18 November 2016

Hammond should be cautious about further borrowing for infrastructure


There is no doubt that Britain’s infrastructure is in need of upgrading. Britain’s road, rail and air transport infrastructure scores 27th, 19th and 18th respectively out of 138 countries analysed by the World Economic Forum.

There are also well documented problems associated with broadband provision in the UK. According to the Ookla speedtest, the UK is only the 30th fastest average internet speed in the world.

The political class are responding to the need for infrastructure improvements and a boost to economic growth by pushing for greater borrowing – particularly as the cost of government borrowing continues to be relatively low.

But this is missing the point. The UK’s infrastructure investment gap – the amount of extra investment needed to support expected rates of growth – is a relatively modest 0.4 per cent of GDP.

Thus an improvement in the quality of infrastructure projects could yield much greater infrastructure improvements compared to a policy of simply seeking more public funds.

All too often, infrastructure projects end up being very bad value for money. It is estimated that nine in 10 large infrastructure budgets are over budget. Rail projects are particularly prone to this, being over budget by 45 per cent on average.

The so-called “Hiding Hand Principle” may be partially responsible for the cost overruns on many infrastructure projects.

This is the theory that ignorance about future obstacles allows planners to go ahead with the project. Once the project is under way, they will then adapt to overcome any obstacles that arise, often at great expense, because the sunk costs make it seem like it’s too late to abandon the whole thing.

Underestimating costs and overestimating benefits for a given project leads to a warped benefit-cost ratio. This can lead to projects being started despite being economically unviable and can lead to major lost opportunity costs by forgoing other projects that would yield greater returns.

So rather than engaging in an arms race for more public borrowing for infrastructure, the Government would be wise to focus more of its attention on how to improve infrastructure policy.

The advantages of having private finance involved in infrastructure projects are well established: if the right structures are in place, these projects are more likely to have a robust business case and will be able to tap new sources of funding rather than have to “queue up” for Treasury cash.

Where projects can be entirely financed by the private sector, and operate in a competitive market, the Government should treat these positively. That includes areas such as airport expansion and the promotion of the shale gas industry.

In many cases, public finance or a government guarantee of some kind is necessary, but the Government’s record in these cases is patchy to say the least.

A range of external interests (including representatives from the private sector) have helped ensure that Crossrail 1 will open on time and on budget. Regrettably, the same cannot be said for the proposed High Speed 2 project, which has no such range of interests.

The Government has been clear that private sector involvement will be minimal in this project. This may partly explain why its estimated budget has risen from £30 billion in 2010 to over £50 billion currently, with some forecasts predicting the cost may end up at £80 billion.

There is clearly a need to ensure that efficiencies are driven through infrastructure projects by involving private interests in the process.

But first, the Government needs to find a replacement for the discredited Private Finance Initiative model, which has left UK taxpayers with £200 billion of liabilities.

One alternative method of encouraging private sector finance into infrastructure would be the use of project bonds.

Using the well-developed capital market expertise in the City of London, these could offer an opportunity for institutional investors to participate in specific infrastructure projects, thereby bringing private investment and skills into new projects.

The degree of risk taken by the private sector would vary on a case by case basis, but to avoid private investors receiving excess profits, the Treasury could receive equity warrants enabling it to share in the profits if returns exceed a certain level.

That should go some way to reassuring taxpayers that problems with PFI would not happen again.

Such an idea is by no means a “silver bullet” for Britain’s infrastructure issues, so the Government should of course seek to trial the use of project bonds initially. However, it could well be one way of improving the quality of infrastructure projects coming forward.

But the strategy of simply borrowing more for infrastructure is highly questionable. It won’t improve the quality of infrastructure projects and evidence suggests that increasing debt to GDP ratios can end up hampering economic growth.

In his Autumn Statement, Philip Hammond should focus on ways of improving infrastructure policy, instead of going along with the consensus of yet further borrowing.

Daniel Mahoney is Head of Economic Research at the Centre for Policy Studies.