The Regulatory Asset Base And Project Finance Models

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The Regulatory Asset Baseand Project Finance ModelsAn Analysis of Incentives for Efficiency01Discussion Paper 2016 01Dejan Makovšek andDaniel VeryardInternational Transport Forum,Paris, France

The Regulatory Asset Base and Project Finance Models:An Analysis of Incentives for EfficiencyDiscussion Paper 2016-1Dejan MakovšekDaniel VeryardInternational Transport ForumParis, FranceFebruary 2016

The International Transport ForumThe International Transport Forum is an intergovernmental organisation with 57 membercountries. It acts as a think tank for transport policy and organises the Annual Summit oftransport ministers. ITF is the only global body that covers all transport modes. The ITF ispolitically autonomous and administratively integrated with the OECD.The ITF works for transport policies that improve peoples’ lives. Our mission is to foster adeeper understanding of the role of transport in economic growth, environmental sustainabilityand social inclusion and to raise the public profile of transport policy.The ITF organises global dialogue for better transport. We act as a platform for discussionand pre-negotiation of policy issues across all transport modes. We analyse trends, shareknowledge and promote exchange among transport decision-makers and civil society. The ITF’sAnnual Summit is the world’s largest gathering of transport ministers and the leading globalplatform for dialogue on transport policy.The Members of the Forum are: Albania, Armenia, Argentina, Australia, Austria,Azerbaijan, Belarus, Belgium, Bosnia and Herzegovina, Bulgaria, Canada, Chile, China(People’s Republic of), Croatia, Czech Republic, Denmark, Estonia, Finland, France, FormerYugoslav Republic of Macedonia, Georgia, Germany, Greece, Hungary, Iceland, India, Ireland,Israel, Italy, Japan, Korea, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Mexico,Republic of Moldova, Montenegro, Morocco, the Netherlands, New Zealand, Norway, Poland,Portugal, Romania, Russian Federation, Serbia, Slovak Republic, Slovenia, Spain, Sweden,Switzerland, Turkey, Ukraine, the United Kingdom and the United States.International Transport Forum2 rue André PascalF-75775 Paris Cedex [email protected] Discussion PapersThe ITF Discussion Paper series makes economic research, commissioned or carried out in-houseat ITF, available to researchers and practitioners. They describe preliminary results or research inprogress by the author(s) and are published to stimulate discussion on a broad range of issues onwhich the ITF works. Any findings, interpretations and conclusions expressed herein are those of theauthors and do not necessarily reflect the views of the International Transport Forum or the OECD.Neither the OECD, ITF nor the authors guarantee the accuracy of any data or other informationcontained in this publication and accept no responsibility whatsoever for any consequence of their use.This document and any map included herein are without prejudice to the status of or sovereignty overany territory, to the delimitation of international frontiers and boundaries and to the name of anyterritory, city or area. Comments on Discussion Papers are welcome.2

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelAbstractGovernments world-wide have sought value for money by augmenting the traditional approach topublic infrastructure delivery and management by introducing private capital. Two well establishedplatforms for private capital participation are the Regulatory Asset Base (RAB) Model and the ProjectFinance Model (broadly termed PPPs). This paper reviews available evidence on the efficiency indelivery and operation of major infrastructure of each platform relative to the traditional approach.Overall the basic concern with the RAB model is that its application might lead to excessive capitalexpenditures, to strategically inflate the base on which the return is being calculated. By contrast,given the complexity of PPP projects and the inherent uncertainty associated with such long-livedcontractual commitments, it is questionable whether competition leads to efficient outcomes. Bothapproaches have some potential advantages and this paper investigates, whether it is meaningful tomerge them.ITF Discussion Paper 2016-1 — OECD/ITF 20163

