Innovative Financing & The Myth of the Shovel-Ready Project

Content originally written for and posted on Meeting of the Minds.

With every new Administration in Washington there are always sweeping promises about improving the nation’s infrastructure. Since the last recession, these promises have become inextricably linked with talk about mobilizing private finance.

In 2009, after the immediate impacts of the recession abated, it was clear that cities, dependent on tax income, were going to be cash strapped for years to come. Which means while our infrastructure was getting worse, the money to fix it or upgrade it was getting harder and harder to find. This jumpstarted a national conversation—led by pension funds, environmental and social responsibility divisions at big banks, and impact investors—about how private capital could fill the public financing gap through instruments like P3s, Green Bonds, Social Impact Bonds. While there have been a handful of one-off examples and exciting new models, nearly a decade of talk about financing has not translated into substantially larger or speedier private investments in infrastructure.

Why? Because the mantra “if you build it, they will come” unfortunately doesn’t translate to infrastructure. More often, if you built it right, no one will notice.

The highest value infrastructure investments for cities today are those that help clear the massive backlog of deferred maintenance projects, but the greatest value for investors are new greenfield projects that lock-in long-term revenue streams. This mismatch is most evident in the lack of a clear pipeline of financeable infrastructure projects.

Innovative financing doesn’t magically create new projects, let alone a whole pipeline of shovel-ready financeable projects. To understand why, let’s look at a few of the sexier financing tools which get a lot of air time.


Green Bonds
: Green Bonds, like other municipal debt, are tax-exempt issuances specifically earmarked for funding projects, assets, or business activities that have positive environmental and/or climate benefits. In 2016, issuances topped USD 50 billion by September (nearly 5x the 2013 issuances supporting everything from brownfield development, to transportation and energy projects). In addition, the number of corporations issuing green bonds has grown significantly in recent years, but most have been used to support corporate finance rather than project finance.

Social Impact Bonds: A Social impact bond (aka Pay for Success Financing or Social Benefit Bond), is tax-exempt municipal debt structured as a contract between private financiers, often philanthropies, and a public-sector agency. Funds are provided to pay for improved social outcomes that result in public sector savings. Investors are only repaid if and when improved social outcomes are achieved.

Payment for Ecosystem Services: PES contracts are most often structured as legal agreements whereby a user of an ecosystem service makes a payment to an individual or community whose practices, like land use or deforestation, directly affects the value of that ecosystem services.  Because payments are based on the quantity of services provided, ecosystem service programs must concretely measure the ecosystem benefits generated, which can be a difficult task. These schemes work best when private companies, public-sector agencies, and non-profit organizations collaborate, and have most often been used internationally to support corporate social responsibility agendas.

All three of these innovative finance tools have one thing in common: each one requires projects that are already designed, quantified, and valued. This means that public entities have had to invest up-front in designing a project to generate savings that can be attributed to a specific entity. Therefore, a city must have collected significant baseline data upfront, made sure that they can measure changes in that data across the lifetime of the investment, and committed that they have the capacity to capture those savings as payment commitments under contractual agreements. All of which can be a burden for big cities, let alone many of the small and midsize or rural communities across the country that are often both cash- and data-poor.

In all of these cases the biggest barrier to expanding innovative finance for infrastructure is the lack of funding available to design and develop strong infrastructure project proposals, not to build them. So, what can we, do to hasten the development of the project pipeline?  The first step is making it easier for cities to design new and innovative projects that tackle real problems, like upgrading aging and failing combined sewer systems, not just creating ribbon cutting opportunities.

Often being innovative for a city means being the second or third to do something. So, making sure successful projects are searchable and replicable is key.  The Atlas Marketplace has started to do that by capturing information about the people, policies, financing schemes, and procurement documents that got projects built.

The second step is improving project predevelopment starting at the ideation and design phase. Instead of relying solely on long-term capital improvement plans that respond to historic needs, cities should work to identify cross-sector opportunities that can create savings that up new opportunities. Like laying rentable dark fiber every time a road is repaved, or upgrading water infrastructure to reduce the costs of mudslides. This works best when cities engage early with financiers and engineers to unearth opportunities by issuing challenges or broad requests for ideas.

Finally, building local capacity is essential. There is a big difference between the type of data that governments need to support investment and the type of data private financiers need to support investment. Being clear about that and not conflating the two will go a long way in closing the gap between projects and money.

