Highway robbery?

With the new Sydney cross-city tunnel controversy (see http://guambatstew.blogspot.com/2005/10/i-can-see-clearly-now.html ) "people have asked why the State Government has leased us out. Why have the private sector deliver public infrastructure when the Government can borrow funds more cheaply?

"These partnerships are being pursued to improve the procurement of public infrastructure. Given the controversy over the Cross City Tunnel, this seems improbable. But when one considers the success of public-private partnerships in delivering projects on time and on budget, and their role in stimulating innovation in the design, construction and operation of infrastructure services, their attractiveness makes sense.

"What gets measured - and rewarded - gets done." So says Gary Sturgess, executive director of the Serco Institute, a corporate think tank based in London, who was the cabinet secretary in the NSW state Greiner (Liberal [conservative] government. (http://www.smh.com.au/news/opinion/private-funding-still-a-better-way-forward-for-public-projects/2005/10/23/1130006000223.html)

Good government could build good infrastructure. It is more expensive to have the private sector do it. Mr Sturgess notes that the government has lower borrowing costs than the private sector. Beyond that, the government is a non-profit entity so doesn't have to remit profits over and above borrowing costs. It doesn't have to pay hefty executive salaries, benefits and bonuses. Moreover, it retains all the increase in the growth of the equity value of the assets.

With all those financial advantages, why in the world would the government farm out its infrastructure projects? Because, as Sturgess said, it gets done. Simple as that. Left to its own devices, our government seems incapable of providing infrastructure for us. The Ministers, from Premier down, lack the political will (and that alone) to see the projects through.

Now, I'm not making a value judgment on who, public or private, should develop and operate our infrastructure projects. (Nor is this any attempt to address how we go about deciding if we need them or in what priority.) Assuming the need for any particular project, what matters is getting it done sooner than later, in the most cost effective and socially agreeable manner.

What is important, if government is to contract out its development and operating management responsibilities, is, as Sturgess candidly pointed out, that the government absolutely must develop or acquire the procurement management skills needed both to obtain the contracts and oversee their execution: "The controversy of the past fortnight reminds us that governments need to acquire and retain high-level commissioning and contract management skills."

These skills are not naturally born, nor instrinsically given as part of surviving your way up the civil service ladder. They are highly sought after by the very people government will be up against in the procurement process. But that is no different from the other personnel needs government has, like providing competent and competitive lawyers, accountants, engineers, nurses, doctors, etc.

"'The government is quite immature at designing and negotiating these deals. We are getting deals that are highly biased in favour of the banks', says Australian Institute of Project Management president David Dombkins. 'The community is paying two to three times what we should be paying for these deals.... If it goes bad, the community pays for it; if it goes well, the banks keep the profits and, worse than that, the deals are set up to escalate the tolls radically.'" (Australian Financial Review, Tunnel takes its toll on PPPs, 24 Oct.)

"Flack has also been generated by claims from former NSW Auditor-General Tony Harris that toll roads should remain in government hands to ensure the taxpayer is not fleeced. Sydney University academic John Goldberg has also been attacking the industry, saying that its financial structure is unsustainable and that Transurban in particular survives on massive government handouts in the form of infrastructure bonds." (http://www.smh.com.au/news/business/were-playing-it-safe-on-toll-roads-says-chief/2005/10/23/1130006001913.html)

In a related story, the current darling of the PPP world, the Millionaire's Factory Macquarie Bank, has been under a bit of pressure on its stock price, although it has risen so far that a little off the top is hardly severe pressure. (See, http://www.smh.com.au/news/business/macquarie-banks-halo-is-slipping/2005/10/23/1130006001901.html, excerpts following.) "The Macquarie model has been described as a juggernaut but the truth is more elegant. Macquarie Bank is like a star. It spits out red-hot globs of magma that become its satellites, spinning distantly in orbit under sway of their parent's gravity but with no physical connection to their point of origin. These planets - let us call them listed trusts - feed Macquarie an endless stream of fees ($700 million last year) and use its expertise to function and grow. But, theoretically at least, they operate with financial independence. Should one suddenly disintegrate after colliding with an errant comet, the sun shines on unaffected. Nevertheless, the market's mad love affair with Macquarie Bank and the many satellites it has spawned appears to be waning. Brokers who were once bullish are increasingly cautious and some investors are beginning to ask what for years has been the unutterable question. Does the invincible Macquarie Model have feet of clay?

"Conventional wisdom is that the [Macquarie Bank PPP] model is tailored to function with a limited class of assets and some are worried that the bank may be applying it too broadly. How far, they ask, can the Macquarie universe expand without collapsing in on itself? The model desires assets that generate continuous cash flow without much input. Toll roads, for example, where Macquarie began, need only to be built and maintained but the cash will roll in without too much upkeep. They must be "securitisable", ie, easily converted into shares that can be bought and sold on an exchange. That means they need to have a clearly defined purpose and distinct boundaries within their management units. Preferably, they should have a monopoly or nearly so."

There are a few things I want to say about that.

First, if the projects meet the model as described, the financing aspects are functionally equivalent to bonds. Bonds historically trade at a lower rate than equities. Government bonds are about as cheap as you can get. Projects should, from the governments - and taxpayer's - point of view be priced only a bit above the government bond rate. Anything significantly more than that simply contributes to the millionaire factory.

Secondly, whenever you have government in the business of creating monopolies, you have to be very clever and very careful to keep the monopolists from using their monopoly power to price as high as they like. Any such deal must be transparent, at least to an independent review body, from the very beginning of the process, including the design of the project, the drafting of requests for proposals, the tender process, including evaluation and negotiation, through to final completion, including the demand and pricing for changes and "unforeseen" contingencies. Government should not be in the business of empowering private monopolies without very strict controls to prevent abuse of the monoply power.

Finally, I have read recently but not been able to find the quote, so take this with a grain of salt and suspend any belief in what I'm about to say until or unless you or I am able to confirm it, that at lease one of the PPPs (maybe one done by Macquairie - I can't specifically recall?) was so structured that it appeared to me to be really too good to be true.

The way the merchant banks tend to do these deals is they set up various "vehicles" to provide various functions, such as one to get the contract, one to develope the project, one to finance it, one to management it, and so on. Each of these vehicles spins off money back to the bank. The management fees have particularly been big spinners for Macquairie. "These planets - let us call them listed trusts - feed Macquarie an endless stream of fees ($700 million last year) and use its expertise to function and grow. But, theoretically at least, they operate with financial independence." (Id.)

You would reasonably expect that, if you owned the assets, you could determine who you want to manage them, and to change management if you thought it in your best interest to do so. Well, the thing I remember reading but can't quote said that, when the management vehicle was set up, allegedly independent from the bank, the bank's fees were guaranteed by contract for the life of the project even if there was a change in management (so why would, or could, any owners take on a new management if they also had to pay the old one?).

I would have thought that the directors of the assets would have had a duty to the owners to make sure that they were not tied into such a deal. But as it happens the original directors were appointed by and directed (you'd suppose at face value) by the bank. As my securities law professor would have asked, the only time I ever got that close to securities law, way back in the mid-'70's, "does that pass the 'smell test'?" If it fails the test, what liability, if any, would the bank have? You have 30 minutes to write your answer.