Larry Summers uses the deferred-maintenance-as-expensive-debt in recent post:

“Borrowing to finance maintenance should not be viewed as incurring a new cost but as shifting from the fast-compounding liability of maintenance to the slowly compounding liability of explicit debt.”

OK, I certainly agree with the debt analogy. But regarding the proposed (implicitly obvious) solution that on-balance sheet borrowing is cheaper, this is true but an ivory-tower observation. The problem is that although “explicit debt” will almost certainly have a much lower interest rate than deferred maintenance accrual cost, it is also on-balance sheet (using up statutory debt capacity), requires fixed repayment and is less flexible.

And not as if budget flexibility is getting less important – here’s Moody’s view in a recent Governing column:

“As a result, revenues become more unpredictable and policymakers have to become more cautious. Unfortunately, it looks like that dynamic is here to stay.”

I think “more cautious” does not mean “more prudent” in the long run but is in fact consistent with leaving expensive liabilities in place if they’re off-balance and flexible and the only alternative is traditional debt.

Both of these observations point to possible role for innovative P3s that are debt-like (i.e. cheap like an availability payment) but also flexible for in effect refinancing deferred maintenance (along with financing upgrade/expansions too) on existing social infrastructure.

So I guess that’s the case for brownfield P3s — not really a “sale”, or a “monetization” or “asset recycle” — but in fact more like transferring credit card balances from a stupidly-expensive card to some other relatively flexible (but much cheaper) form of borrowing.  Not exactly complicated?

One quick clarification when I refer to P3s as a ‘second-best’ solution to revenue volatility in various places – I don’t mean they should be considered a ‘less-bad gimmick’ than real outside-fiscal-constraints culprits like deferred maintenance and underfunding pensions.

Those gimmicks are bad because they’re expensive and opaque. P3s can and should be consciously structured to be cost-efficient, transparent and discipline-enforcing, even if part of their purpose is to provide some down-cycle relief to fiscal constraints. Explicitly measuring P3 value in that way also highlights why first-best solutions for revenue volatility (e.g. bigger rainy-day funds, more stable mix of revenues etc.) should be the ultimate goal, especially if the real cost of the current set of gimmicks is further exposed in the process.

So I think P3s done primarily for fiscal constraint relief can be put on the good-guy side of public policy if (and maybe only if) they’re done correctly.  Since you can’t really hide something as big and obvious — and usually controversial — as a P3, I think a lot of people will be making sure that happens.  Contrast that to just sweeping deferred maintenance under the fraying rug.

There is plenty of interaction between public infrastructure and public pensions. The two sometimes seem to be the Scylla and Charybdis of US state and local crises – if you can avoid one, you’ll be wrecked by the other.

One more hopeful angle in this connection is an idea which surfaces often – if public pensions would just go ahead and invest in low-risk, steady-return, non-volatile public infrastructure, then both crises start to fix themselves. And P3s are the mechanism by which this can happen.

Maybe – but I’d bet not in the way described, despite some fundamental validity in the concept. There are intrinsic limitations to P3 development in the US re US public pension investment in that area, and these limitations will likely determine a development path which might be very different:

• A lot of essential public infrastructure is indeed “low risk” – low-tech, long-lived physical assets whose revenue streams are mandated through taxes or based on monopoly power. But why would highly-rated US state and local governments sell these low-risk assets? Absent short-term fiscal constraints, the long-term cost of capital for most US local government is probably much lower than private sector targets, mainly because taxpayers are captive investors who both require and receive the benefits of local infrastructure.

• You could argue that for a small community and a large project, there could be some diversification benefit from selling stakes, even for low risk assets. But how often does that happen? Small communities usually only need small projects, and the big projects get done by states or big towns or cities. Even a mega-project for California or NYC doesn’t pose material risk to their overall portfolios or economies. Boston survived the Big Dig – a lot of waste yes, but even so, I don’t think the project moved the needle on the city’s muni bond rates.

• There’s a better argument I think for public sector transferring low-risk infrastructure assets (or the opportunity to build them) to their own pension funds as a kind of “payment in lieu of cash” that also has some political alignment benefits and fiscal constraint relief. I think this is what was happening with the Australia Queensland Motorway deal and maybe applies to Montreal transit/Caisse deal too. But it seems that this type of deal requires a level of social consensus (and centralized authority?) that might be rare in US context. US public pensions are already a very controversial issue, including about “fairness” and other red-hot buttons, so I don’t see transfer-in-lieu-of-cash deals happening here (at least overtly). Of course there have been and will be US infrastructure sale/leaseback-type deals where the cash proceeds are used to pay down pensions (Allentown, Bayonne, etc.) but in these the investors are operating companies and the deal is in part justified by needed expertise or major capital improvement – so no role for pensions in the asset per se.

