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Federal Credit for Surface Transportation: Exploring Concepts and Issues Draft Policy Discussion Paper

U.S. Department of Transportation Federal Highway Administration November 1997

1. Assessing the Need for Federal Credit

Introduction

The continued growth of the U.S. economy depends, in large part, on a comprehensive and interconnected nationwide surface transportation system. The nation's growing population and increased shipping demands are straining the capacity of existing facilities.

The federal-aid grant program has enabled the construction of an extensive national transportation system. However, the program's financial limitations are becoming evident in the face of growing investment needs and the lack of available public funding to meet those needs. This funding shortfall is particularly acute for large new investments and major expansions of existing highways and other transportation facilities, the costs of which can amount to hundreds of millions of dollars each.

Federal assistance in the form of credit (direct loans, loan guarantees, and other lending arrangements) rather than outright grants is currently being used to stimulate investment in other sectors such as housing, education, and agriculture. Federal credit has achieved important social and economic goals in these areas (e.g., affordable housing, universal access to higher education, and a stable food production system). A federal credit program oriented toward large surface transportation projects of national significance could be an important step in closing the current funding gap and supporting the national economy in an era of constrained public resources. It could provide significant new financial flexibility for the states and substantial leverage to attract non-federal investment.

The Economic Value of Transportation Investment

Technological advancements, the globalization of business, and the emergence of just-in-time delivery methods have changed the nature of economic activity. Today's transportation consumers demand more from the transport system than the simple movement of goods and people. They want greater speed, flexibility, and reliability; enhanced safety; improved national and regional access; easier intermodal connections; and smoother passage across the nations borders with Canada and Mexico.

The globalization of business and corresponding reduction in technological, economic, and political barriers have created an economic climate in which the U.S. relies increasingly on foreign trade. Between 1970 and 1995, foreign trade (total exports and imports) as a share of gross domestic product more than doubled from eight percent to 18 percent. 1 The new global economy requires improved access to airports and seaports, greater investment in intermodal facilities, and increased development of trade corridors.

New, more demand-responsive delivery systems are also placing greater demands on the performance of the nation's transportation network. Just-in-time delivery service (which usually takes one to three days) allows for rapid turnover of inventory, thus reducing the costs associated with storing raw materials and manufactured goods. The cost savings of just-in-time delivery methods provide economic benefits to manufacturers, distributors, consumers, and ultimately the national economy.

The economic productivity gains from transportation investment are significant. A recent study estimated that in the four-decade period from 1950 to 1989, U.S. firms realized annual production cost savings of 18 percent from general highway investment (18 cents per dollar invested in all roads) and 24 percent from investment in non-local roads. 2

Increased Demands and Constrained Resources

Growth in both passenger and freight travel is straining the capacity of the nation's roads and bridges, border crossings, and intermodal transfer facilities. From 1980 to 1995, the nation's population increased by 15.5 percent, gross domestic product was up 46 percent, and total imports and exports expanded from $466 billion to $1.327 trillion. 3 Since 1980, total ton-miles and intercity passenger-miles have grown by 30 percent and 60 percent, respectively. 4 This comes at a time when limited resources and the normal deterioration of the nation's roads and bridges are contributing to a shift in public investment from capacity expansion to operation and maintenance of existing facilities. Although this shift towards preservation has slowed the decline in roadway conditions that occurred during the 1970s, it has contributed to a steady increase in the extent and duration of congestion.

In 1975, only 41 percent of peak-hour travel on the urban Interstate system occurred under congested conditions. In 1993, 66 percent occurred under congested conditions. 5 The growth of congestion has significant long-term environmental, safety, and economic effects on the nation. A recent study estimated that the time lost and fuel wasted due to congestion cost the average U.S. citizen $370 annually. 6 These costs are expected to rise as growing investment needs and stagnant public funding contribute to declining performance.

Total public spending on capital improvements to highways and bridges was approximately $39 billion in 1993. The U.S. Department of Transportation (DOT) estimated that $49.9 billion in highway and bridge capital investment was needed in 1994 just to maintain 1993 conditions and performance of the nation's highways, and that $68.2 billion in highway investment was needed to provide a higher quality of service justified by direct benefits to highway users. 7 Postponing investment can be costly. DOT estimates that deferring one dollar in highway resurfacing for just two years can result in spending four dollars in highway reconstruction to repair damages.

The funding gap for transit is smaller in nominal amount, but similar in relative magnitude to current spending. Total public spending on capital improvements to the nation's public transit systems was $5.7 billion in 1993. DOT estimated that in 1994, $7.3 billion in capital investment was needed just to maintain 1993 conditions and performance, while $11.8 billion was needed to provide a higher quality of transit service. 8

The economic drag created by a deteriorating transportation network can be substantial, as shippers and motorists incur higher vehicle maintenance and fuel costs, safety hazards, and time delays associated with congestion and poorly maintained roads. The unfunded costs of maintaining current (1993) conditions and performance - $10.9 billion per year for highways and $1.6 billion per year for transit - total only $50 per person, much less than the $370 per person now lost to poor performance.

