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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