The Role of Government in Infrastructure Funding

Speech by David Cunliffe MP

Parliamentary Private Secretary to the Ministers of Finance, Revenue and Commerce.

To the 'Establishing and Funding Public and Private Sector Partnerships: Practical lessons from overseas applied to New Zealand' Conference.

Carlton Hotel, Auckland.

Wednesday 28 August 2002
3.30 pm

You have given me a very broad ranging brief, and I intend to respond with a broad-ranging overview of the issues associated with Private Public Partnerships and the funding of public sector investment. I am delighted to be with you today.

"PPP" is an acronym not unlike one I have just acquired - "PPS" or Parliamentary Private Secretary (in my case to the Ministers of Finance and Commerce). In both cases the press has used its imagination for alternative descriptions! However, my remarks today are personal ones, and do not purport to be a definitive statement of Government policy.

The theme of the conference seems to be that private public partnerships are the answer. My response is that in different circumstances they may or may not be. But more substantially, what is the question?

The Government's Approach to Infrastructure Funding

The primary question is what is the appropriate role for public sector investment in a modern developed economy? How that is funded is a subsidiary matter.

We have seen a quite fundamental change in philosophy and practice since the change of government in 1999: a change that is perhaps more substantial than most in the retail media, and even many financial market analysts, have picked up.

Capital Adequacy

The 1990s were a decade of minimalist government. The aim of fiscal policy seemed to be to run operating surpluses. The aim of running operating surpluses was to deliver rounds of tax cuts.

It is fair to say that apart from the early years of "Ruthenasia" - the cuts of the 1991 Mother of All Budgets - the main emphasis of fiscal policy was not reductions in the level of public services. To be sure, funding was squeezed, and it was squeezed at some risk to the effectiveness of service delivery. But it was squeezed not slashed.

>From my distant observations of the practice of the times, it seemed to me that the emphasis was on allowing operating surpluses to grow, partly by banking, not spending, the dividends of nominal GDP - and hence revenue - growth, and partly by pushing hard on reducing the level of public debt. Lower debt meant lower debt servicing costs, which, all other things being equal, meant higher surpluses for distribution as tax cuts.

This was disarmingly - and horribly superficially - attractive.

The superficiality of this approach lay in two of its basic logical weaknesses. The first is that the easiest way to cut debt is not to spend on anything that may need financing through borrowing. Public sector investment - particularly on large infrastructure projects - was cut to the bone. The effects of cuts like that do no show up immediately - or even on the three year electoral radar screen.

But as Rachel Hunter would say, it won't happen overnight, but it will happen. Gradually the infrastructure gets outdated, clogged and even run down.

There have been a number of econometric studies done on the impacts of infrastructural investment, largely inspired by the American economist Aeurbach. About twenty years ago, the conventional wisdom was that infrastructural investment had a multiplier impact on economic output.

That view got challenged by more sophisticated models that looked at the counter-factual. What would have happened if the money spent developing the infrastructure had been spent - or more specifically not spent - elsewhere. Lower public debt, perhaps lower interest rates or tax rates, and compensating private sector investment - that sort of dynamic.

When the dust settled on the computer models, the new conventional wisdom was that infrastructural investment impacts mainly on the rate of productivity growth. It took rocket science to confirm what we tend to know instinctively. There is no point investing in a state-of-the-art, just-in-time rig if it is going to spend eight hours of every working twelve stuck in an Auckland traffic jam.

Power outages, port congestion, misaligned skills development hardware, water shortages, extensive waste disposal regimes and costs - the list goes on - all tend to reduce the potential output that both labour and capital - especially more sophisticated labour and capital - can generate.

So this was the huge logical contradiction of the 1990s. Cutting public sector investment in infrastructure threatened the long-term potential for productivity growth - the very thing that is the essence of robust GDP growth and debt servicing capacity.

The second problem with the logic of 1990s fiscal policy was that it was based on a superficial attraction that less debt is better debt. But just as any individual, family, company or local authority can have too much debt, it can have too little.

If a government under-gears its activities, it runs the risk either of overburdening the current generation in meeting the capital needs of future generations, or it lowers the long-run growth potential and social capital of society.

If there is one feature that marks out a difference between the fiscal stances of pre and post 1999 governments, it is the time horizon they follow. Since 1999, governments have taken a longer term view, both on the social front - for example by partially pre-funding the inevitable rise in the relative cost of New Zealand Superannuation and by putting health funding on a medium term funding path - and on the economic front by taking a realistic view of infrastructural needs.

Capital Budgeting and Prioritisation

This brings me to the first of the issues I have been asked to address: establishing the priorities for infrastructure needs. That exercise is not complete, and nor should it ever be. Prioritisation should always be a continuous process of review. Some things happen - like the need to recapitalise Air New Zealand - which require past priorities to be rescheduled.

