October 14, 2013
Report questions public project estimates
The costs of public sector investments in infrastructure projects are underestimated and should include the risks to taxpayers who backstop them, according to a report released by the C.D. Howe Institute.
The report, The Valuation of Public Projects: Risks, Cost of Financing and Cost of Capital, finds current evaluations of public projects suffer from serious flaws, exposing taxpayers to unaccounted-for risks and bad investment decisions.
“While there may be good reasons for government investments, we should account for the costs properly,” said Marcel Boyer, professor emeritus of economics at l’Université de Montréal, one of the three authors of the report, in a statement.
“We find there is no significant difference in the cost of capital for a given project between the public and private sector, once the risk borne by taxpayers is taken into account.”
It is often said that the private sector is in a good position to manage project costs and meet deadlines, but not, generally, to fund or finance projects, noted the authors.
The underlying argument runs as follows: because the interest rate on government borrowings (the government’s financing cost) is lower than what is available to the private sector, the cost of a project will necessarily be lower if it is funded by government.
However, a significant portion of the government’s cost of capital is unaccounted for or not recognized.
This portion is the implicit option granted by taxpayers to their government to require additional funds one way or another to meet commitments to lenders, when a project does not meet the expected level of profitability.
“Discounting a project’s cash flows at an essentially risk-free rate is often justified by ‘the virtually unlimited taxing power of the Crown’ — the project appears risk-free to lenders,” said Boyer.
“But, it is obviously not risk-free for taxpaying citizens.”
The authors identify the implications for the evaluation of public investments and relevant public policies such as direct subsidies to businesses, government endorsements of corporate borrowings, the comparison of public sector versus private sector delivery of public projects and government portfolios of risky investments dedicated to the future repayment of the debt.
The best way for a government to assess and make transparent the risk to taxpayers would be for governments to submit the project to an auction: the government would offer a number of local and international financial consortia responsibility for the project, in exchange for a premium paid by the government.
For the government, the anticipated cost of the project is equal to the most favourable premium generated by the auction.
Visit www.cdhowe.org for more information about the report.
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