Severe budget constraints will limit many governments' ability to fund improvements, and private financing will have to fill the gap. Both the public and the private sectors must change their attitude if they are to reconcile their conflicting interests and meet the huge challenge presented by infrastructure requirements over the next 20 years, say Boston Consulting Group's Marco Airoldi, Lamberto Biscarini and Vito Saracino.
Global focus on infrastructure is back. Faced with the worst financial crisis since the Great Depression, governments have increased spending on public projects as part of fiscal stimulus packages designed to support economic growth. Viewing the situation as a one-off combination of circumstances threatens to obscure the scale of the task facing governments; unless action is taken, the inadequate state of global infrastructure will be a bottleneck for future growth.
Massive pressures
When US President Barack Obama presented the salient elements of his economic-recovery plan, he emphasised the urgency governments attach to infrastructure investment as a means of supporting growth. “We'll invest your precious tax dollars in new and smarter ways, and we'll set a simple rule—use it or lose it,” he said, adding that if states fail “to act quickly to invest in roads and bridges in their communities, they'll lose the money.”
In response to the financial crisis and ensuing global recession, governments have increased spending on transportation, the urban fabric, energy, water, and other public-works projects to support economies. In the US, public-infrastructure investments made up $133 billion of the $787 billion stimulus package funded by the American Recovery and Reinvestment Act of 2009. Public-spending increases made up 2/3rd of total stimulus plans in the Group of 20 Finance Ministers and Central Bank Governors (G-20) countries, and infrastructure spending was a big part of that proportion.
The need for infrastructure spending, though, is not the immediate response to the economic crisis. Rather, it is the result of the inability of infrastructure worldwide to meet the forecast growth in demand.
US road traffic doubles every 28 years, but at the current road-building rate, it would take 370 years to double existing lane miles. Traffic threatens to overload the network in future. Airport runways are under pressure, and ports on both coasts have insufficient capacity to meet demand. Lack of funding has left ageing water-treatment and distribution facilities unfit to cope with rising demand and new regulations.
Economic development in emerging markets will drive increasing demand for already inadequate transportation infrastructure and utilities. In India, 40 per cent of traffic is borne by two per cent of the country's roads—the National Highways. Road and airport use is predicted to rise by 10 per cent per year until 2030, while container traffic in ports is rising by 15 per cent per year, creating severe bottlenecks.
However, severe budget constraints resulting from the response to the financial crisis will limit the ability of governments, particularly those of the Organisation for Economic Co-operation and Development (OECD) countries, to fund development. Many central and local governments lack adequate financial, project-management, and operating capabilities to meet such challenges in an efficient manner.
The Boston Consulting Group (BCG) estimates that $35-$40 trillion will be required over the next 20 years to satisfy the rising need for infrastructure development globally, (See Exhibit 1). Also, it is estimated that governments, at best, will be able to fund half the requirement, leaving a shortfall as large as $20-$25 trillion.
Inadequate infrastructure
Infrastructure—both its capacity and its quality—is extremely deficient in most of the developing and developed world.
Public infrastructure, which comprises the facilities that are required for the economy and society to function, is generally divided into two groups:
• Economic infrastructure required for day-to-day economic activity, such as transportation, utility, and telecommunications networks
• Social infrastructure that is considered essential for the functioning of society, such as schools and hospitals
The role of governments in providing public infrastructure is accepted because private companies are not sufficiently motivated by economic and social benefits to build freely available infrastructure, such as roads and street lighting. However, faced with multiple spending pressures, governments in developed economies have allowed infrastructure built in the 1950s and 1960s to crumble, while growing demand and new regulatory requirements have imposed increasing strain on existing facilities. For instance, the deadly collapse in 2007 of the Interstate 35W Mississippi River Bridge in Minneapolis highlighted the state of the 600,000 US bridges, 27 per cent of which are deficient.
Also, the infrastructure of fast-growing emerging markets, such as China and India, is inadequate for their current needs, and can't meet the rising demand driven by economic growth, urbanisation and expanding populations. These are only a few examples of long-term economic problems that must be addressed if country's wish to achieve their potential over the next 20 years.
Increasing demand will vastly outstrip historical levels
The key driver for future infrastructure spending over the next 20 years will be increased demand in both emerging and developed economies, powered by rising per capita GDP, population growth, and increased urbanisation.
There is a clear link between economic development and demand for transportation infrastructure. For example, the number of air miles travelled per person rises in line with a nation's per capita GDP, while the means of transportation shift from bus and train to car and air. Road traffic also closely tracks per person GDP growth, and use of airports, rail, water, electricity, and ports is also linked to economic growth. The requirements of emerging markets will be enormous. China will make up more than 25 per cent of global GDP growth in the next 20 years, and the BRIC countries (Brazil, Russia, India, and China) will account for more than 45 per cent. BRIC will make up more than half of the growth in road use and more than 40 per cent of the growth in airport passenger traffic through 2030.
