As we increasingly incorporate a lot of the environmental externalities into the incentive architecture of the market economy, opportunities to improve our stewardship of finite natural resources will improve. Not only do we have to do things better, the approach underlying the circular economy encourages us to do better things.
Economic analysis starts from an assumption that people act in a rational way. Over the past few years economists have been exploring why people seemingly break this assumption on a regular basis. Understanding how people react to information, incentives and the way in which choices are presented is becoming increasingly key to developing effective approaches to designing and delivering public policy. It was one of the reasons I recently completed a short course on behavioural economics.
Coronavirus is forcing utilities to rapidly reappraise their pricing, to assist communities. I have been looking how to stress test utilities in response to Coronavirus. This follows observing the deferral of a recent regulatory pricing review and extension of the regulatory pricing period by a year for a water utility here in Australia. That action in and of itself will not address the impacts of Coronavirus.
I had some thoughts about a possible review approach. Specifically:
i) the financial capacity of the water and waste units to respond to requests by the governments to support their communities; and
ii) the ability of water and waste activities to defer some capital expenditures beyond the governments’ current budget horizons.
My initial thoughts are that this might be in the form of a series of financial stress tests that consider:
i) the implications of extending the current path for rates based on governments’ current asset management approaches;
ii) reducing charges by dropping any surplus generated to assist households over a period nominated by governments;
iii) deeper reductions in charges based on deferring capital and operating expenditures through the current period of budgets and perhaps beyond;
iv) implications for the path for charges beyond the current budget outlook, including taking into account the impact of deferring of capital expenditures designed to drive greater efficiency of service delivery; and
v) commercial implications of significantly lower volumes of services to businesses on utilities’ operations and margins, which might be significant in terms of trade waste issues.
A high-level review of engineering costs, capex and opex, could feed this financial analysis based on available information. Although not a full cost pricing determination, the review would help a government and utility business managers quickly figure out what level of relief can be given by the water and waste activities to households and businesses while minimising future rises in charges.
From an economic perspective, it may be simpler for governments to subsidise water and waste activities through temporary community service obligations (CSOs) directly. If that were a viable policy option, this could be a key piece of analysis to help set the level of the CSO, lay out KPIs for that CSO and establish the criteria for unwinding the CSO when measurable impacts from Coronavirus have passed.
The coronavirus pandemic will have significant impacts on how we design, develop, fund and operate infrastructure. As the pandemic evolves, the nature of these impacts will emerge, creating increasing risks. There is a stark difference between the impact of the Global Financial Crisis (GFC) and this pandemic. The former was initially a financial liquidity impact that affected cash flows around infrastructure investment and operation.
The pandemic’s first impacts are likely to be around the loss of human capacity in the systems that support this complex sector. The near term impacts are likely to be more associated with loss of certainty, affecting planning, operation and funding of infrastructure.
There is a range of considerations; which will have varying degrees of impact on governments, communities, organisations and people.
i) Demand-based assets are vulnerable because of the drop in use as with the coronavirus takes away discretionary spending. This particularly so for transport infrastructure, which directly engages with end consumers. Supply chains for these assets will be affected.
ii) Contracted assets have some increasing counterparty risk. Energy assets, for example, depend on the continuing creditworthiness of their counterparties. Many utility services may be called on by state actors to contribute to the overall effort to address the economic impacts of coronavirus.
iii) Merchant infrastructure potentially faces higher volatility in commodity prices and heightened uncertainty of demand. This kind of infrastructure operates at the margin of markets, rather than profiting from significant baseload provision at low, guaranteed margins. It will vary across markets for infrastructure services.
iv) Some specialised infrastructure has exposure to sports. This group of assets has both contracted and demand-based revenues. In Australia, we see the challenges facing our principal football codes with the loss of stadium revenues. It has exposed football codes that have not been developing multi-year contracts for stadiums and areas, and cannot defer refunds and provide credits for future ticket purchases. Some infrastructure owners have not undertaken sufficient risk analysis to determine the financial reserves for significant events.
v) Expect construction delays and cost increases as labour and material shortages occur, as well as the introduction of appropriate occupational health and safety processes are developed to address coronavirus.
vi) Expect the possibility of some operating underperformance of infrastructure assets associated with possible labour and material shortages. As operating environments are adjusted, with some delays in scheduled maintenance, this should only be a short-term impact. Retaining the capacity to do critical maintenance is essential.
vii) Contractual triggering of force majeure declarations may become more likely. The effectiveness of these declarations will depend on the specific wording in each contract, which may create many disputes around non-performance.
viii) Policy exclusions in business interruption insurance may affect the ability of infrastructure asset owners and operators to respond. Management teams are going to have to think more about internal liquidity policies and how to structure their cash flows in both infrastructure transactions and operations.
ix) The debt position infrastructure owners and operators will be compounded by refinancing challenges. More volatile credit markets mean more considerable uncertainty about the costs of refinancing when it is needed. Understanding debt maturation profiles and alternatives will be essential. Assets with long concession periods or very long useful lives possibly have a better ability to manage their short term debt profiles.
