The Financing of PPPs via Value Capture: Learning from the USA
Abstract
This paper considers the use of value capture as a means of financing public-private partnerships (PPPs) in the United Kingdom (UK). Although some of the techniques that come under the heading of value capture are used in parts of the UK, they have a much wider application in the United States of America. Having briefly outlined the methods by which UK PPPs are financed the paper then describes some of the main value capture mechanisms. The findings of a series of interviews and two case studies are then presented. Although such a means of financing is likely to meet resistance from third parties who will be expected to bear some of the burden due to them directly benefitting from the construction of an asset, it is recommended that value capture is considered by UK policy makers.
Introduction
Although there are a variety of arrangements that can come under the umbrella of public-private partnerships (PPPs), the most controversial remain those that contain the characteristics of the Private Finance Initiative (PFI). The use of private money to finance the construction of public sector infrastructure assets, such as schools and hospitals, was deemed to be flawed from the outset as public money was cheaper to borrow. However, the proponents of utilising private funding maintained that the efficiencies gained in the construction and operating phases of the asset would compensate for the higher rates of interest. Moreover, there was more private funding available meaning a greater number of projects could be undertaken than under conventional procurement. However, this latter argument has been weakened over the past few years due to the economic recession affecting most Western countries and the subsequent reluctance of banks to lend despite a number of government initiatives. This paper looks at a method being used in the United States of America (USA) that is not new, but has gained in popularity in recent years. Value capture has been used to finance a number of transportation PPPs in the USA and is seen as more socially just, as it passes some of the financial burden onto those who will benefit from the road or railway station in a particular locale. Such beneficiaries include local businesses, property developers and residents. The paper presents the results of a number of interviews with key players in PPP schemes involving value capture and also presents two case studies of projects that have used this means of finance. Whilst some of the methods outlined are being used in certain parts of the United Kingdom (UK), the authors believe that lessons can be learnt from the USA that could lead to a far wider application.
The Financing of Public Private Partnerships
Criticising the use of PPPs, and its forerunner the PFI, in the construction and subsequent operation of public sector assets has been the focus of a large amount of studies in the UK. The arguments for and against the initiative have been presented many times (see for example: Arthur Andersen, 2000; Ball et al., 2003; Broadbent et al., 2008; Commission on Public Private Partnerships, 2001; Edwards and Shaoul, 2002, 2003; Edwards et al., 2004; Froud, 2003; Gaffney and Pollock, 1999; National Audit Office (NAO), 2003; Pollock and Price, 2008) and it is not amongst the objectives of this paper to repeat these. The amount of projects under the previous Labour government grew steadily until 2007 (see Her Majesty’s Treasury (HMT), 2006) when the first affects of the banking crisis began to have an impact on lending. Major PPP projects that made use of private finance tended to use a mixture of debt and equity with the respective split normally being in the region of 90% and 10%. For several years debt consisted of bank lending and the issuing of bonds, the latter being backed by the monoline industry, which guaranteed bond repayment if an issuer defaulted. However, following the housing market decline in 2007 this industry collapsed resulting in the closure of the wrapped bond market (BBC, 2009). Consequently, the only viable source of finance for infrastructure projects was banks; however, the demise of Lehman Brothers in September 2008 meant that the global interbank lending market dried up as banks stopped trusting each other. At the height of the crisis, banks were unable to fund themselves at the wholesale money market reference rates and there were suggestions that those rates had become unrepresentative. A global review by PricewaterhouseCoopers (2008) reported that interest rates for lending to infrastructure projects had risen between 1.5 and 2 per cent above the lowest rates obtainable by governments, causing difficulties for both existing and new PPPs. With respect to existing PPPs, loan repayments become more difficult, refinancing problematical due to the reluctance of banks to provide funding and, for concession-type PPPs such as toll roads, forecasted earnings were unlikely to be achieved due to a slump in domestic demand (Hall, 2009).
