CBO Study Gets It “Almost” Right on Highway Public-Private Partnerships

Best federal study yet on highway PPPs still gets a few things wrong

“Highway PPPs Don’t Always Cut Costs, CBO Warns.” That was the rather sensationalist headline on The Bond Buyer‘s January 10th news story on the release of a new report from the Congressional Budget Office, “Using Public-Private Partnerships to Carry Out Highway Projects.” Despite what some might consider that negative finding (although, it’s true, as I will explain), the CBO has done what I consider the best job thus far of any federal report at explaining to Congress the real value of public-private partnerships for highway infrastructure.

By far the worst job was a July 2011 report by the Department of Transportation’s Office of Inspector General (OIG), which I critiqued in my August newsletter. That report’s main criterion for judging whether a public-private partnership (PPP) is better than conventional procurement is their relative cost of capital. Because a private concession company seeks to make a profit (in technical terms, because the cost of equity is higher than the cost of debt), OIG dismissed PPPs as “more costly” than conventional procurement.

In sharp contrast, the economically literate analysts at CBO understand that a valid cost comparison must quantify the risk transfers involved in a public-private partnership, especially long-term PPPs. In conventional procurements, the public sector takes on the risk of construction cost over-runs, late completion, and (if it’s a toll project) the risk of insufficient traffic and revenue-all of which are typically transferred to the concession company in a long-term toll PPP. Those potentially large costs to the public sector (i.e., taxpayers) were ignored by OIG in making its simplistic comparison. By contrast, CBO discusses risk transfer as one of the main benefits of a well-structured PPP procurement. And when the value of those risk transfers is taken into account (as well as today’s widespread availability of tax-exempt debt for PPPs), CBO concludes that the financing costs are about the same between conventional and PPP procurements.

The CBO report also does a good job of explaining the different role of incentives in (a) conventional design-bid-build highway contracting, (b) design-build procurement, and (c) long-term design-finance-build-operate-maintain procurement. Comparing (a) with (b), there is much larger scope for costly change-orders in the conventional approach, whereas when the designer and builder are the same team, and operating under a fixed-price contract, they have strong incentives to value-engineer the project to stay within the budget; they also have stronger incentives to get it completed on time. Even stronger incentives are at play when the same entity not only designs and builds the project but is also responsible for operating it and maintaining it for 50 years. That means it would be foolish for it to cut corners on construction in an attempt to minimize the initial cost, because as the de-facto owner/operator for 50 years, its aim is to minimize life-cycle costs. (Hence, it may well spend more up-front on durable construction that costs a lot less to maintain, which the public sector almost never does.) CBO’s analysts do a good job of explaining these critically important points, to which the OIG team seemed oblivious.

Those good points notwithstanding, the CBO report suffers from two blind spots which are typical of the federal mindset (from Treasury to the congressional tax-writing committees to GAO and CBO). First, the analysts argue that PPPs (in the form of toll concessions) will not increase the amount of highway investment, because, after all, the money must all come ultimately from the same tolls and/or highway fuel taxes as in purely public-sector projects. In an abstract, academic sense that may be true. But in a real-world, political sense, it is demonstrably false. What long-term toll concessions are doing is, as some critics have put it, “outsourcing the political will” to use market-based tolls.

One example (out of many) is right under their noses just outside Washington, DC: the express toll lanes being added to the Capital Beltway under a long-term toll concession. The only solution the Virginia DOT had to the Beltway’s chronic congestion was a $3 billion plan to add high-occupancy vehicle (HOV) lanes. That plan was going nowhere, partly because it required massive property takes but also because VDOT had nothing approaching $3 billion. It was the private-sector (Fluor and Transurban) that proposed instead a $1 billion project to add the same amount of lanes but using congestion pricing to pay for it (and a less-grandiose footprint that cut the cost by eliminating nearly all of the property takes). Sure, in theory VDOT might have eventually thought of that, but in the real world they didn’t. Nor should they have saddled the taxpayers of Virginia with the traffic and revenue risk that Fluor/Transurban has willingly taken on.

The other misconception concerns federal tax revenue. The CBO report repeats the mistake of considering the private sector’s use of tax-exempt revenue bonds for such projects as a net cost to the federal government. This is incorrect for two reasons. First, in the real world, few if any of these projects would be done as PPPs if tax-exempt debt were not available; hence, the model that says the feds would otherwise be collecting tax revenue from buyers of taxable toll revenue bonds is highly unlikely. Instead, if done at all, the projects would be done by state toll agencies which have always used tax-exempt municipal bonds. So there is no difference in federal revenue from bond interest between a PPP project and the traditional state toll agency alternative.

The other reason it’s incorrect, which CBO misses, is that as a for-profit toll road industry starts building and operating highways that would otherwise continue being done by public-sector bodies, the net difference to federal coffers will be the corporate income taxes paid by (we hope) profit-making toll road companies. Ironically, the OIG report acknowledged this difference, but considered it yet another disadvantage of PPPs-they have the “added cost” of paying taxes!

Despite those concerns, the CBO report is still the most insightful assessment yet from a federal agency, and is well worth reading.

Robert Poole is director of transportation at Reason Foundation.