January 9, 2012
Using Public-Private Partnerships to Carry Out Highway Projects
The United States has a network of over 4 million miles of public roads. That system has faced increasing demands over time: The number of vehicle miles traveled (both passenger and commercial) rose from approximately 700 billion in 1960 to just under 3 trillion in 2009. In 2010, the federal government and state and local governments spent about $160 billion to build, operate, and maintain roads. (This study adopts the practice of the Federal Highway Administration in using the words “highway” and “road” synonymously.) Almost all of those infrastructure projects were undertaken using a traditional approach in which a state or local government assumes most of the responsibility for carrying out a project and bears most of its risks, such as the possibility of cost overruns, delays in the construction schedule, and, in the case of toll roads, shortfalls in the road’s revenues. Some observers assert that an alternative approach, using a public-private partnership, could increase the money available for highway projects and complete the work more quickly or at a lower cost than is possible through the traditional method. Specifically, such a partnership could secure financing for a project through private sources that might require more accountability and could assign greater responsibility to private firms for carrying out the work. For example, a private business might take on the responsibility for specific tasks, such as operations and maintenance, and their accompanying risks.
In this study, the Congressional Budget Office (CBO) finds that private financing will increase the availability of funds for highway construction only in cases in which states or localities have chosen to restrict their spending by imposing legal constraints or budgetary limits on themselves. The reason is that revenues from the users of roads and from taxpayers are the ultimate source of money for highways, regardless of the financing mechanism chosen. The cost of financing a highway project privately is roughly equal to the cost of financing it publicly after factoring in the costs associated with the risk of losses from the project, which taxpayers ultimately bear, and the financial transfers made by the federal government to states and localities. Any remaining difference between the cost of public versus private financing for a project will stem from the effects of incentives and conditions established in the contracts that govern public-private partnerships.
CBO also finds, on the basis of evidence from a small number of studies, that such partnerships have built highways slightly less expensively and slightly more quickly, compared with the traditional public-sector approach. The relative scarcity of data on public-private partnerships for highway projects, however, and the uncertainty surrounding the results from the available studies make it difficult to apply their conclusions definitively to other such projects.
Approaches to Providing Highways
The traditional approach to providing roads, known as the design-bid-build approach, is used nearly uniformly across the United States. It is mainly a public-sector endeavor, in which state or local governments pay for projects with some combination of their own funds, funds provided by the federal government, and borrowed funds that are ultimately repaid by revenues from taxes or tolls. Once funds are secured, a public manager—generally a state department of transportation or other public authority—either designs the highway project itself or contracts with a private firm to design it. A different private entity, which is usually selected on the basis of the lowest-cost bid, then carries out the project. A public agency manages the longer-term operations and maintenance of the highway, although that public entity may, again, contract with a private firm to perform some of those tasks.
Under the traditional approach to highway projects, private firms that have signed contracts to construct a road or perform other project-related tasks take on only a limited amount of risk. For example, they retain the ability to pass on to the public agency any increase in their costs as a result of unforeseen changes in the scope or details of the project, a feature of the traditional approach that increases the chances that the private firm’s costs will exceed its bid price. For its part, the public sector retains a high degree of control over the highway during its useful life.
The term “public-private partnership” refers to a variety of alternative arrangements for highway projects that transfer more of the risk associated with and control of a project to a private partner. That transfer is achieved in part by bundling some of the elements of providing a highway. Among the most extensive public-private partnerships are those in which a private firm provides financing for a highway project, designs and builds it, and then, in exchange for the right to charge tolls, operates and maintains it over its useful life. The most common type of public-private partnership, however, is the more limited “design-build” agreement in which one contractor agrees to both design and build a highway rather than having the public sector manage each of those steps independently.
In a partnership, the contractor assumes greater risks than it would under the traditional approach because the terms of the partnership’s contract generally limit the private firm’s ability to renegotiate the contract in the event of higher costs. Nevertheless, that advantage to the public sector of transferring the risk and control of a project to a private firm may have a downside: It may limit the government’s ability to respond to changing conditions or to achieve other objectives that might improve the welfare of the state’s or locality’s citizens but reduce the private partner’s profits.
The use of such partnerships for providing highway infrastructure is limited in the United States. Between 1989 and 2011, the value of contracts for all projects whose costs exceeded $50 million was only about $41 billion, representing a little more than 1 percent of the approximately $3 trillion (in 2010 dollars) that was spent on highways during that period by all levels of government. The use of public-private partnerships is increasing, however, and by one estimate accounted for between 30 percent and 40 percent of all new miles of urban limited-access highways built between 1996 and 2006. This study addresses the potential role of the private sector in two aspects of building highways: the financing of projects and the provision (that is, the design, construction, operation, and maintenance) of highways.
Private Financing of Highways
Most highway projects are paid for with current state or federal revenues and are not financed through borrowing. But sometimes a project is large enough that the state or local government, or other public authority, must borrow money to move the project forward. When that is the case, the public entity can provide financing either through traditional public borrowing—by issuing government bonds, on which investors are generally willing to accept a relatively low rate of return because the bonds are backed by the taxing authority of the public entity—or by joining with a private partner to obtain private financing. Private financing can provide the capital necessary to build a new road, but it comes with the expectation of a future return, the ultimate source of which is either taxes or tolls.
