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The New Privatization
States and cities are selling their roads, bridges, and airports for eye-popping sums.
Ive got a bridge to sell you sounds like a sleazy salesmans pitch. But if Indiana governor Mitch Daniels offers you one, maybe you should believe him. Daniels has already auctioned the rights to operate the Indiana Toll Roada 157-mile road linking the Chicago Skyway in the west to the Ohio Turnpike in the eastto a private group for $3.8 billion. Hes got other state assets hed like to sell, too, if he can just get the Indiana legislature to go along. Meantime, Chicago mayor Richard Daley has harvested $1.8 billion auctioning the Skyway itself to a private group, and another half-billion or so turning city-owned garages over to private operators. Now hes trying to sell Midway Airport; it could fetch $3 billion.
These deals are the leading edge of what could become the biggest injection of competition and private capital into American government in generations. Across the country, cash-strapped governors and mayors are discovering that their airports, bridges, toll roads, water systems, and other revenue-generating operations are worth far more than they thought, and are eyeing auctions that might produce windfalls similar to those in Chicago and Indiana. Theyre also looking to recruit private investors to build and operate new toll roads, bridges, and other infrastructure.
If the deals can overcome resistance from anti-privatization groups and from politicians who benefit from keeping a stranglehold on government assets, they could help make up for decades of underinvestment in infrastructureand thereby renew Americas landscape. Theres probably $100 billion in domestic capital alone thats being raised to invest in these transactions, and when thats leveraged with debt, youre probably looking at up to $400 billion in money thats ready to go to work, says Dana Levenson, Chicagos former chief financial officer and now an investment banker at Royal Bank of Scotland. Add foreign investment to the mix, and the sums get even more impressive.
The trend proves the axiom that whats old can be new again. Private investment in infrastructure, especially bridges and roads, was common in early United States history. Immediately after the Revolutionary War, for instance, investors put up $465,000 to build the Philadelphia-Lancaster Turnpike, a 66-mile toll road that proved so popular that it led to further waves of private investing in highways. During the first half of the nineteenth century, private funds provided the young republic with some 600 toll roads. And as the country spread westward during the second half of the century, infrastructure investors helped ease the way, with 100 toll roads in California alone. In fact, the private sector kept building roads until the automobiles arrival prompted more extensiveand costlygovernment safety regulations, which at the time made toll roads a largely unprofitable venture. Government turned to new methodsespecially municipal bonds, which investors like because they arent taxedto finance infrastructure.
Privately financed infrastructure has made another appearance in postWorld War II Europe. Starting with 1955 legislation, France began to tap private investors to build and operate what eventually amounted to 3,400 miles of autoroutes between cities. Margaret Thatchers energetic privatization drive in 1980s England sold existing government assets and spawned scores of public-private construction projects. The Soviet Unions collapse led to extensive privatization in former Eastern bloc countries during the nineties. The U.S. Department of Transportation figures that worldwide, more than 1,100 public-private deals have taken place in the transportation field alone over the last two decades. Total value: approximately $360 billion.
Though the United States has applauded all this privatization, weve done little here at home by comparison. While politicians in both parties embraced a reinventing government ideal in the early nineties that sought to bring greater competition to the public sector by outsourcing government services, union opposition slowedand, in many cases, derailedthese efforts. At the same time, tax-free financing, which doesnt exist in most other countries, gave states and municipalities an incentive to build with lending instead of turning to the market.
But state and local governments, spending ever more on such items as Medicaid, education, and bloated public-employee pensions and benefits, have given infrastructure the short end of the stickeven as traditional financing sources, such as proceeds from gas taxes, havent kept pace with the growing need. Over the last 25 years, as the miles driven on U.S. roads have doubled, road spending has increased by less than 50 percent. Deterioration is the inevitable result. Nearly a fifth of Americas roads are in pitiable shape, according to the U.S. Department of Transportation, and nearly one out of every three bridges earns the departments structurally deficient rating. Road congestion, a by-product of too little new building, costs the American economy about $65 billion annually, as trucks and cars snarled in traffic burn up time and fuel. The clogging is likely to get worse. These costs have been growing at about 8 percent per yearalmost triple the rate of growth of the economy, Tyler Duval, assistant secretary of the Department of Transportation, informed Congress in February.
The bill for alleviating these woes will be gigantic. Texas, for example, estimates that it must spend some $100 billion extra on current and new roads to keep up with its anticipated growth over the next quarter-century. Oregon calculates that it needs an additional $1.3 billion a year just to keep its existing transportation network from crumbling. Most states face similar financing gapsand thats not including the billions of dollars necessary to update airport security and expand water ports.