• I think what actually ends up on the private infrastructure market are “high-risk” deals – risky either because the public-sector credit is dodgy (Puerto Rico airport, Greek ports, maybe the Portuguese toll roads?) or there’s higher technology/non-monopoly business risk (water desalination?). I think there’ll be strong growth in this sector globally and maybe in the US – but is there a role for US public pension equity stakes in this risk/high expertise category? I’m not sure about this – this is where I tend to agree with the DB analyst and your colleagues. If the asset profile is so risky that the local public sector needs to sell it, then it’s probably too risky for public-sector pension funds – certainly not a low-risk slam-dunk in any case. Also, it’s hard to see any intrinsic competitive advantage that US public pension funds have in this area – even if they buy/develop expertise, they’ll be competing with specialized industry investors. Even as a co-investor, absent any political angle (always a bad way to go) I think the best they’ll do is secondary market-type returns – not necessarily bad, but nothing special.

So in general I don’t think a special role for US public pension investment in infrastructure will develop along risk/return lines – the low-risk stuff is not for sale, and public pensions don’t have any special advantages (in fact many disadvantages) re the high risk stuff. But I do think there’s a special role for US public pensions – both in terms of their intrinsic capabilities and developing unique expertise — in providing specialized infrastructure debt capitalization for highly-rated US local governments to help them mitigate the impact of fiscal constraints:

• By “fiscal constraints” I mean the type of balance-budget rules, statutory debt limits, prohibition on short-term debt, etc. that are almost universal in the US public sector. The constraints provide good discipline in the long run (and probably big reason why local government highly-rated in first place). But when revenues become volatile, constraints can cause arbitrary short-term restrictions that lead to expensive and inefficient actions – deferring needed maintenance and investment, delaying pension funding, stop/start social programs, etc. during the down cycle and unsustainable new spending during upcycles. All of this is a lot more expensive than it should be, especially in context of the real low-risk long-term profile of the US public sector.

• The first-best solution is to change the rules to provide for more efficient approach to revenue volatility – but not likely to happen soon and maybe not practical. The third-best solution is budget gimmicks and inefficient deferrals – what we’ve got, and nobody likes it. In reality – all the hype aside – I think the main interest in P3s in the US really stems from their potential as a second-best solution to allow infrastructure investment and financing to operate outside some fiscal constraints. Classic example: AP P3s are used mainly to create life-cycle maintenance discipline and avoid hitting statutory debt limits. Main value of a demand-charge P3 for monopoly-type infrastructure is probably to reduce the public sector revenue volatility. Nothing to do with risk transfer and often not much about cost-savings at the project level either – really about fiscal management.

• By definition, second-best solution is not as good as first-best. But the point is that they are better than third-best gimmicks used now. Unlike hidden deferred maintenance and kicking the can on off-balance sheet pension funding, a P3 can be transparent and provide specific, contractually-based relief for some fiscal constraints where the outcome is measurably better in the down cycles and discipline during the up-cycles is enforced.

• If P3s-as-second-best-solution is the reality for low-risk infrastructure, then the question becomes: how could the product be improved? I think one answer to that could be a focus on P3 debt capitalization that is better suited for volatile tax or project revenues than the muni bond market. In effect, current AP P3s do some of that re statutory debt limits. But there’s scope for more – repayment not fixed schedule but tied to fiscal conditions, non-recourse positions on essential assets, down cycle maintenance financing etc.

• I believe that US public pensions – with their large pools of long-term liquid funds and natural alignment/experience with the public sector – could be a big source of such specialized debt. The debt needs flexibility in timing and terms of repayment but not ultimate risk, so fundamentally investment-grade. There’s potential for above-market returns on a bigger scale of investment, which I think is what pensions need (vs. small but risky equity home runs). And this is one area where public pensions have the basis to develop some unique expertise – they already exist in (and suffer from) a context of public sector constraints and many of their trustees and officials are public-sector people who understand the fiscal budget realities. In effect, they’ve got an inside track to understanding how to mitigate fiscal constraints (to design specific relief) but at the same they are obligated to act in the interests of their beneficiaries (that’s where the discipline comes in).