While it’s fun to talk about innovative financing, it’s time we change the conversation. Moving forward let’s focus on building a pipeline of innovative projects that opens the door for private financing. Because if we build it to make money, the private investors will most definitely come.

P3s are great, we want P3s! But what about…?

Last week, we proposed rethinking public-private partnerships (P3s). Instead of closing a financing gap, P3s should fill a project execution gap. This change in perspective can better align incentives upfront and address the fundamental fact that public and private partners have different priorities.

Today, we’re taking a closer look at the issues cited as top barriers to traditional P3s: political risk, payments, and responsibilities. Lack of clarity for any of these three issues will exacerbate differences and drive a wedge between partners when project financing, rather the project delivery, is the goal. Let’s dive into each area of concern, and consider how a focus on execution rather than financing could lead to more successful public-private-partnership.

 Political Risk: Traditionally in the US, P3s are developed after the project scale and scope has been established, and the project has become so big, complex and/or long-term that it cannot be entirely financed on a city’s balance sheet. These types of expensive, complicated, and long-term projects leave public and private partners exposed to all sorts of non-market risk — not the least of which is politicians changing their minds or being voted out of office mid-project. In traditional financing-focused P3s, changing political dynamics can doom an entire project. But if a P3 is designed for execution rather than just financing, then private partners are involved in troubleshooting and negotiations from the beginning, not just once it’s clear the money will be hard to find. That early engagement between public and private partners builds trust in a city’s staff and institutions, beyond individual elected leader(s) — which is key to ameliorating political risk. In addition, early engagement means all parties are driving towards and end goal that is focused on addressing local needs, not just on financing a solution. Some cities are already encouraging early engagement and participation with private partners through broader use of competitions and Requests for Information.

 Payments: Quality cash flows are one of the greatest risks for any public-private-partnership. Many public infrastructure deals have failed or been slammed by citizens because real cash flows end up being very different than were predicted. The Indiana Toll Road is just one of several P3s that filed for bankruptcy after revenue came in much lower than projected. On the other hand, Chicago’s 2008 parking meter deal with Morgan Stanley caused a citizen uproar when the city’s inspector general concluded, a year later, that it had undersold the rights by about $1 billion, forfeiting an important source of revenue for the City. When a project is designed from the start to focus on service delivery instead of solely on financing, there is often opportunity to uncover non-traditional funding sources. The same is true when designing a P3. When private partners are at the table to start, more creative work can be done to clearly identify and quantify a range of potential payback streams. Having private partners help design, verify, and securitize cash flows results in a better deal for the city, the developer(s) and the investor(s). That’s why availability-payment projects, which are focused on service delivery and often require earlier engagement by private partners, are often more successful and growing in popularity compared to revenue-backed P3s.

 Responsibilities: Designating a single entity — or at least a very clearly defined process — responsible for capturing, aggregating, and monetizing direct and indirect revenues is key to successful P3s. The easiest way to clearly define these responsibilities is through a contract between the city, the developer(s) and the investor(s) that allocates risk among the partners by defining sources of revenues, scope of work and payment terms, goals, and bonuses. A P3 focused on execution rather than financing helps define these lines more clearly so each partner can focus on what it does best. Government would set goals and standards to protect health and safety. Developers and investors would set targets, build and manage cost efficient systems. Government organized P3 offices have been used to successfully execute these arrangements internationally in Canada and Australia, and at the state-level domestically in Virginia, California, and Michigan. P3 offices provide the technical support public agencies need to coordinate public and private partners. These offices are effective because they steer governments towards projects that can thrive with P3s and help with upfront planning, and structuring using their in-house financial expertise.

P3s are an effort to make building and maintaining big-dollar, complicated, long-term infrastructure projects more efficient and affordable. P3s are complicated. There will always be questions about political risk, payments, and responsibilities. But well-conceived P3s — those focused on project delivery instead of financing — can effectively align incentives and address risks for all partners upfront. Not only can these well-conceived P3s save taxpayer money and reduce burden on local governments, they can also result in better service delivery for residents and maximize the social benefits of a project.

For example, the City and County of Honolulu partnered with Covanta on the H-Power waste-to-energy plant with the goal of eliminating landfills from the island while creating a sustainable energy source. Since its initial completion in 1993, the plant has not only consistently met or exceeded environmental permits and invested in innovation, it has also generated more than $201 million in revenues for the City, which has more than covered the costs of operation. More and more, we are also seeing examples of startups and other technology firms developing exciting P3s with cities to upgrade infrastructure systems.