The total cost of the capital for a highway project, whether that capital is obtained through a government or through a public-private partnership, tends to be similar once all relevant costs are taken into account. In general, the overall rate of return demanded by investors depends on their perception of the risk of losses associated with the project. A construction project is never without such risk, even when a government guarantees repayment of any debts incurred to finance construction. Someone always bears that risk: That is, some form of explicit or implicit equity investment is necessary to absorb potential cost overruns or revenue shortfalls. For highways that are financed by -public debt, taxpayers play the role of equity investors, bearing the risk that revenues might be less (or more) than the payments that have been promised on the debt. A comprehensive measure of the cost of financing a highway project will account for the cost of both equity and debt financing, even when the equity is provided indirectly by taxpayers.
The choice between public and private financing may affect the incentives to manage the project efficiently and hence the project’s costs and schedule. Private investors who make equity investments receive payments only after all other claimants to the project’s revenues (such as holders of debt, suppliers, and workers) have received what is owed them; those equity investors thus have an incentive to minimize costs and delays if they are granted control over the project. Debt holders generally are not given such control and have little incentive to work to improve how the project is carried out because they are insulated from the effects of most cost overruns and other risks. By itself, however, the incentive to control costs and meet schedules is not sufficient to guarantee the project’s effective execution. In cases in which private financiers have limited control, they may not be able to influence the efficiency with which the project is carried out.
How a project is financed may also affect who bears its costs. Financing a project with bonds whose interest is exempt from federal taxation or with funds that reflect other subsidies from the federal government shifts the project’s costs from state taxpayers to federal taxpayers. It does not, however, reduce the total cost of the project’s financing.
To date, investors in the small number of public-private partnerships that have financed and built highways in the United States have in most cases overestimated the toll receipts from the completed roads. Thus, the projects have not produced large enough returns to justify those investments. Such a record is evidence that those investors assumed significant risk in that they built the highways and did not receive the payments they expected. Their losses may explain why more-recent partnership agreements for highway projects have reduced the private partners’ exposure to the risk of lower-than-expected toll revenues by guaranteeing payments (from the public partners) regardless of how much the roads are used. In addition, more-recent agreements have reduced private partners’ debt-service payments—that is, interest payments on any money borrowed to finance the projects—by increasing the share of financing provided by the state or locality or by the federal government. Accordingly, financing provided by the federal TIFIA (Transportation Infrastructure Finance and Innovation Act) program and tax-exempt private activity bonds issued by municipalities (to finance projects of private users) have become increasingly prominent sources of funds for highway projects.
Private Provision of Highways
If a public-private partnership arrangement is chosen for a highway project, the government involved must design, implement, and monitor contracts that allocate risk and control between the public and private partners. Although contracts of that kind are difficult to create because the parties involved cannot anticipate all contingencies, they are essential to establishing the right incentives to perform the work efficiently and manage the project’s associated risks. In particular, they may help reduce the total cost of the project by bundling tasks that under the traditional approach would be performed by separate entities.
A drawback of a partnership arrangement for the public sector, however, can be its loss of control of a project. Contracts for public-private partnerships may in some cases turn over some toll-setting authority to the private sector. Higher tolls are likely to result, an outcome that may conflict with other public-sector goals. A loss of control may also lead to conflicts about and renegotiations of the terms of the contract, which may be costly for the public sector. More generally, less control of a project by the public partner over the long run may make attainment of the government’s future objectives more costly; it may also complicate efforts to adhere to a contract written many years—or even decades—earlier and still protect the public’s interests.
Assessments of whether public-private partnerships can provide highway infrastructure more efficiently than traditional methods are challenging, in large part because of limited data and research. Only a few studies have focused on the private provision of a highway project—that is, on design and construction as well as on operations and maintenance. That research found that the use of the design-build type of public-private partnership slightly reduced the cost of building highways relative to the cost under the traditional approach and slightly reduced the amount of time required to complete the projects. The studies typically estimated that the cost of building roads through design-build partnerships was a few percentage points lower than it would have been for comparable roads provided in the traditional way. (However, estimates of such savings are quite uncertain, and the effect on costs of using design-build arrangements in the future could differ significantly from what the estimates in those studies imply.) Moreover, under such partnerships, many of the roads were built more quickly. Studies found that for projects with contracts valued at more than $100 million, the total time required to design and build the road declined by as much as a year on some projects—in part because the public-private partnership bundled the design and construction contracts and so eliminated a second, separate bidding process for the additional tasks.
Information about using public-private partnerships to operate and maintain roads is limited. In recent years, two older highways built in the traditional way, the Chicago Skyway and the Indiana Toll Road, have been converted to private management, making them subject to control by the private sector. Comparing the cost of operations and maintenance for those highways under public and private management indicates that both roads experienced reductions in costs after a private firm assumed control. A variety of factors in addition to the transfer of control, such as the recent recession and the associated reduction in traffic, probably contributed to that result.