A2 PRIVATE INVESTMENTS IN NEW INFRASTRUCTURES

A2 PRIVATE INVESTMENTS IN NEW INFRASTRUCTURES


Abstract The Lisbon Strategy demands large investments in transport projects, broadband networks and energy infrastructure. Despite the widely-acknowledged need for investments in new infrastructures, European and national public funds are scarce in the current economic climate. Moreover, both policy-makers and economists largely agree that the public financing of such investments should no longer be the standard, as it may have been some decades ago. As a result, private investors become increasingly important when it comes to investments in infrastructure. Yet, such investments are generally high, they involve political risks, and they often have uncertain returns and long payback times, which implies that private parties may also be reluctant to invest. Departing from these drawbacks for private initiatives, we address the question as to what policy-makers can do to improve the climate for private investment in new and innovative infrastructures in the fields of energy supply, telecom and transport. This paper formulates seven imperatives to stimulate private investment in innovative infrastructures:

1.

Allow private companies to earn a decent profit

2.

Create political stability and certainty for companies

3.

Stimulate innovative financing structures

4.

Allow money to flow

5.

Refrain from making technological choices

6.

Allow contractual freedom

7.

Reduce the administrative burden

Author(s): Barbara Baarsma, Joost Poort, Coen Teulings, Michiel de Nooij SEO Amsterdam Economics, Roetersstraat 29, 1018 WB Amsterdam, www.seo.nl 54


1 INTRODUCTION: INVESTMENT AND RELIABILITY An important way to increase the reliability of infrastructures is by building new and innovative ones. New infrastructures generally increase overall capacity and incorporate state-of-the-art technologies that meet higher reliability standards. What is more, new infrastructures that compete with existing infrastructures constitute a redundancy that enhances overall reliability. For example, the chance of fixed and mobile telephony breaking down simultaneously is almost negligible. From the point of view of reliability, competition between infrastructures is therefore preferable to competition on infrastructures, regardless of the other economic aspects involved. In the years to come, substantial investments in new infrastructures will be required throughout Europe. In order to reach the goals set in the Lisbon Strategy – to make the EU the world’s most dynamic and competitive economy by 2010 – large investments in transport projects, broadband networks and energy infrastructure are considered to be indispensable. In addition, several EU Member States have formulated their own ambitious investment plans. Many of these investments are necessary to fight a lack of capacity on existing infrastructures, but there are also other grounds for investments in new infrastructures (see Box 1).

Box 1: When investments in new infrastructures are economically feasible From an economic point of view, duplicating infrastructures is often inefficient and pointless. Particularly network infrastructures such as water pipes, electricity grids, and natural gas pipes, have high fixed costs and low variable costs, making a (regional or national) monopoly the most efficient market structure possible. Economists refer to this situation as a natural monopoly. Yet, there are four circumstances in which new infrastructures can be desirable:

1. Congestion on the existing infrastructure Alternative or new infrastructures may be desirable when economies of scale or density on the existing infrastructure run out, most notably resulting in congestion. For example, population growth or increased commuting in an area can require an upgrade of existing infrastructure, or the construction of a bypass motorway.

2. Superior technology New infrastructures can also be feasible if the technology or business model employed makes the new infrastructure superior to the existing one in terms of production costs, service quality or product variety. High-speed trains, decentralized electricity production, and broadband Internet access are examples of these types of new infrastructures.

3. New products and services New infrastructures may introduce entirely new products and services. The introduction of mobile telephony is the obvious example here; some twenty years ago no-one knew how widespread and indispensable it would become to make phone calls on the way.

4. Enhance competition Investments in new infrastructures may enhance competition and as such improve choices for the customer, reduce prices and improve cost efficiency. An example is the Euro tunnel, the UK-based operator of the high-speed, cross-channel transport system that links the UK and France by rail. Before the tunnel existed, the crossing could be made by air or by sea. The key market, however, is that for accompanied vehicles and lorries. Euro tunnel and the two principal ferry operators (P&O and Sealink) expected prices to drop by at least 20% on the route between Folkestone and Calais because of the increased competition between infrastructures. As always, the boundaries between these four categories are blurred. For example, investments in innovative and superior infrastructures are often triggered by congestion on or dissatisfaction with existing infrastructures. As such, the roll-out of broadband networks was spurred by the explosive growth of bandwidth usage, which the existing dialup connections could no longer facilitate. Broadband Internet connections in their turn can sustain entirely new services such as teleconferencing and gaming over the Internet. Similarly, mobile telephony is an entirely new communication service for travellers, but at the same time it is a substitute for fixed telephony, as is shown by the recent decrease in the penetration level of fixed lines in the Netherlands.