Public funds arent about to solve this crisis. Rocketing gasoline prices have made it politically unpalatable to increase fuel taxes, and some state and local budgets are already buckling under big annual debt payments from decades of borrowing. States are desperate, says David Osborne, coauthor of Reinventing Government and, more recently, The Price of Government. He predicts a perfect storm of fiscal stress as the population ages and fewer taxpayers must support bigger government. The situation isnt going to be getting better; its going to get worse, which is what has suddenly made more politicians interested in privatization. Does no one notice the risk of inaction? Indianas Daniels asked critics on Capitol Hill last year.
Confronting a $3 billion transportation-funding shortfall, Indiana decided to use an auction to extract the Toll Roads long-term value. In effect, a private operator gave Indiana a fat up-front payment in exchange for the right to collect tolls on the road for 75 years. Like the Chicago deal, which hands over the Skyway for 99 years, the Indiana lease is basically a sale, since its term exceeds the roads anticipated life. Each agreement requires the private operator to invest in rebuilding the road as it falls apart and to follow a lengthy list of operating standards, from how best to fill potholes to how quickly to clear roadkill.
The private operators readily agreed to these conditions and still bid higher than anyone expectedbecause they saw value in the roads that the local governments didnt. Until now, the only way that local governments could wring value from these properties was to levy tolls or fees on them, and then use the proceeds to pay back money borrowed in the municipal bond market. Fiscal experts long assumed that because municipal financing is tax-free and therefore attractive to investors, this approach would get the best return on investment. But the Chicago and Indiana transactions have exploded that notion, demonstrating a basic principle that anyone whos ever bought or sold on eBay readily understands: the true worth of something is what folks are willing to pay for it. Using tax-free financing, Chicago thought that it could extract at most about $900 million from the Skywayhalf of what the auction eventually brought in. Indiana pegged the Toll Roads value at just $1.8 billion, $2 billion less than it got from the private sector. Theres no way that the state could have come up with nearly $4 billion for the tollway using traditional government financing, says Matt Will, a finance professor at the University of Indianapolis.
The vast differences in valuations highlight essential differences between the private and public sectors. For starters, private financiers investing in these dealsmostly managers of international pension fundsoften have a greater taste for risk than do investors in government bonds, who typically require governments to rely on the most conservative revenue projections. The winning consortium in the Chicago Skyway auction estimated that traffic would grow annually by about 3 percent; the citys own study used a more conservative 1 percent growth rate. The variation of merely a few percentage points of growth, stretched out over decades, helped create the huge divergence in the Skyways perceived value.
Further, the Skyway sale transfers risk from the taxpayer to the private owner. If the roads traffic doesnt grow as anticipated, the investors must accept a lower rate of return; the taxpayers will already have their money. Of course, if traffic outpaces expectations, the investors get a windfall. The Skyways new ownersa partnership between Australias Macquarie Bank and a Spanish construction firmhave shown that they intend to make their property live up to the brighter projections. Within three months of closing the deal, they had installed an electronic toll-collection system to help zoom traffic along and assigned additional collectors during rush hour to gather cash more quickly. The result: reduced wait times, boosted Skyway useand more money coming in. Chicago didnt bother with any of these reforms when it managed the road, a Macquarie managing director testified before Congress last year. Unlike the city, he said, Macquarie was heavily incentivized to run the road efficiently.
For local politicians, shielding public jobs or maintaining jurisdiction over an asset is sometimes more important than improving results. Quasi-public authorities, for instance, now operate many toll roads, bridges, airports, and ports, and too often they serve as patronage mills. To take one example, a federal investigation of a powerful Pennsylvania state senator revealed that the states turnpike commission handed out lucrative consulting contracts, paying some $220,000, to one of the senators friends, who appeared to have spent most of his time running the pols private estate. The investigation has given a huge lift to Governor Ed Rendells proposal to lease the Pennsylvania Turnpike, and it is just the latest to uncover patronage and lousy management at the commissionwhich was supposed to have gone out of business after building the turnpike six decades ago, but today employs about 2,000 people, including 500 administrators, to operate the 537-mile road. The turnpike commission has traditionally been a patronage cesspool, says Matthew Brouillette, president of the Commonwealth Foundation, a Harrisburg-based think tank that supports the lease.
Even when outright patronage isnt involved, civil-service pay scales and cushy union contracts rarely inspire public employees to maximize results. Chicagos Levenson recommended selling the citys parking garages, for instance, because they simply didnt run at capacity, even though they charged less than most competing private garages. Government is just not set up to give the person supervising those garages a $20,000 bonus if he raises capacity, or fire him if it fails, says Levenson. In a study that Daniels commissioned after taking office, Indiana found that it spent 34 cents to collect every 15-cent toll. We would be better off using the honor system, Daniels quipped.
