EcDev Journal

Another Toll: Public-Private-Partnerships and the User Fee

Posted on Thursday January 02, 2020

By: Alec Klimowicz

Email: ajklimowicz@gmail.com

Introduction

A burgeoning practice to fund major infrastructural projects is called public-private-partnerships (“P3” or “PPP”). This practice takes on a wide variety of governmentally involved projects and alleviates the procurement issues by way of bringing in a private party for funding. Just like any investment endeavor, the private party needs some sort of remuneration to make funding the project worthwhile. With Canada’s infrastructure debt being rather large, which from the specific perspective of an investor, can raise an eyebrow to potential, long term investments. While there is a plethora of features to be included in the partnership, this paper will focus on one of the elements, mainly, user fees.

User fees

In the case of Highway 407, located in the Greater Toronto Area, the initial building cost  in 1999 was 30 billion Canadian Dollars. If the government had to pay for the entire project, some issues would most likely arise, especially, how to pay for it. The 407 is a toll road, thus users are paying to use the highway per visit and distance. That toll is the user fee and the vehicle for which the private party will use to embark on a particular investment. This user fee, however, can be divvied to either the government or the private party directly. Where ever this user fee goes, typically, will define the type of procurement the particular P3s has. In the event the user fee goes to the government, the P3 is a availability pricing mechanism, and in turn, the government takes on the risk of the project. A private party can still fund the project within an availability pricing agreement, however, the government will pay the private partner with installments contractually agreed upon. Consequently, if vehicles are not using the 407, then the government might not make enough money to pay back the investor.

In the alternative, where the private party directly sees the user fee deposited into their account, the risk transfers over and the impetus for revenue success befalls on their regulations. This is referred to as revenue-based pricing. Giving an investor stronger control is a unique element to P3s that allows the private partner to hire, and or, control the financial modeling to pay themselves back how they see fit. When the private partner is spearheading this component of the P3, efficiency tends to be maximized, compared to when the government has to operate the asset. Highway 407 happens to have a revenue-based pricing mechanism built in the P3 agreement. Furthermore, this sort of agreement can be enticing to private investors and does not need to be solely used for toll roads.

Some of the largest institutional investors around the world, including Canada’s largest pension funds, are “looking to participate in new-user-fee-supported infrastructure” (Dachis 2017). This apparent opportunity can help minimize Canada’s infrastructure debt, which is not concretely calculated, however is somewhere near 570 billion, according to the Canadian Chamber of Commerce (CCPPP 2017). This deficit is quite large, and some accounts suggest it could even be higher (CCEA 2016). With this large gap, tapping into the funds of Canada’s largest pension institutions seems opportunistic. To put a number on the opportunity, Canada’s largest pension funds have invested “87 billion of their 1 trillion-plus in infrastructure" (Dachis 2017). The small caveat here is of that 87 billion, most of it outside of Canada (Dachis 2017). Private investors are not labeling Canada as a non-investable place; rather, Toronto stands out as one of the top locations for P3s, even described as a global hub for P3s (Service Works Global 2015). The ability to understand user fees, which is one of the driving forces attracting institutional investors, fosters this crucial component for captivating private institutions.

User Fees and Their Limit

User fees have their place in P3 models and are not necessarily applicable in every project. An example of a P3 project where a user fee would not be an appropriate fit is schooling, given the public emphasis placed on free access to education. However, this is one example and the value of user fees should not be negated as a result. User fees have the ability to mitigate tax increases through their implementation, since the funding for a project would no longer come solely from taxes, but from the user directly (Dewees 2002). This presupposes that the people using the asset are amenable to user fees rather than tax increases. User fees benefit the private-partner in a number of ways. There is less risk related to getting paid back since they are reassured by consistent cash flow from the entity paying fees to them. If the private-partner gets a percentage of the user fee, then they not only have a less risky investment, but have tangible evidence for their investment’s return (Dachis 2017).  In the case of Canada, however, using the availability pricing mechanism, user fees need to be set at an economically beneficial level for the user fee to be effective, which will incentivize institutional investors to embark on Canadian-based endeavors.

For user fees to be aptly priced, the public must find it advantageous to pay the fee, and, also, sufficient revenue must be made to fund the project. First of these conditions precedent is allocative efficiency (OECD 2008). Allocative efficiency is pricing the user fee where “the last unit produced just equals the value of that unit”, and in finality, makes the added unit of output “the variable cost or marginal cost” (Dewees 2002). By effectively pricing the user fee at the marginal cost, the result values the project for what it is worth; if that value is equal to or greater than the cost of carrying out the project, “the resident will consume it” (Dewees 2002). This implies that if the value of the project is below the cost of carrying out the project, consumption will not likely take place, and the user fee will need to be reduced. Private-partners, when evaluating a project, will seek infrastructural projects where profits are maximized according to this principle. Where the investment is riskier for the private-partner, because the revenue the government may be relying on for the private-partner’s installments, it is inefficient. For allocative efficiency, the user fee cannot be above or below the marginal cost, the result of being either above or below “leads to waste of some sort” (Dewees 2002). Setting the user fee above the marginal cost will lead to some consumers avoiding, or simply not using, the product, since it costs more than they would value it otherwise. The same applies for below value assessments, but the waste befalls on the entity collecting the user fee. If users are willing to pay more, the private-partner may look at this and wish to raise the user fee. The public-partner, however, may preference the public good, and may keep the asset as low-cost as possible. Private-partners will be less inclined to invest in projects that prioritize the public good. For allocative efficiency to be executed from the private-partner’s perspective, resources must be allocated to maximize profits (OECD 2008). Canada, arguably, has great potential to open user fee control to private-partners, which would attract institutional investors.