Despite the widely-acknowledged need for investments in new infrastructures, European and national public funds are scarce in the current economic climate. The Stability and Growth Pact, which requires EU Members to keep their budget deficit below 3% of GDP, does not distinguish between public expenditures and investments. In periods of economic downturn, this makes it hard for governments to find public money for new infrastructure, or to contribute to an increase in European funding. Moreover, both policy-makers and economists largely agree that the public financing of such investments should no longer be the standard, as it may have been some decades ago. Instead, society looks to private parties to act when it comes to investments in infrastructure. Yet, such investments are generally high, they involve political risks, and they often have uncertain returns and long payback times, which implies that private parties may also be reluctant to invest.

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Taking these drawbacks for private initiatives into account, the central policy question of this paper is: What can policy-makers do to improve the climate for private investment in new and innovative infrastructures in the fields of energy supply, telecom and transport? The paper is organized as follows. Section 2 briefly discusses when, from an economic point of view, public (co)funding of investments in new infrastructure may be inevitable, and when private initiatives should prevail, given the proper conditions. Boxes emphasize the main lessons in this section pertaining to private investment in infrastructure. Section 3 returns to the central policy question and focuses on what those proper conditions are. Section 4 concludes with some final remarks.

2 WHY PRIVATE PARTIES MAY UNDERINVEST IN NEW INFRASTRUCTURES Considering the infrastructures for energy supply, telecom and transport in all their diversity, an initial observation is that private parties are willing to invest extensively in some types of infra-structure, but are reluctant to invest in others. Most networks for mobile telephony, for example, were privately financed by companies that subsequently laid out vast amounts of money for licenses to build and operate UMTS networks. Private companies have constructed broadband connections between major economic centres within and outside the EU in such an abundance that prices have dropped to the point of bankruptcy for some. In the airline industry, new private airline companies – particularly low-cost-carriers – have mushroomed since the deregulation of European air traffic. Many other infrastructures that were state monopolies throughout most of the twentieth century, have been successfully privatized over the past twenty-odd years. Interestingly, also those infrastructures that most countries have not ventured to privatize, generally originated from purely private initiatives made back in the nineteenth century. What (if anything) has changed since then? Here below, from an economic theoretical point of view, we explain why private parties may under-invest in new infrastructures, and when governments have economic justification for intervention.

When public investment is indispensable Every standard work on micro-economics puts it so neatly: “In a market with perfect competition, a Pareto-optimal allocation is realized automatically”. In plain English, this means that “free market forces lead to the best pricequality ratio and the highest welfare levels for consumers”. In practice, however, perfect competition hardly ever occurs. Particularly in the case of infrastructures, various imperfections of markets are at play. Depending on the severity of these “market failures”, it may sometimes be necessary for a government to intervene. In some cases this can be done by imposing regulation, but in certain 56

circumstances public investment is indispensable for new infrastructures. Yet in all cases, it is important to realize that a need for public intervention or investment should not be equated with a need for public supply. A host of empirical research has shown that for most of the time private or privatized firms are more efficient, more profitable, financially healthier, and more willing to invest than otherwise comparable state-owned firms.

