Significance of O&M in Infrastructure

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Installation of new infrastructure assets creates streams of services and improvements to existing services for users. Benefits accrue to these uses as well as a wider set of stakeholders. Maintaining the service potential is a critical element in ensuring that value for money is achieved from the initial capital investment.

However, many governments and asset managers are under significant pressure to trim maintenance budgets and scrimp on operating costs. In some contexts, this emerges as an extreme build-neglect-build scenario. Many Pacific Island nations experience this, as do a number of smaller Australian local government authorities. The full lifecycle cost of infrastructure assets is not factored into the budget planning processes of these organisations. Similarly, many private sector operators of infrastructure have commercial and financial incentives to focus on next quarter financial performance rather than long-term service provision from these assets.

The back end of infrastructure is seen as much less interesting, but it is where all the benefits are generated. So approaches to operating and maintaining these infrastructure assets is as equally critical as the planning and investment decisions to deliver them.

Two broad maintenance strategies are predictive maintenance and condition based maintenance. Predictive maintenance is like regular scheduled servicing based on the design performance of an infrastructure asset. It is less costly to implement but also less likely to match the actual performance of the asset. Condition based maintenance requires the collection of data and information about the actual performance of the asset and provision of a tailored asset maintenance response.

The approaches set up an economic challenge. Should an infrastructure manager simply maintain its assets according to schedule and only collect data and information on condition at the times of regularly scheduled servicing? Or should some initial data costs be incurred to change and adapt design-based, predictive maintenance? Decisions to underfund reasonable maintenance activities need to be made with good information and in an appropriate strategic context.

So it depends. In one sector, for example, the response is clear but not clear-cut. Analysis of wind turbine maintenance to address gearbox, generator and blade failure scenarios shows that for small wind turbines, predictive maintenance is more cost effective than condition based maintenance. Condition based strategies were based on an array of sensor data (optical, oil, vibration and temperature). However, for larger turbines, condition based maintenance where there is a high expected gearbox failure rate is a much better approach. In that instance, the cost of collecting additional data and information enables timelier and more appropriate servicing of the turbines.

For these reasons, infrastructure owners and managers need to ensure there are effective asset management and maintenance policies included in their strategic asset management frameworks. It is not enough to supply the assets, as only the services from them will be able to generate the full suite of expected benefits. This can only be achieved when the design potential of these assets is realised over time.

Household Debt and House Prices

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Lytton Advisory was at the Economic Society 2017 Business Lunch in Brisbane yesterday. RBA Governor, Philip Lowe, gave a very lucid presentation on Australian household debt and house prices.

Over 25% of mortgagees have a buffer of three or more years on their home loans.  The top two household quintiles by income are carrying the largest debt burdens.

Recent regulatory changes imposed on banks by the Australian Prudential Regulatory Authority will tighten up lending to property investors.  This may create some short-term breathing room to address fundamental supply-demand imbalances in some of the Australian property markets. It may also take a bit of the speculative heat out of the Sydney and Melbourne property markets.

The RBA Governor touched on a number of other issues as well.  Details can be found at:

http://www.rba.gov.au/speeches/2017/sp-gov-2017-05-04.html

Infrastructure Complexity

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Why does delivering infrastructure have to be so complex on so many different levels? It seems hard to correctly identify infrastructure, assess the need for services from those assets, discern which infrastructure to maintain, rehabilitate, replace or build new. Further, there are strong disagreements at the political level, between infrastructure agencies and, within infrastructure agencies, between different asset managers.

Complexity arises from the involvement of a broad array of participants in the provision of infrastructure assets, as well as the managers of the services provided from those assets.

It also arises from complex streams of benefits. In addition to benefits accruing to consumers of infrastructure services, there are often significant streams of benefits that are positive externalities. Wider benefits to society from improved health services, better access to education, cleaner water supplies, stable supply of electricity, and improvements to travel time and quality of the trip. A healthier workforce improves productivity. A more educated populace can generate higher disposable incomes. Purer water supplies enhance public health. Stable electricity supplies reduce business interruptions. Improved transport systems make labour markets function better and increase intra and inter city productivity. The benefits are multifaceted and often hard to quantify on cost-benefit analyses.

