Number 86

18 November 2016

Economic Bulletin
INFRASTRUCTURE CAN BE A BAD
INVESTMENT

Image Credit: Birmingham News Room/Creative Commons

US & UK politicians are calling for more government spending on infrastructure. Philip
Hammond should be cautious of this approach at the Autumn Statement.

UK Government should focus on improving the quality of infrastructure development

(particularly by harnessing private investment), not simply allocating more public funds.

Over-investment in infrastructure can be damaging. 55% of Chinese infrastructure projects are

estimated to destroy economic value.

Nine out of ten large infrastructure projects are over budget. On average, rail projects are 45%
over budget.

Trialling of new Project Bonds could boost private investment. Warrants awarded to the Treasury
mean taxpayers benefit from excess profits, avoiding problems with the discredited PFI.

UK Government should encourage private investment in the areas of broadband, airports, ports,
energy industry, roads and social housing.
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INTRODUCTION
Keynes is back, or so it seems. Often justified in terms of being affordable in a world where
the current cost of government borrowing is extraordinarily low, advocating high levels of
infrastructure spending is firmly in fashion. In the US, Donald Trump is proposing to invest
$550 billion on building the roads, highways, bridges, tunnels, airports, and railways of
tomorrow, exactly doubling Hillary Clintons pitch in the presidential election to spend $275
billion in direct spending on infrastructure (plus another $225 billion in loans). In the UK, the
Shadow Chancellor John McDonnell MP has proposed an even more lavish 500 billion
infrastructure programme (equivalent to 27% of annual UK GDP, compared to Trumps
planned 3% equivalent of US GDP). Although more modest in scale, the Chancellor, Philip
Hammond MP, has also announced his intention for more spending on infrastructure.
But is this race to spend more and more on infrastructure sensible? And would it not be
better to focus on the quality of infrastructure spending, as opposed to the quantity?
To ask these questions is not to suggest that todays UK infrastructure is ideal. Much needs
to be done in areas such as, for example, broadband, energy, (some) rail improvements,
airport expansion and seaport development. The right questions to ask are how these
projects should be prioritised; how they should be funded; and what should be the role of
the private sector in bringing sensible projects to fruition.

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1. THE UKS INFRASTRUCTURE NEEDS

Figure 1: UK Global Competitiveness Index

Source: World Economic Forum

Arguably, the UK is well ahead of many of its OECD competitors, ranking 9 th out of 138
countries in terms of its infrastructure provision, according to the latest World Economic
Forum Global Competitiveness Index.
However, this relatively encouraging index score conceals issues in some specific areas.
The UK scores much less well in terms of road, railroad and air transport infrastructure,
scoring 27th, 19th and 18th out of 138 respectively. There are also well documented problems
associated with broadband provision in the UK. According to the Ookla speedtest, the UK
has the 30th fastest average internet speed in the world.

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Quantifying the infrastructure investment gap is difficult. However, one authoritative

estimate has suggested that it is relatively modest at 0.4% of GDP in the UK, or around 7
billion.

2. NEED FOR CAUTION ON INFRASTRUCTURE SPENDING

Infrastructure investment can of course help spur economic growth and productivity in
certain circumstances. The International Monetary Fund, for example, has said that: where
needed and where fiscal space is available, fiscal policy in advanced economies should be
supportive of short and medium term growth with a focus on boosting future productive
capacity, in particular through infrastructure investment.
But this is not to say that infrastructure investment per se is necessarily a boon for economic
growth. IMF economist Andrew M Warner has warned: When you flip the infrastructure
switch, the light doesnt necessarily turn on. The returns are a long way from being
automatic.
Over-investment in infrastructure can even end up having a negative impact on the macro
economy. This can been seen in China where Professor Deepak Lal has noted that 55% of
recent projects in China are judged to be destroying economic value. China spends the
highest proportion of GDP on infrastructure in the world, and it is estimated that it will
overinvest 3.3% of GDP in infrastructure over the next 15 years (see figure 2).
Figure 2: Infrastructure gap in China
Economic infrastructure (% of GDP)

Source: McKinsey

Excessive spending on infrastructure programmes can also cause problems in itself, not
least in adding to national debt burdens. For example, Professors Kenneth Reinhart and
Carmen Rogoff have found that debt to GDP ratios over 90% lead to median economic
growth rates falling by 1%. Other studies suggest that the fall could be as high as 2.2%.
Furthermore, if the Government uses its current borrowing capacity on unproductive
infrastructure projects, it may well have a harder time borrowing in the future for some more
urgent need.

3. PROBLEMS ASSOCIATED WITH LARGE INFRASTRUCTURE PROJECTS

Those of a conservative disposition may also feel uncomfortable with the idea of large
infrastructure projects as they assume a level of knowledge and certainty that is rarely
available at the outset of a development. And, in practice, multi-billion pound projects have
proven to be fraught with difficulties. McKinsey estimated, for example, that on average rail
projects go over budget by 44.7% and their demand is overestimated by 51.4%. And Professor
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Bent Flybjerg of Oxford University has shown that nine out of ten such projects have cost
overruns; overruns of up to 50% in real terms are common, over 50% are not uncommon
Similarly, benefit shortfalls of 50% are also common and above 50% not uncommon, again
with no signs of improvements over time and geography.
Why have large projects often historically proven to be extraordinarily bad value for money?
Professor Bent Flybjerg has identified the danger of the Four Sublimes:
1.