The second condition for pricing user fees optimally is “rationing efficiency” (Dewees 2002). User fees would be used under this condition to be priced in a way that rations the asset. In other words, when the project has high demand but the supply is inadequate and will not meet demand, “the price should be above the marginal cost of production” (Dewees 2002). The result of this would be to ensure that the product is available to, and paid for respectively by, the consumers that “value it most” (Dewees 2002). The last condition, is rather simple, where cost efficiency must be utilized. Cost efficiency encompasses the two previous conditions, however, directly with respect to the cost of the project. Essentially, total cost should not exceed the most efficient amount to build the project. The conditions listed above establish a foundation for how user fees should be priced, but the application of user fee methodology explicitly shows how user fees can be configured to meet these conditions. These applications are a two-part tariff, capacity pricing, and setting prices sufficiently above marginal cost, with respect to price elasticity.

User fees have a unique ability where it can be approached to cover fixed costs and/or capital costs (Dewees 2002). The first of which is the two-part tariff, and this includes an initial fee for use, with an additional fee for usage per consumption (Dewees 2002). The 407 is a good example of this, where a driver must pay an initial fee to begin usage of the road, and then, is charged per kilometer. The initial fee is a fixed cost for the consumer, and is also used to account for the fixed costs of the project. Fixed costs make it easy to forecast future revenue, as opposed to the more volatile “marginal cost per unit consumed.” The marginal cost per unit consumed is implemented so that the “right amount is consumed so that allocative efficiency is achieved,” which is the first condition listed above. Private-partners can see potential in two-part tariff user fees for two possible reasons (Dewees 2002). The first possible reason is that allocative efficiency is achieved, which gives the private-partner peace of mind when accounting for their return on investment. This peace of mind is intuitive, since, costs are being accounted for and, as a result, their investment can be paid back. The second possible reason is that the two-tariff user fee has two different sources of revenue. The fixed portion is easily accountable, and then based on demand, profits could go up. This differs per project because demand is not universal. However, certain projects can attract institutional investors if this user fee can be manipulated according to the institutional investor’s discretion, while they account for this demand.

The second approach coincides with the second condition above. User fees should be adaptable to times of excess capacity. When consumption is unusually high, that would mean “consumption presses on capacity” (Dewees 2002). Thus, user fees, in the short-run, have a reason to be priced to account for times of “limited supply” (Dewees 2002). Private-partners could be concerned with this, since, if user fees are not accounting for such a scenario, especially in the context of toll roads with quotas on the private-partner, they could lose money from excess demand. Not only could a fine be in place, or cause a deduction in their installment from the public-partner, there is also opportunity cost lost by not increasing the user fee. Examples of user fees that could combat this issue are, “peak-load pricing, time-of-use pricing, and seasonal pricing” (Dewees 2002). The third approach addresses capital cost accountability for user fee pricing. This approach is fluid and not as popular among consumers, however, private-partners may consider it to have potential. This approach is pricing the user fee “above marginal costs to pay for capital costs” (Dewees 2002). The outcome, however, is a decrease in consumption. This limits access to different types of consumers, yet in the case where the asset is inelastic, the consumer will pay the user fee even when above marginal cost (Dewees 2002). The Chicago Skyway is more of an inelastic good for consumers traveling from Gary, Indiana who work in the city of Chicago. There are few highways that can get them to the city in a timely fashion, so they are willing to pay the user fee, which has been increasing (Enright 2006). Consumers in the Chicagoland area (I am one of them), utilize different avenues to get downtown, whether that be one of many highways or trains, but coming from south Chicago, even Northwest Indiana, the Chicago Skyway is your best and only option. Just to reiterate for emphasis, the institutional investors that this paper aims to attract own the Chicago Skyway. The Chicago Skyway pricing model exhibits all three types of user fees mentioned above (Chicago Skyway 2004).

 Conclusion & Note to The Economic Developer

Pricing mechanisms, namely with respect to user fees,  are essential when attracting private investors to P3s, especially, institutional investors. Whether the project is utilizing an availability or a revenue-based mechanism, the consortium will evaluate the viability of the project differently. Institutional investors seem to gravitate towards assets that have user fees, accompanied by high demand. Profits for private partners in P3s proliferate according to increase in demand when they have some decision-making over the user fee rate. Ultimately, institutional investors do not necessarily need the revenue-based model, but certainly require some revenue sharing.

Investors like to have control over their investments, which is where the Economic Developer enters the room. Economic developers have to identify in their city, town, or neighboring areas where opportunities for these projects and then start to formulate a presentation to private investors, or an invitation to invest. Make clear which aspects that need to be kept as close to a public good as possible, and where other revenue streams can flow to polish the investment opportunity. This is a great way to improve and enhance the Economic Developer’s area and should not be given a cold shoulder. If there is a project that needs funding, but the money does not seem to be in the budget, consider the potentiality of a public-private-partnership.

Alec Klimowicz, BA Financial and Business Economics Specialized Honors