What the current Government has done is put a lot more emphasis on capital budgeting. Historically, we have tended to focus on the operating surpluses and spend endless days agonising over the last million of operating expenditure or where an extra million can be wrung from a user charge or a tax rate change.

Indeed in the next budget round expect all the action to be around the $500m of new spending - approximately 1.2% of the total. Then a few hundred million get allocated to the capital programme - or taken off it - with nary a second thought. That might have been logical when the intention was to invest as little as possible on the capital side of things anyway, but those days have now passed.

A lot more effort is now going into assessing the capital needs associated with different state functions, into profiling when the money will be spent, and into setting the priorities. That is a complicated process when it has to address a decade of neglect.

The list is now quite long: school building programmes associated with demographic change; modernising hospital facilities, re-equipping the defence forces around an appropriate role for a modern defence force, building new correctional facilities, waste-water treatment, roading and so on.

What is perhaps more certain and significant is that the government has relocated the emphasis in its fiscal management around a long-term debt objective. Until 1999, the balance alone was king: surplus good, deficit bad. No matter the composition; no matter the consequences.

Increasingly, the government has recognised that although we can run a surplus for quite some time, if it is built on the back of infrastructural neglect, it will come back to bite us.

On the other side of the coin, a deficit in any one year is no great hardship: it is the sustained and structural deficits like those run during the Muldoon years that do the damage. They build the debt that generates the debt servicing costs that ruin the fiscus.

And sitting behind all of this is the need to borrow to meet the costs of capital works that will be consumed - and paid for - over many decades.

At the end of the day, the fundamental question comes down to this - can you pay your debts? This resulted in a change in the specification of the government's fiscal objectives, first in the 2001 Budget Policy Statement and confirmed in the 2002 Fiscal Strategy Report.

If you read that, you will see a hierarchy of fiscal constraints.

The overarching constraint is to manage total debt at prudent levels. In the longer term, gross sovereign-issued debt will be below 30% of GDP, on average, over the economic cycle. The operating balance will be in surplus, on average, over the economic cycle sufficient to meet the requirements for contributions to the NZ Super Fund and ensure consistency with the long-term debt objective.

In other words, the surplus must meet that part of the capital works programme that is needed to keep borrowing within the range of the long-term debt objective. Revenue and expenses must be consistent with operating balance requirements.

It is clear from this that while on the one hand the government has acknowledged the need for a robust infrastructure, on the other hand it does not have an open cheque book for infrastructure investment.

There is therefore a top-down fiscal constraint, the nature of which will depend a bit on the growth rates that are achieved, the needs to meet current operating expenses, and the requirements of NZSF transfers. Given the deferred maintenance of the 1990s and the queue of claimants for relief, capital budgeting is likely to be tight for at least the next three or four years.

Public-Private Partnerships: Potential and Constraints

This is where PPP's enter: using new methods of financing to ease any debt constraints that might be impacting on infrastructure investments.

Before I get back to that, let me park one topic that I was asked to address: the Venture Investment Fund. It does involve private participation in a public venture that revolves around financing. But VIF is specifically around a very detailed part of the innovation chain: venture funding at the seed and start-up end of the spectrum.

It is a specialist area on which I am not qualified or mandated to comment extensively. Suffice it to say that with a 2:1 private contribution ratio, the VIF has successfully leveraged an additional $300m per annum in innovation capital.

The Government has been somewhat cautious about PPP's, for both practical and philosophical reasons.

Let me start with philosophy and principle. One of the core aims of the incoming government in 1999 was to restore trust and confidence in government. That trust and confidence had been bruised by what the public saw as repeated examples of political parties saying one thing and doing another.

The Labour Party has a firm commitment to no more privatisations, and had to be clear that it was not going to privatise through the back door. That policy has not changed.

I know that a well constructed PPP is not privatisation but an appropriate sharing of risk, a better mobilisation of finance and accessing expertise and best practice. However the fact is that it is also unknown and untried here, and caution is accordingly essential.

As Government representatives and industry participants, we must also take account of the need to ensure the public understands and accepts the proper role - and limits - of private financing initiatives. To do otherwise is to invite opposition - often mistaken but nonetheless genuine - and to limit the sustainability of the initiative.

Also, at a practical level, a lot of approaches to engage in discussions on PPP's were directed at Ministers. For better or worse, we have, over the last few decades, moved public sector management away from politicians.

We have increased the responsibility of politicians for policy, for financial allocations and for priority setting. But the operational implementation of policy has been vested in public sector managers. Lobbyists were going to the shareholder when they should have been contacting the buying office.