On the supply side, it is often too easy to overlook the range of solutions that are on offer. After a need has been identified, solutions could well include non-built options. This may involve active demand management, improving utilization and output of existing assets, repairing and rehabilitating existing infrastructure, changing the infrastructure asset operating environment to foster demand for alternatives.

The options analysis needs to be undertaken at the output/outcome level, rather than at the input/resource level. That is where actual economic value can be identified. To do otherwise creates the risk of estimating the cost of sub-optimal options.

Complexity also arises in terms of finding the financial resources to commission and operate infrastructure assets. Also, implementation through procurement and construction may have complexity.

Large, nationally significant infrastructure contains a lot of first pass risks. Getting the right scale and scope of infrastructure to match the most likely demand profile requires a lot of analysis.

Many infrastructure assets contain hiding optionality benefits. The ability to set the ultimate scale and scope, as well as the possible staging to achieve that is a significant real asset option. At the outset, a lot of choices can be made that close off options later on. Least cost solutions are not necessarily the best solutions where service quality between options can vary.

So what gets bought and how it gets built becomes critical.

Ultimately financial resources are committed. This is because small annual benefits are often realized over long periods. This is in contrast to large initial construction costs. Construction costs and some measure of operating expenses have to be funded. User charges do not always cover these costs. Finance addresses the imbalance of cash flows inherent in infrastructure. Ultimately, infrastructure must be paid for either by users or taxpayers. There is a significant range of public and private financing mechanisms. Financing choices are complex and can carry different risk profiles. This can affect asset valuation, as well as commercial risks around viability.

These are all significant touch points highlighting infrastructure complexity. They warrant detailed consideration and investigation in each infrastructure project.

Entrepreneurs

At the heart of economic progress are entrepreneurs. An entrepreneur is someone who starts up a business by creating a new product of service that someone else wants to buy.

Entrepreneurship involves high levels of creativity and innovation, and is not without considerable risk. Converting a great idea into a physical prototype or beta version of a service requires managerial skills, lots of time and lots of energy. It can also require a solid approach to patenting a product. Entrepreneurs have to interact with governments, potential investors and lenders, patent attorneys, as well as identifying, recruiting and driving high performing staff.

Joseph Schumpeter was amongst the first to conceptualise entrepreneurship. He drew a clear distinction between inventions and innovations, noting entrepreneurs not only invented but also included new means of production, new products and services as well as new forms of organisation.

Today we can see this in the business models of firms as different as Amazon, Google and Facebook. In the past, innovation in production led to mass production assembly lines, lean manufacturing, and, more recently, mass customisation of industrial and consumer products. Innovation in customer service is now increasingly blurring the boundaries between producer and consumer, as some information sevrices are crown sourced, and businesses operate platforms that simply facilitate social interaction on defined topics. The consumers develop and drive the content. Innovation in the service and knowledge economies is becoming increasingly important.

However, new ideas, methods and products/services are also accompanied by high levels of risk. So the rewards need to be significant. Not all innovators capture the rewards. Entrepreneurs have to address risk, ambiguity and uncertainty in order to be successful. They employ a wide range of strategies including: continuous improvement methods, application of technology; use of business analytics/intelligence; frugal/lean approaches; optimised talent management and development of leading edge/future oriented products and services.

Is the role of entrepreneurship critical to economic growth or does public policy in many countries overemphasis it at the extpense of improving the productivity and efficiency of existing industries? What do you think?

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This Micro Brief is part of an ongoing series provided as a general public information service.  These concepts underpin modern economic analysis.  Find out more about smarter capital investment decisions using economics at http://www.lyttonadvisory.com.au.

Human Capital

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Capital in economics usually refers to assets that yield income and other useful outputs over time.  People usually of bank accounts, shares in companies, assembly lines or steel plants.

