Monday, July 30, 2007

Private toll roads: take the money (and concrete) and run?

There's a big debate going on in Texas about private toll roads, especially for the Trans Texas Corridor. The legislature slapped a two year moratorium on them last session, although with enough loopholes to be pretty toothless. I've been very skeptical myself. Private companies have an inherently higher cost of capital (their bonds aren't tax free like municipal ones, and they need a profit margin), and 50+ year non-compete clauses scare me. Who knows what roads will need expansion over the next 50 years? Can you imagine what a mess Houston would be today if we were stuck with the roads - and capacities - planned in 1957? It seems better to have the flexibility of a public agency, like HCTRA or TXDoT, that can adapt its road network to changing growth demands, rather than being locked in to a bunch of multi-hundred-page private contracts (and people have noted to me that these companies hire higher-dollar lawyers than the government - not a good sign for the public toll/taxpayer).

But I've recently been thinking about an alternate view. A tremendous amount of private capital is sloshing around out there in private markets just itching to build infrastructure for a decent return. All of the private investment models assume status quo trends in growth and commuting. But what if we're going into a long-term mega-boom in gas prices as global demand outruns supply, as well as getting near the tipping point on telework technologies? (aka "why am I driving an hour a day to go from one computer screen to another?") That could radically reduce commuting and the tolls they might be able to charge. If we assume that is a likely future scenario (and I believe it is), then the best strategy for the state is to collect billions in road building and cash (they prepay for the concession) now while the market is hot, knowing that these investors are likely to lose their shirts over the long haul, but by then it will be too late - the roads will have been built, and they aren't going anywhere. Texas gets the infrastructure, and private investors eat the cost.

It's a very viable scenario. But it does require quite a leap of faith to think you're smarter than the market. And I'm usually a believer in the wisdom of crowds/markets. But in this particular case, I think the market is ignoring the potential impact of these changes (energy costs, telework) on their returns. Why? Mainly because of the short-term focus of our financial markets and money managers. They want their bonuses this year and next year. To be perfectly honest, they don't care too much if they buy some bonds for their clients that implode in 2012 or 2020 or whenever (that's someone else's problem). What matters is how those investments look in their portfolio today, and they look good based on past history (shades of Enron, anyone?).

So should Texas take the money and run? I'm not sure this completely turns me in favor of private toll roads. But maybe it brings me back to a more neutral stance, since I can see a happy outcome either way. It'll be interesting to see how it all plays out. Stay tuned...

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25 Comments:

At 8:23 PM, July 30, 2007, Blogger Max Concrete said...

You describe this scenario as very viable. I would call it possible but highly improbable. I think the investors are looking long term and concluding that potential gain outweighs the risk.

First, the rapidly expanding population will offset reductions in driving due to increased use of telecommuting (assuming there is any increase in telecommuting.) The latest forecast I saw was for 31 million in 2030, and of course population will go much higher over a 50-year toll concession.

Second, if gasoline prices zoom upward, consumers will shift to smaller cars to allow continued increases vehicle-miles driven. Technology will advance; it is hard to know how far and how fast, but we can expect big changes within 50 years to allow more driving with less petroleum.

Third, even if these projects lose money it does not mean that tolls will go down or restrictions disappear. Most likely non-performing projects would be sold at their new market value, and investors would be extra diligent in raising tolls and enforcing restrictions on competition (ie publicly-funded alternatives). After all, monopolies are what investors want.

So that leaves the concession fee which TxDOT will be able to extract from investors on a few projects. In Houston, most likely the only large concession fee would be produced by the Grand Parkway (something like $1 billion in an estimate I saw). Even the richest projects, like SH 121 in suburban Dallas, are on the order of $2 billion. Let's just assume that all of hypothetical $1 billion concession for the Grand Parkway is unwarranted by future revenue. In theory that's a $1 billion gain for the public, but look at the consequences: no control of tolls, the loss of the ability to expand alternate routes, and loss of the public interest in decision-making for 50 years. And for just about everyone reading this, 50 years is forever for practical purposes.

 
At 7:47 AM, July 31, 2007, Blogger Tory Gattis said...

All good points. But it's all relative. Bidders are bidding now knowing current population trends and gas cost expectations. Anything unexpected that mitigates those expectations means they overpay. If the demand is not there, they will have to reduce tolls to increase demand and maximize revenue (or at least not raise them as much as they thought they would be able to).

You're very right about the noncompete risk still being there. And I also realized after I made the post that this really applies more to urban projects than the TTC, which is not as driven by commuting.