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelTable of ContentsIntroduction. 6Methodology . 8The traditional model baseline . 9Infrastructure delivery using the traditional model . 9Quality and delivery approach . 9Delivery efficiency . 9Infrastructure operation under the traditional model. 10Operational efficiency . 10Operational flexibility. 10Assessment of the traditional model . 11Towards private participation . 11The Regulatory Asset Base model . 12Overview of the Regulatory Asset Base model . 12Infrastructure delivery using the RAB model . 14Quality and delivery approach . 14Delivery efficiency . 15Infrastructure operation under the RAB model . 16Operational efficiency . 16Operational flexibility. 18Other value for money considerations for the RAB model . 18Cost of debt financing. 18Estimating the appropriate returns to capital . 19The Public-Private Partnership model . 21Overview of the PPP model . 21Infrastructure delivery using the PPP model . 22Quality and delivery approach . 22Delivery efficiency . 23Infrastructure operation under the PPP model . 24Operational efficiency . 24Operational flexibility. 24Other value for money considerations for the PPP model . 25Cost of debt financing. 25Risk and return considerations for bidders . 26Discussion . 28Project RAB finance . 29Summary . 31Conclusion . 33Bibliography . 354ITF Discussion Paper 2016-1 — OECD/ITF 2016

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelBoxesBox 1. Cost of financing in RAB and a PPP .26FiguresFigure 1.Figure 2.Figure 3.Figure 4.An Regulatory Asset Base structure example . 13Cost overruns in electricity transmission projects in the USA in 2013 . 16An example of a PPP model for infrastructure delivery and operation . 22An illustration of the Project RAB finance during construction . 30TablesTable 1. Characteristics of alternative infrastructure delivery and operation models. 31ITF Discussion Paper 2016-1 — OECD/ITF 20165

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelIntroductionInvestment in infrastructure is important for productivity and growth, for future generations aswell as today. A recent study by McKinsey compiled multiple sources of information on the so called“infrastructure gap”, estimating the needs at USD 57 trillion over the next 30 years (Dobbs et al.2013). Almost half of this amount is in the transport sector. Despite the inherent difficulties inaccurately estimating it, the infrastructure gap in clearly large.The traditional approach to investing in infrastructure relies on governments using its revenue(either from taxes or borrowing) to finance the design and construction of new or upgradedinfrastructure. Although the design and construction can be procured through competitive tenders fromprivate firms, the traditional model relies on continued government ownership and operation onceconstruction is completed.In recent decades, many governments have responded to limitations of the traditional model byseeking increased private sector involvement in the funding, financing, delivery and operation ofinfrastructure. The two primary challenges with the traditional model driving this change are: difficulty in finding sufficient government finance, either because of weakness in taxrevenue or a reluctance (or inability) to increase government borrowing evidence (or policy preference) that government ownership and operation of infrastructureassets results in worse price and/or quality outcomes compared with the private sector.This paper explores the two primary models through which private sector involvement has beenintroduced into the financing, delivery and operation of infrastructure: the regulatory asset base model(RAB) and the project finance model (or Public Private Partnerships, PPP).In the RAB model, private (or corporatised state-owned) companies act as the infrastructuremanager: they own, invest in and operate infrastructure assets. The infrastructure manager receivescharges revenue from users and/or subsidies to fund its operations and recoup investment costs. Theinfrastructure manager would behave much like a natural monopoly in the absence of regulation –setting prices too high in an attempt to earn “super normal” profits. An economic regulator is thereforeestablished to provide efficiency incentives and to cap prices, revenue or rates or return received bythe infrastructure manager to improve social welfare. Efficiency incentives aim to mimic theincentives that would be faced by the market if it were competitive. The efficiency gains in this casearise primarily through the interaction between the regulator and the infrastructure manager “duringthe contract”.In the PPP model (also termed Private Finance Initiative, PFI, in the UK) of public infrastructuredelivery, the government calls for tenders for a contract for a single infrastructure project. Thesecontracts commonly take the form of a Design-Build-Finance-Maintain-Operate (DBFMO) contract.The contract gives the successful private consortium responsibility for all aspects of project financing,delivery and operation for periods often spanning decades. The contract sets out how the consortiumreceives revenue: either from the government in the form of a periodic “availability payments”, and/ordirect from users. (The latter case is associated with demand risks that are generally beyond the scopeof this paper.) The efficiency gains in this approach are primarily determined at a single point in time:by competition between the bidders for the contract (ex-ante).6ITF Discussion Paper 2016-1 — OECD/ITF 2016

