Is Infrastructure Finance Such a Big Headache?

Infrastructure upgrades and facilities are desperately needed around the world, but governments often struggle to pay for the high costs of developing and maintaining them. The newly published Lincoln Institute book Infrastructure Economics and Policy: International Perspectives includes two chapters that address issues related to infrastructure finance, including the development of innovative and replicable financing models. 

Basics of Infrastructure Finance 

In Chapter 9, economist Akash Deep of the Harvard Kennedy School explains why financing is a key challenge in infrastructure development. Governments must typically pay the costs of infrastructure up front, while the benefits are spread out over many years. This difference between the timing of costs and benefits is generally bridged through borrowing.  

It is important to note that financing differs from funding. The funder is the entity that ultimately bears the cost of the infrastructure, either the general public (in the form of taxes) or the direct users (in the form of user charges). Those who finance the project are the borrowers and lenders who reconcile the timing of the benefits and costs. Those borrowers and lenders can be public or private. The capital structure can be determined to reflect the riskiness, and the cost of financing, and thereby the financial value of infrastructure. Proper structuring and risk allocation can make infrastructure finance more efficient and less risky. 

Because infrastructure investments often have a long payback period, investors are typically less interested in infrastructure than other assets. Deep illustrates the potential for innovation in financing infrastructure, including efforts to tap the huge and growing savings in insurance and pension funds. Managers of such funds prefer the combination of modest but stable long-term returns that infrastructure offers, but they are often required to maintain their debt portfolio at investment grade or higher. One solution developed by the European Investment Bank is to provide direct financing (in the form of subordinated debts) or financial guarantees to make the investment less risky for insurance and pension funds. 

A more widely imitated innovation is infrastructure funds modeled after those pioneered by Australia’s Macquarie Group in 1996. The Macquarie Group introduced features such as pooling equity from multiple projects, active asset management, financial engineering, and listing on capital markets–reforms that made infrastructure equity funds more liquid and especially attractive for pension funds. Infrastructure funds have attracted both institutional and retail investors, thereby significantly expanding the pool of equity available for infrastructure investment. 

Infrastructure Finance through Land Value Capture (LVC) 

The benefits and costs of infrastructure are typically specific to the location where the project will occur. In urban locations, where the supply of land is limited and the infrastructure on it is often immobile, the benefits created by infrastructure often result in an increase in the value of land. In such cases, the public sector can fund infrastructure improvements by imposing property taxes, selling development permissions, or utilizing similar measures to capture all or part of the uplift in land value that the improvements create. Such measures ensure that the parties who benefit from the improvements pay to support them. 

Chapter 10, written with Yu-Hung Hong, former director of the Samuel Tak Lee Real Estate Entrepreneurship Lab at MIT, and Du Huynh of Fulbright University Vietnam, examines the record of land value capture around the world. Value capture is especially promising in developing countries, which have enormous infrastructure needs but fewer alternative funding sources. Chapter 10 focuses on the experiences of Brazil and Vietnam with one of the most important types of value capture—the sale of development rights.  

The case of São Paulo, Brazil, is internationally known and widely praised; the city developed a market-oriented value capture program, auctioning Certificates of Additional Construction Potential, or CEPACs, to developers in exchange for the right to build at greater density in designated areas. The city has used the proceeds to pay for affordable housing, transportation upgrades, and other public goods. 

The case of Ho Chi Minh City, Vietnam, is more controversial: through ad hoc procedures, the city sold the development rights to convert rural land for urban development. Both cases confirm that sales of development rights can generate substantial proceeds, often more than enough to pay for the extra infrastructure needed for the associated development. But the examples also show that successful implementation requires a clear and widely accepted delineation of property rights. Also important are a system of registries and impartial courts to record and protect those rights, a realistic and reasonably detailed land use master plan, and politically skilled sponsors. 

As both chapters illustrate, governments around the world are finding innovative ways to finance infrastructure. Given the urgent need for global infrastructure investments and upgrades, these methods should be more widely implemented and embraced.  

José A. Gómez-Ibáñez is the Derek C. Bok Professor Emeritus of Urban Planning and Public Policy at Harvard University. Zhi Liu is senior fellow and director of China Program at the Lincoln Institute of Land Policy. They are the editors of Infrastructure Economics and Policy: International Perspectives. 

Image: Octavio Frias de Oliveira Bridge, São Paulo, Brazil. Credit: R. M. Nunes via iStock/Getty Images Plus.