The OECD countries will require half the global investment in infrastructure, and water needs are expected to absorb half that sum as quality requirements become increasingly stringent.
Failure to act will impede economic growth
Governments are spending on infrastructure to support their economies in the short-term. But without the necessary $35-$40 trillion that we believe will be required over the next 20 years, long-term economic and social development will be hindered by serious blockages, (See Exhibit 3).
For example, inadequate infrastructure combined with rising oil prices will constrain global trade and drive up supply chain costs for manufacturers and retailers. A recent BCG study showed that the hidden costs of logistics, such as long and unpredictable delivery times, can turn a profit into a loss.
Bottlenecks have been the result of slow privatisation plans and inefficient infrastructure planning. The US airport privatisation programme struggled to take off in the late 1990s, because progress was hampered by flawed plans, public opposition, and political decisions that limited the private-sector involvement. Construction of necessary runways averaged 10 years from announcement to completion. Given the poor condition of the existing infrastructure and the projected increases in demand, current financial, planning, and political challenges will combine to create a global crisis in the provision of essential public projects.
Meeting the challenge jointly
Although infrastructure spending plays a major part in the fiscal stimulus packages that governments have put together to combat the recession, the cost of that support will severely hinder their ability to fund the infrastructure development needed to fulfil long-term economic potential.
Large budget deficits and public debt will constrain governments' financial flexibility, while trade deficits and net debt will limit ability to raise funds domestically.
While some liquid economies, such as China, will be able to fund their own needs, others facing greater constraints will require additional sources of funding. Brazil, France, India, Poland, Turkey, the UK and US, to name a few, are likely to seek funding from private investors.
Turning to the private sector
Involvement of the private sector should, if effected properly, yield benefits for governments beyond financing. For instance, industrial companies have developed construction, project management and operating capabilities that governments can leverage to reduce costs and reform public services. Payment aligned with delivery creates pressure for prompt completion, and private sector involvement allows governments to concentrate on outcomes (through regulation) instead of service. Well-designed contracts also can improve the upkeep of assets by transferring maintenance to the private partner.
There are four main types of potential investors in infrastructure development, but their roles are shifting.
• Pure concessionaires are traditionally moderate-growth companies that generate a high proportion of their revenues from the operation of infrastructure concessions. Financially experienced operators can benefit from governments' need for credible and efficient management of new infrastructure.
• Construction companies, both specialised and diversified, have been major participants in the past. In the short-term, high debt will limit the ability of some to win infrastructure projects, particularly large privatisations. Their engineering and construction capabilities will remain important in greenfield, site reuse or large brownfield projects.
• Private-equity funds that specialise in infrastructure raised $250 billion from 2000 through 2009, making them significant potential participants. They will have to build operational and management capabilities to replace the high-leverage, aggressive bid prices and large tariff increases that characterised their early move into the infra arena.
• Sovereign wealth funds (SWFs) with diversified and typically long-term portfolios managed about $3 trillion in assets in 2008. A small but increasing percentage of this money will be invested in infrastructure, particularly in developing countries. SWFs that are overexposed to the instability of the western financial sector will be attracted by lower-risk longer-term investments.
In addition, pension funds had about $17 trillion under management in 2008. SWFs and pension funds will be interested in infrastructure investments, but they will need to partner with specialised operators to compensate for their relative lack of experience in the infrastructure business.
Changes required in both sectors
Both governments and the private sector must play a part in building successful PPPs and contributing to the development of infrastructure for the collective good. The role of each is distinctive.
Governments should assume responsibility for the following:
• Strengthening political commitment
• Developing reliable regulatory frameworks
• Improving long-term planning, project prioritisation and project governance
Private investors need to assume responsibility for the following:
• Going beyond financial-deal structuring to develop solid operating capabilities
• Paying much more attention to the quality of the service provided
• Being selective in deal sourcing
Government actions
Governments must demonstrate clarity and consistency of vision and goals. In many countries—for example, Italy—differences in practices and attitudes of the local-government bodies make it difficult for the private sector to invest with confidence. Public institutions must build and demonstrate institutional capacity that is adequate to handle the PPP programme and deal with individual projects.
Countries such as Australia, Canada, and Chile are setting the standards for PPP models and pipeline strength on the basis of their clear commitment and record of effective execution. However, many countries, including the United States and other highly developed economies, still have progress to make if they are to emulate the best models and encourage private investment efficiently.
