Innovation happens when new resources become available to meet a defined need.

There’s an awful lot of institutional (and very smart) money interested in US infrastructure — there’s clearly no lack of new resources.  I think the problem for infrastructure financing innovation has been the absence of clarity about public-sector needs.  Everybody knows local governments need something to help pay for infrastructure under difficult fiscal conditions — but what exactly?  Much of the current discussion focuses on privatization or P3s as alternatives to traditional or simple lease-type forms of financing, a binary characterization that is roughly accurate for currently available options — but only marginally useful for developing new ones.

In reality, all current and potential financing alternatives exist on a spectrum of increasing benefits and costs (click on picture to enlarge):

Looking at this way does a few things.  First, it reminds us that there’s no free lunch when smart money invests capital — increasing benefits inevitably mean increasing costs.  So if you’re looking for a solid net benefit, you’ll need to carefully define exactly what benefits are most valuable to you.  Risk transfer on an infrastructure asset is always nice-to-have, but unless you really need it, it’s not likely worth transferring to a sophisticated investor who knows how to price it.  Cost efficiency is obviously a good thing, but efficiency might come at a political price that is not worth paying.  The end result is a focus on identifying real needs, not pre-packaged solutions, which is where we need to start for innovation.

Second, once you start identifying needs, it’s clear that measuring the specific benefit of addressing a specific need (and its concomitant cost) is crucial for designing an alternative that has a compelling case to do it.  This naturally leads to a customized, unbundled approach, which I think dramatically increases the chances that a proposed alternative will work.

Third, and most importantly, thinking about infrastructure financing alternatives on a spectrum provides some real guidance as to where innovation should be focused.  There’s not much scope for innovation in the traditional end of the spectrum (which is inflexible by definition, and perhaps properly so).  On the other end, full privatization and demand-charge P3s are very powerful tools, with lots of potential benefit and cost, but they’re only applicable for a few asset classes and public-sector financial situations.  The middle of the spectrum — on a sliding scale of asset size and complexity, and public sector fiscal constraints — covers a lot of real-world situations in the US right now.  This is where I think the action should be.

When it comes to financing infrastructure in the current economic environment, US state and local governments would benefit from more options.  And private-sector investors are very interested in finding more value-added ways to invest in the sector.

But innovative capitalization options might not fit easily within the public-sector’s current framework of fiscal constraints.  A partnership structure provides open-ended flexibility, but for many assets a full P3 involves too much complexity, transfer of control and cost to be a practical solution. Simple non-profit SPV structures can be effective in expanding the public-sector’s framework, but current versions are limited to traditional financing.

The answer in many cases might be found in the middle — an SPV structure designed to include innovative capitalization options on an unbundled basis, with the capability to develop, evaluate and manage those options.  Here’s an overview of how I think that might work:   Capitalization Management Trust.

There’s much common sense in this column in Politico today. It’s right to say there’s no magic bullet for infrastructure investment. It takes real resources from someone, somewhere to cover the real cost of real assets. Any other view is just a fantasy. That’s the essence – and the dilemma – of funding. You can’t simply create it with talk.

I also completely agree with his point that expanding and improving federal infrastructure loan programs like TIFIA, RRIF and (as he should have included) WIFIA should be one of Washington’s highest priorities. The power of these programs is vastly underutilized, especially with respect to innovative flexible financing to help state and local governments deal with revenue volatility and uncertainty. The nature of loan programs also works well with the federal government’s own budget issues – both political and substantive. A small credit subsidy can support a big volume of relatively low-risk loans, a category that includes most essential public infrastructure. So Congress and the Administration can deliver loan programs with “yuge” volume numbers and potential benefit for state and local governments without doing too much damage to the federal deficit. I’m guessing that this alone will lead to a radical expansion of loan programs when all the other options are proved to be too expensive or controversial. Maybe Rahm is just getting ahead of a parade he sees must come eventually? Not at all surprising for such a political insider – and, as such, actually encouraging.

But he seems to be missing something: Financing (debt from the private sector or loan programs like TIFIA) needs to be repaid from funding (taxes or user fees from someone, somewhere). Although they’re both measured in terms of money, financing and funding are not at all the same. Financing doesn’t actually “pay” for anything. It just shifts the timing of eventual payment, which must be funded. Yes, a low or subsidized interest rate helps lower the eventual funding need a bit, but even if rates are zero, principal repayment is required. So you’re back to the original problem: Where will the funding commitment come from? You could fairly restate Rahm’s sentence at the end of the first paragraph as: “Any plan for financing infrastructure that does not include funding is fairy dust.”

Is Rahm confused about the difference between financing and funding? Blinded by the fairy dust in dreams of gigantic loan programs? Maybe, but I think that’s unlikely for an ex-investment banker and crafty politician. Certainly a subsidized interest rate would help junk-rated Chicago more than most US local governments, but surely he knows that the city would have to find funding to repay a loan from an expanded TIFIA or WIFIA….

