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COMPARISON OF SHADOW TOLL FINANCING TO OTHER METHODS
Project Development: The Financing Issue
Elements of financing include: (1) the types of revenues used to pay for the project; and (2) the types of financing instruments used, such as tax-exempt debt versus private equity. The following graphic should not be read to imply that, for instance, user fee revenues result in taxable debt. Rather, the graphic indicates that there is a range of pledged revenues which differs between a public and a private financing and there is a range of financing instruments available to each as well. It is important to note that purely private capital is only derived when the developer's balance sheet supports the issuance of taxable debt and/or developer equity. That is, the private sector participant is putting its full financial resources, and not just project derived revenues, behind the financing instrument. Purely private capital is very rare with public purpose infrastructure projects. Typically, third-party passive investors provide necessary capital via their purchase of municipal bonds, corporate debt, and corporate stock. If all capital costs are assumed equal, it can be shown that publicly issued tax-exempt debt will practically always result in lower project cost.
Where a project falls along the public to private continuum largely determines the project's benefits, risks, control, costs, and accountability. The financing issue is often at the core of project development and private sector participation discussions. The public or private entity that finances a given project in all likelihood will own the project and will heavily influence other development issues. The importance of project financing is probably why the term "privatization" is often used to mean the investment of private sector capital to finance public use transportation infrastructure. The ability to finance —whether public or private — is largely dependent upon the adequacy and stability of project dedicated revenues to support the debt service on bonds and/or the return on equity. The capital markets provide the mechanism which bring together the project sponsor trying to raise funding and third-party investors willing to purchase project debt or equity. Increased private sector participation in the design, construction, ownership, and/or operation of a public purpose transportation project does not necessarily increase or significantly impact the capacity to finance the project.
Private Capital: Limited Applications for Transportation Finance
Private Capital
It is important to this analysis to understand how the private sector raises capital and what it costs. Generally, the private sector raises capital in one of two forms: capital investment in private sector taxable debt and private sector capital equity. In the first case, a private sector entity raises project capital by selling bonds or some similar product which usually provides a lien upon some specified revenue source and pays interest at a taxable rate. Purchasing the private sector entity's debt makes the investor a general creditor who has certain legal remedies to force repayment and who has priority over an equity investor. Private sector equity investment essentially makes the private investor a project owner, although the ownership could be either minority or majority interest, and subjects the private investor to the risk of loss of capital with no or only limited recourse to secure repayment. The ownership and risk associated with equity investment generally require a higher rate of return on capital in order to induce the investment. Whether private sector taxable debt or private sector project equity, one distinguishing character istic of purely private capital is that a private sector entity is creating an investment opportunity for which a private sector investor is expecting a return on capital (Haugen, 1986).
Two points of interest concerning private capital are particularly relevant to this critical analysis. One is that the ability for a private sector entity to raise debt or equity capital is dependent upon a revenue stream, usually derived from or related to the transportation project being financed, that is sufficient to provide the required return on capital. This truism is no different than the public sector's ability to raise debt capital by issuing tax-exempt bonds, i.e., a revenue stream sufficient to allow the issuing entity to meet debt service payments is required. The second point of interest is that the return on private capital, whether the taxable interest rates paid on private sector debt or the internal rate of return on equity capital, is typically higher than the return required to attract investment in public sector debt. Put simply, a public entity's cost of capital for a given transportation project — all things being equal — is lower than a private sector entity's cost of capital.
In many municipalities throughout the United States there is a major effort to involve the private sector to build and operate transportation systems. The theory driving the use of these approaches is that business can more efficiently build and operate a transportation project than government. The private sector is not constrained by the project approval process (other than legally required approvals such as an environmental impact statement), does not have to follow government procurement practices, can build the project on a "privatized" basis (design and build), and can provide more efficient construction management. On the operating side, the private sector does not have to follow civil service employment requirements and can avoid government procurement procedures for spare parts and material supplies (Curry, 1992). These advantages may be more significant than the major financial fact confronting capital intensive transportation projects in the US, i.e., debt service levels for a privately financed project (not using tax-exempt debt) are higher than those for a publicly financed project of comparable cost.
Participant Investor Versus Passive Investor
There is a distinction between what will be referred to as the participant investor and the passive investor. The participant investor is a private sector entity that is willing to contribute capital to a given transportation project if they are to be awarded a franchise, a construction contract, etc., i.e., they will invest as long as they are a participant in project development in some additional capacity other than just financial. The passive investor is a private sector entity seeking an acceptable risk-return relationship from a purely financial perspective. The passive investor is generally, although not exclusively, a general creditor of the project seeking to buy taxable bonds or some similar form of structured debt yielding in the range of 10 percent to 20 percent interest on principal. As a general creditor, the passive investor will be in a stronger position with respect to ability to receive project cash flow. The passive investor may also invest in project equity, but does so solely on the basis of adequate cash flow return.