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelThese two approaches could be considered as two diametrically opposite solutions to the samechallenge of infrastructure financing, delivery and management. The sharp distinction made hereserves to allow analysis. In reality competition between investors in the RAB model also serves toprovide an incentive to efficiency, at least at the outset. Similarly, a DBFMO contract need not beentirely devoid of incentive regulation1. In between the two basic approaches, there are also otheralternatives, which take various forms, from management contracts to other types of concessions.These are not discussed in this paper.The central advantage of RAB is that in developed economies it offers one of the lowest costs offinancing, only marginally above that of government bonds. At the same time, incentive regulation canprovide adjustable high powered incentives for operational efficiency during the life of theinfrastructure. One of the bigger challenges of RAB is incentivising efficient capital expenditures,which is a problem that appears to be more adequately solved in PPPs. These are well established fordelivering projects on-time and on-budget; however, the cost of financing PPPs is substantially higherthan for RAB, and the PPP contract is considered to be relatively rigid during the operations phase.The question this paper asks is whether it is feasible and desirable to merge the advantages ofboth approaches – the low cost of finance and continuous incentives for operational efficiency in theRAB, with efficiency in infrastructure delivery of the PPP – in a single model? To attempt to answerthe question, the paper first reviews the available empirical literature and assesses the infrastructuredelivery and operation performance of the traditional model (section 3), the RAB (section 4) and PPP(section 5) approaches. We then discuss whether there is room to combine any elements of the twomodels, which would lead to an improved infrastructure delivery and management vehicle (section 6).Section 7 concludes.This paper was originally published as “The Regulatory Asset Base Model and the ProjectFinance Model: A comparative analysis“ (ITF Discussion Paper 2015-5) in February 2015. Feedbackon the complex issues raised in that earlier paper has prompted us to improve and streamline thestructure for enhanced presentation of the material and better accessibility of the conclusions. DanielVeryard has been added as co-author to reflect his valuable input. Comments on an earlier version byDarryl Murphy, Frederic Blanc Brude, Daniel Loschachof, J.L. Guasch and Marian Moszoro aregratefully appreciated.1Around the world region specific differences may induce confusion. A concession is a specific term incivil law countries. In common law countries however, projects that refer to discrete pieces ofinfrastructure are also referred to as concessions, although they could be better described as BOT typeprojects.ITF Discussion Paper 2016-1 — OECD/ITF 20167

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelMethodologyThis paper compares the relative performance of three alternative models for delivering andoperating infrastructure in capital-intensive network industries: 1) traditional procurement, 2)regulated asset base (RAB) and 3) project finance (PPP). We assess these models by examining andcomparing their performance in the available empirical literature and economic theory.The paper focuses on capital-intensive network industries (e.g. road, rail, utilities) as they haveelements of natural monopolies that make investments candidates for each of the delivery models ofinterest. An important aspect of these industries is that demand is mainly an exogenous factor for theinfrastructure manager. Nevertheless, the paper assumes the basic incentive structure is the same inany project finance PPP and thus draws on available evidence also from other sectors where relevant.To demonstrate the scope of the analysis, a project life-cycle can be divided into five stages, eachwith its own considerations: Project selection (outside the scope of this study) – which markets should be served? Whatservice capacity should be built? Which service technologies should be provided to the users(e.g. light rail versus bus rapid transit)? Quality and delivery approach – which materials, techniques and technologies should beapplied in construction? What quality of asset should be built? Will life-cycle costs beminimised (for a given service output)? Delivery efficiency – how well can specified capital projects be delivered, without excessivecost overruns and delays? How well are the risks of delivery estimated and managed? Operational efficiency – given the assets available, can the operator produce a given outputat low cost? Can the service contract be re-negotiated easily at low cost to government? Operational flexibility – to what extent are prices, quantities and service levels locked in orflexible? What costs are incurred by governments if they wish to make changes during theoperational period?Only the first of these life-cycle stages is not considered in this study. This is because in two ofthe delivery models under consideration, project selection has generally been decided ex-ante (beforeany delivery contracts have been tendered) regardless of whether a project is desirable or not. Only inthe RAB model is project selection within the scope of the delivery framework itself. Infrastructuremanagers are involved (with the regulator/state) in the selection and procurement of projects, but thisaspect of the RAB model cannot be compared with the other models which rely purely on governmentproject selection decisions.Decisions made during phases two through four determine which party bears the various deliveryand operational risks. This risk allocation in turn influences the incentives for performance and canhave a significant influence on the cost of financing. The assessment of models considers these pointsin terms of the returns required by private participants and the resulting value for money forgovernment.8ITF Discussion Paper 2016-1 — OECD/ITF 2016