 
At 8:42 AM, July 31, 2007, Blogger Ian said...

Sometimes you confuse me. You argue about the sanctity of the single family auto suburb and government's need to keep the hell out of regulating it... unless it's for subsidizing the huge cost of highways (and other infrastructure) to build more single family auto suburbs.

Anyway, I've already given up on the whole highway thing. If they all vaporized tomorrow, I'd still get around just fine. I don't use them to get to work, and I don't use them in day-to-day activities. Nothing I hate more than spending an hour a day in a car, spending my mental energy trying to drive. Let's just say I've already positioned myself for a 'long-term mega-boom in gas price.' I'd recommend the same strategy to most other people, because I'll comment on the whole telecommuting thing: it is not a replacement for being in the office. At the least, it definitely won't save the single family auto suburb.

 
At 9:43 AM, July 31, 2007, Anonymous kjb434 said...

Ian,

You've said you've given up on highways, but the reality is that you desperately rely on them daily whether you use them personally or not.

Highways are the life engine of the US and we are now seeing European and Chinese economies (both or rapidly expanding their road networks).

More goods are moved through the national highway network than air and rail (an rail cargo is expected to increase dramatically in the coming years and still won't catch up).

So the reality, if highways disappear, your life will be substantially affected.

 
At 9:52 AM, July 31, 2007, Anonymous Brian Shelley said...

I can’t swallow the whole idea of roads being cheaper because the government has a cheaper cost of capital. If this were true then we should push the government to nationalize every industry.

It is possible that the government could build these roadways with less up front capital. However, the government cannot economize like a private entity. Their bidding process is not totally centered on the lowest bidder like a private company. There are minimums for minority-owned and small employer companies. There are political demands as to where overpasses and connections be built. These aren’t huge, but they are important.

The real waste is in the operation of the tollways. Politics will set the price of using the road like we recently saw with Harris County and the congestion pricing attempt for Westpark. As with any government agency, because profit is not the main focus excess resources are used.

Government doesn’t run things cheaply, not because it is run by idiots or lazy slobs, but because their focus is keeping everyone happy instead of striving for efficiency and profits.

 
At 11:10 AM, July 31, 2007, Anonymous Anonymous said...

That idea sounds okay in theory, but the non-compete clause is too long.

Also, politicians like to get re-elected, and that means bringing home the bacon for their contributors. In this case, it would likely mean re-negotiating those 50-yr contracts to give more $$$ to the companies that foolishly signed the original contracts which did not allow for much of a profit margin.

 
At 3:08 PM, July 31, 2007, Blogger Tory Gattis said...

> unless it's for subsidizing the huge cost of highways

Again, it's not a subsidy if it's paid for by users, either via the gas tax or user tolls.

Brian: I agree with most of your points. But because municipal bonds are tax free at the federal level, it does give them a lower cost of capital. Investors are happy to take 4% bonds from a govt entity, whereas they would want 6%+ from a private entity. Then there's the required profit margin privately. But you're right on the messed up incentives. Don't know how far that goes to mitigating the cost of capital difference.

 
At 3:27 PM, July 31, 2007, Anonymous Brian Shelley said...

Tory,

Am I missing something? Why does it matter that the cost of capital is higher? Wouldn't they be privately funded?

 
At 5:11 PM, July 31, 2007, Blogger Tory Gattis said...

Let's say it's a billion dollar road that needs to be built. A public entity - like HCTRA - can float tax free bonds at around 4%, and pay them off with the tolls. A private entity will have to pay much more for both its bonds (taxed) and profits for equity - then pay that off with higher tolls. Run a 30-year amortization at 4% vs. 6+% (really probably a blend of bonds around 6% and equity around 10+%), and you'll see a huge difference in the total cost - and the toll-payer has to eat that cost.

All that said, I think these deals sometimes find a way for the private company to use municipal tax-free bonds for financing, using a government entity as a middleman.

 
At 5:12 PM, July 31, 2007, Anonymous Anonymous said...

The biggest driver of value difference between a public and private owner of a toll road is the toll rate structure. A public toll road agency is subject to much more public pressure to keep rates lower (e.g. westpark) than a private owner. This more than offsets any cost of capital difference and, all else being equal, makes the road more valuable in private hands. If you take away the non-compete provisions though, that introduces tremendous uncertainty into the model and reduces the value (and the concession payout to the public) considerably.

 
At 9:29 PM, July 31, 2007, Anonymous Brian Shelley said...

