Select Committee on Transport Written Evidence


Memorandum by T Martin Blaiklock (LR 64)

INTEGRATED TRANSPORT: THE FUTURE OF LIGHT RAIL AND MODERN TRAMS

  I refer to the above Inquiry. The focus of my interest in this Inquiry lies in the financial aspects, specifically, "the effect of different financing arrangements (public/private) on the overall cost of light rail systems".

  I have been a consultant and practitioner in infrastructure and urban transport project finance,—PFI, PPP and the like,—for the last 25 years or more. Further, for the last 15 years PFI/PPP has been the bedrock for many, if not most, major transport infrastructure projects in the UK. Most likely this will increasingly be so in the future. Is this a desirable trend?

BALANCE SHEET ISSUES

  The main driver for the UK PFI/PPP program has been to remove, where possible, the financial burden for infrastructure development off the Government's balance sheet. The EU Directive No 18 of February 2004 provided some guidance as to what was allowed, ie if the construction risk and either of the demand or availability risks are carried by the private sector, the deal is deemed "off balance sheet".

  It has to be said, however, that a number of institutions and regulators (eg the IMF) believe that such a ruling may not go far enough. The contingent liability for the public sector project sponsor, particularly with respect to termination payments, can be potentially onerous in the early years of such projects, notwithstanding that the project may be deemed "off balance sheet" by the EU. One might expect, therefore, to see a tightening of this EU ruling before long. However, it is this type of ruling, and the attempts to get around such a hurdle, which makes PFI/PPP deals inherently complex, and on occasion this has significant cost and timetable implications, eg the LUL PPP.

FUNDING STRUCTURES

  Most urban transport systems are not self-supporting, ie not commercially and financially viable on their own. Historically speaking, I believe the only example of such a project, which has been self-supporting, was the Hong Kong Mass Transit, which in the event was funded using government guarantees. More so than not, projects in this sector need some grant subvention, either during the construction period or during operations, or both.

  The NAO Report on Light Rail (ref. HC 518 of April 2004) indicates that for many such projects in the UK the majority of the funds for construction were derived from governmental sources (ref. Table 2, p 15). Hence, one needs to examine much more closely the form and structure of these sources. Assuming that public sector grants are available to the extent that the commercial and financial viability of the balance of the project can be reasonably assured, the private sector will most surely provide the balance of equity and debt required, provided that the amount of funding needed justifies the up-front costs of project analysis, due diligence, etc

  Hence, in many ways the form and structure of Government support for Light Rail projects are key. As the NAO Report and other sources show, these projects consistently demonstrate financial failure, and there must be a reason!

PROBLEM NO 1: ANALYSIS PROCEDURES USED

  Most of the Light Rail projects reviewed have been implemented in the 1988-2003 period. During this period, HM Treasury (via the Department of Transport, often seemingly in a subsidiary role) have laid down precise and somewhat inflexible rules as to how the future benefits and costs in such projects should be evaluated. In particular, evaluations were undertaken in "real" terms, ie excluding inflation and financing costs,—a methodology favoured by economists, not investors and bankers,—and using a discount rate of 6% per annum. This created many problems and led to incorrect decision-making. The reports of project failure have not been surprising!

    —  Flaw No 1: undertaking project analysis in "real" terms can be useful for resource accounting at the national level, but it has significant shortcomings when applied at the micro-level for individual projects. By excluding inflation and financial aspects, it can lead to under-funding of projects, ie a project evaluated in "real" terms with a present value cost of £100 million could well turn out to require funding of £115 or £125 million, after inflation and funding costs are taken into account. Most investors and lenders live (like the rest of us) in the actual world (!!), and undertake their analyses in "nominal"; terms, ie including inflation of costs and revenues and the costs of finance—and, possibly, tax, too, although that is an arguable point.

  In a period like the last 10 years, when inflation has been low, the disparity between the two methods and, hence, the incidence of under-funding have been relatively small. However, when inflation is high, as it was in the early-mid 1980s, then the differences can be very significant.

  This flawed methodology, however, impacts on the Government contribution to Light Rail projects via the assessment of the Funding Gap. This represents the amount of subvention Government might provide. As it is calculated in "real" terms, invariably there is an under-estimate as to what this amount should be from the outset of project planning. With project implementation extending over 3-5 years, such under-funding can become a serious issue.

PROBLEM NO 1  ANSWER: UNDERTAKE EVALUATIONS IN "NOMINAL" TERMS!!

    —  Flaw No 2: the second issue concerns the discount rate to be used. As cost and revenue projections for such projects extend over 20-30 years, the discount rate is crucial. A discount rate of 3.5% over 30 years gives a 45-50% higher present value than with a discount rate of 6%.

  Conventional project analysis theory suggests that the discount rate to be used should represent the "cost of capital" of the project sponsor. As this may be difficult to precisely identify, an informed guess should be made, eg use the market interest rate for borrowings for the same period. For Government the cost of gilts for a similar period is the starting point.

  For much of the period in question (1990-2003) the cost of gilts (ie in "nominal' terms) has been 5-7%. During the same period inflation has been 2-3%, or thereabouts. Hence, if one is undertaking analyses in "real" terms one would expect the discount rate to be 3-4%. Yet, the Treasury insisted on a rate of 6%! Furthermore, there was no doubt in Treasury minds, apparently, as to the correctness and unchallenged status of their choice of 6%, and sensitivity analyses by doubters over the discount rate were not encouraged!!

