Do new contracts remove usage risk when investing in toll roads?

Up until the global recession of 2008 infrastructure projects, including those with usage risk, were seen as being ideally suited for certain types of institutional investors where part of the offering needed to be a steady, inflation-hedged, and long-term stream of revenues. Since the recession however, institutional investors have become increasingly shy of investing in some types of infrastructure projects, such as Toll Roads, where usage can vary, often more significantly than previously assumed, and thus the returns from the investment vary more than desired.

One answer being promoted is to consider Public Sector Availability Payments on usage risk projects like Toll Roads. This is a contractual arrangement that has been designed to get around the risk of infrastructure returns fluctuating as a result of changing user patterns. Availability Payments work on the basis that the public sector is better able to manage usage risk than the private sector and so payment is made by the public sector to the private sector irrespective of demand, so long as the facility is available for use.

Another part of the appeal of Availability Payments on Toll Roads is the added benefit that the setting of toll levels over time is returned to the public sector, allowing pricing structures to be adapted in response to evolving policy agendas, rather than set in stone for decades through concession contracts. For example, in an economic downturn, tolls can be reduced to boost economic activity. Alternatively, if there is a need to manage excessive demand, tolls can be raised. This approach also enables wider objectives to be pursued, if and when desired, such as maximising the use of the new road, rather than inappropriate local roads, by environmental, economic and social ‘high impact’ vehicles such as trucks.

A good example of this was the decision by the UK Department of Transport to introduce on the Dartford Crossings, at the end of the private sector concession, a zero toll for traffic between 10pm and 6am. The aim was to encourage greater use of this very busy facility in the less busy night time period and away from the most congested day time period. Such a change in toll policy, while not impossible when the crossings were operated as a concession, would have required extensive negotiation and agreement on an appropriate compensation payment for the concessionaire.

Europe and Canada were among the early adopters of Availability Payments, but because there was no widespread tradition of highway tolling, these were for roads without a toll. Examples include the M25 in the UK or the Sea to Sky Highway in British Columbia, and it seems likely that the next private finance highway project in Canada, the Regina Bypass, will also follow this model. While it would be wrong to imply there have been no situations where Availability Payments have been used by the private sector to finance toll facilities, the track record is thin, with most of these examples relating to tolled bridges such as Mersey Gateway in the UK or Goethals in the USA (and neither of which are operational yet), rather than Toll Roads.

But is all investor usage risks removed with the arrival of Availability Payments for Toll Roads? Can investors heave a collective sigh of relief that the burden of usage risk, which has weighed heavily on some in recent years, has been removed from their shoulders? There can be no doubt that Availability Payments remove usage uncertainty from the revenue stream on a Toll Road. If the road is available, payment is made, irrespective of use and therefore revenues collected.

However, this does not entirely remove all the risk related to usage. The whole-life cost of a road is related to the amount of traffic that uses it. If a road is designed for one level of traffic, but, in reality, is used by greater volumes or different weights of traffic, operating and maintenance costs can increase dramatically. This has a knock-on effect on profits. If operating costs are higher than expected, investment returns will be lower.

While this is true for all roads, evidence to date from the UK and Canada on Availability Payments for roads without a toll would suggest this is a risk that investors feel is manageable. This is because, while the worry with Availability Payments is that traffic usage will be under-forecast, in recent years the main problem, especially with the negative impact of the recession, has been traffic over-forecasting.

What many appear to have failed to realise, is the introduction of tolls into the equation changes all this. The toll level charged can have a dramatic impact on traffic volumes. In particular, a decision to levy a significantly lower toll than expected can mean a lot more traffic than anticipated on the Toll Road. Without a concession agreement that ensures tolls will be set at defined levels, investors will inevitable face more political risk around the setting of toll levels, and this normally means lower rather than higher tolls.

Further, with the differential between toll and vehicle type now sitting outside the control of the investor, the obvious concern is a decision by the public sector to increase car tolls but to decrease truck tolls, thus keeping revenues relatively neutral, but potentially increasing truck traffic significantly. Such a strategy might be seen as politically popular, boosting economic growth and reducing the social and environmental impact of trucks on un-tolled local roads.

The need for road maintenance is closely correlated to trucks rather than cars, and while the precise relationship appears more complex than we previously thought (it is now thought that while for some types of pavement deterioration a doubling of axle load causes 15 to 20 times as much damage, for other types doubling the load only doubles the damage), more trucks does mean more maintenance cost.

Further still, operating and maintenance costs, impacted and exacerbated by potentially higher usage or greater loads, are likely to become more evident further through a road’s lifespan, which means a greater risk for the new generation of long-term investors, such as pension funds, who are increasingly looking to such infrastructure projects as an option to secure a regular long-term return on investment.

The challenge is to show how Availability Payments restore private finance as a cost effective means of adding additional road capacity today in a situation where that would not otherwise get built, and are thus a vital component in the engineer’s ability to maintain city or regional competitiveness, while its introduction can be flexible enough to ensure we are not creating problems for the future due to greater than anticipated traffic use and hence costs.

Buro Happold is looking at how contractual commitments can be made that keep tolls within defined ranges, giving the public sector some flexibility on toll rates while ensuring dramatic changes in tolls, and especially removal of tolls, are not possible (at least without compensation).  We are also exploring a mechanism that allows Availability Payments to be adjusted upward marginally if traffic levels are higher than predicted.  However, without such mechanisms in place, it seems investors will need to add undertaking traffic forecasts, especially of trucks, back on their to-do list, and put ‘usage risk’ back into their risk evaluations of toll roads, even if they are being financed by Availability Payments.

Come and talk to us to explore alternative investment approaches to today’s biggest infrastructure projects.

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