Generally, the participant investor is willing to contribute equity, possibly in the form of paying for up front development costs, and will expect a return on equity of 18 percent to 30 percent over the long term. A participant investor may also purchase some form of structured debt, such as deferred or subordinate construction notes, as a means to stimulate the project's financial feasibility. As an active participant in the project, the participant investor's risk as an equity contributor or subordinate note holder is offset by the profits received from project management fees, construction profits, operations contract fees, etc. These are profits all of which (1) occur if the project moves forward and (2) are in addition to any return on equity or interest earned. From this perspective, and taken to a simplified extreme, one can view the "equity" that a participant investor is willing to contribute as the resources that same entity would have to commit to respond to a public request for proposals or competitive bid for a project contract. From the participant investor's perspective, why not expend those resources developing a project concept in a less competitive process and call them "equity" for which an 18 percent to 30 percent return might be achieved, in addition to the award of a contract and the associated contract profits.
The participant versus passive investor analysis can be taken one step further by consider ing the source of backing for capital contributions to a transportation project. Private sector project proposals solicited by state DOTs under "privatization" or public/private partnership programs often include promises of private capital for the project. However, the proposed private capital is almost never contributed directly from the private developer/contractor/operator but is raised from third party institutional investors via a "shell" project corporation and supported solely by project revenues such as explicit tolls or shadow tolls. The third party institutional investors, who are the passive investors described above, include hundreds of mutual funds, bank trusts, insurance companies, pension funds, etc. (there is no shortage of institutional investors for either taxable or tax-exempt financial instruments) who are seeking an appropriate risk-return relationship. The distinction is that the private sector project participant is not risking its own capital by "pledging" its balance sheet and income statement to provide the return on equity. It is simply creating a conduit to raise passive investment capital based solely on the financial merits of the project itself.
These distinctions are important ones, and several relevant points can be derived. First of all, the profit motive clearly stands out for the participant investor. Also, the popular notion that says a huge untapped pool of private capital is available and waiting for public use transportation infrastructure begins to break down. Project development and construction companies may be willing to commit relatively small amounts of "equity" capital toward the development of transportation projects, but typically only if they are awarded lucrative project management/ construction/operations contracts. The true investors in transportation infrastructure, i.e., the passive investors looking solely at the financial risk-return relationship, largely consist of those institutional investors which have become comfortable with the various development risks associated with user fee transportation infrastructure projects, namely toll expressways. These financial companies, and many similar ones, are just as likely if not more likely to be passive investors in publicly developed transportation projects, especially if a municipal entity is willing to mitigate some project risks with credit support. (As suggested later in a case study, shadow tolls could be used as credit support to assist project financing.) A public entity can create a conduit financing enterprise such as a 63-20 not-for-profit corporation and pledge project-derived revenues to debt issuance just as easily as the private sector, and at a lower tax-exempt cost of capital. The statutory and legal complications associated with public issuance of debt are no more difficult to overcome than the procurement, management and public equity issues associated with privatization techniques. In short, "privatization" does not mean that a new source for capital investment immediately becomes available where it otherwise was not.
Recent Applications of Privatized Capital For Surface Transportation
There have not been many recent examples of successful privatized financings. Two of the first much heralded "private" capital financings, the TCA San Joaquin Toll Road and the Osceola Parkway, were publicly owned and used tax-exempt financing together with a public/ private development partnership (Miller 1990; Reinhardt 1993a; Osceola County 1992). Probably the two most notable transportation project financings which have used privatized capital are the Caltrans SR 91 Toll Road and the Dulles Greenway Toll Road. The various development issues for each of these innovative projects are summarized by the following table. These projects have been greatly praised. Public Works Financing (Reinhardt, 1993b) wrote about SR 91, "California, even wealthy Orange County, doesn't have enough money to build all the infrastructure it needs. Every transportation dollar raised by the private sector contributes to the public goal of improving mobility." The fact this statement ignores is that these private sector contributions were raised largely from third party investors and are being repaid from the tolls paid by the citizen and business users of the facility. No private capital has been raised that could not have been raised on a public basis and at a lower tax-exempt cost. Such is the fallacy of most "privatized" capital techniques.