Some of these risks might be mitigated in part by the following:
i) Government intervention is more likely to occur. While some government actions might have adverse impacts. Across a range of infrastructure classes, governments might take interaction to support the overall performance of the economy.
ii) Infrastructure businesses are more protected at the enterprise level. Many firms operate in multiple markets and hold multiple sets of infrastructure assets. Also, many infrastructure businesses operate long-live assets with capex plans that can be modified and significant management discretion on operational tempo and allocation of surpluses.
iii) Infrastructure projects typically have strong capital structures. How cash flows are applied is tied to contractual requirements and ensuring funds flow to relevant parties. This is the core of traditional project financing. Infrastructure projects without recourse to full cash-funded debt reserves are exposed to prolonged delays and a slow economic recovery.
Our response to coronavirus is only limited by our understanding of it and our ability to imagine and execute solutions.
Lytton Advisory was in the Middle East last year for an assignment. It got us thinking about comparisons of urban transport systems and what constitutes value for money.
Here is one to consider. A few simplifications have been made to bring capital cost, new route length and population into perspective. These projects are at the core of these cities’ transport systems.
Brisbane’s Cross River Rail is building 10.4 km of new rail line and four new stations. A further eight existing stations will be upgraded. The cost is stated to be A$5.4 billion or around US$3.5 billion.
Cross River Rail – US$336 million per kilometre. The population of Brisbane is 2.5 million. Cross River Rail costs about $134 per person per kilometre. Riyadh is installing a complete metro system for US$22 billion. This will build six metro lines totalling 176km with 85 stations.
Riyadh metro – US$125 million per kilometre. The population of Riyadh is 6.9 million. Riyadh metro costs US$18 per person per kilometre.
Station densities on the new routes are one every 2.6 km for Cross River Rail and one every 2.1 km for the Riyadh metro.
It appears that Cross River Rail is more expensive on a per new kilometre per resident basis by a factor of 7.4 times. There are plenty of reasons why Cross River Rail might be more costly, but surely more is going on than just tunnelling and labour costs.
So is Cross River Rail better value for money than Riyadh metro?
Thanks, Gene (Adept Economics) for hosting me on an episode of your podcast series Economics Explained. It was great we were able to unpack a few things about city infrastructure for your listeners, particularly regarding Brisbane’s Green Bridges program and Cross River Rail.
Municipal waste-to-energy (WTE) systems incorporate significant uncertainty and risk. However, they provide ways to achieve significant environmental and economic sustainability for communities. With growing uncertainty, there are significant challenges around when and how to exercise flexibility.
Flexibility is important because as a mechanism it helps ensure better sustainability for WTE systems with long-term lifecycles. Flexibility of capacity expansion, in particular, is an important consideration given the expenditures that are typically required. Multi-stage stochastic modelling can help develop an optimal decision rule to guide decision making on capacity expansion using a real options approach.
Research on the expected net present value (ENPV) arising from flexible design suggests significant improvements are possible over the fixed rigid design in terms of economic lifecycle performance. The ability to make multi-stage decisions in any time period based on available information as uncertainties are resolved is an advantage over lifetime capital investment decisions that are typically set in the first year of WTE projects.
Through work with UTL Utilities, we bring strong cost benefit analysis and real asset option approaches to this kind of infrastructure investment.
Constrained water supplies in Far North Queensland are hindering economic development and can threaten water security of a number of towns. Inaction on supply has been driven by feasibility, concerns, funding gaps and worries about environmental sustainability. (1) In addition, politics focussing narrowly on dams as the supply solution runs the risk of missing other smart infrastructure and demand management opportunities to improve supply apart from just bulk storage. (2) Project proponents are also challenged often challenged by a user pay model required by the National Water Initiative. (3)
A strong evidence base of economically viable, financially feasible and prudently sustainable investments is needed to unlock these constraints. The balance between the public purse, private irrigator interests and environmental sustainability needs to be reset.
If considering just dams, what is an appropriate period of cost recovery? If an appraisal period is less than the economic life of the dam, usually an estimate of residual value would be included in the final year of the analysis. For example, a 25-year appraisal period for a 50-year asset, may include an asset value offset of up to 50% in the final appraisal year to ensure cost recovery over the appraisal period approximates around half of the expected use of the asset.
Similarly, where a dam is considered by policy makers to be a catalytic piece of infrastructure that supports and enables economic growth opportunities, an argument that there are economic externalities needs to be established. In effect, this means that not all the economic benefits are being captured by the users – providing a basis for partial public funding alongside expected user revenues. This externality argument is the logical basis for identifying the level of offset to user revenues. It presupposes both other uses for water as well as downstream benefits captured by non-users.
As a starting point, getting the evidence together to make the preliminary case for the residual value argument and a market failure argument around significant externalities is critical.