It is critically important that regulations on affordability, service quality, adequate capacity, and safety and security allow private operators the freedom to generate returns and make efficiency and innovation gains in a predictable regulatory environment. For example, tighter controls on the part of UK regulators have contributed to Heathrow Airport's poor performance in terms of growth, service levels and prices.
In addition, investment proposals from governments are still too often motivated by short-term and sometimes-opaque considerations that lead to substandard outcomes. Governments that create open and transparent discussions on infrastructure choices and plans—and involve all the main stakeholders—are still extremely rare. In this regard as well, Australia, Canada, and Chile stand out as best-practice exemplars, leaving others lagging some distance behind.
Addressing these issues, intense debates are taking place in some countries, including the US and UK, about the need for dedicated and largely independent bodies, such as national infrastructure banks, to increase the effectiveness of project planning and governance and to ease access to finance.
Private-investor actions
To identify profitable opportunities, the private sector has in the past relied too heavily on deal-structuring capabilities. These capabilities will be a reduced source of competitive advantage in the future. Instead, operational value-creation capabilities are now essential for extracting value from assets. First-class operating capabilities will be necessary to optimise operating costs and investments and to increase revenues. For example:
• A European toll-road operator was able to nearly double its earnings before interest, taxes, depreciation, and amortisation (EBITDA) in 10 years. Less than half of that growth was from traffic and tariffs; most of it was generated through efficiency improvements and growth of ancillary revenues.
• Nearly half the sales of one successful airport operator are linked to non-aviation revenues such as retail, car parking, accommodation and advertising.
The more complex the asset being managed, the greater is the relevance of these capabilities. This is particularly true as political and public opinion grows increasingly sensitive toward tariff increases by private sector operators—especially when the increases haven't been justified by improvements when it comes to the level of service.
The following examples illustrate the public's close scrutiny of private-sector infrastructure operators and their need to intensify their focus on providing demonstrably good service.
• In the United States, several state authorities complain that drivers are suffering post-privatisation tariff increases that are not associated with traffic or safety improvements.
• In South America, a private water supplier imposed tariff increases of 30-40 per cent before making any capital improvements, generating public riots and other negative reactions against water utilities.
Especially in countries where public opinion is a powerful force, expectations of better service levels and unrest over unjustified tariff increases are growing. Just as governments must accept the principle of private profit from public infrastructure, private operators must learn to create and market service improvements.
Finally, the investors and industrial companies must have strong deal-screening capabilities. It is their responsibility not to move into sectors or countries where managing regulatory, construction and market risks is likely to be challenging.
Before making an investment, private participants must carefully assess the following aspects of the proposed transaction at hand:
• The attractiveness and riskiness of the country, sector, and specific deal
• The transparency of the legal framework and contract
• The relevance of their own experience and capabilities to the target sector's and country's key requirements
Conclusion
Governments that limit their tasks to announcing new infrastructure development plans and fail to offer acceptable risk conditions and stable PPP frameworks or to build the fundamentals for effective implementation will struggle to attract long-term private-sector participation in the development of infrastructure within their country.
Private sector participants that do not master operating capabilities, are unwilling or unable to improve and market service quality, or do not pursue deals with manageable risk are those players that are most likely to destroy value and undermine the confidence in private participation as a concept in the provision of public goods and services.
Improving the quality of cooperation between the public and private sectors on infrastructure development is essential to support economic growth over the next two decades.
Infra Gaps
Some examples of how the inadequacies in world infrastructure surface:
• Serious water shortages and water-quality issues are widespread, affecting developed areas such as California and the United Kingdom. London, for example, suffered a drought in 2006. India has plentiful supplies of water but is extending its distribution and collection network because of health concerns. China risks water shortages, especially in its northern region, which includes Beijing.
• In China, cities and major industrial areas such as Beijing and Shanghai experience recurring electricity shortages. India's energy shortfall is nine per cent on average and 40 per cent at peak.
• In 2003, the Northeast United States (and Ontario, Canada) and Italy suffered power blackouts, each of which affected more than 50 million people.
• Roads linking Western and Eastern Europe face mounting congestion owing to the continuing growth of heavy-goods vehicle traffic. The cost of traffic congestion in the United States is $60-$70 billion per year, and by 2020, much of the US road network will reach its saturation point.
• The ports of Rotterdam and Antwerp have faced significant delays. In March 2007, Rotterdam sent away more than 30 ships and 50,000 containers. US ports on both coasts are unable to meet demand.
The authors are with the Boston Consulting Group. Airoldi is a Senior Partner and Managing Director (Milan), and may be reached at airoldi.marco@bcg.com. Biscarini is Partner and Managing Director (Milan), and may be reached at biscarini.lamberto@bcg.com. Saracino is Principal (Milan), and may be reached at saracino.vito@bcg.com.
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