Thursday, August 23, 2018


A low cost of capital but a high cost of inadequate investment.

Why, when interest rates are so low and there is a global glut of capital, are there not much higher levels of
investment in infrastructure?

The Genoa bridge collapse is a reminder of the high human and economic cost of failure to provide the safe infrastructure on which a modern society depends. In the case of the failed bridge the blame game is now in full cry, and the causes to which its sudden and catastrophic collapse can be, will be, or are being attributed are numerous and not necessarily mutually exclusive. They include:

·        questions over the original 1960s design.

·        failure to heed expert professional advice that the bridge was at imminent risk.

·        reluctance on the part of populist politicians to countenance any form of infrastructure spending, combined with

·        a readiness to shout “Project Fear” in response to expert opinion.

·        constant pressures to reduce public spending

·        failures of those responsible for bridge upkeep,. the adequacy of maintenance and monitoring of its structural integrity.

Mostly these factors relate to unwillingness to spend money on infrastructure investment, and the search for excuses to avoid doing so. Tony Barber, writing in the FT (17 August) argues as follows.
“… the case for more government spending on infrastructure is unanswerable. Of course, … controversial questions of taxation, spending priorities and state borrowing. But unless these questions are addressed, the next catastrophic bridge collapse is only a matter of time.

For “catastrophic bridge collapse” read “global climate crises”. The parallels with action on climate policy are both clear and frightening. Action on climate is as essential to our collective future as bridge maintenance is to road safety. The cost of the investment spend is small in relation to the costs of failure (an economic disaster for Genoa and for Italy). And most spending to deal with climate issues is essentially infrastructure in one form or another.

The parallels extend to the politics. As with the Genoa bridge, populist politicians (eg Redwood, Rees Mogg and Lawson) prefer to decry expert opinion, in this instance the science of climate, as “climate alarmism”. The ultimate costs of failure (to tackle climate issues) will, as with the bridge, be much higher both in absolute terms and relative to the necessary levels of investment. Infrastructure is commonly a public good, with collective benefits, and no doubt many people would prefer to enjoy the benefit without having to pay a share of the cost. For climate policy, reluctance to pay is reinforced by the knowledge that the problem is not even contained regionally or nationally, but is global. Unilateral national action is therefore of limited value. If the world is in reality doomed to endure climate catastrophe because of the indifference or inadequate response of other big players (eg the USA, China, the EU, India), then national investment, however well executed, provides little benefit to the country that undertakes it. It is a classic “free rider” problem.

We consistently overestimate the cost of the necessary investments.

Why are so many politicians are able to convince themselves, and indeed much of the press and public, that the cost of essential infrastructure investments is unaffordable? Part of this comes down to consideration of how such capital projects are financed and stems from fallacies that surround much of the conventional analysis of the real cost of that capital, and how that investment should be rewarded.

How is it that governments are currently able to borrow at rates of interest that are close to zero, or even negative in real inflation adjusted terms, while EDF’s Hinkley Point project is reported as providing a lifetime return of around 9%?  Needless to say such a rate of return means a high cost to the consumer.

The cost of capital reflects risk? But this is a very specific definition of risk.

Conventional capital market theory (the well known CAPM model beloved of finance theorists and the basis of much of financial analysis) does indeed link the cost of capital to perceived market risk. But it is a very specific definition of risk, defined as the extent of the correlation between the stock market price of an individual share and the volatility of the stock market (eg the FTSE 100 index) as a whole (the “beta” value). It does not depend on the riskiness of an individual project, since it is assumed that investors will diversify away from individual risks, even risks as big as that of a massive overrun on construction costs. Project specific risk, in this context, is irrelevant.

The same conventional theory suggests that the cost of capital, viewed as the return over the whole life of an asset, should equate, loosely at least, to the rate of return achieved by utility investments generally. Utility earnings tend to have a rather low correlation with the general economy and the various share indices, implying a low cost of capital. The costs of climate change, and hence the benefits of limiting those costs, are almost entirely independent of any short term market volatility.

And the same is true for almost any “essential” investment, a category in which we can place both bridge structural repair and investment in mitigating climate change. In commercial terms these should be seen as low risk investments, and financed on a basis that properly reflects that. Conventional finance theory, therefore, is entirely consistent with the use of very low discount rates for appraisal of essential infrastructure and “public good” investments.

We can manage risk and contain the cost of capital.

Recent UK history abounds in expensive mistakes in relation to major capital investment programmes, and many of these relate to a failure to get the right links between risk and reward (the cost of capital) or to manage risks in the most appropriate way.  These include notorious private finance initiative (PFI) projects in which the public finances (via the NHS) have been forced to bear the burden of high returns on capital, even though most of the real risks have remained with the public sector or been de facto underwritten by government. There are two major principles that should help avoid these mistakes in the future.

The first is to recognise project specific risks and separate them from calculation of appropriate returns over the full life of an asset. Many major capital projects, such as nuclear power stations or tidal barrages, are intrinsically subject to significant uncertainties over construction costs and the risk of cost overruns. These may be shared between the construction business and the utility company that operates the asset, and will be embodied in the cost attributed to the asset at the time of its commissioning. The contractor will need to be properly rewarded for the risk taken during construction. But thereafter, within a well regulated sector, the asset enjoys a safe “low beta” utility return. Investment should therefore be appraised on the basis of a very low cost of capital.

The second is to ensure that economic regulation of utilities (eg the power sector) is appropriate. This means providing a degree of security over the future regulatory framework to protect the investors (in the asset) from expropriation of what is for them a sunk cost, if necessary through revenue guarantees.   If the framework is inadequate in providing this kind of regulatory reassurance, the investment will inevitably carry a much higher “project specific” risk premium. The public sector will in effect be paying very heavily for risks that are within its power to avoid.

Lord Stern attracted a great deal of criticism following the Stern Review, for arguing for very low discount rates to be applicable to assessment of climate mitigation investment. Recent experience of ultra-low interest rates, and indeed some of the indications of the rates attainable for major projects, with appropriate guarantees, suggests that low discount rates may be the most appropriate for evaluating and comparing low carbon investments.