FOR WHOM THE TOLL SELLS / THE ECONOMIST BUTTONWOOD COLUMN ( HIGHLY RECOMMENDED READING )

Buttonwood

For whom the toll sells

The investment attractions of infrastructure

Dec 3rd 2011
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IF YOU build it, they will fund. The British government has announced a plan to build infrastructure and boost economic growth, and called on the private sector to finance the bulk of it. The hope is that pension funds will supply about £20 billion ($31 billion) of the targeted £30 billion. In theory, the right kind of infrastructure project boosts the long-term productive potential of an economy and pays for itself—while providing much-needed jobs in the short term.


British pension funds have generally promised retirement incomes that are linked to inflation (albeit with an upper limit of 5%). So that has made them enthusiastic buyers of inflation-linked government bonds; so much so that the real yields on such debt are close to zero, even on very long-dated issues. That ought to make them eager buyers of other types of security with built-in inflation linking.

Infrastructure projects, such as toll roads, are generally presumed to be good hedges against inflation. The assumption is that revenues will keep pace with other consumer prices and that the cashflows will be secure because of implicit government backing.


Only 2.5% of portfolios are currently committed to infrastructure, but that may be due to the limited number of opportunities. Governments have traditionally funded projects from general tax revenues, rather than raising the money on a scheme-by-scheme basis. The exception has been the private-finance initiative (PFI). Contractors raise money to build schools and hospitals and the government then makes a series of payments over the lifetime of the project.


The PFI gives pension funds an indirect way of investing in infrastructure, via the shares of the contracting companies. There are also listed utilities in the water and energy sectors that offer funds the kind of secure dividend-payers they seek. And then there are infrastructure funds, managed by the likes of Macquarie, which invest in projects around the globe.


There are some well-known examples of pension funds buying part, or all, of British infrastructure projects after they were built; CalPERS, the Californian state pension fund, owns nearly 13% of Gatwick airport, while two Canadian funds own the operating rights for the high-speed rail link to the Channel Tunnel.


But the idea behind the new plan is rather different. Pension funds would create a pooled vehicle that would bid for greenfield projects and employ a contractor to do the work. The investors, which will include the Pensions Protection Fund (PPF)—the backstop for private-sector schemes—will own the entire capital structure and can divide cashflows as they like.


The risks in such schemes will inevitably be greater. Upfront costs are high and construction projects are notorious for running over time and over budget. Contracts signed by one government could be undone by a future one. In the same statement in which he unveiled the infrastructure plan, the British chancellor halved the tolls for crossing the Humber bridge.


Potentially, however, the returns could be high. And, as Alan Rubenstein of the PPF points out, British pension funds would have to devote just an extra 2% of their assets to infrastructure to raise the £20 billion the government is seeking. A failed project will not bring the pension funds down with it.


However, the plan does raise some further questions. The PFI has been criticised, both for the way it hides government spending “off balance-sheet” and for the way it raises the cost of capital, estimated in one report to be 8%. The fact that pension funds are hoping for high returns should make politicians pause. If the British government can raise finance at a nominal rate of 2%, and a real rate of zero, surely it makes sense for it to finance these projects directly?


Supporters of privately funded infrastructure would argue that the process is likely to be run more efficiently, and is less subject to political whim, than a publicly funded project. At least the road or bridge will actually be built.


The infrastructure plan may also point to a longer-term possibility. Two academics, Carmen Reinhart and Belen Sbrancia, have suggested financial repression as one way out of the debt crisis—forcing domestic investors to accept negative real returns. Pension funds are being invited to invest in these plans on a voluntary basis. But their assets are a very tempting pool for politicians to tap. Some day in the future, pension funds may find they are obliged to invest in such projects, regardless of the potential returns—for the good of the country, of course.