Examples of Privatized Capital Financings
CALTRANS SR91 DULLES TOLL ROAD DESIGN Genesis Private Proposals--Public Selection Private Proposal/Private Initiation Determination of Service Characteristics Private Consortia Private Certificate Holder Principal Objective Expand Capacity and Private Profit Private Profit CONSTRUCTION Construction Design/Build Design/Build Right of Way Assembly Private Lease from State Private Proffer FINANCE Pledged Revenues Tolls Tolls Financing Instrument Taxable Debt, Subordinated Debt, & Sponsor Equity Taxable Debt, Subordinated Debt, & Sponsor Equity OWNERSHIP Ownership Build-Transfer-Operate Build-Transfer-Operate Legal Structure Franchise Franchise Reversion to Public Sector Yes Yes OPERATION Operation Private Private OVERSIGHT Toll Regulation Regulated Return on Equity Regulated Return on Equity (Miller, 1990)
Whether private capital or public capital, these projects embody the basic concepts of project revenue financing which are the same in either case. And the project revenue which is the ultimate financing source is the user fee revenue paid by citizens and businesses. The users of these facilities will now be forced to pay high tolls in the future in order to cover the private sector's higher (than the public sector) cost of capital. Both of these projects utilized taxable debt with yields in excess of 10 percent and equity with expected returns in excess of 20 percent. Although the return on equity has yet to be achieved, it can be reasonably assumed that the overall cost of capital for the private Dulles and SR 91 Toll Roads will be almost double the 6 percent to 8 percent tax-exempt cost of capital for the San Joaquin and Osceola Parkway Toll Roads. Differences in capital markets conditions were relatively minor compared to the differ ences in cost of capital.
Public Solutions For Project Financing Enhancement
The one argument for privatized capital that seems to sometimes be true is the private sector's willingness to fund the early stages of development, when project risks are at their greatest, if future participation in project management/construction/operation is included. These early development costs were privately funded in the Dulles Greenway project. However, going back to previous discussion of participant investors versus passive investors, it seems that the private sector's willingness to fund early stages of development comes primarily from participant investors who stand the most to gain from a successfully developed project. Passive investors, bound by the basic fundamentals of project revenue financing (whether the project is public or private), will not commit capital until a project is better defined and some development risks mitigated.
This issue brings forth an important question of how to fund early project development costs, such as preliminary design and environmental assessment. If private (participant investor) capital is not cost effective, then what is available that is cost effective? For years many states have been financing wastewater facilities through mechanisms called revolving loan funds. In concept, a state finances — through grants, taxes and/or bond proceeds — a loan pool that is then used to make low cost and/or subordinate loans to municipalities needing to finance wastewater facilities. The State of Florida brought this concept to highway financing when it created a Toll Facilities Revolving Trust Fund ("TFRTF") initially funded by State gas taxes and highway funds. The TFRTF makes low cost or even interest free loans to municipal entities trying to start up the development of a Toll Road project. The TFRTF loans are then repaid on a subordinated basis from any toll revenues derived from the fully developed project and in excess of operations and debt service. The revolving loan fund concept for public surface transportation has now been introduced at the Federal level via US DOT's state infrastructure bank ("SIB") pilot program. At the time of the writing of this report, legislation which makes permanent and expands upon this concept is pending in the next transportation act re-authorization. In addition to direct loans, it has been suggested that the revolving fund concept could be modified as a form of credit enhancement, which would lower tax-exempt borrowing costs and aid project financial feasibility (Feldman, 1993).
These ideas could be modified to include the shadow toll concept or a variation thereof. For example, rather than loan money to a project for construction costs, a State SIB could pledge shadow toll payments to a project on top of explicit tolls so that the bonding capacity of the project is increased. A similar variation that would offer credit enhancement would be an "inverse" shadow toll, i.e., any shortfalls of actual traffic to projected traffic could carry an associated shadow toll payment from a SIB or some other governmental entity. The inverse shadow toll would, in effect, provide a line of credit which would "guarantee" the projected revenue stream and should result in a lower project cost of capital. When combined with a revolving loan or SIB line of credit concept, any shadow toll payments to the project would ultimately be repaid from explicit tolls once they became sufficient.
Public/Private Partnerships
Private sector project development techniques embody much more than private capital investment and, as discussed, most "privatization" techniques in the US generally work better without private capital investment due to the lower cost of capital resulting from governmental tax-exempt status. Public/private partnerships, defined previously on page 2, can incorporate the best ideals of "privatization" without a loss of public control over a transportation project and without the excessive cost of capital and profits associated with private capital investment. The many benefits of public/private partnerships have been well debated and documented.
