David Seltzer, Distinguished Practitioner
The National Center for Innovations in Public Finance
University of Southern California
September 25, 2002
Good morning, ladies and gentlemen. My name is David Seltzer, and I am a principal at Mercator Advisors, LLC, a consulting firm that advises public, private and nonprofit organizations on infrastructure financing issues. I also am affiliated with The University of Southern California’s National Center for Innovations in Public Finance. The National Center, established two years ago, undertakes research and helps provide mid-career professional training in the field of infrastructure finance, including the growing use of public-private partnerships for project delivery. I would like to submit for the record a copy of a report USC published last year on California’s 10-year experience with Innovations in Public Finance, which may prove informative to your Committees.
Previously, I had the privilege of serving as Capital Markets Advisor for three years at the U.S. Department of Transportation during TEA-21’s authorization, and before I that spent over 20 years assembling bond issues for transportation and other public agencies as an investment banker. So having worked in the public and private sectors, I have clearly violated both ends of the timeless dictum of “neither a borrower nor a lender be.”
You will be hearing testimony this morning from a distinguished array of Federal, state, local and private sector experts in connection with new financing initiatives for reauthorization. Since many of the new ideas draw upon tax incentives as well as other Federal policy tools, I commend you on making this is a joint hearing of both the tax writing and surface transportation authorizing committees.
I found when in Federal service that the wide array of financial tools, techniques and even terminology can be bewildering. If I may, I’d like to put on my academic hat for a couple of minutes and try to present an analytic framework that may be helpful in comparing so-called “Innovative Finance” options.
The term “innovative finance” in Federal transportation parlance encompasses not only new financing techniques such as State Infrastructure Banks and TIFIA credit support, but also new approaches in the areas of project delivery, asset management, and service operations. In many cases, the techniques involve some form of public and private sector partnering. Private participation is seen as offering the potential to transfer risks, achieve production or operating efficiencies, and attract additional capital.
In order to systematically analyze the cost- and policy-effectiveness of an innovative finance proposal, I believe it would be useful to employ a “Federal Policy Comparator.” A comparator is a scientific instrument used for measuring the features of different objects. In much the same way, it should be possible to compare various innovative finance proposals within an analytic framework to determine which proposals would be most effective.
The Federal Policy Comparator would seek answers to three central questions:
1. Which Federal Policy Incentives are most suitable to attaining the proposal’s objectives?
2. Does the proposal achieve balance among Sponsors, Investors and Policymakers? And
3. What is the Budgetary Treatment of the proposal?
· Regulatory Incentives make existing programs and tools more flexible, in order to expand project resources or accelerate project delivery. (GARVEE Bonds are one such example, in that they broadened allowable uses for grants to include paying debt service on bond issues that fund eligible projects. Other regulatory reforms include design-build contracting, in-kind match and environmental streamlining.)
· Tax Incentives involve modifying the Internal Revenue Code to attract investors into transportation projects. (Examples include private activity bonds, tax credit bonds, and tax-oriented leasing.)
· Credit Incentives provide Federal assistance in the form of Federal loans or loan guarantees to reduce the cost of financing and fill capital gaps. (Examples include Federal credit instruments provided through TIFIA and the Railroad Rehabilitation and Improvement Financing (RRIF) program.)
· Generally, there is a tradeoff between the budgetary cost of the incentive and its degree of effectiveness in making the desired capital investment feasible. For instance, many regulatory reforms have little or no budgetary cost, but they also generally provide only very incremental assistance in advancing projects. Tax measures typically are a “helpful but not sufficient” pre-condition for investment; the project must be on the margin of viability to benefit from them. Credit assistance can fill funding gaps and attract co-investment, but its uncertain cost depends on risk factors and interest rate subsidies. For instance, a complex and capital-intensive initiative such as Maglev may confer significant mobility, environmental and technology benefits. However, it also may well require deeper tax and/or credit subsidies in order to bring projects to fruition than that afforded by an incentive such as private activity bond eligibility.
2. Does the Proposal Achieve Balance Among Sponsors, Investors and Policymakers? To be successful, each innovative financing initiative should be designed to meet the requirements of three distinct groups of stakeholders. First, the proposal must be attractive to project sponsors—the public or private entity responsible for delivering the project. Attractiveness to the project sponsor can be measured in terms of its cost-effectiveness, flexibility, and ease of implementation. Second, the proposal must make sense to investors—offering them a competitive risk-adjusted rate of return. Capital is notoriously unsentimental, and the innovative finance tool must compete for investor demand against other investment products in the marketplace. And finally, the concept must make sense to Federal policymakers. This entails not only achieving public policy objectives but also being affordable in terms of budgetary cost. These three groups—project sponsors, investors and policymakers – can be thought of as the legs of a three-legged stool. If any one leg of the stool has shortcomings, the proposal will wobble, and probably not be supportable.