Whilst still in power the Labour government put forward a number of initiatives to try and ensure any viable PPP project was not prevented from proceeding due to a lack of funding. These included mini-perm structures (see KPMG, 2009 for a full description) and lending by HMT itself (see HMT, 2009). However, neither of these were overly successful with only a handful of PPPs using mini-perms (KPMG, 2009) and only one major PPP partly financed by HMT (NAO, 2010). In Scotland the use of the non-profit distributing model (see Hellowell and Pollock, 2009), whereby PPPs are financed totally by debt, are considered to flatten out overall risks when compared to equity-based PPPs or public procurement. However, the model has received little attention outside Scotland. When the Coalition Government came into power in 2010 they immediately announced major overhauls to the PPP initiative and as well as scrapping the associated Building Schools for the Future programme (BBC, 2010) also stated that they would increase the value for money from any future projects. More recently the Chancellor of the Exchequer, George Osborne, announced a major capital investment programme using both money from pension funds and overseas (BBC, 2011). However, whilst both sources of funding differed from conventional debt they will still result in future generations of taxpayers having to repay the financiers of assets from which they may not personally benefit. A fairer system would pass some of the burden onto those most likely to gain and this is the rationale behind value capture.
Value Capture
The concept behind value capture can be traced back to the work of 19th century French physiocrats, although in the 20th century the approach ‘compares closely to the thinking of Henry George and his followers’ (Batt, 2001, p. 208). The physiocrats believed that ‘land is the unique source of wealth’ (Quesnay, 1767/1963, p. 232) and living in age when agriculture was a major economic activity ‘regarded production in terms of the transformation of materials and food taken from the land’ (Christensen, 1989, p. 18). Henry George deemed that land was the property of all and that pure rent, that is income received from this resource, was unearned and undeserved. He called for ‘the immediate punitive taxation of pure Ricardian rent without compensation to landowners’ (Whitaker, 2001, p. 12). Initially George felt that all taxation, barring that on land values, should be abolished, but this stance was eventually modified by his Georgist followers when it became clear that a single tax would never be sufficient to cover all public expenditure in post-war (i.e. the First World War) America (Blaug, 2000). As the returns from tax on land continued to fall throughout the twentieth century (Andelson 1979) the Georgist ideas were deemed outdated, however the merits of a land-value tax as one amongst many still remain and provide the core thinking behind value capture.
Value capture is a means of financing capital infrastructure investment through means of capturing the added value of property, which results directly from the investment. In many cases this might be a value that could realise an immediate benefit for the owner, for example a developer selling land in the vicinity of a new access point for a road for a higher price than could have been obtained before the investment. In other cases the value relates to owning a property that is again in the vicinity of piece of infrastructure that may bring about value in the future (e.g. increased property prices) but also has a non-financial value in that the owner has less distance to travel before using the asset. Therefore funding for the project can be partly obtained by taxes or levies imposed on those most likely to benefit from the investment, making value capture, according to Batt (2001), economically neutral. This means that it imposes ‘no distortions on economic choices because land, particularly strategically located land, is limited in supply’ (p. 208). Prior studies have also underlined the extent to which land can sustain tax burdens (see Andelson, 1998).
Value capture has mainly been used in the USA on transportation projects, although it could be argued that any new asset that increases the value of surrounding land and property would benefit from such a funding mechanism. For example, a social infrastructure project such as a school might not add value to any land in close proximity, but could lead to higher prices slightly further afield. A number of value capture techniques are now briefly described (adopted from Levinson and Istrate, 2011).
Tax Increment Financing (TIF)
Under this arrangement a region will target a district for economic development and finance this development (via a private contractor) through property tax revenues generated from the growth in a district’s assessed property values. The advantages of TIF are as follows: it is self-financing because it permits new development without reducing the region’s total tax revenues; it provides substantial capital to allow economic development that would not have otherwise occurred; it restores the full tax base back to all taxing jurisdictions once the project is completed and TIF bond paid off, moreover as a result of the development the tax base may increase thereby reducing the local tax burden; and development initiated through its provision can serve as a catalyst for economic expansion by attracting more businesses and thus leading to an increase in the aggregate value of property both inside and outside the TIF area (Greuling, 1987; Man and Rosentraub, 1998). TIF is being used in Scotland and is therefore an example of a value capture technique utilised in the UK (see Scottish Futures Trust, 2011).