Public/private partnerships using shadow tolls can also be implemented with a government entity or "not-for-profit" organization as the sponsor or administrator receiving funds and dis bursing construction moneys and shadow tolls. This would permit the dual advantages of tax- exempt financing and private sector efficiencies to be realized. As an example of how public/ private partnerships might work with shadow tolls, consider value capture techniques. Such techniques include benefit assessments, tax increments, and even direct payments from private entities (with no associated repayments). The concept of value capture is that the private entities which stand to gain the most from transportation infrastructure improvements — such gains being derived from increased access, increasing property values, etc. — help to pay for such infrastruc ture via one of the capture techniques. Any of the value capture techniques could be combined with shadow tolls, i.e., the assessment or increment paid would vary according to actual traffic. Such an approach may be more acceptable to private participants who may have difficulty estimating the real economic impacts a project might hold for them. For credit reasons to be discussed, value capture shadow tolls would probably best be used as revenue enhancements but not as the primary backing for project financing.
Shadow Tolls: Capital Markets Considerations
The previous sections have indicated that: (1) a transportation project's financing can largely be dis-aggregated from many other elements of overall project development: and (2) private sector financing is probably not desirable, all other things being comparable, in that it carries a higher cost of capital. Furthermore, access to the capital markets is far more dependent upon the financial merits of the project to be financed, including any dedicated revenues, than upon any particular form of private sector project development participation. These conclusions provide a more focused lead into an analysis of shadow tolls as a method of financing. More specifically, shadow tolls can be compared to explicit toll revenues and to tax-backed revenues as sources to support a project debt financing. (A comparison of cash funding via grants and capital reserves versus debt financing would make another useful analysis but is not the focus here as it is assumed that grants and capital reserves, if available, would be used before debt financing.) In making this comparison, it will be assumed that a public purpose transportation project will be publicly owned and publicly financed to avoid unnecessary confusion related to differences in cost of capital.
General Capital Market and Credit Issues
There are numerous factors which are evaluated by capital markets participants such as credit analysts and institutional investors when making decisions regarding credit ratings and investment yield requirements. Many of these factors are uniform for all public infrastructure financings without regard to the specific revenues pledged to the repayment of debt. The uniform credit considerations include socioeconomic data, entity administration and management, and the legal contracts and bond covenants. Socioeconomic data considerations focus on the regional trends in population, employment, property values, retail sales, building permits, etc. Administra tion and management considerations include the political structure, stability of management, long- term capital planning, and public need/support for the project. Legal and bond considerations include the strength of contracts with funding partners, the ability to raise additional revenues, the projection of revenues including feasibility reports, the flow of pledged revenues pursuant to the bond indenture, and debt service coverage requirements (S&P, 1997). All of these factors should generally impact the creditworthiness and marketability of a proposed transportation project financing equally, except for the projection of revenues and ability to raise additional revenues. It may be more difficult to estimate future revenues with shadow tolls and especially with explicit tolls, as compared with straightforward tax-backed revenue sources, due the difficulties in estimating traffic.
Toll and Shadow Toll Credit Issues
Toll road financings have their own unique issues which require additional capital markets analysis. One of the more important distinctions between toll roads and most other financings is that toll roads face competition from toll free roads (S&P, 1997). Toll roads must offer meaning ful time savings to travelers in order to cause them to voluntarily pay a toll to use the facility. Some utilities, especially public power and solid waste, also face competition although typically to a lesser degree. But most public infrastructure financings are backed by revenue streams which are not subject to competition. The typically easy access which drivers have to toll-free roads puts toll revenues among the most difficult to predict, especially in urban areas where there are often many route alternatives and roads are built or improved almost continuously. The competi tion issue is one area where shadow tolls may offer a better credit than explicit tolls and therefore improve access to financing when compared to explicit tolls. Because usage is "free" to travelers using a shadow toll facility, traffic should be easier to predict as it will be based upon times savings and not a time savings/toll cost analysis. Other credit factors unique to toll road financings include the toll rate structure, trip characteristics, rate setting procedures, toll collec tion procedures, and maintenance standards (S&P, 1997). Some of these factors only apply to explicit tolls and not shadow tolls. A summary table of explicit toll and shadow toll credit risk considerations is provided by the following table. Due to these unique credit issues, toll-revenue- backed financings typically have a lower credit rating and a higher cost of capital than tax-backed financings for the same geographic region and/or issuing entity.
