by Azfar Ali Khan and Randall Bartlett
One can be forgiven for not remembering the musical lyric in the title. It comes from the 1998 song “The Way” by Fastball, and marks what would be considered by most to be a one-hit wonder. But, while the relevance of Fastball and “The Way” in music history remains up for debate, the question this lyric asks is as relevant today as ever. And this is particularly true in the context of infrastructure investment in Canada, and the role that the Canada Infrastructure Bank (CIB) will play in that investment.
In the 2016 Fall Economic Statement, the federal government outlined the broad strokes of its soon to be established CIB. A key recommendation of the Finance Minister’s Advisory Council on Economic Growth and Prosperity, the federal government expounded further on the CIB in Budget 2017 and again, more recently, in the Budget Implementation Act (BIA). The BIA has put even more meat on the bone, although information on this one-of-a-kind crown agency still makes for some pretty thin pickings and public consultations appear to be sparse.
The CIB is meant to use a relatively small amount of capital to leverage additional private-sector investment in Canadian infrastructure. But, while the CIB is being designed with some laudable features and the noble goal of making tax-dollars go further, there are some questions that remain unanswered. These relate to both the design of the CIB itself, as well as the context in which it is being established. Indeed, there is an information vacuum related to infrastructure in Canada when compared to other jurisdictions, including credible and consistent estimates the current stock, its useful life, and the future needs which the CIB is meant to address.
Where are we?
Understanding the current state of Canada’s infrastructure stock is a necessary first step towards ensuring that new infrastructure investments financed through the CIB are appropriately targeted and focused on areas that will have the greatest impact and benefit for Canadians.
Since 2002, Infrastructure Canada has identified approximately $52 billion in infrastructure investments from over 10,200 projects at the federal level alone. Provincial/Territorial/Municipal and private sector investments would be in addition to these federal investments. Do we have a good picture of the current state of this and pre-existing infrastructure? The capacity utilization, future demand, vulnerability, resilience, financial performance and service standards are all components, among others, of assessing the current condition of our infrastructure. And, quite frankly, we don’t have a clue about most of this information.
If we had this information, it would allow us to understand the strengths and weaknesses of Canada’s current infrastructure stock across the public transit, green, social, trade and transportation, and rural and northern communities outcome areas identified by the federal government. This information would help to ensure that new infrastructure investments work towards optimizing Canada’s economic growth and prosperity as they will not be considered in isolation but within the holistic context of the current infrastructure stock.
Where are we going?
Once this information has been collected and we know where we are, the next step to investing in infrastructure is to know where we’re going. This ‘needs assessment’ involves estimating the current and future infrastructure needs of a jurisdiction, with various types of infrastructure relying on different metrics. Take, for instance, public transit. The need for investment in public transit is a function of various considerations, such as urbanization rates, population growth, demographics, income growth, etc. Other types of infrastructure assets, such as ports or bridges that cross international borders, rely on projections of other economic indicators, such as trade flows, tourism, trade barriers, and the like. And, while forecasts are never perfect, they at least allow for a framework by which future infrastructure needs can be determined by asset type and region.
But while this work is not being done in Canada, other jurisdictions are pursuing it in earnest. For example, the UK’s National Infrastructure Commission (NIC) is currently undertaking a detailed assessment of its national infrastructure that is aimed at identifying the UK’s infrastructure needs and priorities to 2050. This comprehensive assessment is made up of two phases. The first phase will identify the vision and priorities up to 2050, with this report scheduled to be completed in the summer of 2017. The second phase is an assessment of the UK’s national infrastructure that will be completed sometime in 2018. It will be informed by considerable engagement and wide consultations and will provide non-partisan advice and recommendations. The underlying premise behind the creation of the NIC was to promote excellence in the planning and delivery of major infrastructure projects to rectify decades of poor strategic infrastructure decision making. When the NIC’s reports and recommendations are published, the UK Government will be required to formally respond. As a result, it will be crystal clear to all UK citizens at the end of this significant exercise “where they are going”!
What is the gap that needs to be filled?
With the needs assessment done, it can then be married with the evaluation of the current stock and useful life of existing infrastructure assets to get an idea of where an investment gap exists. Using this framework, this ‘infrastructure gap’, as it’s more commonly known, can be determined at as granular a level as by asset type and region or as at aggregate a level as for the country as a whole.
But without some idea of what the size of this gap is, we can’t know how much money needs to be invested. Unfortunately, current estimates of this gap in Canada put it between $0 and $1 trillion, meaning we don’t have a clue. This suggests that at an aggregate level, infrastructure investments announced since the Finance Minister’s Advisory Council recommended the establishment of the CIB may be for naught. Indeed, to go a step further, without infrastructure gap estimates being developed at the provincial-territorial level by asset type, we don’t even know what and where the investment needs are. And, as we know from experience, the misallocation of infrastructure investment can lead to more smoke (inflation) than fire (economic growth), as scarce resources in the economy are moved to the wrong projects. This would defeat the purpose of making these investments in the first place.
If you build the CIB, will they come?
It is only by getting the infrastructure investment architecture right – credible estimates of the current stock and life cycle of existing assets accompanied by a needs assessment by region and asset type – that one can then determine which projects will get the biggest bang for the buck. These are the projects that, if owned by the public, should achieve the best value-for-money for taxpayers. If these assets are instead owned by private-sector players, such as pension funds and asset managers, this architecture is still crucial to understanding the overall risk and return characteristics of these investment opportunities, and ultimately the return on investment.