…or does it? Perhaps the column’s transition from strong words about funding’s harsh reality to
advocating a politically-realistic expansion of federal loan programs (with some obligatory local chest-thumping in between) is more subtle and artful than it looks.

In a sense, financing always has one intrinsically committed source of in-built funding: default. If you don’t repay a loan, the lenders have in fact paid for whatever was financed, however unintentionally. In the private sector, the lenders naturally then take the asset they paid for and sell it to recoup. But when the lender is the federal government, and the asset is Chicago public infrastructure – well, things are different. Perhaps the loan will be “restructured” with a much longer term and payment holidays. Or forgiven outright. Either way, federal taxpayers who thought they were providing financing will now be the source of real funding, something they would not have agreed to otherwise (but I’m sure Chicago taxpayers and infrastructure users will appreciate).

Rahm’s complaint about RRIF’s “onerous credit rules” is quite telling. A federal financing program without real credit standards indeed becomes a funding option for a borrower with less-than-stellar credit and pie-in-the-sky income projections. If a financed project succeeds and there’s plenty of user fees, or if tax revenue is growing in a revitalized and booming city, the loan gets repaid from abundant local funding. If not (which is more likely), then hardball negotiation begins in a political context. With some nerve, political influence at the federal level and little to lose in terms of reputation (e.g. you’re already junk-rated), chances are I think very good that the erstwhile financing will – without the bother of much political debate — become funding.

Rahm describes the RRIF program as a “massive bait-and-switch” due to program credit standards and perhaps from a borrower’s viewpoint that’s correct if they were expecting something other than financing. But a “massive bait-and-switch” is exactly what federal loan programs without high credit standards and other lender protections will become for federal taxpayers. A bit of sardonic humor?

I was recently asked to provide a little more detail about what I mean when I talk about P3 “innovation”.  Fair question — no simple answers.  But answering it even incompletely helps concentrate the mind.  So here’s some quick thoughts.

I think there’s actually two broad paths that are likely to emerge, depending on how the infrastructure asset (or its recapitalization) is being funded:

• For tax-funded social infrastructure where P3s are mainly in form of availability-payment P3s, innovation will occur in the actual contractual and capitalization structure of the transaction. This is necessary so that AP-P3s better dovetail into the actual fiscal constraints that US state and local governments face – and there’s a lot of scope for improvement so innovation can make AP-P3s more useful (hence more uptake). This is really the point of the column I have in Governing on the topic and a one-pager about a “built-in rainy day fund” for AP-P3s.

• For user-fee funded economic infrastructure (e.g. toll roads, ports, airports and similar “active business” operations) I think the necessary innovation is not fundamentally in the transaction itself.  Current forms work well, since they’re really modeled on private-sector business, and there’s less need to dovetail into specific fiscal constraints.  Instead, critical innovation is needed in the way that the public sector measures and communicates the value of monetizing the user-fee income stream. This has to be anchored squarely in the public sector’s general fiscal context, not just project-level cost efficiency or risk transfer. It’s always necessary to do a project-level Value for Money analysis to assess potential cost savings from a P3. But a lot of the current interest in P3s and asset-recycling comes governments facing fiscal constraints. So assessing the cost of those constraints – and the potential benefit of P3s in mitigating them – requires an additional evaluation approach beyond the project level. This is of course the general objective of the Stanford ‘Value for Funding’ initiative for improving measurement of P3 value.

For an example of the second path, revenue volatility and uncertainty in general is a real problem for the public sector now – it causes all sorts of additional (and mainly hidden) costs like deferred maintenance and unfunded pension obligations. When these costs are included, the value of a relatively volatile stream of income (like tolls or airport revenues) is reduced. A private sector investor/operator like a toll road investor doesn’t have these type of public-sector constraints and hence doesn’t incur such costs – so the revenue stream is more valuable. Even if every other cost parameter is equal, and even though the public sector’s cost of capital is generally lower than any private-sector company, it still might increase economic efficiency and social welfare for the public sector to monetize volatile income streams. This type of measurement is the concept behind the “Cyclical Accrual” methodology (though that was mainly done for simple, low-risk social infrastructure the  methodology is pretty much the same).

There should also be “innovation” – more like simple improvement or expansion – in the federal programs and policies like TIFIA, WIFIA, PABs, reprising BABs and federal rules in general. But in general I think federal policy/programs/rule reform don’t lead but follow increased demand for P3s (unless there’s a huge subsidy involved like the 2009 ARRA programs – not likely in current federal budget/political environment). So I think the innovation will be driven by the private sector in the two areas above.

Audio version here – view as a slide show and it will auto-run from the beginning.