Spill-Over Benefits

Many nationally significant projects that might be undertaken would produce large benefits in terms of avoidable user costs (reductions in travel time, accidents, and vehicle operating costs), savings in federal and state agency costs (e.g., more processing of commercial vehicles at border crossings), and reductions in pollution and other environmental side effects. Yet these projects are difficult to build, because the benefits spill-over to many jurisdictions in different levels of government and large numbers of people and firms. The economic, institutional, political, and other challenges associated with developing such projects often exceed the resources of any single beneficiary or group.

A classic justification for a federal funding role occurs when large benefit spill-overs are present. Current transportation funding sources at the federal level, however, are not sufficient to advance many of these large-scale projects. Federal credit assistance targeted at such projects could make them more feasible and produce widespread benefits that could not otherwise be possible.

Public/Private Partnerships

A growing number of large, capital-intensive projects are being developed under public/private partnerships. Such arrangements allow governmental units to draw upon private sector development techniques, management skills, and financial resources to help build new infrastructure facilities.

A variety of approaches have evolved in advancing public/private partnerships. California solicited proposals for toll roads and awarded franchises for their development and operation. Minnesota and Washington have developed open solicitation processes. These are procurement procedures incorporating innovative ideas for projects that might be partly or completely financed by the private sector and typically involve some type of public/private partnership. Public/private partnerships have become routine with Intelligent Transportation System (ITS) projects. State and local agencies commonly barter access to public rights-of-way to telecommunication companies desiring to install fiber optic cables in return for receiving a certain amount of bandwidth. Recently Minnesota issued a request for partnership proposals for a project involving deployment of a Roadway Weather Information System, an Advanced Traveler Information System, plus the generation of data useful for maintenance and construction operations.

Public/private partnerships now cover the entire spectrum between pure public and pure private provision of transportation facilities and services. They pertain to all modes and frequently involve the application of advanced technology. A federal credit program targeted at nationally significant projects could foster additional public/private partnerships; leverage scarce federal, state, and local dollars with private capital; and encourage the equitable and efficient sharing of risks between the public and private sectors.

Capital Market Gaps

In some cases, private capital investment is discouraged by the size, complexity, uncertainty, and long-term time horizon associated with start-up transportation infrastructure projects. Generally, such projects are one-of-a-kind investments and require substantial analysis to evaluate.

Typically, these one-of-a-kind projects lack the up-front capital needed to finance debt service because project revenues tend to be weak in the early years, but are forecast to grow over time. Given the uncertainty of the projected revenue stream and operating costs, investors and rating agencies may require that the project revenue bonds, the proceeds of which fund construction, show a relatively high coverage margin. Coverage margin is the margin of safety for payment of debt service on revenue bonds, reflecting the number of times by which annual net revenues after operations and maintenance costs exceed annual debt service. A high coverage margin (such as 1.75 times) gives investors a substantial safety cushion if it can be achieved, but constrains the level of annual debt service permitted. This reduces the amount of up-front capital that can be raised through debt issuance. In the case of capital-intensive projects, a funding gap may result.

Currently, there are three principal options for addressing this gap in the market:

Project sponsors could seek to utilize a thinner coverage margin (such as 1.10 times) for their debt financing. However, such debt likely would be rated sub-investment grade (i.e., speculative). The major capital market funding source for debt financing of infrastructure - the municipal bond market - is generally risk-averse, and there is only a limited market for non-investment-grade obligations.

A second possibility is to close the funding gap with contributed capital (public or private equity). Frequently, however, the public and private partners in a project have already pledged the maximum amount they are willing or able to contribute to the project by the time the financing is arranged.

The third option is to issue junior-lien or subordinate debt, with a secondary claim on project revenues to the higher coverage margin debt. However, junior-lien debt can be difficult to market. Fixed income (bond) investors strongly prefer predictable, periodic payments (such as semiannual). They are generally reluctant to accept the initial uncertainty of an uneven or irregular cash flow, which is more likely for obligations that only have access to residual cash flows after senior debt payments are met. The possibility of a payment default on the junior bonds, which would trigger a cross-default on the senior debt, undermines the marketability of both series of bonds.

This situation defines the need for a new source of secondary or supplemental capital in the credit market. An investor with a long-term time horizon and fewer liquidity requirements. An investor willing to accept a subordinate claim on project revenues, a slimmer coverage margin, and a flexible repayment schedule in view of the substantial spill-over benefits.