And, when it comes to private-sector opportunities, infrastructure is an asset class that just keeps on giving. For instance, in a recent report by JP Morgan, analysts determined that the expected returns to infrastructure investment are very high when compared to other asset classes, while the risk to these investments is very low (Exhibit 1). One could therefore think of infrastructure, as some in the investment industry have suggested, as having ‘equity-like return and bond-like risk’. But it gets better. Beyond examining infrastructure only in isolation, it is also important to consider the relationship is between the return on infrastructure investments and the return to other asset classes, such as equities. This is called the correlation and, in general, the correlation between the returns on infrastructure and other investments is very low. As a result, adding infrastructure to a portfolio of other assets tends to both add high returns while lowering the level of overall portfolio risk.
But while infrastructure as an asset class is associated with high return, low risk, and good diversification benefits, it doesn’t mean that investors will jump at the opportunities to invest. For instance, many of the investments trumpeted by the CIB are likely to be ‘greenfield’, meaning new construction such as the building of a road. Canadian institutional investors have a pretty thin history of investing in these types of assets, instead preferring ‘brownfield’ investments – those that have already been built and have an established revenue stream such as a pre-existing toll road. As such, Canadian investors will either need to venture further into building new – an area where they have limited experience – or foreign ownership of Canadian infrastructure may increase dramatically. As such, Canadian infrastructure may not just be increasingly owned by private-sector players, but also foreign players. Importantly, increased foreign ownership of Canadian infrastructure is not necessarily a bad thing, particularly if that is where the expertise lay. It is just an implication worth noting.
Another noteworthy implication in the debate of ‘greenfield’ vs ‘brownfield’ is that, in environments of fiscal deficits and restraint, other jurisdictions place an emphasis on optimizing current infrastructure over large-scale new construction. For example, in their 2016 State Infrastructure Plan, the Queensland government in Australia explicitly identified an option ranking preference as a filter for assessing infrastructure investment decisions across governments. The ranking preference in order is as follows: reform (improving service performance through reform); better use (improving service by influencing demand); improve existing (improving service performance through capital outlays to upgrade existing infrastructure); and, as a last option, build new.
Other important considerations for private sector involvement include: how the financing for these projects will be arranged; the size of the deals and how they may be bundled; the role that the federal, provincial-territorial, and municipal governments may play in aligning its political priorities with highest value-for-money projects; etc. We hope many of these considerations will be addressed as more information becomes available.
Why the CIB?
It is important to note that investors are most likely to prioritize those projects with the highest return and lowest risk, as one would expect. Therefore, it is the higher-value assets which are most likely to be subject to private ownership. Since it is Canadian taxpayers that will pay for these assets regardless of whether they are publically or privately owned, this does beg the question: Why would taxpayers sell their most valuable assets to the private sector, thereby transferring these high risk-adjusted returns from the public sector to the private sector? To date, this question remains unanswered.
In spite of this, the primary reason given for the introduction of the CIB is that it will allow all levels of government to leverage a small amount of public investment to attract much more private investment. The ratio given in the stylized example from federal government’s budget documents is a 4:1 ratio private-to-public investment. But this makes one wonder why the federal government doesn’t just borrow the funds for these investments. With yields on 30-year Government of Canada bonds currently sitting around 2.2%, the federal government can almost literally get ‘money for nothing’. Nobody in the private sector can borrow at this rate over 30 years.
Some have suggested that the reason is that ratings agencies would not look favourably upon the federal government borrowing hundreds of billions of dollars for infrastructure investment. But this argument doesn’t hold up. Borrowing money is largely a balance sheet transaction, and if it’s used to invest in infrastructure there will be assets to match these liabilities for many years to come. Further, looking to the IMF’s World Economic Outlook database, where economic variables are determined on a similar basis, one observes that Canada has the lowest net debt-to-GDP ratio in the Group of Seven (G7) – the group of the world’s largest advanced economies. According to IMF data, general government net debt in Canada could have been about $450 billion higher in 2015 and would still have only matched the German net debt-to-GDP ratio – the G7 country with a net debt-to-GDP ratio closest to Canada – of 47.8%.
The case for the CIB is weak
In summary, the arguments above outline how the case for the Canada Infrastructure Bank has yet to be made. First, no level of government has a good handle on the size of its existing stock of infrastructure and what it’s useful life is. So, do we as a country know where we are? No. Has any jurisdiction published a comprehensive needs assessment that would allow us to know where we are going? Again, the answer is no. And without these two fundamental pieces of analysis, we don’t know how big the existing infrastructure gap is and where infrastructure investment will get the biggest bang for the buck. One could make a strong case that the priority for the Canadian government should be to complete the analysis on its existing stock and future needs before shovelling money out the door. This would give the CIB the necessary evidence base to optimize where to leverage infrastructure investments.
Finally, even if we did have all of this information, the case for establishing the CIB is not compelling, as it has the potential to increase overall costs to taxpayers while privatizing the most high-return, low-risk infrastructure assets. So, why the CIB? We don’t know, and ‘just because innovation’ is not a good enough answer. As Fastball so eloquently said back in 1998, and which remains so obviously relevant in the case of the CIB, “But where were they going without ever knowing the way?”