Special Assessment Districts
Under such an initiative a fee is levied over a certain area for an identified new transportation project to fund the infrastructure in part or in whole. The rationale being that such an investment that would reap benefits for businesses in the area; that is the value of property and land would go up and more people would move into the region adding to the customer base of the businesses. However, a crucial factor involves getting the agreement of the community to raise local taxes.
Joint Development
A joint development is a development adjacent to (or on top of) a piece of infrastructure that serves it, such as a transit station or a highway interchange. Payments come from the private sector for property and development rights in several forms, including one-time lump sum payments for the purchase of property or development rights, annual lease payments, financial contributions to station construction costs and connections fees from retailers. The ‘connections’ in the latter refers to retail outlets that are connected to the station in some way.
Air rights
This refers to capturing the real estate value of transportation by selling or leasing the space above (or below) transportation facilities for development. Typically this is imposed after the road, rail line, or transit station is constructed so it recovers value after creation, although it could be applied simultaneously with infrastructure creation. In the latter case however, it would be a form of joint development.
Impact fees
This is a one-off fee levied on a developer who is looking to build homes or offices in a particular area and is imposed on each building constructed. This technique works on the principle that government provides infrastructure and land development consumes it. Such fees work better when there are many developers, none of who alone would have the scale to do a joint development, and in the context of roads where there is a dispersed origin and destination pattern.
Land-value taxes
Under such a scheme the property tax (a major source of funding transportation projects in the USA) is reformed by separating the value of a property associated with land from that associated with the building. Because the value of the land is determined by its accessibility, which is created by the community at large via transportation networks and the location of activities, a tax only on land value better captures the benefits of transportation than a tax on both land and buildings. The nature of the land-value tax makes it difficult to use it to fund a single project and it is therefore more appropriate as a source for funding a comprehensive transportation programme. Hawaii and Pennsylvania (particularly Pittsburgh) have used the land-value tax, but otherwise it is not used widely across the USA.
Transportation utility fees
These fees replace the share of general fund tax revenue going to transportation with a charge that is roughly proportional to expected transportation use. Therefore, these fees tie the benefits to costs of infrastructure and are much simpler to implement than a more comprehensive user fee. Such a technique has been used in a number of states including, Colorado, Florida, Idaho, Oregon, Texas, Washington and Wisconsin. These fees are levied annually on properties within an area likely to benefit from transportation infrastructure and earmark transportation funding, separating it from general revenue. This financing mechanism increases the tax base over which transportation charges can be levied more than property taxes, because non taxable properties must still pay a utility fee.
The paper now turns to the results of interviews held with key players in PPPs that have used value capture and two relevant case studies. However, prior to that the methodology used will be outlined.
Methodology
A combination of semi-structured interviews and case studies were used in order to ascertain some of the ways in which value capture has been used in the USA. Semi-structured interviews allow the researcher to understand a complex process, particularly where those involved have different perspectives on the matter in question. The use of semi-structured interviews allows these perspectives to be understood in the same terms in which the participants understand them (Blumer, 1969). This approach enables the researcher to ‘access the perspective of the person being interviewed’ and ‘to find out from them things that we cannot directly observe’ (Patton 1990, p. 278). For the purposes of this paper three employees of the Washington Metropolitan Area Transit Authority (WMATA) were interviewed, as WMATA is seen as one of the most innovative authorities when it comes to using value capture (Lari et al., 2009). Moreover three members of Washington’s Downtown DC (District of Columbia) Business Improvement District (BID) also took part in the research. BIDs are used throughout the USA, as well as in the UK, and are private non-profit organisations that provide capital improvement and resources to enhance the areas they are responsible for. They are similar to special assessment districts (see above) in that they impose an agreed tax on property owners within the BID. Additionally two USA academics with an interest in this area and two members of different Washington-based think tanks were interviewed. The interviews lasted for one hour to 90 minutes.