A carefully structured credit program could draw on the federal government's unique position as a patient investor to fill these market gaps until the capital markets develop the capacity to absorb the risks associated with large, start-up transportation facilities. Addressing these risks would reduce the transactional friction associated with financing large and complex projects. This transactional friction is reflected in unnecessarily large reserve requirements, coverage margins, capital costs, and transaction fees.

The Evolution of Federal Assistance

Since 1916, the federal government has supported surface transportation investment through a grant-based funding strategy known as the "federal-aid" program. Since 1957, revenues derived from the federal gas tax and other excise taxes have been credited to the federal Highway Trust Fund (HTF) and allocated among the states pursuant to various formulas for reimbursement of eligible costs. Under this approach, DOT reimburses state capital expenditures on transportation infrastructure at prescribed federal matching rates (historically, 80 or 90 percent); the remainder of project costs is covered by the states.

The conventional federal-aid program has enabled the construction of an extensive transportation system, including the nation's 46,000-mile Interstate system. However, exclusive reliance on a grant-based reimbursement program may no longer be the most productive approach for funding certain large infrastructure projects.

Mindful of current fiscal limitations, the federal government in recent years has attempted to provide new funding techniques that complement and enhance the existing grant-reimbursement approach to leverage additional capital investment in transportation infrastructure. Through the enactment of the Intermodal Surface Transportation Efficiency Act of 1991 (ISTEA) and the issuance of Executive Order 12893 in 1994 (which directed federal agencies to promote infrastructure investment by improving program management and increasing private participation in funding strategies), federal policy has sought to encourage innovative financing initiatives. In response to that directive, the Federal Highway Administration implemented in 1994 a test and evaluation research program which allows states with innovative proposals to utilize alternate federal-aid funding techniques. The National Highway System Designation Act of 1995 codified several of the new funding techniques and introduced some new innovations, including reimbursement of debt service costs and capitalization of State Infrastructure Banks (SIBs).

SIBs are intended to complement traditional transportation programs by allowing states to offer many types of assistance (e.g., low-interest loans, loan guarantees, and standby lines of credit) to revenue-backed projects through revolving funds. However, federal capitalization grants for SIBs currently are limited to ten percent of most categories of state's annual highway and transit apportionments for fiscal years 1996 and 1997 plus $150 million of "new money" to be shared among the participating states. Moreover, the authorizing legislation limits the annual disbursement of these funds, thus reducing the capacity of SIBs to provide large amounts of credit assistance in the near term. SIBs will require a number of years to build-up sufficient financial resources to gain access to external funding beyond their own contributed capital. Consequently, SIBs, like other start-up credit intermediaries, are best suited to assist portfolios of smaller, relatively homogenous, shorter-term projects that are regional or local in scope. There is a gap in terms of larger projects of national significance.

Figure 1.1 summarizes the various types of projects requiring assistance, the potential financing mechanisms, and the typical scope (state, regional, or national) of such projects. The pyramid's shape reflects the relative number of projects in each funding category.

The base of the pyramid represents the vast majority of projects that cannot generate revenues and therefore will continue to rely upon funding primarily through grants. The federal government has adopted enhanced grant management techniques such as advance construction and grant-supported debt service to move these projects to construction more quickly.

The peak of the pyramid represents the small number of projects that can arrange private capital financing without any governmental assistance.

The middle layer of the pyramid - perhaps five to ten percent of total capital investment - represents those projects that can be at least partially financed with debt payable from project-related revenues, but also require some form of public credit assistance to gain market access.

Figure 1.1 Federal Assistance for Transportation Infrastructure

Figure 1

A federal credit program could complement existing financing techniques by directing resources to projects of national importance - such as intermodal facilities, border infrastructure, trade corridors, and other investments with national benefits - that otherwise might be delayed or not constructed at all because of perceived risk or scope. Federal credit could encourage more private sector and non-federal participation, address important public needs in a more budget-effective way, fill market gaps, and take advantage of the public's willingness to pay user fees to receive the benefits and services of transportation infrastructure sooner than would be possible under traditional, grant-based financing.

1 Statistical Abstract of the U.S., The National Data Book, U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the Census, 1996.

2 Contribution of Highway Capital to Industry and National Productivity Growth - Executive Summary, Ishaq Nadiri, New York University, 1996.

3 Statistical Abstract of the U.S., The National Data Book, U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the Census, 1996.

4 The Bottom Line: Transportation Investments, AASHTO, 1996.

5 Our Nation's Highways: Selected Facts and Figures, FHWA, May 1995.

6 Measuring and Monitoring Urban Mobility, Texas Transportation Institute, November 1996.

7 1995 Status of the Nation's Surface Transportation System: Condition & Performance, Report to Congress, U.S. Department of Transportation, October 27, 1995.

8 1995 Status of the Nation's Surface Transportation System: Condition & Performance, Report to Congress, U.S. Department of Transportation, October 27, 1995.

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