Download PDF Thank you for the opportunity to submit testimony to the House Transportation and Infrastructure Committee hearing entitled, "Northeast Corridor Future: Options for High-Speed Rail Development and Opportunities for Private Sector Participation." I am R. Richard Geddes, Associate Professor in the Department of Policy Analysis and Management at Cornell University, Visiting Scholar at the American Enterprise Institute, and Director of the Cornell Program in Infrastructure Policy.
I am pleased that the Committee is examining opportunities for increased private sector participation in the delivery of passenger rail transportation services in the Northeast Corridor (NEC). Increased private participation has the potential to significantly improve the overall experience of passengers traveling on the NEC as well as the value realized by American citizens from this critical asset. Increased private participation is not a panacea but, if properly implemented, can be an important part of the solution to the problems that continue to plague passenger rail transportation in the United States. Social benefits stem from three main qualities associated with private participation: (i) high-powered, focused incentives to maximize revenue and minimize cost; (ii) business acumen, knowledge, and experience; and (iii) fresh resources in the form of access to debt and equity capital markets.
Those benefits of private participation are currently being realized in many aspects of the U.S. transportation sector. For example, the entire U.S. freight rail system can be viewed as a large, multi-faceted public-private partnership (PPP). The public sector there provides right of way and creates the institutional setting, while freight companies finance, maintain, and operate tracks, signaling, and rolling stock. Private expertise and resources have long been used to design and build highways, bridges, and tunnels in the United States. Private partners are increasingly also called upon to finance and operate major facilities such as toll roads and HOT lanes. Private firms are now operating large urban bus systems and are making even larger contributions in providing transportation services in many developed and developing countries. Private participation through PPPs is also significant in other U.S. network industries, such as water, sewerage, and energy.
PPPs are the main vehicle for incorporating private investment into the provision and operation of infrastructure. It is thus useful to define PPPs in general. The term PPP refers to a contractual relationship between a public-sector project sponsor and a private sector firm or firms coordinating to provide a critical public good or service. A PPP is subject to the standard rules of contracting, with clear performance standards. It is useful to think of a PPP as one application of a broader contracting approach.
There are many ways in which private participation through PPPs can improve social welfare by playing a greater role on the NEC. Private participation can enhance social welfare by creating new types of service, by improving the quality of existing service, and by lowering the cost of providing a given service. It is useful to distinguish between two main ways in which private partners can participate in providing transportation services. Private investors can be called upon to make substantial, sunk investments in transportation infrastructure, such as in tracks, yards, right-of-way, signaling, etc. on which they require assurances of a rate of return over time. After investing, private partners often also maintain and operate the infrastructure and rolling stock. Institutional arrangements in this case must be designed to make such long-term investment rational in the first place.
In the second case, private partners contribute by bringing capital, focused incentives, and expertise to the management of existing transportation assets. Although substantial investment in technology, upgrades, and renovation may be required, policy in this case is typically less concerned with ensuring the security of investment returns over the long term than on capturing the social benefits of private innovation and expertise in managing existing assets. It is important to stress that, in all cases, actual ownership of transportation assets remains with the public sector, and under improved public control through transparent contracts that articulate clear, enforceable performance standards. I focus on the role of private participants in this second capacity because many of the long-lived assets required to operate the NEC are already in place.
Increased private, for-profit participation may not be appropriate in all services the government provides. There is a consensus in economics that private participation may not be efficient where contracting with a private partner is complex and costly due to the inability to oversee – or monitor – the quality of service provided. To provide a possible example, one may be concerned about contracting out the operation of a wildlife sanctuary to a private firm for fear that the private operator would not maintain the environment in the sanctuary to a certain socially desirable standard, which may difficult to monitor. Stated differently, the quality of the wildlife's environment could be very costly to contract over because it is difficult for the public contract sponsor to observe.
