Michael Keating, Luke Fraser. Infrastructure: Improvement or Impoverishment?

Fairness, Opportunity and Security
Policy series edited by Michael Keating and John Menadue.

To paraphrase Paul Keating, right now every galah in the pet shop seems to favour more infrastructure spending. The current Prime Minister wants ‘to be remembered as a Prime Minister who built the roads of the 21st century’. The business community is similarly demanding more infrastructure investment, while both Treasury and Reserve Bank, both of whom might be expected to be a bit more critical of spending proposals, have added their blessing to infrastructure spending.

In recent years, however, total infrastructure investment has already risen sharply. Public capital formation (largely infrastructure investment) was 36 per cent higher in 2013-14 than in 2006-07, and as much as 44 per cent higher in 2009-10, partly in response to the GFC. Capital formation in transport, postal and warehousing in 2013-14 was 48 per cent higher than in 2006-07I, and in only seven years its net capital stock increased by a staggering 39 per cent.

Calls for more assume that all infrastructure investment is warranted economically and will add to national productivity. Yet no attempt has been made to justify this assumption, which is beggared by almost all past experience.

The real problem with much infrastructure is that unlike most investments, the revenue stream and consequent rate of return are negligible or non-existent, whereas normally that rate of return would indicate where more investment is warranted. Happily since the micro-economic reforms in the 1980s and 1990s, investment in power supplies, urban water, communications, and air and sea transport are now mostly subject to market disciplines, and can be presumed to be justified[1]. But that is not the case for investment in road, rail and irrigation infrastructure, which have largely resisted competition reform.  Furthermore, few such projects have been submitted to proper cost-benefit analysis, so it is anybody’s guess as to whether spending taxpayers’ money in this way is justified.

Road spending: $140 billion of debt within a decade?

Most of the transport investment has been in roads. In 2012-13 (the latest year for which figures are available) Australia spent $24.9 billion on its roads – a figure higher than the entire Australian Defence budget for that year. But since 2007-08, a combination of stagnant fuel excise revenue and increasing road expenditures has meant that revenue from motorists no longer covers road spending. Accumulated deficits from road investments between 2007-08 and 2012-13 have now added $26.1 billion to Australia’s public sector debt, and as much as $6.6 billion alone in the latest reported year, 2012-13.

A reasonable projection of planned road expenditures indicates that the accumulated stock of debt to FY2023-24 could be of the order of $114 billion[2].   When added to the already accumulated debt, this amounts to a total accumulated road-derived public sector debt of $140 billion within a decade (a matter until now entirely unreported).

Moreover, despite an obsession with public debt, no government has provided any economic justification for most of this roads expenditure. Rather Infrastructure Australia has been highly critical of Australian road planning and assessment. Its 2013 State of Play report described Australia’s last major public sector infrastructure monopoly as ’standing out’ for poor performance: Australia’s roads ’have no economic efficiency objective’, ‘no coordinated planning or design’, ‘ no review of proposals or results’, and ‘no commercial medium for users to influence capacity or design’.

If investment in productive outcomes is the goal, some road projects touted as the highest priority for the nation make one wonder just how bad the ‘also-ran’ projects must be: Melbourne’s now-cancelled East-West Link project – a multi-billion dollar project with a business case returning as little as 45 cents for every dollar invested – should never have been approved. Sydney’s massive Westconnex tollway project is underway (total cost $14,900 million, 2014 prices), but has not yet been judged fit for government investment by Infrastructure Australia.

Almost all multi-billion dollar road projects have similarly escaped scrutiny: Queensland’s Bruce Highway upgrade (total cost $8,956 million, 2014 prices) is but one example amongst sixty-three $100 million dollar-plus road projects budgeted by governments for the coming 5 years which have not been sanctioned by Infrastructure Australia, despite bipartisan agreement that this must occur (the lone budgeted project to receive approval is the Pacific Highway upgrade).

Reform of road planning, funding and expenditures

The Government’s recent Review of National Competition Policy found that ‘Lack of proper road pricing distorts choices among transport modes … and also contributes to urban congestion… with road users facing little incentive to shift from peak to off-peak periods, greater capacity is needed.’ Accordingly the Review concluded that ‘Reform of road pricing and provision should be a priority. Road reform is the least advanced of all transport modes and holds the greatest prospects for efficiency improvements.’

Cost-reflective pricing is critical to progress. Unlike twenty years ago, technological leaps mean that road pricing based on distance, location, and congestion, is now feasible at low cost. The revenue raised could then signal the genuine (measurable) priorities to which all future investment should be linked.

However, full road pricing may well not be appropriate in all circumstances, or even in a majority of circumstances. For existing roads that have spare capacity and do not help create congestion, it is more efficient to reduce that spare capacity by increasing the traffic even if that means providing a free ride. In addition, many roads may fulfil a community service obligation to ensure that people have access to their homes and places of business, and full cost recovery is then impossible.

For these reasons other approaches to road planning and financing should also be strengthened. Above all, proper system design is required: infrastructure works best as an internally-consistent system, not as discrete projects dreamt up in isolation to alternatives or without due analysis of their interaction with other parts of the whole. System design should ask simple questions: what problem am I trying to solve? What are the opportunity costs of different approaches to solving the problem? To date, no such authoritative design function is in evidence at any level of transport bureaucracy.

Given that road revenues are now failing by tens of billions of dollars to meet road spending, system design can help governments avoid generating further billions of dollars in public sector debt without merit. It enables government to establish a hierarchy of transport solutions based on their ability to satisfy aggregate transport demand and their likelihood of paying for such outcomes by project cash-flows alone.