The Technological: The excitement engineers and technologists get in pushing the
envelope for what is possible in longest-tallest-fastest types of projects.

2. The Political: The rapture politicians get from building monuments to themselves and for
their causes, and from the visibility this generates with the public and media.
3. The Economic: The delight business people and trade unions get from making lots of
money and jobs off megaprojects, including money made for contractors, workers in
construction and transportation, consultants, bankers, investors, landowners, lawyers,
and developers.
4. The Aesthetic: The pleasure designers and people who love good design get from
building and using something very large that is also iconic and beautiful, such as the
Golden Gate Bridge.
The Hiding Hand Principle

The Hiding Hand Principle advocated by Albert Hirschman is the idea that ignorance
about the future obstacles of a given project allows planners to go ahead with the project.
Once the project is underway, planners will then creatively overcome any obstacles that
arise because it is too late to abandon the project.
This theory is often used as a critique of modern day cost benefit analyses. Vital former
infrastructure projects, the argument goes, would not have been built had these cost-benefit
analyses been applied at the planning stage of these projects.
Professor Flyvbjerg has also explained that this is a complacent way of viewing infrastructure
programmes. Underestimating costs and overestimating benefits for a given project which
the Hiding Hand Principle in effect advocates leads to a falsely high benefit-cost ratio.
This can lead to projects being started despite being economically unviable and can lead
to major opportunity costs by forgoing other projects that would yield greater returns.

4. HOW TO PRIORITISE INFRASTRUCTURE

In an ideal world, all infrastructure projects would be funded entirely by private operators,
who would assume all risk in a project and who would seek a financial return by providing a
service in a competitive marketplace. However, many infrastructure projects are by their
nature inherent monopolies while others generate no direct financial return or may require
some government insurance against tail risk.
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In addition, according to a note published by Deutsche Bank, even under favourable

assumptions the private sector could only provide just 15 to 20% of the projected
infrastructure funding shortfall globally. The UK, however, is rather unusual among advanced
economies in the extent to which it relies on the private sector to finance and provide
infrastructure. The majority of the investment in the pipeline is expected to be financed from
the private sector. On the face of it, this appears to be positive. However, there are a number
of things to take into consideration.

In many cases, private investors receive government guarantees that do not require them
to take on significant risk. For example, over half of planned investment in UK
infrastructure will be in the area of energy (see Figure 3) most of which is private
investment in renewables that requires large and compulsory consumer subsidies.
While private sector investors risk is limited in these incidences, the renewable energy
generators are offered a guaranteed strike price for the power they produce.

There are fewer privately financed projects being successfully structured and closed
now compared to before the financial crisis due to the abandonment of Public Private
Partnerships, according to the British Bankers Association.

There will inevitably be certain circumstances where particular infrastructure projects will
need government support. In almost all mega projects an Act of Parliament or a National
Policy Statement is required to give a project the go ahead.

Figure 3: Planned investment in the UK by source of finance (2016 onwards)

Source: House of Commons Library

5. WHAT CRITERIA SHOULD BE USED TO PRIORITISE INFRASTRUCTURE?

Those projects which are entirely financed by the private sector, and which will operate in a
competitive market, should in principle be treated positively by the Government whose
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responsibility should be limited to ensuring the right regulatory environment. This would
include projects such as:

The Third Runway: The great majority of funding for the expansion of Heathrow airport
will come from the private sector. Furthermore, private investors will take on a substantial
amount of risk. The commercial risk of an underused new runway, for example, would in
theory lie with the private investors rather than government.

The roll out of high speed broadband: There is mounting evidence that BT Openreach
should be referred to the Competition and Markets Authority to see whether competition
can be boosted in the broadband industry (See Break BTs Monopoly on Broadband).

The shale gas industry: Shale requires no public subsidy and all risk lies with the private
sector. This highlights the need for planning impediments to the shale industry to be
removed.

The development of the hinterland around UK ports: proposals to create Free Zones
around UK ports would require no public investment, with the development risk and
return being borne by the UK port sector.

The use of private sector expertise and finance to build new social housing: the
Government should explore new solutions to affordable housing development such as
that put forward by Simple Space. Entirely funded by the private sector, this aims to
deliver housing developments that incorporate 50% genuinely affordable housing for
rent on any Council owned Brownfield sites whilst also creating new Private Rented
Sector portfolios and significant new income streams for the Council.