Case studies are seen by Yin (2003) as having certain distinctive characteristics; they are empirical enquiries that investigate a contemporary phenomenon within its real life context, especially when the boundaries between the phenomenon and context are not clearly evident. He further observes that the use of case studies is appropriate as a means of assessing contextual conditions, when they may be highly relevant to the phenomenon being studied. It was felt for the purposes of this research that two case studies would further enhance the findings from the semi-structured interviews as they provide some robust examples of value capture in practice. Therefore, Washington DC’s Union Station and the Metrorail (metro) station at Bethesda, Maryland, both of which are PPPs and were part funded by value capture techniques, were seen as appropriate subjects for case studies.
Findings from the Interviews
The interviewees were firstly asked what had led to the renewal in the use of value capture over the past two decades. The majority felt that in an era when there was increasing pressure on federal and state budgets alongside a universal reluctance to increase general taxation, it was only fair to levy those who directly benefit from either a new access point for a highway or a station within their locale. Such a view concurs with that of Smith and Gihring (2006), who stated that most mass transit systems are financed not by those who use them but largely by subsidies from local public general funds. Such ‘subsidies necessitate either higher taxes, reduced spending on other public services, or both’ (p. 751). One member of WMATA stated:
There is only so much money to go around, so why should someone subsidise the building of a metro station in an area that they don’t even live near?
It should be noted that whilst the comment above referred to residents living within the same state as the station, both states and local government in the USA are allowed to issue their own bonds to pay for PPPs and other procurement arrangements. Such bonds are tax-exempt, which means that interest payments are not subject to federal income tax. In effect this means that the federal government (and thereby the general taxpayer) is indirectly providing funding for any projects financed via this means.
Another contributing factor was the urgent need for economic development in many parts of the USA due to the effects of both globalisation and more recently the recession. Therefore governments had to both maintain and improve infrastructure whilst facing budget constraints. Whilst PPPs were seen as one method of achieving this, it was essential that any financial exposure by the state was minimised. This point was underlined by one of the members of a think-tank:
PPPs are not the answer to all of our state’s transportation and infrastructure problems, but I believe they can at least start to address the issues we face. Moreover, to preserve budgets governments need to use as much private finance as possible and pass the responsibility for repaying some of the debt to property developers and other asset speculators.
It is often claimed that during the contract negotiation phase of PPPs, public sector workers are disadvantaged when dealing with their more commercially aware private sector counterparts (see for example Organisation for Economic Co-operation and Development, 2008). The interviewees were asked whether this was an issue when trying to persuade businesses within a special assessment district to pay extra taxes. One member of WMATA felt that is was:
One of the most important aspects of trying to broker a deal with the private sector is timing. You have to know when the maximum amount of funding can be leveraged from a local business or property developer. This is a skill that is lacking in the public sector.
However one of the BID employees did not think this was a major concern. They stated that many public sector employees who were involved in such negotiations were either experienced in this area or had come from a private sector background and were therefore no less competent. Their own team consisted of personnel with legal, accounting, finance and even engineering expertise and thus they could call upon a wide range of skills during the negotiation process. Some other transit authorities or transportation departments were renowned for using consultants for the negotiation phase of a contract, regarding them as a resource they could scale up or down as necessary. However, the member of WMATA made the valid point that any consultant still has to be managed, which is a skill not all public employees have.