• To the extent this is true for debt capitalization of new infrastructure investment, I think even more relevant for “asset-recycling” brownfield recapitalizations – in these cases the whole focus would be improving the capitalization of existing assets re fiscal constraints, so pension fund capabilities even more central to possible solutions. Transactions in big scale and near-term. Where the proceeds of the recapitalization go to paying down unfunded local pension liabilities, there’s possible added benefit of that local pension becoming familiar with product and in turn investing in another city’s or state’s recap – precedent seen up close is powerful factor in adoption – before they just dump the proceeds in the stock market.

Bottom line: While I agree with the idea of potential synergies between P3s and pensions, I don’t see risk/return being the fundamental driver in market development. Instead, I think US public pensions have unique potential to provide specialized debt capitalization and recapitalizations for infrastructure P3s as second-best solutions for fiscal constraints. I think this is where a large market will actually develop.

As a follow-on to my post the other day, here’s some further thoughts on risk and uncertainty, applied to revenue volatility:

• If long-term secular trends reflect low risk levels, fiscal volatility should revert to a mean where essential spending is almost certainly accomplished in the long run – that is, there is a low risk that the public sector will default on its fundamental obligations. This is true of most US state and local governments. But the path to get there is highly uncertain.

• Non-wealthy taxpayers and especially beneficiaries live in the short run, so for them a high level of uncertainty results in a high risk that something bad will happen. Contractual recourse for certain redress in future is not available to them – the ballot box is not at all precise or responsive. So allocating uncertainty to these parties is effectively allocating risk (in the sense of a “predictably bad outcome”).

• In contrast, infrastructure commitments are intrinsically long-term, which sets the stage for institutional investors to take a long-run view and incorporate the state’s low risk profile in their agreements. With detailed long-term contracts, the outcome of short term uncertainty (e.g. low payment this year) can be precisely and certainly addressed in future (e.g. a higher payment at some point). In effect, the state can allocate a high level of uncertainty – but not risk – to the investor.

• More specifically, cost-effective flexible debt capitalization can deal with the uncertainty of cash flow timing as long as the risk of ultimate repayment is low. Over the course of a 30-year infrastructure financing, a AAA-rated state is well-positioned to provide that assurance.

So overall, a P3 solution can allocate short-term fiscal uncertainty to the private sector (which is able to deal with this efficiently) but long-term risk would be retained by the state (which is well-positioned to keep it). This will reduce the harm of uncertainty when it results in a high risk of a bad outcome – directly for the infrastructure (planning, deferred maintenance) and indirectly for other “crowded out” spending programs (especially social services).

A minor additional point: one objective of a traditional-type P3 is “risk transfer” – it is useful to make it clear at outset that next-generation P3 is different, focused on “uncertainty transfer”

Something surfaced in a recent book I read by Mervyn King (ex-BoE governor) called End of Alchemy — the relevant parts are about about the limits of risk management in central banking.

One of King’s central points is that  “risk” is actually fundamentally different than “uncertainty”.  Risk, when strictly defined, includes more/less quantifiable probabilities that you can “optimize” around.  That does sounds familiar.

But “uncertainty” (“Knightian uncertainty” is the technical term, it seems) is by definition unquantifiable – and the best you can do is “cope” with it.

King then shows pretty convincingly (and consistently with my own experience) that central bankers, securitization experts, rating agencies, etc. all thought they were modelling “risk” to a high level of precision in the lead-up to 2008 FC — but they really weren’t.  The probabilities were not remotely correct.

In hindsight, that seems pretty obvious — even 20 years of data is meaningless in context of modelling something so complex as human financial markets.  Maybe a million years would do?

So for complex economic processes, it’s better to “know that you don’t know” and assume “radical” uncertainty — and then set yourself up, not to model precise outcomes, but ways to cope when the SHTF, to be blunt.

It dawned on me that a lot of this applies to P3s when we talk about “risk transfer”.

Maybe that’s valid for some specific physical properties of an infrastructure asset component.

But for something as complex as toll road usage?  Not likely.  If this risk gets transferred in a P3, it’s not “optimizing” risk allocation but naked speculation — one side will win big, and one side will lose.  Or neither. Or both.

The better question in a P3 risk transfer is not “who might win?” but “who can cope with this better when the SHTF?”

It strikes me that some of the lessons apply to practical modelling of P3 value – and that maybe the real role of P3s for complex assets like infrastructure is less about transferring insurable risk (because there’s not much of that actually) and more about the ability of the private sector to “cope” with uncertainty more efficiently (which seems true and might be actually measurable).