However these are not the only forms of economic capital.  Education, expenditures on medical care and training in business skills are also capital.  That is because they raise earnings, improve health or add to a person’s good habits.  Economists regard these as investments in human capital.  This is because people cannot be separated from their knowledge, skills, health or values in the way they can be separated from their financial and physical assets.

Increasingly, skills such as creativity, empathy, contextual thinking and big picture thinking are becoming increasingly important.  These provide a critical response in maintaining high standards of living in the face of low wage competition.

It is an aggregate economic view of people acting within economies.  An attempt to capital social, biological, cultural and psychological complexity as they interact in economic transactions.

Unsurprisingly many economists explicitly connect investment in human capital development to education, productivity and innovation.

So should the sum of us be simply expressed in terms of our relative merit in an economic system?

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This Micro Brief is part of an ongoing series provided as a general public information service.  These concepts underpin modern economic analysis.  Find out more about smarter capital investment decisions using economics at www.lyttonadvisory.com.au.

Updated: 18/1/17.

Value Uplift and Capture

money_bridgeValue capture and uplift associated with infrastructure projects are often discussed but not well understood. This is because the issue sits at the crossroads of competing public and private interests, as well as institutional imperatives of project proponents.

From an economic perspective, it is a method of generating funds from economic rents – unearned private benefits from public investments – to deliver infrastructure projects. In the Australian context it is increasingly heralded as a potential new source of investment funds. However aspects of this approach have been used in both the US and the UK.

While there are over one hundred studies on value uplift around transport modes, impacts of other infrastructure types remain less well understood.

The Bureau of Transport, Infrastructure and Regional Economics has identified a range of factors assessing land value uplift challenging:

  • separating factors driving uplift to identify the infrastructure impact;
  • sampling errors in the estimation of land prices;
  • determining the catchment for beneficiaries / the project area of influence; and
  • isolating value uplift from network effects.

In essence, value uplift is where value flows from an infrastructure network are capitalised into land values. This is often observed regarding transport networks.

For the reasons outlined above, identifying value uplift is difficult in terms of identifying both who benefits and at what value. It is also why it has not been widely used to fund public infrastructure. However, there are two factors driving consideration of value capture funding:

  • economic rents accrue to landholders benefiting from economic infrastructure – in effect private, unearned returns from public investment in public assets – these are above and beyond use benefits and raises a critical equity issue; and
  • use revenues, particularly from public transport investments, are insufficient to fund infrastructure expenditures and are often complemented with significant subsidies from the public purse – value capture is seen as an alternative to increasing the general level of taxation revenue.

Overseas experience provides some guide to the types of value capture approaches, and each approach has its own pros and cons:

  • tax inventive funding – hypothecated value uplift based on an expected increase in property tax revenue. Commonly, a government issues a bond, effectively guaranteeing a return that matches the expected value uplift increment. The value at risk, however, remains with the government issuer.  This is one of the reasons most government treasuries oppose issuing these bonds – there is no transfer of financial risk associated with the value uplift increment.
  • betterment taxes – land owners thought to be direct beneficiaries of an infrastructure development – but not necessarily users themselves – pay a levy. The levey is typivally on the unimproved capital value of the land. A key challenge with this approach is achieving a correct attribution of the increase in land value from the provision of the infrastructure and related services.
  • transaction taxes – typically levied on property transfers. In this case, some of the property value increase attributed to the provision of publicly funded infrastructure will be collected by these taxes. However, this attribution is again difficult to to assess.
  • joint development – usually where a licence or concession is given to a private agency to develop surrounding land in exchange for delivering economic infrastructure and services. This is a significant model for railway development, and is currently in use for heavy rail in Asian countries.

While a range of estimation problems have been identified above, network architecture remains the most significant factor. Hierarchy, connections and density influence this. While the literature on network architecture largely focuses on transport infrastructure, specifically road and rail assets, further analysis is needed of other linear infrastructure (i.e. water, electricity and gas).

Two broad solutions emerge: either a more to a more general land tax; or further detailed investigation of each specific infrastructure project. The important point is to adopt an approach that minimises market distortions and promotes economic efficiency.