Next in this series, we’ll explore various examples of successful execution focused P3s — from the traditional to the more exotic.

P3s are dead, long live the P3!

For cities, President Trump’s budget includes some proposals that are sources of optimism and others that have raised concern. President Trump’s consistent support for increasing investment in infrastructure has been encouraging. If the proposed $1 trillion in infrastructure investment is strategic, the investment could be a great help to those cities struggling to upgrade aging and failing systems. However, the President’s budget also proposes to eliminate or drastically cut many of the programs that cities around the country rely on to provide essential services to their poorest and most vulnerable citizens.

 

Amidst this uncertainty, two things are clear: federal funding will continue to dry up, and cities must take charge where state and national politics are deadlocked. This reality has jumpstarted a decades old conversation on the role and importance of public-private partnerships (P3s).

 

Unfortunately, traditional P3s are complicated for everyone. Not only does each state have different processes and practices, but the American public has varying levels of comfort with private ownership, or even operation, of public infrastructure. It’s those reasons — in addition a strong municipal bond market and regular infusions of federal funding for infrastructure after the 2008 financial crisis — that have kept P3s from proliferating here in the US the way they have in other developed countries around the world.

 

Or maybe we’ve been thinking about P3s the wrong way. Instead of thinking of P3s as a solution to the financing gap, we should approach P3s as filling the execution gap.

 

In the US, P3s have always been touted as a solution to the financing gap: “your city doesn’t have the resources to build an infrastructure project? You should pursue a P3!” But in Canada, and elsewhere around the world, they are used to fill an execution gap. This means P3s are focused on service delivery, optimization, and efficiency — where financing comes as a result, but isn’t the driving factor. May seem like semantics, but it gets to the fact that public partners tend to focus on services and private partners tend focus on ROI. Execution-focused P3s address that fundamental fact that public and private partners have different priorities, and explicitly seek to better align those differing priorities upfront.

 

Execution focused P3s can also better match the types of modern infrastructure systems that technological advances have allowed cities, and their citizens, to demand. These modern infrastructure systems — unlike highways and bridges — are often diffuse and consist of many small pieces and parts. For example, a modern stormwater management system might include thousands of street trees, green roofs, wetlands, and repaved roads to absorb water. Or a large power plant might be replaced with a network of neighborhood generators that turn food waste into energy. Because these systems tend to have a large number of smaller component projects, aggregating them into a single P3 focused on delivering project financing can have insurmountably high transaction costs.

 

Because these more modern infrastructure systems are deliberately designed to more flexibly and efficiently provide the same services to citizens as traditional projects, they tend to result in the same, if not greater, local benefits. In addition, they require extensive citizen participation, open new pathways for private investors to participate, and can take the burden off government budgets to build.

 

Examples of successful execution-focused public private collaboration abound, especially around smart cities technology. Waze, through the Connected Citizens Program, is partnering with cities around the world to use real time data to reduce traffic congestion. The City of Las Vegas released an app this year for Amazon’s Alexa that lets residents pay bills and fees, check the status of applications and permits, and get more information on city services and officials. These technology businesses have figured out how to approach distributed infrastructure systems by focusing on providing a service. We should aim to learn from these successful cases, and apply them to develop and deploy execution-focused P3s for in sectors, like electricity generation and delivery and stormwater management, moving forward.

 

As with any multi-party agreement, there will always be questions about political and staff turnover, ROI, payments, and responsibilities (more on that in future posts!). But if at the outset, a P3s focus is on service delivery and execution, the details — and the money — seem to shake out more clearly and in the public’s favor than they do in traditional financing-focused P3s.


P3s in the Trump Era can’t look like P3s of the past. Instead of being a solution to the financing gap, P3s should be leveraged to fill the execution gap. They should be focused on service delivery, optimization, and efficiency — where private financing comes as a result, but doesn’t drive decisions. And where each partner is focused on what it does best: the government partner set standards and desired outcomes, permits and regulates; developers and investors build and manage cost efficient systems; and citizens actively engage in optimizing solutions for their community.

 

What do you think? What are some of the most impressive technologies, business models, or execution-focused public-private partnerships you have seen? What were the benefits and drawbacks to the public and private partners involved? What was the impact on citizens, and how did they respond?


Like this topic? Keep an eye out for future posts where we explore in greater depth some of the challenges of traditional P3s, as well as highlight examples of execution-focused P3s.