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Basic Infrastructure Services Are Essential for Urbanization – But Who Will Pay?

Julie Kim
Thursday, September 24, 2015

Urbanization cannot happen in a vacuum. Cities need to provide basic infrastructure services—clean water, sewage, roads, electricity, telecommunications, to name a few—to support the basic livelihood of their citizens and businesses.

At US $57 trillion in total and almost 5 per cent of Gross World Product every year from now until 2030, infrastructure funding needs are daunting. The topic has become a regular part of contemporary discussions, nationally and internationally.

With rapid urbanization and the decline in the fiscal health of many national governments, cities are increasingly having to step up to take on more responsibility to pay for these services. Ironically however, there is plenty of money. Worldwide, there is an unprecedented appetite for infrastructure investments from the private investment community. International financial institutions (IFIs) like the European Investment Bank are also increasing their funding at sub-sovereign, city levels. The problem is not a lack of money, but a lack of infrastructure projects that are bankable.

It is vital to note that there is an important distinction between “funding” and “financing”. When growth is moderate, infrastructure can be provided “pay-as-you-go”. Conversely, with rapid growth, we need high upfront capital to build new infrastructure when and where needed. “Financing” is the raising of this upfront capital to expedite the process. For projects to be financeable (i.e., bankable) now, we need clear “funding” streams (i.e., revenue sources) in the future to repay the financing. Ultimately, we need to rely on taxpayers and users (consumers) for the “funding”—and this is where the buck really stops.

Historically, cities relied heavily on direct subsidies from IFIs and national governments for infrastructure. With rapid urbanization, they need to become more self-reliant. The question is, how?

First and foremost, cities’ taxing authorities need to be enhanced to increase the tax revenue base from local property, sales, income, and other taxes. Value capture [i] is one effective taxing tool applied successfully at the local level. Cities can monetize the increase in property value resulting from new infrastructure investments by imposing special assessments, tax increments, or development exactions, or through joint development agreements. An innovative concept in this regard is the CEPAC bond [ii] used by cities in Brazil. Cities there are able to capture the value of increased developable land (above the current zoning level as a result of infrastructure investments) by selling the future development rights as options, which are actively traded in capital market. Revenues from advertising, retail concessions, and naming rights are other vehicles cities sometimes use to increase their funding levels.

Compared to taxes, “user fees” can be tied more directly to the actual cost of producing services, thus perpetual funding shortage situation can be avoided. This term denotes tolls or fees that users pay directly to finance infrastructure, instead of taxes, which are paid by taxpayers. Despite general public hostility, user fees are the key to unlocking private capital and attracting innovative, self-sustaining funding opportunities. User fees often reflect new funding sources and, under certain public-private partnership arrangements, the financing can be non-recourse with no future repayment obligations to the public sector.

The private sector is better positioned for user fee funding because they are incentivized to improve infrastructure services to cater to users’ needs and their willingness to pay. Also, the private sector does not have contractual obligations to political pressures and are able to impose user fee rate increases commensurate with the improved services. The full potential for user fees has yet to be explored. Our collective challenge would be to unleash this new source of funding by creating a new value paradigm for infrastructure that incentivizes the users and their willingness to pay.

Although neither taxes nor user fees are welcomed in the current political climate, our choice ultimately comes down to this: “either taxes or user fees, or no service at all”. Taxes have the advantage of being able to spread out the cost to many, but the benefits are confined to a few and non-benefitting taxpayers are unfairly penalized. Under user fees on the other hand, only those who benefit pay, but the burden on users (and thus on local communities) is much greater compared to the nationally subsidized tax regime. User fees can also create social inequity for the poor who cannot afford to pay. The challenge is to reach a proper balance between these two sources—with the broad view that, effectively, taxes address the broad social equity issues and user fees address the efficiency issues.

There is a limit to how much taxpayers and users can take on to pay for infrastructure. Given the sheer size of the funding needs, business-as-usual will not solve the problem. We need big ideas to tackle the big problem. “Brownfield recycling” is one big idea that has been applied successfully in Australia [iii] in recent years. It is the leveraging of the existing public infrastructure assets (referred to as “brownfield”) by leasing or selling them to the private sector and using the proceeds therefrom to fund new infrastructure projects. Paired with the right set of regulations, this approach provides as close to free, unencumbered funding as possible.

Although brownfield transactions can often be mired in political controversy, there is sufficient evidence to prove that wider public acceptance is possible if the transactions are well managed and effectively communicated and credible institutions such as public pensions are involved on the buyer side. The political controversy is often related the genuine public concerns about transferring the valuable public assets to private hands. Pensions are considered safer in this regard because their interests are better aligned with those of the public.

Earlier this year, the New Cities Foundation launched the Financing Urban Infrastructure Initiative to address these and other critical infrastructure funding issues. Through an urban finance guidebook that will be published in early 2016, we hope to provide cities with a set of practical financing tools to help better respond to the basic infrastructure needs of their citizens and businesses. Cities need to get much smarter and more proactive in creating new value paradigm for infrastructure services—and actively engage local citizens, businesses and international investment community in the process of developing innovative solutions.

Originally published September 21, 2015