The Chicago and Indiana deals success now has political leaders scrambling to find other privatization options. Daley seeks federal approval to auction the rights to operate Midway, Chicagos second-largest airport, as part of a federal project to demonstrate the benefits of privatization. Midway would be the second airport, and the first major hub, to enter the program. (The first was Stewart International Airport in Newburgh, New York, which the Pataki administration privatized in 2000.) In Colorado, the independent state authority that operates the Northwest Parkway, a Denver-area toll road, is evaluating bids for a 50-year lease to run it; the transaction could raise $500 million. New Jersey governor Jon Corzine is thinking of selling the New Jersey Turnpike, which could yield some $20 billion, though hes also considering floating municipal bonds, backed by the turnpikes tolls, which would raise less money but allow the state to continue operating it. Many smaller-scale deals are in the works, too. The Macquarie director said last fall that he anticipated as many as 25 toll-road privatizations in the U.S. over the next two years, potentially pouring $80 billion into government coffers.
Selling existing assets may turn out to be only a small part of this promising story. With far more money to deploy than there are public assets to sell, investors are now vying to help governments build and operate new infrastructure, and budget-squeezed states are taking them up on their offers.
Currently, 23 states have laws that permit such public-private deals, and several of them have already forged agreements. Texas, for instance, has made private capital a key ingredient in a vast road-building project known as the Trans-Texas Corridor. In California, a private company is constructing a nearly ten-mile, $800 million extension of Route 125, south of San Diego, in exchange for a 35-year lease to manage the road and collect tolls. Utah is contemplating private financing to build the Mountain View Corridor, a road connecting Salt Lake City Airport to towns in Salt Lake and Utah Counties, instead of raising its gas tax by up to 50 cents per gallon. Virginia has inked an agreement with Australian toll-road firm Transurban, which already leases the states nine-mile Pocahontas Parkway, to study expanding Interstate 95 with high-occupancy toll lanes. If approved, the project would cost nearly $1 billion. These roads dont exist and in many cases they wont ever exist unless the private sector builds them, says Mark Florian, a Goldman Sachs investment banker and an advisor on several such transactions in Texas.
Private contractors are much better than government at getting construction done on time and on budget. A 2002 government study in the United Kingdom, where public-private transactions are more common, found that 70 percent of public construction undertaken by the government ran late and that 73 percent of it finished over budget. But when government contracted projects to private firms, just 24 percent of them were late and only 20 percent were over budget. In the United States, the Dulles Greenway, one of the few roads built and run privately during the nineties, opened six months ahead of schedule. Theres no mystery here, since private contractors cant start collecting revenues until properties are up and running.
The extraordinary breadth and scope of these deals places America on the verge of a financing revolutionthat is, if it isnt snuffed out by powerful politicians and anti-privatization advocates, whore trying to turn a practical solution for governors and mayors into a partisan issue. Theres no reason that Democrats shouldnt get behind privatization, as they did recently in big projects in Chicago and Virginia. Nevertheless, Democratic congressman Peter DeFazio of Oregon, head of the powerful House Subcommittee on Highways, Transit, and Pipelines, accused the Republican Daniels of selling the Indiana Toll Road to make an ideological point about downsizing government.
Opponents charge that these transactions fleece the public. DeFazio, for instance, accuses Indiana of giving away a valuable taxpayer asset, and populist CNN commentator Lou Dobbs grumbles that for government to sell infrastructure boggles the mind, since it auctions assets built with taxpayer money to the private sector. The commissioners of Harris County, Texas, declined to auction their lucrative roadway system because, as the countys finance director said, If anyone comes in and gives you a billion dollars, they certainly expect to make twice or three times that.
But in state hands, many of these assets, dismally underperforming, have failed to attain their true value. For governors and mayors to liberate that potential without turning to the private sector, they would have to eliminate patronage in the government agencies that run the properties, incentivize public employees to produce better results, and pitch more aggressively to investors in municipal bond offerings. Such changes are possible, but theyre only likely if the public sector finds itself forced to compete. Merely claiming, as Harris Countys commissioners did, that they will adopt private-sector business practices and get better results hardly guarantees that the taxpayer will get his moneys worth.
In fact, its when government is insulated from private competition that the taxpayer really loses out. The Pennsylvania Turnpike Commission, for instance, has floated an alternative to Governor Rendells privatization that would raise billions for the state. But it includes placing new tolls on currently free Pennsylvania roads and raising the states debt, measures so odious, the Pittsburgh Post-Gazette editorialized, that they made a leasing deal look good.