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelThe traditional model baselineThe term “traditional” describes something that has remained more or less unchanged throughtime as an established method. The dominant method of major infrastructure procurement hasremained unchanged for decades, while the processes and technologies for infrastructure planning anddelivery have progressed. This section explores the traditional approach to delivery and operation ofmajor network infrastructure.Infrastructure delivery using the traditional modelThe traditional model is a contract structure where the phases of design and construction aretendered to private companies, either separately (Design-Bid-Build or DBB contracts) or bundled (aDesign and Build or DB contract). The spending on public infrastructure is financed with public fundsor through government borrowing.Quality and delivery approachThe planning, building, and operation phases are commonly each performed by different entitiesin the traditional model. In such a setup each actor “leaves the scene” after his engagement iscompleted, hence limiting incentives to consider future consequences of decisions in each of thephases2. This makes the implementation of life-cycle cost optimisation principles difficult.Equally importantly, the sponsor (the public entity), which should have the incentive to minimiselife cycle costs, is also subject to political short termism. Politicians have an incentive to “cut theribbon” for as many projects as possible, without considering future cost of this infrastructure. Thisleads to the procurement of lower quality infrastructure than might be suggested by life-cycleminimisation.Delivery efficiencyIn large projects, traditional procurement involves the public sector entering into a cost-pluscontract3, which has three main consequences for delivery efficiency: The public sector retains most of the risks of cost or time overruns. The public sector also retains the possibility of changing the scope of the project duringconstruction with relatively small transaction costs. This flexibility also creates moral hazardby making it easier for the public sponsor to conceal the true cost/benefits during the projectselection stage (Flyvbjerg et al. 2002).2In traditional procurement the Design and Build procurement resolves part of the problem with regardto incentives, but it would still be inferior to a contract that also bundles the operations phase.3In this paper we apply the term cost-plus contract as opposed to fixed price/fixed date of deliverycontracts. Cost-plus contracts offer a weak guarantee ceteris paribus to the investor that the projectwill be delivered for the contracted value, including the design and build contract. The fixedprice/fixed date of delivery contract involves a TLS (Total Lump Sum)/turnkey contract, with acomparably strong guarantee to the investor, that the contract value will not be exceeded (provided ofcourse, that the investor does not change the content of the project).ITF Discussion Paper 2016-1 — OECD/ITF 20169