External effects The market failure of external effects occurs in many if not all infrastructures. External effects occur when not all welfare effects of the production and consumption of a product or service have a price. External effects can be either negative – i.e. incurring costs and reducing welfare – or positive, i.e. enhancing welfare by means of additional benefits. In their investment decisions, governments differ from private parties in that they are supposed to take both internal and external effects into account. To illustrate this: a private party will invest in a road only if the costs of building and operating it are lower than the fees they can collect. Governments generally invest if the social benefits (including private benefits like travel-time gains) exceed the total social costs (the costs of construction, noise, pollution, etc.). Goods with negative external effects have a tendency to be over-produced by private parties. In aviation, for example, “excessive” noise pollution occurs because there is no charge for it, or because its price is too low. Such external effects call for government intervention, such as a noise-tax to make the social costs incurred part of the private investment decisions. Hence, negative external effects of infrastructure require intervention to bridle private investment – quite the reverse of the main issue of this paper. In the case of positive external effects or spill-overs, too little is produced. Innovation represents an example. If the benefits of an innovation can leak away to others, companies will invest less in innovation and development than is socially desirable. Intellectual property law (patent law, copyright law, etc.) is a way of enabling innovators to (partially) internalize the benefits of innovations. Positive external effects are often a crucial part of infrastructure investments, in particular in innovative infrastructures (types 2 and 3 in Box 1). Investment in a high-speed-railway, for example, can improve the competitiveness of a region by enhancing accessibility and connecting markets. A new underground line will raise property prices in the vicinity of the stations. Since private investors cannot capture such spill-overs, they may not be able to earn a decent rate of return, even though from a social point of view the project may benefit welfare. In such cases, (financial) government intervention is called for to spur private investment. A special kind of spill-overs are strategic interests in certain infrastructures. A good example here is the Galileo positioning system (see Box 2).


Box 2: Galileo positioning system The Galileo positioning system is a public-private initiative of the European Union. Its total costs are estimated at € 3 billion, two thirds of which to be invested by private parties. In September of 2003, China also decided to invest € 230 million in Galileo. The Galileo project consists of a network of 30 satellites allowing one to determine one’s global position with great accuracy. The signal used for positioning up to a certain accuracy is an “open service”, without encryption. More refined positioning will be available at a price. To a large extent, Galileo will be a close substitute for the American Global positioning system (GPS), which has become a commodity among sailors and mountaineers and which is also used in car navigation systems. Nevertheless, the project has a strategic value as the GPS signal can be “switched off” at the liberty of the US government. In the light of the fast adoption of positioning technology, this implies a technological dependency of European countries that may justify investment.

Public goods Public goods can be seen as an extreme case of positive external effects. They are another source of market failure. The two distinguishing features of public goods are “non-exclusiveness” and “non-rivalry”. Non-rivalry means that use by one consumer is not at the expense of the use by another. In other words, the marginal costs of an extra user are zero, which introduces a strong natural monopoly tendency. Non-exclusiveness of public goods means that it is impossible to exclude people from its use and hence to recover investment costs by charging a user fee. Classic examples of public goods are defence and dikes. Technological innovations have increasingly enabled the exclusion or charging of users on infrastructures, where this was once thought impossible. Ten years ago, for example, local and urban roads were considered practically non-exclusive for practical reasons. In 2003, the introduction of a £ 5 toll for cars entering the city of London (enforced by a network of some 800 cameras) did away with this dogma. Political and social ambitions can still make charging for such infrastructures undesirable, however, as will be discussed below. Positive external effects and public goods lead to under-investment in infrastructure by private parties. For example, because a private investor himself does not earn any money by reducing congestion, he will be less inclined to invest in road infrastructure.

Other grounds for public intervention In the case of positive external effects and public goods, public funding for part of new infrastructures may be required. On top op that, there are a number of fundamental justifications for governments to intervene, albeit not by investing. We will mention them briefly.

A lack of competition Government intervention may be required when competition is seriously threatened. In infrastructures this is usually the case in (natural) monopolies such as the electricity grid and railway lines. Profit maximization under a monopoly implies under-provision - and over-charging - of goods. On the other hand, competition also has a price, as free market forces may focus too much on efficiency gains, thereby leading to under-investment in quality. Specific regulation may be needed to ensure that efficiency improvements are not made at the expense of network reliability. A lack of competition generally leads to under-provision - and over-charging - of goods. Still mo-nopolies may be necessary to obtain the rents needed for private investments in infrastructure.