For example, dating back to the 1993 Federal Infrastructure Investment Commission, there has been a wide-stated interest in trying to voluntarily attract pension fund capital into the infrastructure sector. Public, union and corporate plans represent over $3.6 trillion of assets, yet they have virtually no U.S. transportation projects in their portfolios. Why? Because the dominant financing vehicle to date has been tax-exempt municipal bonds. While the tax-exempt market will continue to be an absolutely critical component of infrastructure financing, pension funds, as tax-exempt entities, place no value on the tax-exemption. Pension funds gladly would purchase infrastructure debt if it were offered at higher taxable yields, but that has limited appeal for the project sponsors who can access the municipal market. Consequently, the three-legged stool is uneven. (I note that various proposals have been introduced recently to create a “win-win” security that is both cost-effective for borrowers and competitively-priced for pension fund lenders—while at the same time satisfying Federal policy drivers.)
3. Finally, what is the Budgetary Treatment of the proposal? Efficient markets rely upon transparent pricing signals to function properly. However, oftentimes when Federal proposals are being developed, the key pricing information– budget scoring—is at best translucent, if not completely opaque. It seems it is the mysterious scoring of a proposal, and not its policy effectiveness, that too frequently drives the ultimate policy decision – perhaps a case of the “tail wagging the dog.” Better information on budgetary costs earlier on in the process would benefit the development and evaluation of alternative policy options.
Unlike corporate and state and local entities, the Federal government makes no budgetary distinction between current period operating outlays and long-term capital investments. Nor does it distinguish between full faith and credit general obligations and limited special revenue pledges. From the perspective of infrastructure advocates, this is both inequitable and inefficient: Inequitable in that costs are not shared by future beneficiaries, and inefficient in that there is a bias toward considering those proposals that have the lowest front-end costs, rather than looking at cost-effectiveness over the long-term.
Some Federal innovative finance concepts attempt to overcome this problem by drawing upon either credit reform budgetary rules (a rare case where Federal accounting is on an accrual basis and conforms to best commercial practices) or by utilizing the tax code (where the PAYGO rules recognize tax expenditures on an annual basis).
While some may consider these tools to be unnecessarily complicated attempts to circumnavigate cash-based accounting, I believe they offer the benefit of rationalizing the budgetary treatment of capital spending and facilitating sound decision-making on Federal infrastructure policy.
In conclusion, I submit that by using this three-part Federal Policy Comparator as an analytic framework, policymakers can more systematically compare the budgetary cost with the policy effectiveness of proposals. It would allow comparisons of initiatives as varied as private activity bonds for intermodal facilities, shadow tolling for highways, national or regional loan revolving funds for freight rail, tax credit bonds for high-speed rail, and reinsurance for long-term vendor warranties. By way of illustration, I am including as an attachment a pro-forma Federal Policy Comparator analysis of four current or proposed Federal innovative finance tools for surface transportation – GARVEE Bonds, TIFIA Instruments, Private Activity Bonds and Tax Credit Bonds.
Thank you very much for your time. I would be happy to answer any questions you might have.
Appendix A. Federal Policy Comparator PowerPoint Slides
& Recommendations: A Roundtable
Discussion of California’s Experience with Innovations in Public Finance,
The National Center for Innovations in Public Finance, University of Southern
Table 1: Key Drivers on Innovative Finance Proposals for Project Sponsors, Investors and Federal Policymakers
Project Sponsor / Borrower
§ What is the effective financing cost (IRR)?
§ How high is the Annual Payment Factor?
§ Is the transaction reported as a direct or contingent liability on the Sponsor’s balance sheet?
§ What legal steps (state legislation, etc.) must be taken to utilize it?
§ How difficult is it for Management to implement it?
§ Is the risk-adjusted rate of return competitive?
§ Is there a secondary market for the product (liquidity)?
§ Are there other investment risks (tax compliance, call risk, etc.)?
§ Will it help diversify the investor’s portfolio exposure?
§ Are there any other strategic reasons for investing aside from its return?
§ What is the proposal’s budgetary cost?
§ Is the finance tool cost-effective (how much leveraging of Federal resources)?
§ What is the overall economic return (benefit/cost ratio)?
§ How well does it achieve multiple Federal policy objectives?
Ø Improve Access
Ø Enhance Mobility
Ø Shift Risks away from the Government
Ø Attract Non-Federal Resources / Private Participation
Ø Accelerate Projects