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Model A large number of potential contractors can participate during the bidding stage, includingparticipants that would be unable to accommodate major risks.A large body of literature assesses the on-budget cost performance of the traditional infrastructureproject delivery ex post. The relevant part of the literature focuses on construction contractperformance where cost performance is measured against the contract price (Blanc-Brude andMakovšek 2013 include a literature review). On this measure, systematic cost overruns for roadinfrastructure are found to average below 9% under the traditional approach4.Infrastructure operation under the traditional modelOperational efficiencyOnce infrastructure is delivered, its management and operation is traditionally transferred to astate-owned infrastructure manager. The challenges typically faced in the operation phase include poorperformance incentives and an under-recovery of efficient life-cycle costs.Infrastructure managers share several characteristics with natural monopolies (sunk costs thatlimit new market entrants, economies of scale and scope, etc.). Accordingly, they are not subject toadequate competitive pressures that would provide incentives to innovate or reduce costs. Forexample, within large monopolies unions organise more easily and can exert considerable power onthe company and its owner (Salinger 1984, Rose 1987, Hendricks 1977). In a related point, Savedoffand Spiller (1999) explain how the threat of government opportunism leads publicly owned companiesto protect their cash flows against interventions (e.g. by hiring too many employees or grantingexcessive benefits).State-owned infrastructure managers tend to under-recover efficient life-cycle costs due togovernment short-termism or “time inconsistency” (Helm 2009). Government short-termism stemsfrom voter expectations: voters appreciate a low upfront price with little concern for the consequencesfor the distant future generation from running down the asset. Persistent lack of renewals caneventually lead to (non-linear) excess current maintenance requirements, which entail even higherexpenditure than before.Effectively the incentives for efficiency are dependant solely on how well the state performs itscorporate governance function.Operational flexibilityThe advantage of the traditional model during the operational phase is that the government hasdirect (or indirect) control over prices, quantities or service levels. If economic or technologicalconditions differ to those that were expected when an infrastructure investment was made, thegovernment is able to implement changes without any contractual penalties or without costly or timeconsuming renegotiation procedures.410A related, but separate, part of the literature measures performance against “decision to build”estimates that are made earlier in the project life-cycle (i.e. during the “project selection” stage, e.g.Flyvbjerg 2002, 2003; Odeck 2004; Cantarelli 2012a,b; Makovšek et al. 2012). This literature findsthat transport infrastructure costs between 8% and 40% more than is estimated initially.ITF Discussion Paper 2016-1 — OECD/ITF 2016

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelAn adjustment in the national transport policy for example may require a change in theinfrastructure development plans. In roads or railways for example, demand on each section of thenetwork affects demand on the other links. If a major part of the network was managed by differentPPPs a more radical change in the network would require a renegotiation with all the PPPs that wouldbe affected by the new policy.Assessment of the traditional modelUnder government ownership, infrastructure is financed with public funds or through governmentborrowing, which has a lower cost than private financing5. The government also has greater flexibilityto respond to changes in future circumstances without contractual penalties and complicatedrenegotiations.Against these advantages, the main challenges for the traditional model of infrastructure deliveryand management is the weak incentives to maximise a project’s value across delivery and operation(including a lack of certainty of on-going funding).Towards private participationIn economics it has long been theoretically argued, but only recently empirically established, thatthe performance of the private ownership in a competitive market is superior to public ownership(Meginson and Netter 2001). In recent decades, some countries have aimed to apply this success ofprivate ownership to network industries. However, the natural monopoly characteristics of manynetwork systems (sunk costs, long lived assets and externalities) mean a simple application of privateownership would lead to multiple market failures. As such, some form of government interventionremains necessary to achieve socially optimal outcomes. For instance: Setting the appropriate investment allocation – Helm (2009, 321) notes that it is ultimatelythe state that decides on the overarching objectives of expenditure programmes, includingpublic infrastructure. Externalities – It is impossible for the investor to directly capture positive externalities and tomonetise them and he will not voluntarily be held liable for the negative externalities.Addressing both would be in the interests of society. Sunk costs – because investments in large physical infrastructure are sunk, it is unlikely thatprivate investors would commit to investments where there is a risk of expropriation.Participation of private capital in infrastructure delivery and management in suchcircumstances is not possible in the long run. To make it possible, a credible commitment bythe government is necessary.The next two sections present two approaches that have evolved to introduce more private sectorinvolvement in network infrastructure development – the RAB under incentive based regulation andthe PPP. A brief description of each approach is followed by the analysis of the delivery and operationdimensions as above.5This issue is partly addressed in the PPP section. However, an in-depth discussion of whether this isultimately the case is outside the scope of this paper.ITF Discussion Paper 2016-1 — OECD/ITF 201611

Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelThe Regulatory Asset Base modelThe previous section summarised that capital-intensive network industries have manycharacteristics of natural monopolies, which imply that the development of fully fledged competitionis not possible. While the traditional approach to this ch

The International Transport Forum The International Transport Forum is an intergovernmental organisation with 57 member countries. It acts as a think tank for transport policy and organises the Annual Summit of transport ministers. ITF is the only global body that covers all transport modes. The ITF is