Description of Private and Public Financing Alternatives

The genesis of the conventional argument, typically favored by politicians, is that a government should fund infrastructure development, because it can borrow capital at a low interest rate. It is very true that infrastructure assets tie up enormous capital, major projects typically in the scale of hundreds of millions in euros, and therefore it is obvious that the costs of debt service make up a significant portion of total costs. It is also true that the governments in well-developed economies have a very low risk of default, having consequently an excellent credit rating, translating to a low cost of borrowing.

It seems intuitively appealing then for a government to use its access to cheap capital to borrow and fund infrastructure development projects.

However appealing the practice seems at first thought, it is based on an incomplete or even erroneous understanding of the framework of financial markets in both theory and practice. There is nothing wrong with a

129 In other words, we will hold social externalities B, the required investment I, taxes t and private revenues R, and costs C constant.

government borrowing funds on its general credit, which is excellent and therefore the applied interest rate is low. But what happens when a government allocates these funds to an inherently risky venture is, in brief, that the government violates the principles of financial markets, incurring an opportunity cost and subsidizing a certain producer with an amount equal to the implicit costs included in the opportunity cost.

5.2.2 Public Finance and Public Organization

The line of thought needs some elaboration and simple notation. To keep the analysis simple, it suffices to accept a widely held assumption that financial markets operate on the basis of four basic principles discussed earlier in the review of the theory of investment.¹³⁰ These principles effectively ensure that capital, a key input and production factor to any economic activity in the widest possible sense, is allocated efficiently. For the purpose of illustration, let us first assume a two-stage model, in which at stage one a government borrows a certain amount of capital denoted by D, at an interest rate of r_f, which is presumably very close to the risk free rate given an excellent credit rating. At stage two the government invests the same amount I = D into a capital-intensive project.

Let us also assume that one such alternative is a public-sector led infrastructure project, which involves constructing a highway and maintaining it for a time span of T years. The infrastructure will be in operation for T minus construction period P, after which it is simply disposed at zero value. Let us also assume that the project is inherently risky, which is a very reasonable assumption for any economic activity. In the case of constructing and operating a highway for a long term, risks arise from material and labor availability and cost, engineering calculations, technological solutions, geological uncertainties, weather conditions, plain human error, and many other possible sources of disturbance to the project execution. The realization of these risks could

130 See section 2.2.1

cause extra costs, schedule delays, and lower-than-expected performance of the completed infrastructure.

Let us again assume that the construction period P is one year, the construction requires an initial investment of I, and when completed, having the highway in operation incurs a constant, annual cost of C, and having the infrastructure asset and the complementary services required to operate it effectively delivers total annual societal benefits of B, where B >

C. Then, in principle, we could rely on basic investment theory to evaluate intelligently the viability of the project. We would proceed by a standard calculation of discounting the annual net benefits N = (B – C) to the present day and comparing the resulting present value PV to the initial investment I to determine the net present value NPV. For the purpose of discounting, we would need to determine an appropriate discounting factor r for each of the periods I =1,2,…,T. Let us assume that the discounting factor is defined by r^i, for each of the periods i, respectively. The NPV of the project, as a function of r, would then be defined as NPV(r) = ∑(N_i / r^i) – I.

5.2.3 Private Finance and Private Organization

Let us next assume that there is another party, a private comparable to the public party and willing to consider taking responsibility of the project, in other words constructing the infrastructure and operating it similarly until T. The party is a separate private company, with no operating history or assets (except for a minimum equity contribution of E). The party would also finance the project entirely on debt D, and since E << I, we can reasonably omit the effect of E in the analysis. Let us also assume that this party has access to the exact same resources and is equally capable of delivering the infrastructure. In essence, the private party could create equal annual societal benefits of B at equal annual cost of C, and would require equal initial investment of I = D. The stream of the net benefits generated by the public and the private party throughout the time span T would then be identical, and the net present value as a function of the cost of capital, would be NPV(r) = ∑(N_i / r^i) – I for both.

The next task would be to determine an appropriate discounting factor. In business parlance, it is common to use a figure called the cost of capital r_d as the discounting factor, which in essence captures the uncertainty related to the future B and C projections. It is a measure of return a business must offer to investors, i.e. what investors expect from a particular venture, all risks considered, within the framework of financial markets. In particular, since r_f is the rate of return expected from a completely risk free investment, the project cost of capital r_d is obviously higher (r_d > r_f), since the project, as explained, is inherently risky, and more risk is acceptable only with a higher expected return.

The private party would need to evaluate the project on its own merits and access the financial markets to raise funds for the project as a separate economic unit. Potential debt investors would assess whether or not C and B projections are realistic, and assuming so, they would be willing to lend an amount D of funds at an interest rate r_d, which is a fair rate given all actual risks inherent and other risky investment opportunities available.

5.2.4 Comparison of Public and Private Alternatives

The question then is whether the project should be undertaken by the public or the private party. To evaluate these alternatives objectively, we could use the NPV as a standard criterion and require that the alternative with a higher NPV should be chosen. It inevitably follows that at stage 2 the government should invest in the project, because given its excellent credit rating, the net present value associated with the course of action where the government invests is higher than the course of action, where a private company invests.

More formally, since r_d > r_{f ,} it follows that NPV(r_d) < NPV(r_f) – the discounting factor that the private party uses is higher than the government one, and therefore its NPV is lower. In other words, it would make sense for the government to take charge of the project, fund it on its general credit and overtake construction and operation activity (typically using private sector subcontractors, but this is not the point). This is essentially

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