Tory,

A little ECON 301. For a single company, they strive to set their price equal to cost plus profit margin. Fortunately for the consumer they don't have to take this price. The profit maximizing price for the toll road company does not necessarily equal costs + profit margin.

No matter how they built the tollway, consumer's preferences don't change. They will react to the price. If they think that costs + profit margin is too high they won't drive it. It's supply AND demand that sets the price, not the input costs.

Many new cutting edge products have prices well above costs. We have seen the margins on gasoline skyrocket recently. In a highly competitive market the prices will tend to approach costs + opportunity costs because other companies will want to get in on the action, but I don't think a tollroad counts as a highly competitive market.

 
At 8:21 AM, August 01, 2007, Blogger Ian said...

"Again, it's not a subsidy if it's paid for by users, either via the gas tax or user tolls."

I know this is off topic, but I didn't bring it up (I think other Ian did). Government funding of highways may not technically count as a subsidy, but it by no means relies on free market principles either. To wit: highways are typically funded by ginormous bonds that are only repaid by user fees as the demand for the roadway grows. Transit is funded by a similar mechanism, true, but when has transit ever received as many "non-subsidies" as did, say, the Interstate system? God said "let there be roads" -- and there were tons of roads everywhere. God said "let there be mass transit" -- and we get some buses serving poor parts of town and EVENTUALLY a light rail or two. Fair? I think not. Smart? Definitely not.

 
At 8:29 AM, August 01, 2007, Blogger Ian said...

"I'll comment on the whole telecommuting thing: it is not a replacement for being in the office."

Now, more on topic: I agree, telecommuting will never replace the office. Such a system would completely undermine one of the primary draws of a city: having people and ideas in close proximity for spontaneous innovation. My office has strongly considered going "virtual office" to cut down on rent costs and decrease commute times -- but I doubt we will ever do it because working with someone over the phone cannot replace working with someone on a project face to face, looking at maps, quickly pulling out reference books. Only when the virtual world reaches the level of "The Matrix" may teleworking be feasible -- but then, what's the point? We'll still have virtual commutes!

 
At 9:01 AM, August 01, 2007, Blogger Tory Gattis said...

On telecommuting: agree it doesn't replace face-to-face, but you don't need face-to-face 9-to-5 Mon thru Fri. You can come in occasional days or just a few hours for key meetings, and do the rest from phone and computer. Recently read that the *average* office employee now spends 3 hours a day on email. And very high quality video conferencing is coming very quickly (I've seen the demos, and it gets cheaper by Moore's Law), which will further reduce the needed office face-to-face time. All of these reduce commute demand during rush hours.

 
At 9:08 AM, August 01, 2007, Blogger Tory Gattis said...

Brian: can't argue with any of your economics. But you can't get past the fact a private company's financing costs are higher than govt, because of our tax code. Cost of money is just as big a deal, if not bigger, than cost of concrete and construction equipment. If, as a politician, you want the lowest possible tolls for your facility and voters, you need to keep costs down.

 
At 11:52 AM, August 01, 2007, Anonymous Brian Shelley said...

Let me reiterate more succinctly. Costs do not set the price of anything. Customer demand sets the price.

 
At 12:58 PM, August 01, 2007, Anonymous kjb434 said...

^^^

I agree with Brian on this one. It's no different with Sony and Microsoft selling there game systems for below cost to win market dominance. The prices for their devices would be way above the price point the vast majority of game console players would pay for.

The same thing for the toll roads. There will be a price point where people will not ride.

 
At 2:13 PM, August 01, 2007, Blogger Tory Gattis said...

Point taken. Then let's flip it around. Let's say there's an optimum price that maximizes revenue over the life of the road. Let's just say that total maximum revenue is $2 billion. If the govt builds it for $1 billion, they can take the extra $1 billion and use it elsewhere. If a private company spends $1.5 billion, because of higher financing costs, they will only have $0.5 billion left over, which they will bid to win the contract. In the first scenario, the public gets a billion, in the second, we only get half a billion. Costs are costs. They have to come out of someone somewhere, and higher is always worse.

 
At 8:02 AM, August 02, 2007, Anonymous kjb434 said...

^^^
Tory,

That may be another reason to keep it non-privately operated. If a toll agency such as HCTRA has an extra $100 million laying around at the end of the year, the public will want to know what will it be spent on.

Many of times it gets spend on toll road upgrades. Harris County is also using it for non-toll road construction and maintenance. I've worked on several county road projects for Harris County that utilized toll revenue for engineering and construction costs.

A private company would see this as income and potentially mostly profit.