  The above has resulted in:

    (a)  significant under-estimates of the value of future net benefits of Light Rail schemes; and

    (b)  the under-funding of projects approved.

  Overall, it is not surprising, therefore, that many of these Light Rail schemes reviewed were seen as financial disasters!!

  Now that the Treasury discount rate is 3.5% "real", project assessments should be rather more realistic and better decisions made. However, flaws remain in the Government system of evaluation.

PROBLEM NO 2: NO SUBVENTIONS FOR OPERATIONS

  A second problem is that the Department of Transport have followed the view that no subvention should be paid to support operations of Light Rail schemes. Given the difficulty of deriving accurate and reliable traffic projections and that the economic benefits may often support the requirement for subvention, this stance by the Department seems at times to lack reality or logic. Again, another flaw in the way such projects are evaluated by Government. This is much in contrast to the perspective taken by our Continental partners.

PROBLEM NO 3: PLANNING RULES

  Just over two years ago the ODPM undertook a study of the impact of the UK planning regime on economic development: "Planning, Competitiveness and Productivity" (HC 114, 2003). At the time I wrote:

    "The current parlous state of UK transport infrastructure has just as much to do with the inability of the planning process to support infrastructure development, as finance. The two are inter-dependent.

    The lack of a continuous policy of upgrading infrastructure and transport, in particular, over the last 30-40 years (under different governments) has left a UK contracting industry diminished in capital strength such that it cannot on its own undertake such necessary (large) projects. It is a fact that a number of such projects have had to be "rescued" by non-UK contracting groups, eg Bechtel for Eurotunnel, JLE Extension, etc.

    Others have the precise data supporting these arguments: I have not. The negative impact of inadequate transport infrastructure on the productivity and competitiveness of UK industry, tourism and quality of life, however, can confidently be measured in £ billions.

    The facts relating to inadequate planning procedures, which have cost the country dearly in lost opportunity and congestion, include:

    1.  Channel Tunnel Rail Link: conceived as complementary to the Eurotunnel project in 1986, approvals not given and contracts not awarded until 1996-97. The projects remains incomplete;

    2.  Manchester Metrolink: commercial/financial viability established in 1983-84, but it did not open for operations until 1991-92;

    3.  Birmingham North Relief Road: plans and funding ready in 1992: the project remains incomplete today;

    4.  Terminal 5, Heathrow: 10 years plus(?) in the planning and approval process, and incomplete today;

    5.  London—M25: there have been no new River Thames vehicular crossings (apart from the odd widening of existing bridges) within the M25 since the invention of the motor car.

    There will be others. Is not this ample evidence that the current planning procedures do little to promote the dynamic development of our economy and improve our quality of life? Private PFI/PPP investors will not have the patience to wait so long for projects to be given planning approval."

  The above just as much applies to Light Rail schemes today. Indeed, Table 12, para 3.3 in HC 518 shows how long some UK Light Rail schemes have taken to gestate. Hand in hand with any improvements in planning procedures, there should also be a fairer compensation culture upheld by Government for those who are directly impacted by the implementation of any scheme promoted.

PROBLEM NO 4: ENHANCED PROPERTY VALUES

  It is a well accepted fact that those who live and have business premises close to infrastructure schemes such as Light Rail benefit through the enhancement of property values once the infrastructure is in place.

  The key issues are:

    1.  How can such enhancements, particularly the incremental enhancement over what otherwise would have happened anyway, be measured;

    2.  How such incremental enhancement is captured to benefit the project itself; and

    3.  Timing. It is normal for such benefits to accrue well after the infrastructure scheme has been funded in the first place.

  There is no prescriptive answer to these issues, but it is interesting to note that our Continental (and North American) colleagues again seem to be much more advanced and pragmatic about developing such schemes. These usually involve some form of local taxation. Unfortunately, our financial authorities have never been great supporters of such local taxation. Hence, no progress. Hence, no projects!!

  When I worked on the Manchester Metro in 1983-84 we examined the feasibility of such schemes. The authorities were not interested. Twenty years on it is being examined again, I understand, for Crossrail. Progress, indeed?!!

CONCLUSION

  Any visitor to many mainland European cities will see the transportation and quality-of-life benefits of the various Light Rail schemes there. In the UK we have failed miserably to give our citizens comparable facilities.

  The private sector will respond with funding, if the schemes are commercially and financially viable. Those yardsticks have rarely been achieved, mainly through flawed Government analysis procedures, over-bureaucratic planning and lack of commitment to ensure such schemes become a reality and a success.

  Invariably this means that such Light Rail schemes must be a key component of an integrated urban transport network, which possibly means constraining one transport mode to benefit another. Leaving the market to provide what service is needed—a policy largely adopted in the UK over the last 20 years—has clearly not worked.

  The ball is now well and truly in Government's hands, if we wish to see a change! It is to be hoped that the above provides some clues as to where to start, and party politics should take a back seat for once!! Infrastructure developments invariably exceed the lifetime of any one party in Government.

T M Blaiklock

Consultant

Infrastructure & Energy Project Finance

February 2005



 
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