be expecting revenues of R = I(r_p) each year, debt service costs of I(r_f) each year, and making an expected investment profit of π_i = I(r_p – r_f) each year.

Then exactly how high is r_p? To answer this question, suppose next that the hypothetical debt investors who consider investing in the project are also able to access funds at the risk free rate of r_f,¹³² and since we assume that they are willing to finance the project by providing debt capital at a rate of r_d, they are expecting revenues R of R = I(r_d) each year, debt service costs C of C = I(r_f) each year, and making an expected investment profit π_d of π_d = I(r_d – r_f) each year.

131 See section 2.1.3

132 Typically banks are able to access funds at an even lower rate. The interest that banks pay to consumers and firms that make deposits, their main source of funds, is lower than the prevailing risk-free interest rate.

Then the government, in considering functioning like a bank, should be willing to invest in the project if it is offered the same rate of return r_d that other debt investors expect from this venture, considering all the risks inherent in the project projections. Therefore, the government should be indifferent between investing in some other portfolio of assets and investing in the project, if r_p = r_d.¹³³ And the periodic opportunity cost of investing itself in the project, and not in a portfolio of assets, is equal to the revenue foregone, OC = I(r_d). Moreover, the total OC over the life of the project is I(r_d)^T.

5.3.2 Implicit Costs of Public Finance

The government, by investing itself in the project, thus foregoes the opportunity of receiving revenues of I(r_d). Its periodic explicit debt service costs are, given an excellent credit rating, still defined by the risk-free rate r_f of borrowing, and amount to only I(r_f). However, the opportunity cost just calculated includes both the explicit and implicit costs, and therefore the periodic implicit costs of investing itself in the infrastructure project are defined by I(r_d) – I(r_f) = I(r_d – r_f), where r_d > r_f,, because the project is inherently risky. The total implicit costs of the government investing in the project are thus defined by I(r_d – r_f)^T, and are essentially equal to the customary conception of differences in private and public sector cost of capital.

This implicit, economic cost is typically ignored in PPP analysis, and explains – moreover quantifies – the apparent cheapness of sovereign funding.

The figure (Figure 21) below illustrates the line of thought. At stage 1, the government borrows D, at the risk-free rate, shown by (1). At stage 2, the government leaks the funds at the same cost to a public party to invest in a risky infrastructure project, denoted by (2). The government simultaneously incurs an opportunity cost, because given that the

133 The rate rd is essentially also the rate at which the private supplier can raise capital.

government has access to cheap capital, it could have at stage 2 chosen to invest the same capital amount in an efficient portfolio of assets, which provide an expected rate of return r_p = r_d > r_f, denoted by (3).

Government

Infrastructure Asset Debt Markets

D

I r_f

Public supplier

Private supplier I

D Financial Markets I

r_p

D r_d

D (1)

(3)

(5)

(4)

(2)

Figure 21 Illustration of the implicit costs the government incurs

By choosing to forego this investment opportunity, the government therefore loses a lucrative opportunity to make an investment profit. If the government were a typical rational, risk-averse, insatiable investor, and a responsible governor of citizens’ funds, it would, like everybody else within the framework of financial markets, be indifferent between investing in the infrastructure project, which has a risk level captured in r_d, or investing in an efficient portfolio of risky assets, which provide an equal expected return of r_d. The rate of return r_d is consistent with what outside investors would expect from this particular infrastructure venture, all risks considered, within the framework of financial markets, denoted by (4).

5.3.3 Competitive Market Perspective to Public Finance

What happens from the perspective of the private supplier candidate is that the government intervenes in the construction market and favors a public producer, usually a government agency, by supplying it with unnaturally cheap capital, which in the case of a capital-intensive infrastructure project represents a key production factor and a decisive competitive advantage,

equal to the government’s implicit costs of capital. This is nothing else than a form of subvention, which, in fact, is prohibited by competitive legislation.

Economic theory attests that it is beneficial for a social planner, i.e. the government, to ensure that certain public goods such as highways are provided, but economic theory also promotes fair competition and that for any given purpose the most efficient means are chosen. Our analysis so far assumes that the public and private parties are identical in their capabilities, so it is awkward that the analysis automatically leads to choosing the public alternative. In fact, this is wrong: there is no reason why a government should favor a public party over a private party when alternatives are available, and the government is effectively violating sound economic principles captured in legislation as well. The government could, in principle, borrow on its general credit and leak the funds at the same cost of capital to the private party, which would ensure a fair competitive setting, which is shown by arrow (5) in the figure above.

5.4 Further Illustration of the Implications of Public Finance