Secondly, again for better or for worse, we have tended to fragment managerial responsibility into self-contained and largely independent units. As I understand things, many of the big PPP projects in the UK, and even in Australia, have related to system-wide purchase or construction projects: the National Health Service for example. Here, decisions are made at a much more decentralised level - DHBs for example.

We also have a much smaller economy, in which sizeable public sector investment projects are less frequent. This means that there will not normally be the same frequency of opportunities around which to develop best practice and sufficient competencies to allow a competitive tendering process to evolve.

The risk is that specialist agencies will try and clip the New Zealand business onto routines and personnel built up in jurisdictions where the landscape has material differences.

Road Construction: An Example

Let me provide an example from the road construction industry.

Transfund NZ is the major funding agency for road building. It contracts road construction via the implementing agencies, Transit NZ and other road controlling authorities, who in turn employ designers, draughtspeople, contractors and so on. A feature of road construction is that substantial overruns of cost and time were historically commonplace.

One reason for that is that in the road building system, risk is difficult to manage down the contracting chain from the funder to the implementing agency, to the lead contractor, to the subbies. Rather, typically risk flows the other way - overruns at the bottom end flow right back up the system and eventually vest in the Crown.

In a world of ultra-tight contracting margins and competitive bidding processes, there must be a temptation in the industry to "bid low, vary up." With average "variations" often in the range of 20-30% of the principal, the problem could be said to be structural.

Various measures are being employed in the industry to control risk and cost, and Transfund is to be commended for its role in value management. Both the timeliness and costs performance of major roading projects have improved.

However the question is whether public-private partnerships can further assist. Let's consider the options.

Design-Build-Fund-Operate (DBFO) initiatives can build in risk assessment from the very start of the engineering analysis and design. Those who finance the deal bear that risk throughout the life of the project. They therefore face strong incentives to contain costs and manage efficiently. They are also able to tap private sources of finance to supplement public sector resources.

So is this then infrastructure 'nirvana'?

PPP Constraints

Not necessarily.

Scale is a big issue. The overheads associated with constructing the contract in a competitive bidding process means that the realistic minimum project size for a robust PPP may be somewhere in the $100 million range.

Those deals are few and far between in a New Zealand context. So maybe we see $50 million as the threshold? But what is being sacrificed to make contracting cost effective? I think that these are some of the issues that have to be addressed.

Second, good PPP's are not easy to write. Contracts need to be extensive and complex. They must deal with a range of risks and variables that may be difficult to foresee. It can be difficult for small to medium contractors to manage this process, especially given the scale factors described above.

Good PPP's depend on very good contract construction, so that risk is appropriately distributed. The worst case scenario is that the private partner corners the margin and the public partner shoulders all the risk. I recall certain Think Big projects as examples of what not to do in this regard.

It follows that we need to be very clear about what drives the financials in a PPP regime. It must be about transferring - or at least sharing - project risk, in return for a share in the benefits of managing and financing public sector investment projects.

It cannot be in clipping the ticket on a quasi monopoly, or in devising tax efficient ways to finance a project in one part of the public sector at a disguised cost to the revenue base.

Finally, the impact on the consumer of the charging regime for a PPP must not be regressive, inequitable or at odds with other key social or economic policy objectives.

The clearest example is toll roads. Labour policy - confirmed in the Governor General's Speech from the Throne - is to consider potential toll projects provided that consumers have alternative routes that leave them no worse off than before the toll link was constructed.

A toll road which provided the only means of access to an essential service or route would not pass muster on this test.

However the Government would do due diligence, on a case by case basis, on toll-based PPP projects that complement existing routes, and ensure that other governance and policy criteria are met. These policy criteria must include the social equity and public interest principles mentioned above.

It also goes without saying that an effective competition policy regime is important to underpin these goals. In the case of utilities and network infrastructure such as water - where increasing returns to scale often underpin local monopolies - regulators must be appropriately vigilant guardians of the public interest.

The Future

So where to from here?

The Government has made its determination to restore the public infrastructure deficits of the 1990's clear by taking a long term perspective to the strategy and needs of the transport sector.

We are determined to crack the gridlock problem, particularly in Auckland, and we recognise the potential for PPP's to contribute significantly to this.

The Government has also made clear its willingness to consider appropriate, high quality investment in turnkey projects - including infrastructure and, potentially, including PPP's.

But we will go into it with our eyes wide open, aware of the challenges to be met, the need to benchmark best international practice, and to avoid the mistakes of the Think Big era where Government was saddled with unnecessary and expensive risk.

We want above all to move forward in partnership with the private sector. We look forward to working with you to further refine and develop the contribution that PPP's can make to building world class infrastructure for New Zealand.

This conference is a significant step in that process of discussion, and we look forward to receiving feedback on your deliberations.

Thank you for the opportunity to share some thoughts with you today.

ENDS

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