Because they involve "hard" assets, the types of activities being consideration for increased private participation on the NEC are, however, precisely those activities where the private partner's performance is readily observable. They can be provided for in a contract with measureable performance metrics. Private participation on the NEC is thus likely to improve social welfare substantially. Those gains can be captured for all citizens though upfront concession payments, as I describe below.
Opportunities for Value Capture on the NEC
The NEC is composed of a rich array of valuable transportation assets, many of which are underutilized under existing arrangements. The incentives, expertise and resources associated with private participation allow for that substantial latent value to be both enhanced and captured.
Competitive concession bidding is the key mechanism through which such latent value can be realized. For example, the substantial value inherent in improving the management, maintenance and operation of a single station on the NEC can be extracted by requiring potential private partners (which may include a consortium of firms, as well as sub-contractors) to bid on the basis of the largest upfront concession payment they will offer. This endows the private partner with high-powered incentives to enhance the station's value as much as possible, since it becomes the residual claimant to any value created. A residual claim refers to the explicit property right to capture the profits from an economic activity. The concepts of residual claims and residual claimants are critical to understanding how private participation will generate enhanced value from NEC assets.
A private residual claimant can generate additional value from station operation in many ways. A private operator has the incentives, skills and resources to realize the greatest value possible from the station. This can be done through both revenue enhancement and through cost reduction. The partner may be able to increase revenue through more intensive use of concessions for food and beverage service, concessions for shops, through waiting-room naming opportunities, waiting-room bench-naming opportunities, and development opportunities near stations, among many other possibilities. Through restoration and innovation, revenue opportunities can take advantage of the historic nature of the NEC's critical infrastructure facilities, some of which predate the First World War. The key insight is that, by creating well-defined residual claimants and requiring them to bid against one another for station operating rights, upfront concession payments allow society to immediately realize the new value created.
A recent highway transportation example is illustrative. In January 2012, the Maryland Transportation Authority announced approval of a 35-year PPP concession for the redevelopment and operation of two travel plazas (Maryland House and Chesapeake House) on I-95 in Northeast Maryland. As an illustration of the private sector's access to capital, the concessionaire, Areas USA, will invest $56 million to redesign and rebuild the aging travel plazas. The State will receive an estimated $400 million in added revenue over the life of the concession.
The travel plaza PPP came on the heels of Maryland's PPP agreement with a private partner to renovate and operate the Seagirt Marine Terminal in Baltimore. Under that agreement, The Maryland Port Administrated leased its 200-acre marine terminal to Ports America. In return, Ports America will build a container berth with a 50 foot depth. This will allow the Port to accommodate ships with a larger draft, which will attract more shipping. The Seagirt PPP received the North American Logistics Deal of the Year Award for 2010.
A third example is provided by the PPP completed in June 2011 between Violia Transportation and Nassau Country, New York to manage and operate all aspects of its transit service, which includes almost 300 buses and 180 para-transit vehicles. With a population of 1.3 million people, the Nassau County system is now the nation's largest privately operated municipal bus service. Although the PPP is relatively new, the early assessment is positive, and holds important lessons for the NEC. Buses are cleaner and more reliable due to a renewed emphasis on service quality and on customer needs. Enhanced reliability has generated greater ridership. Violia adopted a new website, and developed an innovative logo and visual style for Nassau's buses. Improvements have occurred without hurting passengers. Fares were not increased and routes were not eliminated. Because of its operational focus, the Nassau bus contract has been termed a public-private operating partnership, or PPOP.
In each of the above cases, the use of a PPP identified and tasked skilled, motivated, well-defined residual claimants with an incentive to maximize facility value. The citizens of Maryland and New York will share in the value created by private partners. A similar approach can be applied on the NEC.
