Why capital recycling is an asset and liability for governments

Capital recycling has been touted as a means of bridging Australia's widening infrastructure gap, but there are several reasons why it's not a silver-bullet solution for governments.

The Conversation

The provision of new infrastructure is a high priority for the Abbott government.

It is a worthy cause. New infrastructure will ensure we remain competitive in the international market. Reducing logistics costs could compensate any decrease in agriculture productivity, which may arise because of climate change. Tackling the infrastructure gap over the next few years will also ensure we are better prepared for the full impact of the ageing population. Public funds to finance infrastructure, or to undertake other typical government roles such as providing social insurance or defence, will be in short supply once this impact takes hold.

The Abbott government, however, faces a difficult task to deliver on its ambition to become an infrastructure-focused government. The main challenge is financing infrastructure in a political environment where public debt is inherently bad, and the government narrative (both at the federal level but also across many of the states) is that there is a budgetary crisis.

Private funding through public private partnerships was once considered the solution to this conundrum. But it’s now understood that while PPPs can provide a meaningful contribution to funding infrastructure, they can turn negative if not carefully designed.

Along with a colleague at the University of Auckland, I studied the consequences of the private partner entering the post-construction phase with substantial debts. In two research papers we showed that the need for private partners to borrow large amounts to meet up-front construction costs creates real potential for strategic manipulation of the government.

From PPPs to capital recycling

More recently, capital recycling has taken centre stage as a favourite solution to funding infrastructure. Under this approach, the government sells existing income generating assets to build another asset.

Victoria has become the first state to take advantage of the federal government’s 15 per cent incentive payment for privatising assets, moving to sell the Rural Finance Corporation to Bendigo and Adelaide Bank for $1.78 billion. It will also offer a 40-year lease of the Port of Melbourne, with the funds from both sales to go towards upgrading rail tracks in regional areas.

In a world where governments face constraints on how much they can borrow to invest in income-generating assets, capital recycling can make sense. For example, if the public sector has a greater ability to bear demand risk than the private sector for some types of projects (like ports or airports), governments can fund the construction of the port or airport and own it until demand uncertainty is less material and the asset generates a reasonably steady income stream. An additional advantage is that if governments build to sell, there may be a more realistic (and less political) project assessment.

Unfortunately, like PPPs, capital recycling is no magic bullet. To see why, we need to look at the types of assets that can be sold and how recycling can then work.

The simplest case to consider is that of public assets in competitive industries where a change of ownership will not have a significant impact on market outcomes such as prices, quality, and the availability of supply. In this case, selling the assets makes sense if the value of the asset under private ownership is greater than under public ownership and if this value can be realised through the sales process, taking into account transaction costs.

The first condition holds true if the private sector can operate the asset more efficiently. The second condition is more difficult to ensure, but generally speaking a well-designed auction can ensure that the asset is allocated to those who value it the most at a price above the value under public ownership.

The second type of public assets are those in industries where the government is a dominant supplier with the ability to determine prices. In this instance, in addition to the two conditions above, an effective regulatory regime needs to be in place for the asset sale to be worthwhile to society.

Infrastructure Australia included electricity generators and retailers in the first class of assets, and ports, freight rail, electricity distribution and transmission companies, and regional airports in the second category. It valued these assets around $62bn-$76bn. We could add Medibank Private to the first class of assets and Australia Post to the second, adding perhaps another $7bn to the value of assets potentially for sale.

A third class of assets includes those where the government is a dominant supplier but there is no effective regulatory framework or appropriate governance structure. Infrastructure Australia includes roads and water, and wastewater assets in this group.

Roads are likely to be excluded

The water assets alone are valued at $54bn-$63bn, whereas the value of the road assets, while unknown, will be very large. However, the absence of a comprehensive road pricing system and the lack of governance arrangements (to ensure the right roads are built), effectively means roads will not be part of any capital recycling program, except for existing toll roads. A similar argument can be made about the water industry, where a myriad of arrangements exist across Australian states and territories.

This implies that a capital recycling program, covering the sale of assets in the first two types of assets mentioned above, would raise around $70bn. For recycling to work, however, the sale proceeds will need to be invested in other income generating assets. This is where things get complicated.

The estimated capital costs of Infrastructure Australia’s priority list is of the order of $82bn-$91bn. It divides the list into four groups, with the highest priority given to those projects that are ready to proceed and the lowest priority to those projects in an early stage of development.

The key issue is that most projects in the top two highest priority lists, adding up to over $25bn, are either road extensions and upgrades, or urban railways or busways. While worthwhile, these projects will not be suited for a capital recycling program until a comprehensive user pays system is in place. In fact, there are only two projects in those lists that would fit well into a capital recycling program, namely the Oakajee Port ($5.4bn) and the Darwin East Arm Port Expansion ($336m). This is well short of the revenue that may be raised by asset sales and so recycling of capital would not be very effective.

This means that capital recycling, while a potentially worthwhile concept in a world where governments cannot borrow directly, will be at best one additional tool for funding infrastructure. At worst, the proceeds from the sale of assets will be spent to ensure future electoral support on projects that would not pass a cost-benefit test.

The Conversation

Flavio Menezes does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.

This article was originally published on The Conversation. Read the original article.