This led to the next question which focussed upon why some businesses were willing to pay extra taxes for improvements to their area when they were not legally obliged to do so. This is currently an issue for WMATA in the Alexandria region of Washington where there are plans to build a new metro station. Local residents are keen on this proceeding as they currently have a considerable distance to travel to the nearest station; however, local businesses are resisting whilst still hoping to make a quick and profitable sale on land or property as soon as the construction is announced without paying any further fees. Generally however, most businesspeople saw the merit in being located near a transportation nexus. According to one of the academics:
I think that there is an acknowledgement by these private companies that the public sector has made a considerable contribution to such projects, either directly by funding or indirectly by selling land at below market rates.
The other academic interviewed stated that developers tend to make money even if levies are imposed and that in most instances would eventually yield. Furthermore, private companies often gain when there is greater density. However, there were often problems when rail lines (whether over or under ground) crossed state or county lines, as areas that did not contribute to new infrastructure, such as a station, could still benefit. Whilst public sector parties were often willing to share costs, none of the interviewees felt it would be possible to exhort those living, or with commercial interests, in another jurisdiction to the infrastructure to contribute, regardless of potential benefits.
Notwithstanding, there was a general consensus that whilst the public sector own a great deal of land and assets, they were very poor at leveraging value from them and therefore economic development should be undertaken by private firms. As will be seen from the case studies, transportation systems can play a major role in urban regeneration, particularly when hitherto unconnected areas become linked to a rail network. One of the members of a think tank reiterated the point made above regarding government selling land cheaply; feeling that it was a win-win situation:
Selling land below market rates has two benefits: if a project fails it proves that maybe there was nothing to be gained from redeveloping the area, but the government loses very little by allowing a private developer to speculate; and if value capture is not used and the government finances the PPP, costs are kept low by keeping the price of the land to a minimum. Thus a small investment by the public sector could breathe new life into an area.
Clearly the interviewees who worked for a transit authority were going to have fairly strong views when it came to funding for rail as opposed to road, but there was a feeling that the former was seen as a poor relation to the latter when competing for federal or state funding. Nonetheless, investment in the metro (or other forms of public transport) was seen as essential in order to attract young people to an area, as they will often be burdened with debt from their education and will not be able to afford a car. Moreover, a better metro network means savings for other citizens no longer needing to own a car, less stressful and quicker journeys as road congestion is avoided and, from a government perspective, no need to keep building more roads. A final reason for investment in transit (as opposed to roads) is what Leinberger and Doherty (2010) refer to as a shift in residential choices from low-density, car-dependent suburbs to walkable city neighbourhoods, where despite the name public transport is still essential. This leads to what is sometime referred to as the virtuous circle (Levinson and Istrate, 2011); infrastructure creates access, access creates value, value can be captured to finance infrastructure and therefore create further access, and thus value. For these reasons, PPPs making use of value capture were seen as essential so that worthwhile projects didn’t get postponed or abandoned. Interestingly however, not all the interviewees felt that the constant expansion of a railway or metro network would be universally welcomed. For example according to one of the academics:
Some communities like their suburban status and don’t want to become part of an expanded urban area.
Moreover, continuous extensions put pressure on central stations that could subsequently suffer from capacity problems. This point will be returned to in the case studies. A final point was made from one of the representatives from WMATA, which is related to the comment above regarding young people seeking areas with public transport as opposed to those nearer highway access points:
It is vital to attract young, educated people, as businesses can build themselves around the energy and creativity of these workers.
Whilst there are clearly barriers to be overcome in the use of value capture, all interviewees saw it as an essential component in the funding of transportation PPPs. Those having a commercial interest in an area earmarked for a station or highway access point tended to gain and given a certain level of public sector expertise could be persuaded to make a financial contribution. Two examples of successful PPP projects that used value capture are now described.