Privatization foes also claim that profit-hungry private operators will squeeze taxpayers dry by raising tolls or fees precipitously and skimping on maintenance. This charge ignores the detailed operating requirements written into privatization contracts, which limit how much new operators can hike tolls over time and punish owners who fail to meet standards. The agreement for the Indiana tollway lease is far more detailed than anything InDOT [the Indiana Department of Transportation] had to live up to when it was operating the road, says Matt Will of the University of Indianapolis. I dont know if InDOT could have lived up to these standards. Consumer choice also protects taxpayers. The majority of toll roads have opened as high-speed alternatives to already existing routes. Companies know that if their roads become too expensive or unpleasant, drivers will abandon them. The owners of the Dulles Greenway in Virginia initially didnt meet their traffic projections, so they lowered tolls to lure more traffic.
One subtext in the resistance to privatization is that much of the money comes from foreign sources. Parroting a story in the far-left magazine Mother Jones, for instance, CNN commentators have accused Wall Street and the Bush administration of surrendering our roads to foreign investors. Its true that, so far, foreign investors dominate the infrastructure marketplace. Theyre mostly from places like Australia and Western Europe, where such investments are more common. Much of their money comes from pension funds seeking to invest capital in long-term ventures with a more predictable rate of return than the stock market offersa profile that fits transactions like the Indiana and Chicago deals. But far from opposing such deals, taxpayers should welcome them. After all, theyre shifting billions of dollars in overseas capital to the United States. I consider a significant part of my job to successfully compete for foreign investment, says Daniels. I consider it a victory for Indiana when those dollars come here and put Hoosiers to work, as opposed to go somewhere else.
Such ventures are so attractive that American investors are now raising vast pools of domestic capital to participate in them. Goldman Sachs, Carlyle Group, and Morgan Stanley are all creating new funds for the purpose. Ever since the tech boom ended in the stock market, lots of investorsespecially insurance companies and pension fundsfind themselves with big pots of money that they want to invest for the long term in stable, revenue-producing assets like toll roads, says Goldmans Florian.
Still, flimsy as the anti-privatization arguments are, they resonate with taxpayers, who wonder whether complex privatizing transactions will prove too good to be true. Tough opposition in Indiana has scuttled, at least for now, Danielss attempts to follow his toll-road deal with two build-to-operate highway projects. Opinion polls in New Jersey and Pennsylvania show heavy resistance to selling each states turnpike, though Governor Rendells strong advocacy of a Pennsylvania deal and the missteps of the states turnpike commission have begun to turn things around.
To fight public skepticism, local officials must spell out the benefits of these deals with crystalline clarity, hold buyers to exacting standards, and explain to taxpayers the steep cost of the alternatives: either allowing infrastructure to degrade or languish, or hiking taxes to pay for repairs and new building. An American Automobile Association survey found that 52 percent of respondents favored using tolls to pay for road construction, compared with 21 percent who favored higher fuel taxes. Similar surveys in places as different as Washington State, Minnesota, and the greater Washington, D.C., area have all found that Americans favor tolls over fuel taxes by a two-to-one margin.
Also, officials need to make a strong case to taxpayers that they will invest the revenues from privatization wisely. Indiana, for instance, has committed itself to putting all of its toll-road proceeds back into road building. Governor Rendell would deposit the proceeds from Pennsylvanias turnpike sale into a fund that would produce nearly $1 billion a year in interest for spending on roads and mass transit.
Part of the opposition in New Jersey, on the other hand, arises from reports that the state would use the massive proceeds from a turnpike sale to make up for enormous shortfalls in its public-employee pension fund or to finance a property-tax rebate program. Similarly, Chicagos administration has faced criticism for using some of its privatization money to finance short-term budget items, such as a program to help senior citizens pay heating bills. In those cases, the proceeds merely paper over fiscal problems, or buy short-term political gainall at the expense of the future. Even some proponents will balk at privatization if the money winds up squandered in this fashion. We only support the Pennsylvania Turnpike lease if the money is put back into transportation, says the Commonwealth Foundations Brouillette. Otherwise, we oppose it.
The larger danger is that even as more private capital considers these transactions, state and local officials may come to believe that they can rely entirely on such deals to finance spending shortfalls. But not all roads can work as tollways, since they may lack the traffic to pay for themselves. And its unlikely that taxpayers will stomach taking currently free government properties and services and making people pay for them in order to finance necessary maintenance or rebuilding. So even as governors and mayors pursue deals with private investors that may bring them hundreds of billions of dollars, they still must find a way to channel tax revenues into infrastructure.
In short, the tough work of correcting a generation of overspending on Medicaid, education, and public-employee pensions and benefits isnt over, and difficult political battles are ahead. But for the first time in over a generation, Americas mayors and governors are looking at a realistic way to start spending in places that theyve neglected for too long.