Opportunities for contracting operations, improvements, expansion, and management of NEC facilities occur at different levels in the delivery process. The public PPP sponsor must decide how broadly versus how deep into the process it wishes to contract. At the highest level, operations, maintenance, and expansion of the entire NEC, including all train operations, could be contracted to a single private entity, which may represent an allied group of firms. Although the resulting contract would likely be complex – and must be monitored and overseen with care – citizens would share in the massive value created through one large upfront concession payment for the entire line. Because of the inherent value of the transportation alternative provided by the NEC, such a payment would likely dwarf concession fees realized through other recent U.S. transportation PPPs.
The public sponsor could instead undertake private participation farther down into NEC's operations. For example, station management could be competitively bid through a single management contract, with the management of ticketing, for example, undertaken through a separate entity. Still farther into operations, the management of on-board food and beverage services, as well as in-station food, beverage, and newsstands could be competitively awarded through a different PPP. Additional on-board revenue opportunities include advertising on rolling stock, and advertising along the route. Increased private participation presents numerous clear opportunities to capture additional value from existing assets. The key decision is how far into process details it is efficient for the public PPP sponsor to execute and monitor contracts on the NEC versus how much it would like to delegate those responsibilities.
Value Revelation Through PPP Bidding
A key insight from the economics literature on PPPs is that it is impossible to know the value inherent in an infrastructure asset such as the NEC until its operation is subject to market bidding. That is, in addition to value capture, a key purpose of conducting competitive PPP bidding is to reveal the true value of the assets in question. It is also difficult to forecast concession value because the effects of new technology implementation that often accompany private participation on both revenue opportunities and on cost reduction are virtually unknowable until they are implemented.
This insight is highlighted by the fact that state and local governments are sometimes surprised by the large size of the upfront concession fees they are offered for brownfield PPP leases of highway assets, indicating that those assets were more valuable than previously thought. As an aside, value under-estimation often leads to under-investment in asset maintenance, which has plagued many U.S. transportation assets.
Importantly, this analysis implies that the role of the public sector changes as private partners' role grows. The public role shifts from being a service provider to being a designer and monitor of contracts with private partners. Like any business, the public sector must decide where its core competency lies. There is little reason to believe that train station operation, for example, is a core government competency.
An objective assessment of which aspects of the NEC lie within the government's core competency as a service provider should be undertaken, and those aspects that are not core public sector competencies contracted to private partners who are expert in those activities. Once non-core competencies are determined, the public sponsor may need to develop additional skills in contract design, monitoring, and enforcement.
An added social benefit of the PPP approach that increases value is simply that a contract exists. The contract includes details regarding what actions constitute adequate performance. The PPP approach thus encourages the public sponsor to reflect upon, and articulate, what specific actions by the private partner constitute excellent, or poor, performance. This may include metrics about major issues, such as the reliability and frequency of train travel, but also more detailed considerations such as the cleanliness of cabins, restrooms, and dining cars. The PPP approach thus improves the public's control over NEC assets by introducing a transparent, enforceable contract into its operation.
NEC Value Improvements Generated by Cost Management and Risk Assumption
An additional way in which citizens are able to realize added value via PPP concessions on the NEC is through the private sector's greater incentives, resources, and skill in managing costs. Critically, such cost savings will be realized by citizens through a larger upfront concession payment. A lower cost of service may also depend on access to capital markets, since the social benefit of new technology often manifests itself through lower costs for the same type and quality of service.
A final, frequently stated social benefit of including private partners is risk assumption. Train operations on the NEC are inherently risky. This includes operational risks, such as bridge or tunnel problems, but also financial risk associated with changes in ridership. Under the current approach in the United States, taxpayers assume virtually all the risks associated with designing, constructing, operating, and maintaining passenger rail systems. In a PPP, some of those risks can be allocated to the private partner, reducing taxpayer risk. Because private investors are typically expert in risk bearing, this is an important benefit.
One of the hallmarks of the PPP approach is it's inherently flexibility. The range of ways in which private participation can be incorporated on the NEC appears to be limited only by the creativity of the contracting parties. For the reasons I outline above, private participation in the provision of passenger rail service in the United States through PPPs should be encouraged.