Case Studies
Union Station
Washington DC’s Union Station opened in 1907 and at the time was the largest station in the world; yet by the late 1970s it had deteriorated to the extent that it was virtually uninhabitable and was in danger of demolition. However, a mixture of public and political demand led to major renovation work, via a PPP, beginning in 1984 with the completed station having a classical, Beaux-Arts exterior and a modern, clean interior, which as well as the normal functions one would associate with a station also has a large number of high-end and high street shops, restaurants and fast food outlets over three floors. Additionally there are a multi-storey parking area for 1,500 vehicles, an area capable of handling 80 buses, a nine screen cinema and ample office space. This PPP has been so successful that the station now has over 25 million visitors each year and has therefore become a major tourist attraction. The $160 million project was financed by a combination of public and private money in the following way (National Council for PPPs (NCPPPs, 2011a) :
Amtrak contributed $70 million for the construction of new ticketing and passenger facilities;
DC contributed $40 million in interstate highway funds for the construction of a parking deck. These funds guaranteed a bond, whose debt service was to be paid by parking garage fees; and
The private sector partners provided the remaining $50 million through equity financing, serviced by revenues from commerce, rental and sales.
It is not only the station that has benefitted from the renovation, but the surrounding area has also developed economically. The area which extends from the north of the station has been rebranded as NoMa (north of Massachusetts Avenue) and its gentrification has occurred due to private companies investing $3 billion in the area over the past six years (i.e. since 2005). Over that period almost 16 million square feet has been developed and from 2010 to 2011, 1,400 residents made the NoMa district their home. All this came about due to the formation of the NoMa BID, which was tasked with coordinating public and private investment, providing cleaning and safety services, and generally promoting the area. A further contributing factor came about due to another PPP, which spent $110 million developing the New York Avenue metro station, thereby linking the area to a public transportation system. The above station also availed of value capture techniques using the following sources of funding:
$35 million in private funds from area businesses, including $10 million in land, amortised over 30 years;
$44 million from DC; and
$31 million from the federal government, including $6 million for the construction of a portion of the Metropolitan Branch Trail (an eight mile trail that runs from Union Station in DC to Silver Spring in Maryland) (NCPPPs, 2011b).
Notwithstanding, Union Station has almost become a victim of its own success. According to one of the interviewees from WMATA, Amtrak could operate at 30% extra capacity, which means it is currently looking to expand to maximise customer revenue. At the same time, due to the increase in rail passengers, the metro station that serves Union Station also has capacity issues and thus it too is looking to expand. However, such expansions are likely to encroach on one another’s areas as well as that of the retail and food outlets.
Bethesda Metro Station
Bethesda is considered to be one of the more upmarket areas of Washington DC with an estimated average household income of $129,440 and a median housing value of $734,614. Moreover, 78.9% of its eligible population hold a college degree and 48.8% hold graduate/professional degrees (Bethesda Urban Partnership, 2011). Whilst a high number of its residents will travel into the centre of Washington to work, Bethesda has a downtown workforce of its own that exceeds 43,000. Therefore a station that is connected to the metro network is essential and Bethesda’s handles more than 15,000 passengers on the average weekday. Additionally, during weekends, more than 10,000 passengers pass through the station (Bethesda Urban Partnership, 2011).
The PPP in this case study is not the metro station itself but Bethesda Metro Centre, which is located just above it. This PPP used a combination of joint development and air rights to bring in extra revenue to fund future projects. The Metro Centre is a large-scale, mixed use, (i.e. office, hotel and retail) project that brings in $1.6 million in annual leasing revenues for WMATA. According to Cervero (1994), at the time of writing, this was the highest revenue for any single project in the USA. The complex includes 400,000 square feet of office space, a large hotel and 60,000 square feet of retail operations. Moreover, the PPP has led to other commercial and residential development within its vicinity, including a restaurant, arts and entertainment district (Cervero, 2004). Therefore, as with Union Station, the benefits have spread beyond the asset itself. WMATA raised funds for this project in the following ways: it leased and sold its property on or adjacent to the transit infrastructure; it leased or sold development rights associated with its property; it shared operations’ costs of ventilation and heating systems at transit stations; and received the aforementioned connections fees from retailers who want to connect their retail space to the station.
Cervero (1994