Second, rules requiring proper independent cost-benefit analysis of projects should be enforced. All major investments in roads should base themselves on proper business cases submitted to Infrastructure Australia. Approval should only be forthcoming if the project is reasonably expected to deliver an economic rate of return after careful assessment of the value of any external benefits and the extent and cost of any community service obligations, which should be publicly transparent.

Rail investment

The next 5 years of government road and rail network budgets see $46 billion of highway and freeway projects, but only $1.6 billion in national rail solutions. Yet transformational rail infrastructure projects appear to be there. For example, in 2010 a national freight railway spanning Australia’s east coast was found by a Commonwealth-commissioned report to be capable of reducing the cost of interstate freight by 48 per cent. Yet in 2015 this railway remains unbuilt, without any substantial capital allocated to it beyond initial planning funds; at the same time, the government has not entertained simple market testing to build such a railroad commercially and immediately, as often occurs internationally.

Similarly there are urban rail projects worth funding, but they are almost never big new extensions to the network. Australian cities do not have the population density to justify major extensions. Even in Sydney – Australia’s most densely populated city with about 50 per cent and 470 per cent more rail passengers than Melbourne and Brisbane respectively (yet with similar network capacity), past investments in the urban rail network have failed to pay off. Thus after allowing for an annual $1.6 billion worth of external benefits from less traffic congestion, pollution and health and safety, the regulator found in 2008 that an economic rate of return was only possible if the total capital stock was written down to a bit less than half its depreciated book value, and much less than half it replacement cost. This strongly suggests that new urban rail lines are unlikely to generate an economic rate of return, even when allowance is made for the external benefits.

A fundamental problem is that urban rail transit systems have only a very small impact on congestion, except for the main roads into the CBD. This is because these urban rail systems are focussed on transporting commuters to and from the CBD, but in Sydney for example, in 2008 these journeys amounted to only 4.5 per cent of all journeys and 11 per cent of the total person kilometres travelled in Sydney as a whole.

Most journeys in modern Australian cities are across town to multiple business nodes. These cannot be served by the urban rail network, at least as presently designed. Usually modern bus services represent the best public transport option for Australian cities, yet serious bus infrastructure remains under-appreciated.

Instead, urban rail projects that would engender an economic return are often modest efficiency and capacity modifications to the existing network: better signalling, more passing loops, increased station capacity, or filling in ‘missing links’, such as perhaps Melbourne’s Metro Rail project. Such projects become more evident through proper attention to system design, but they are obscured if public policy only seeks to feed the political addiction to ‘icon projects’.

Rural water

The situation regarding rural water is very similar to that just described for urban rail. Water for irrigation has consistently been under-priced, and practically no irrigation scheme in Australia has ever generated an economic return[3], even allowing for the external benefits from flood mitigation and other environmental benefits.

The most important irrigation investment in recent years has been the National Water Plan decision to spend $10 billion on improving water flows in the Murray-Darling Basin. From this, approximately $6 billion was to be spent on improving the supply of water to irrigators by efficiency improvements, with the balance to be spent on buy-backs from the most marginal irrigators. If the water pricing rules agreed to by COAG as part of the Competition Policy reforms in the mid 1990s had been adhered to, it has been estimated that this investment would have required the price of water to irrigators to increase between 10 and 30 fold, depending upon how much of the extra water was reserved to improve environmental flows[4]. Of course, the agreement for proper pricing was quickly abandoned, thus destroying the economic value of the investment.

In addition, the present Coalition Government has surrendered to pressure and the amount of water to be bought back has been reduced, notwithstanding there are plenty of willing sellers who want to get out of what is for them an uneconomic industry. But the consequence of this latest change is that the extra money now being invested in efficiency improvements further reduces the economic returns on this investment. 

Conclusion

Australia is racking up very substantial debts to finance unreformed infrastructure. Many investments appear uneconomic and will therefore lower national productivity, or at least the productivity of capital and total factor productivity.

It is scandalous that this investment escapes proper scrutiny, while at the same time the proponents are calling for cuts in other government programs, including education and training programs that would actually increase productivity and participation.

Going forward the Competition Policy reform agenda of the 1980s and 1990s should be completed so that all infrastructure is properly priced before any new investment occurs.

Luke Fraser is the founder and principal of a transport policy and investment advisory focussed on roads and freight. In 2012 he was appointed to the Prime Minister and Premiers Road Reform Project. Prior to this he was for several years a national road freight industry chief executive, as well as a member of the Australian Trucking Association Council, where he was the industry’s lead representative on pricing reform and market investment models. 

Michael Keating is a former Head of the Commonwealth Department of Finance. Subsequently he was Chairman of the Independent Pricing and Regulatory Tribunal of NSW, and responsible for pricing much of that State’s infrastructure services.

[1] Note that in recent years there has been substantial over-investment in electricity transmission and distribution which is a natural monopoly and therefore not subject to market disciplines.

[2] This projection is based on the National Land Transport Agreement for 2014-19 for Commonwealth road expenditures and assumes no real growth in State and Local Government road expenditures. The CSIRO has projected falling revenues from fuel excise over the next decade and beyond, but the revenue projections used here conservatively assume unchanged excise tax revenue in nominal terms and that the other revenue elements increase at the 10-year average. Sensitivity testing suggests that indexation of fuel excise would still leave a substantial deficit from present road investment plans. A forthcoming academic paper (L. Fraser) examines these matters in greater detail.

[3] Irrigators have never paid a cent for water from the Snowy Scheme. Instead all of the costs are recovered from electricity consumers, and notwithstanding that irrigators have first rights to that water.

[4] Michael Keating, Australian Economic Review, Infrastructure: What Is Needed and How Do We Pay for It? 2008, pp. 231-8.

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