New or "start-up" toll roads, especially those which are not an addition to an existing toll facility system, present even more difficult credit issues which differentiate toll credits from most other public infrastructure credits. First of all, traffic usage is much more difficult to project when there is no existing traffic to use as a historical basis. In addition, the non-recourse nature of toll road financings combined with the increasingly high costs of development and construction typically result in bonding capacity from projected tolls being fully utilized. Therefore, the project has no ability to absorb capital cost increases resulting from construction risks or other risk factors, such as those related to right of way or environmental issues. Capital market participants are increasingly focusing on terms and features of the construction contract, insurance coverages, and contingency reserves available in assessing the creditworthiness of a start-up toll financing. It is quite difficult to achieve an investment grade credit rating for start-up toll facility financings, and a rating above "BBB" is literally without precedent in the past decade or more. Whether or not these same start-up features would apply to a shadow toll facility would probably depend upon the ability to adjust shadow toll rates to reflect any increased capital costs. Of course, such a toll adjustment mechanism would shift risk to the sponsor entity paying the shadow toll.
COMPARISON OF CREDIT RISKS FOR EXPLICIT TOLL AND SHADOW TOLL FINANCINGS FACTORS APPLICABLE TO BOTH UNIQUE TO EXPLICIT FINANCINGS UNIQUE TO SHADOW TOLL FINANCINGS General Traffic Risk, (Not Attributable to Driver Willingness-to-Pay) — Determined by:
- Trip characteristics and land-use patterns
- Maintenance standards
- Availability of competing facilities & comparative time savings1
Toll Revenue Risk — Determined By: Explicit Toll-Related Traffic Projection Risk, Directly Attributable to Driver Willing ness to Pay — Affected by:
- Socioeconomic factors (Disposable income, job growth, real-estate development in area of facility, etc.)
- Availability of competing facilities/comparative time savings1
- Toll Collection procedures/ technology (enforcement capability; ease of payment)
Toll Agreement Risks — Risks specifically associated with terms of tolling agreements, including:
- Political risk, if political action is required to change toll rates
- Socioeconomic risk, if toll rates are tied to socio economic indicators in the agreement
Shadow Toll Revenue Risk — Determined by: Underlying Revenue Risk — Underlying risk associated with revenue source(s) pledged as shadow tolls, including the exis tence or absence of full faith and credit pledge, and all the traditional risk factors used in analyzing municipal revenue risk.
Shadow Toll Agreement Risk — Risk specifically asso ciated with terms of shadow toll agreement, including:
- Political risk, if terms re quire political action to cap ture revenue (such as appropriation, or renewal of agreement)
- Inflation/Overrun risk, if agreement places inflation/overrun liability on same entity responsible for bond payments
Construction-Related Risks:
- Construction Contract Terms
- Insurance Coverages
- Contractor Financial Stability
- Contingency Reserves
1 Note that availability of competing facilities/comparative time savings will affect explicit toll revenues more significantly because explicit toll facility users will have a stronger preference for non-toll facilities, whereas users of shadow toll facilities should be neutral.
Comparison of Shadow Tolls to Other Revenue Sources
Given the above discussion, it is reasonable to conclude that an issue based upon a stable tax-backed revenue stream should achieve a higher credit rating and lower cost of capital than one based only on toll revenue, all else being equal. Although there is no U.S. public finance precedent, it is also probably reasonable to conclude that some of the risks unique to toll facilities, such as the difficulty in predicting traffic, would apply to shadow toll facilities; however, not all risks inherent to explicit tolls are applicable or as onerous when applied to shadow tolls. Nonetheless, it cannot be determined that a shadow toll revenue credit is better than an explicit toll revenue credit without knowing the initial source of the funding for the shadow toll payments.
The credit ratings and cost of capital of a shadow toll revenue source is going to be dependent in large part upon the credit rating and cost of capital associated with the underlying revenue source(s). If stable and predictable revenue derived from a general obligation property tax, sales tax or excise tax (e.g. a gas tax) is the underlying source of shadow toll payments, then the shadow toll revenue will likely represent a better credit and lower cost of capital than explicit toll revenue for the same roadway. Alternatively, if an unpredictable revenue source such as a tax increment or special assessment is used, then the shadow toll may represent a weaker credit than an explicit toll.