Private sector involvement is not a guarantee of success, of course. But it does mean that
the cost of failure is borne by private investors, not taxpayers. And in addition, the risk of
failure is reduced as private investors will not be so vulnerable to the Four Sublimes
identified above. In addition, as Professor Flyvbjerg has stated: Banks typically bring in their
own advisers to do independent forecasts, due diligence, and risk assessments, which are
important steps in the right directionAnd why is this healthier? Because it undermines trust
in the misleading forecasts often produced by project promoters.
The benefit of ensuring some level of external involvement
In some cases, public finance or a government guarantee of some kind is of course needed.
This does not necessarily mean that such projects cannot be run as efficiently as those
entirely financed and developed by the private sector, as shown by the success of Crossrail.
Its funding of 14.8 billion comes from a variety of public bodies, including Transport for
London, the Greater London Authority and the Department for Transport. There are also
contributions from various private sources, including the City of London Corporation and
Canary Wharf. Expected to open on time and on budget, this project could improve the UKs
reputation for delivering major infrastructure projects.
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The key here is that the wide range of different stakeholders, including representatives from
the private sector, can challenge and dilute any early over-optimistic assumptions.
The danger of mega-projects entirely controlled by government
Where there are no such range of external interests involved as in the case of HS2 a
more sceptical approach is needed. The previous Coalition Government acknowledged that
private sector involvement in the financing of HS2 would be minimal, saying that third party
contributions could only deliver a small percentage of the core costs for HS2. This is
disappointing in light of the Shaw report, which highlighted that for rail projects more
generally options for involving private sector finance should be explored.
The estimated costs of HS2 have increased dramatically since 2010, according to the House
of Commons Library. The Conservative Party estimated that the cost would come in at 20
billion in before the 2010 election. By January 2012, the estimate had increased to 32.4
billion. The following year, the overall projected cost rose to 42.6 billion (in 2011 prices). In
November 2015, the total cost was estimated to be 50.1 billion in 2011 prices. External
forecasts suggest that the burden for taxpayers could end up even higher than this, with the
Institute of Economic Affairs suggesting the cost may rise to 80 billion.
In 2015, the House of Lords Economic Affairs stated that the Government had not made a
convincing case for HS2, concluding that the project does not make an adequate case for
the Governments objectives of increasing rail capacity or rebalancing the economy. It also
concluded that overcrowding on Britains railways appears to be caused by commuter traffic,
not long distance traffic, which undermines the case for HS2.
Although recently given the go-ahead by Government, it is not too late to scrap or revise the
project given that it has not yet reached Committee Stage in the House of Lords yet.

CONCLUSION
As Jesse Norman MP noted in the CPS publication After PFI, the Private Finance Initiative for
projects such as the construction of hospitals has been one of the costliest experiments in
public policy making. This type of public-private partnership has left huge costs for
taxpayers, leaving the UK with 200 billion of public debt.
But if PFI is (rightly) discredited, and yet if private sector investment is likely to improve the
development of major projects, what can be done?
A New Financing Model for Infrastructure
The number of privately financed infrastructure projects has fallen since the Governments
abandonment of the PFI model. The Government is reported to be now looking at creating
infrastructure bonds, to be issued by a quango called Infrastructure and Projects Authority.
While details are sketchy at this point, it seems these will be public sector debt and hence
added to the national debt.
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An alternative, but internationally tested, method of encouraging private sector finance into
infrastructure would be Project Bonds. Using the well-developed capital market expertise in
the City of London, Project Bonds could offer an opportunity for institutional investors to
participate in specific infrastructure projects through listed, tradable securities, thereby
bringing private investment and skills into new projects. Although probably requiring a higher
yield compared to the current cost of government borrowing, they could lead to significant
improvements in the quality and efficiency of infrastructure projects for the following
reasons:

Each project would need to demonstrate that it has a robust business case, thereby
limiting the temptations of the Four Sublimes.

Being privately financed, the projects would be off the government balance sheet,
holding down debt to GDP ratios.

Projects would be able to attract new sources of financing, bypassing the need to get in
the queue with the Treasury.

Independently financed projects would be free from Whitehall interference.

The degree of risk taken by the private sector for Project Bonds would, of course, vary on a
case by case basis (but the Government should do all it can to minimise its share of risk).
But to avoid private investors receiving excess profits, the Treasury could receive equity
warrants that would enable it to share in the profits if the project is refinanced after
construction. This should go some way to reassuring taxpayers that problems with the PFI
would not happen again.
Finally, it would be relatively simple to trial the concept of Project Bonds, both to test investor
appetite and their effectiveness in improving infrastructure quality
Other Areas to Improve Infrastructure Quality

Along with the promotion of this new form of financing for infrastructure, the Government
can also do more to encourage privately financed infrastructure projects. This includes:

easing the development of airport capacity.

removing constraints on the shale gas industry.

facilitating Free Ports.

exploring the potential of innovative new privately financed social housing schemes.

examining whether BT Openreach should be referred to the Competition and Markets

Authority over competition in the broadband industry.

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At the same time, there should also be a far more sceptical approach to infrastructure
projects that have very limited private sector involvement. This particularly applies to the
proposed High Speed 2 project (it would of course be interesting to see whether there were
any institutional appetite for Project Bonds for this project). It is not too late to scrap HS2
given that it has not yet reached Committee Stage in the House of Lords.
Daniel Mahoney, Tim Knox and George Trefgarne
Centre for Policy Studies
DISCLAIMER: The views set out in the Economic Bulletin are those of the individual
authors only and should not be taken to represent a corporate view of the Centre for
Policy Studies
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