 
At 8:52 AM, August 02, 2007, Blogger Tory Gattis said...

Understood and agreed. I'm kinda arguing both sides now.

 
At 11:24 AM, August 02, 2007, Anonymous Neal Meyer said...

Before going any further, I would like to point out that various states in America had built more than 10,000 miles of toll roads and turnpikes before the Interstate Highway Act was passed. Those roads were incorporated into the Interstate system and were largely allowed to keep collecting tolls, while the rest of the system was proclaimed to be open free of charge (funded by the imperfect user mechanism of the gasoline tax) to the public.

I've been doing some thinking about the issue of non-compete clauses being insisted upon by private investors who are interested in toll road concessions.

I can understand that interested parties in the private sphere would insist on these as a precondition to operation and ownership of the roads, all in the pursuit of minimizing the investment risks and maximizing profits.

Maybe someone more knowledgeable than I can illuminate, but does anyone know how many private groups are bidding on toll roads and concessions? If there are only one (or a few), then the winner could insist on non-compete clauses as a precondition to participating in a project.

It seems to me that there are two ideas which could be leveraged by local and state governments who are looking at encouraging private investment for roads. First, any project would need to have several (or many) entrants into the competition before any project could move forward. Governments would stipulate that winners would get either of their choice:

A) They would get a non-compete clause in return for stiputating that the concession winner must add road capacity if certain levels of traffic congestion are reached, or

B) They would not get any non-compete clause and face the risks. Governments would be free to act to add capacity on their own. Maybe something could be written into the toll concession that would stipulate that some of the tolls would be turned over to the local authority for the purpose of building nearby roads that will compete with the toll road.

As far as telecommuting goes, it seems to me that there is a subset of jobs in the economy for which telecommuting can be employed. For example, if you are a tradesman or a construction worker, then you have to be on the job site - end of story. You can't tie steel or pull zero AWG copper cables from your desktop screen. Also, there are some fields of endeavor in which being in an office environment really does bring extra productivity. In the oil and gas industry, which groups of engineers, geologists, and geophysicists are working on a project, it really helps that they are together, coordinating and bouncing their work off of each other. Gains to be had from telecommuting are arguably harder to reap than many might think on first glance.

Having said all of that, I see no reason why telecommuting could not be employed more. There is no reason why a big portion of our educational system from kindergarten through university could not be networked out, which would eliminate traffic along major arterials and neighborhoods where there are schools. Some parents are already having their kids tutored from teachers in India. The main thing standing in the way of all this is our entrenched taxpayer funded public education empire.

 
At 11:52 AM, August 02, 2007, Blogger Tory Gattis said...

That is a very interesting approach. Of course, either of them increases risks/costs, so bidders will bid less cash up front for the concession, so politicians are less than eager to put these clauses in. They want the maximum money now, and let the noncompete be someone else's problem in a decade or more.

 
At 1:48 PM, August 02, 2007, Anonymous Anonymous said...

Tory,

I think your point on the lower borrowing cost of public agencies is only part of the picture. The other component of the discount rate of the cash flows would be project specific risk factors. Here a private concessionaire is advantaged in that the non-compete, the established toll rate increase schedule, and freedom from political interference in toll increases...etc combine to make the future cash flows of a privately owned toll road less risky than a public one. So all in, the discount rate applied to private projects is probably comparable and may even be lower than publicly owned.

 
At 3:05 PM, August 02, 2007, Blogger Tory Gattis said...

All the factors you listed do maximize the revenue, which I suppose does reduce the overall risk, but I don't know if that's enough to compensate for the extra financing costs. As far as risk reduction, it seems like a public agency can clearly choose to not compete with itself if it likes, and it should be able to at least raise tolls enough to cover the costs of construction (although raises beyond that are politically problematic, which is where the private operator has an easier time).

 
At 7:05 PM, August 05, 2007, Anonymous Anonymous said...

Tory -- interesting post. I just want to clarify a few issues that have come up in the discussion.

On non-compete clauses--they are often trotted out as an argument against private toll facilities. Opponents like to refer to the SR91 express lanes in Orange County as the prime example of why non-compete clauses are a “bad” thing, but the reality is that non-compete/competing facilities agreements have evolved a lot since those days. The modern day "competing facilities" provisions strike a better balance between the public and private interests. They rarely, if ever, ban all "free" road" additions near the toll road. And they usually provide for compensation for reduced traffic, rather than forbidding public-sector roadway additions.