The more important conclusion to draw is that a shadow toll adds an increased element of variability and unpredictability (and possibly appropriation risk) to the underlying source of revenues and thus will probably result in a weaker credit than the underlying source by itself. Shadow-toll-backed bonds would probably represent a higher cost of capital than simply issuing bonds backed by a direct pledge of a single underlying source. Of course, the revenues required to service the bonds would then be fixed — assuming fixed rate bonds — without regard to the usage of the facility.
Cost Analysis
Credit ratings are project and financing specific, making any generic cost comparison impossible. Furthermore, market conditions change constantly, including interest rate differentials between higher credit quality and lower credit quality financings. Nonetheless, given the above assessment of how risks differ among tax-backed versus shadow toll versus explicit toll credits and given historical interest rate spreads between financings of different credit ratings, we can estimate within a reasonable range of accuracy the financing cost differential.
For purposes of analysis, assume a $100 million new highway project to be financed over thirty years under each of the following revenue scenarios:
- State DOT gas tax bonds which are in the "AA" credit rating category;
A historical estimate of the interest rate differential, assuming no additional credit enhancement, would be 40 basis points (0.40 percent) between the "AA" rated bonds and the "A" rated bonds and also another 40 basis points between the "A" rated bonds and the "BBB" rated bonds. Actual interest rate spreads will vary depending upon the market level of interest rates and the steepness of the interest rate yield curve. (For instance, in the historically low interest rate and flat yield curve environment of early 1998, actual spreads may be as low as 20 basis points from one rating category to the next.) Assuming general credit market conditions such that the interest rate on the "A" rated bonds is 6.0 percent, we get the following results from this simple example.
Bond Rating Interest Rate Annual Debt Service Aggregate Debt Service Present Value @ 6% "AA" 5.600% $6,956,707 $208,701,222 $95,757,903 "A" 6.000 7,264,891 217,946,734 100,000,000 "BBB" 6.400 7,578,516 227,355,466 104,316,986 As shown, the cost differential from one rating category to the next is approximately $4.3 million in present value dollars or 4.3 percent of the total project cost. In aggregate future value dollars, the cost difference over the financing term is approximately $9.3 million.
Mitigating Credit Differentials
It may be possible to mitigate the cost differential due to the above credit concerns. One alternative would be to back a DOT shadow toll security with the state's full faith and credit, the state's overall strongest credit. It is common for states to place a full faith and credit pledge in support of self-supporting revenue bond programs, including highway/gas tax financing programs and explicit toll revenue financings. The analyses presented above may create an argument for using tax-backed revenue bonds to fund highway construction costs as opposed to shadow tolls backed by the same tax revenues because the financing costs would be higher for the shadow toll option. However, if the state has a history of backing bonding programs with a full faith and credit pledge, then financing costs become a moot point as the state's general obligation credit rating is substituted. Given this alternative, the decision to pledge tax revenues outright as opposed to using shadow tolls becomes one of preferences toward traffic risk.
Evaluating Long Term Traffic Risk
The question of pledging revenues to fixed rate debt (or providing full faith and credit backup to shadow tolls) versus an obligation to make shadow toll payments (with no credit enhancement) becomes, to a certain extent, a question of long-term traffic risk and long-term cost. If using solely shadow tolls to support a project financing, traffic lower than projected means the sponsor pays less as the bondholders take the risk (passed through from a DBO if the franchise model is used). However, if traffic is higher than projected, the sponsor pays more (and the DBO gains a large profit if the franchise model is used). Fixed debt service versus variable shadow toll payments thus may be either an advantage or disadvantage depending upon the risk profile of the sponsor entity.
Capital markets participants have studied and evaluated the long-term credit risk associated with start-up toll roads from an investment perspective. This analysis can be useful for public project sponsors considering shadow tolls. In brief, the capital markets analysis suggests that new toll roads often can not cover both amortized construction costs (via debt service) and M&O costs during the early years of operation and sometimes into the intermediate (10 to 12) years. However, in the long term (15 years or more) almost all toll roads receive enough traffic and revenue to more than pay for construction amortization and M&O costs. This researched fact is the reason that many start-up toll roads can receive investment-grade "BBB" category long- term credit ratings. Historically, investment-grade-rated municipal bonds have a very low default rate. Although the credit analysis was based upon explicit tolls and not shadow tolls, it is still instructive for guidance. Public project sponsors may conclude that it is in their best long-term financial interest to use tax-backed fixed-rate debt to finance a highway project as opposed to variable shadow toll payments to back debt. Not only does tax-backed fixed-rate debt have a lower cost of capital, it may also result in lower overall payments for the financed highway due to the elimination of long-term upside traffic potential.
Shadow Tolls as a Financing Source
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