Five Implications of VfF

The Value for Funding hypothesis is that fiscal and budgetary constraints are a major impediment to public infrastructure investment for US state & local governments.

These constraints can be a more a much important factor than the typical ‘Value for Money’ project-level inefficiencies that most current non-traditional infrastructure alternatives are designed to reduce.  This is especially the case for social and relatively simple basic infrastructure assets.

A different type of problem requires different types of solutions — here are five implications for alternative infrastructure financing innovation that come from the VfF hypothesis:

1) Public-Sector Capital:  Improve Deployment, Don’t Replace

One explanation for inadequate infrastructure investment is that the cost of public-sector capital is higher than it was before even though financing rates are at historic lows.  The idea is that taxpayers want a higher return on the resources that they provide to the government to build infrastructure or pay off infrastructure debt, and that this factor overwhelms low interest rates.

This sounds like it might be true in distressed places where capital is scarce, but I think it’s a stretch for most US state and local governments.  There are solid reasons why the cost of public sector capital is low in relatively rich and politically stable communities and despite all their ‘new normal’ challenges that still applies.

I think the VfF hypothesis might offer a better explanation about what’s preventing more public sector capital being put to work.  Even if taxpayers are willing and able to commit to providing capital for infrastructure, I can see voters getting really angry if financing the commitment results in endless budget crises, frequent debt cap rises or ratings downgrades – all the noisy political hot points.  And it’s easy to see why public-sector officials want to avoid all that.  I think that what’s changed since 2008 – not the cost or availability of public sector capital, but the environment where it would be put to work is really uncertain and politically volatile – so fiscal constraints are really binding.

If this analysis is correct, then alternative financing should not try and replace capital that is actually pretty cheap – but instead look for ways to improve how that capital is deployed and financed with respect to fiscal constraints.

2) Risk and Uncertainty: Risk Transfer Rarely Necessary, But Uncertainty Transfer Often Needed

Risk transfer is often talked about as a rationale for alternatives.  I think this is correct in situations where the risk involved can actually be reduced by private-sector expertise or specialized management – in high-tech processes, some complicated construction projects or retail-store type operations.  In these cases, reducing risk means fewer bad outcomes and wasted resources for everyone – it’s a win-win for both the public and private sectors.

But a lot of the long-term risk involved with basic and social infrastructure can’t be reduced by anybody — public or private – because it comes from factors that aren’t manageable, like macroeconomic cycles or environmental conditions.  If you transfer this kind of risk, it’ll be a zero-sum win-lose situation – maybe the private sector will lose a round like ITR, but they’re playing the game to win, so I don’t think this will be typical.  So I think it’s debatable whether risk transfer really works for the public sector for a lot of cases.

But the VfF hypothesis does point to something that’s conceptually related to risk but not at all the same thing – uncertainty itself.  There’s a lot of technical economic literature about risk vs. uncertainty but the basic idea for our purposes is pretty simple – you can be very comfortable with the risk of your overall income over the next 5 years, but very uncomfortable with the uncertainty of sudden expenditures.  There’s no need to sell or insure your income to deal with that – instead you have some savings or a credit card that acts like a shock absorber to smooth out the impact

The public sector – in liberal democracies anyway – is institutionally bad at dealing with uncertainty – they’re really designed for long-term consensus and planning.  In contrast, the capitalist private sector is pretty good at dealing with uncertainty because in effect that’s their everyday environment.  So I think the VfF implication here is that transferring uncertainty – especially in the current new normal — will be a more broadly applicable rationale than risk transfer.  Basically that means looking for shock absorbers to add to alternatives, like rainy-day financing facilities and keeping debt limit and rating agency powder dry to help the public sector cope with uncertainty.

3) Funded Equity:  Contracts for Specific Performance Often a Better Fit for Public Sector

I can see a role for an equity component in an alternative financing when reducing risk or increasing performance efficiency really requires a significant amount of control over the asset and operations.  So again, complex systems, hi-tech or retail-type infrastructure makes sense.

I can also see a role for some small amount of equity with limited control even for the kind of basic or social infrastructure where risk can’t be reduced and performance improvement is pretty straightforward – like just sticking to a maintenance schedule.  In these cases, the equity is there to align incentives – so private-sector has some skin in the game.

That also makes sense – in theory.  But in practice, it seems that if performance contracts can do the same job in terms of incentives and alignment this might be the less controversial approach, even if the net cost/benefit is the same.  As you all know, there’s just a lot of politics out there right now.

I think the main VfF implication here is like a rule of thumb – if most of the benefits of an alternative proposal is coming from Value for Money and control over the asset is necessary to achieve that, the private-sector funded equity makes sense, even if controversial.

But if most of the benefits are coming from Value for Funding so control over the asset is not so necessary, then performance contracts might be the simplest choice to achieve some Value for Money benefits and avoid controversy at the same time.

4) Expanding Debt Options:  Many Fiscal Constraints Can Be Reduced with Innovative Debt

The biggest – and simplest – VfF implication is that different kinds of debt options might go a long way to helping the public sector reduce fiscal constraints, and since the infrastructure debt capital markets are hungry and pretty innovative, that might be a path forward to for alternative design.

There are two reasons I’m coming to this conclusion.  The first is that most currently binding fiscal and budgetary constraints are related to the debt financing of an infrastructure project – the fixed debt service obligations against volatile revenues, using up debt limits, fear of downgrades, etc.  So it makes sense to explore whether different debt structures might have less impact.

Second – and more fundamental — is that although debt is really bad at absorbing risk because the pay-out is asymmetric, it’s actually pretty good at absorbing uncertainty – specifically, the uncertain timing of cash flows – as long as a credit-worthy entity is on the hook to ensure final repayment.  Think of a line of credit.  In the current market, it’s also really cheap, and the US public sector is mostly very highly-rated investment grade, so plenty of capacity.

So if uncertainty transfer has value to the public sector, I think there’s a lot of scope for development in the debt capitalization side of an alternative proposal.

One important thing to note – none of this should preclude using as much traditional muni-bond financing as possible.  You don’t need the whole debt structure to be a shock absorber – just enough to deal with typical levels of uncertainty.  So the innovative debt I’m talking about should only be a small part of the overall capitalization and the alternative framework should not preclude tax-exempt debt issuance.

5) Federal Infrastructure Policy:  Focus on Reducing Constraints and Inefficiencies, Not Form

Finally, current federal infrastructure policy is a bit vague at the moment to say the least, but I think the overall objective of trying to support more non-traditional options for US state and local governments and get more private-sector expertise and capital involved is totally on target.

But I think also that focusing policies on specific forms and frameworks – like revenue-risk P3s – is a mistake.  That’s completely understandable in terms of what’s been talked about for many years, but it’s unnecessarily limiting and runs into some political preconceptions.  It’d be better to focus policy on the actual challenges that state and local governments face and where the federal government has some unique capability to help.

The VfF implication is of course that it would be very effective to focus some federal policy on specific challenges of fiscal and budgetary constraints if they’re the real impediment to local governments deploying their own capital.  Since mitigating these constraints doesn’t really require risk transfers or subsidies, some carefully thought out policies might be relatively practical in terms of the federal government’s own spending constraints.  In particular, I think there’s a lot of scope for federal loan programs to help deal with uncertainty.