Let's look at the SH-121 project in Dallas, for example. The CDA agreement with the Cintra/JPMorgan team (of course, now looks like NTTA will take over) defined a "competing facilities zone" on either side of the toll road. Certain additions of taxpayer-funded highway capacity within this zone would be subject to compensation, but only if the toll road company can demonstrate reduced traffic and revenue from those new roads.

And the more important point is that excluded from compensation are all portions of major freeways; all limited-access highway lanes; and all projects in state and regional transportation and mobility plans.

So to repeat, the toll road company has no right to prohibit any future road development. Its only remedy is compensation, and only if it can prove loss of revenue. And that remedy only applies to a narrow category of road projects other than major planned projects. Moreover, the agreement would have given TxDOT the right to extra toll revenues due to any positive traffic impacts on the toll road from TxDOT road improvements.

Now it is true that a 50-year toll concession extends farther into the future than typical metro area long-range transportation plans. But the reality is that by 2030, the area near the SH-121 will be so built out as to make it extremely costly for anyone—public or private—to add new highways beyond those already planned. On this point, it’s useful to look to the example of the land near the Chicago Skyway, which the city leased for 99 years. The concession agreement in that case includes no protections from competition at all because the area is so heavily developed that it makes new roadways extremely unlikely. I even heard that the Indiana Toll Road concession originally did not include a competing facilities provision, but that (a very limited) one was added at the request of some legislators.

Now of course, you can negotiate concession agreements that have little or no protections from competition. But the trade-off is that it would further increase the toll road company’s risk, and would presumably decrease the amount of revenue it could commit to sharing with the public sector.

On toll increase & profits--many opponents of toll concessions point to fears of profit-maximizing firms that would raise tolls to sky high levels. But the reality is that concession agreements (Indiana Toll Road, Chi Skyway, SH-130 segs 5&6, for example) include strict caps on annual toll increases, typically indexing them to some measure of inflation (CPI, etc.). The agreement for the SH-121 concession even would have included a far-below-inflation lower cap if inflation levels would have risen above a certain level. Further, actual toll rate chosen may not actually be the maximum allowed. It may indeed be the case that a lower-than-max rate would be the rate that would maximize customer usage & revenues. And governments can always strike a revenue sharing arrangement if returns exceed a certain level. The agreements in TX have all included some variant of that approach.

On costs of capital and discount rates--if you're comparing money flows over time, it's standard to use some kind of interest rate to discount future flows to present value. When an investor makes a decision about an investment, a key issue is the value of the resulting cash flows over time. From the investor's standpoint, the interest rate used reflects the level of risk associated with these future funds. An informed investor will select the appropriate rate to use, depending on the nature of the investment. And a government entity should be given a higher discount rate for the reasons I mention below.

As the ultimate beneficiary, representing the public, the “investor” in this case is some government entity, say TXDOT. It has a choice between two "investments": a private sector proposal or keeping it "in house" with some government entity (like HCTRA or NTTA). From the investor's perspective (i.e., government perspective), the internal costs of capital (public vs. private) are of little concern. They're interested in the annual payment--the bottom line, so to speak. Once a private concession is signed, the annual lease payment is almost certain. It has the same priority for payment as operating and maintenance costs, and must be paid before debt service, taxes, or dividends to shareholders.

But for a public toll authority like NTTA or HCTRA, future payments would come only after the payment of operating costs, debt service, etc.--and only if there is money left over. A reasonable investor would be more skeptical about the value of these future payments than a private proposal, and would assign a higher discount rate to the public authority.

Add into that the conservative tax-exempt bond markets vs. private capital markets that absorb more risk. Private entities doing project-specific financing for new road projects can raise more significantly more capital than a public toll authority. Public toll authorities generally don't do project-specific financing--they have to basically leverage their entire systems to do new projects (like NTTA will do with SH-121, if they ultimately reach agreement with the RTC & TTC), with the inevitable downgrades from ratings agencies. So at some point, after leveraging up their systems repeatedly to take on new projects, they'll become overleveraged and increasingly find it more difficult to take on new projects.

The interesting thing now is that under SB792, local and regional toll authorities now have the power to do concessions (if they're reauthorized during the next session). Florida's toll authorities also recently got the same powers, as did a few in Virginia. So we may see more of even the public toll authorities turn to concessions to get new roads built and avoid the inherent limitations of gov't financing.

Lastly, don’t forget that the feds have established some vehicles—TIFIA credits and Private Activity Bonds, for example—to make tax-exempt funding available for a portion of the costs of new facilities done through public-private partnerships.

Best,
Len

 

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