Coordination problems Coordination problems concerning the construction of new infrastructure are another justification for government intervention. Coordination problems stem from a lack of perfect and costless information (also referred to as lack of information transparency or information asymmetry). Government action could be justified in such cases, if the regulatory body is better able to collect and process the necessary information. Coordination may also involve allowing the interest of society prevail over that of individuals. The construction of a high-speed railway line, for example, requires permanent expropriation of land and publicly authorized planning decisions. Coordination may also relate to standardization of technology (i.e., the GSM-standard). A lack of perfect and costless information leads to coordination problems, and thus to under-investment in infrastructure by private parties because they are unable to process all the relevant information.

Non-economic motivations for government intervention In practice, we see that governments intervene not only to correct the aforementioned market failures, but also for other reasons. The issue is then to achieve objectives in areas involving justice, legal security, distribution of income and wealth, ethics and morality. These are all areas in which no univocal statements can be made on the basis of economic theory. The non-economic motives for government intervention can be roughly divided into three situations: inequality, paternalism and social imbalances. When the market outcome is regarded as unjust, intervention is aimed at achieving a more equitable outcome. Regulation in order to prevent monopoly profits is an example common to many infrastructures. “Universal 57


service obligations” are another instance of government involvement aimed at improving equality. The accessibility of an infrastructure such as electricity, telephony, and public transportation for every individual can be desirable for social or moral reasons. If this is considered to be the case, it usually requires interference with the construction plans or pricing strategies for that infrastructure. For example, the Dutch and other governments require that every household is connected to fixed telephony at the same costs. Likewise, a government may decide that it is not fair to charge people for using motorways, and partly for similar reasons, the “open service” Galileo positioning signal is given away unencrypted. The downside of such intervention to eliminate inequality is that it often has a negative impact on competition and private investment. Intervention may also be introduced for paternalistic reasons. This applies to the discouragement of production and consumption of products that the government believes are bad for citizens (e.g. tobacco or drugs), as well as to the stimulation or production and consumption of products that the government believes are good for citizens (e.g. education, theatre visits and wearing seatbelts). Thus, the construction of a broadband network in a poor neighbourhood can be advocated from an emancipatory perspective. Finally, intervention may be motivated by macro economic policy objectives such as creating full employment or reducing inflationary pressure, or to combat regional inequalities. For example, the majority of the public funds that are available for a high-speed railway line to the Northern Netherlands stem from the “Langman-agreements”, aimed at improving the economic performance of the Northern provinces. The EU regional structural funds are another example of such objectives. A lack of perfect and costless information leads to coordination problems, and thus to under-investment in infrastructure by private parties, because they are unable to process all the relevant information. Non-economic motives for government action also affect private investment behaviour. For example, a ban on monopoly rents to protect small consumers, or a strict universal service obligation to improve equality, may shut the door to private initiatives. Paternalistic motives (like broadband Internet for everyone) may also thwart private plans. State subsidies to overcome regional inequalities, or to help loss-making sectors, also affect private investment behaviour.

Pitfalls of government regulation For a long time, it was assumed that the government had a corrective role to play in the event of market failure or in one of the politically undesirable situations described above. Nowadays, reservations about this concept prevail: government intervention can itself lead to undesirable welfare effects that may outweigh the effects of market failure: the remedy may be worse than the disease. 58

Such “government failure” or “regulatory failure” is related to the complexity of regulation and to what is called the “information asymmetry” between the regulator and the regulated sector(s). Market parties have more and better information about their business than the regulator (the government), which gives them an opportunity to manipulate the latter. This leads to sub-optimal regulation, as was first pointed out by Baron and Myerson. It may, however, even lead to what has been coined “regulatory capture”. Economic Nobel Prize Laureate Stigler is famous for pointing out how a regulator may end up protecting the interests of the regulated party. For example, a regulated infrastructure owner may be able to convince the public authorities (by lobbying fiercely) that to preserve universal service obligations, no other parties should be allowed to build competing infrastructures. But information asymmetry works both ways. Private parties do not know what the government is up to and thus they endure regulatory risk. The risk that the government regulates profits away after several years, or that it breaks earlier promises under political pressure, will make private parties reluctant to invest in new infrastructures (Box 3 gives an example related to cable networks). The abovementioned non-economic motives for intervention may also cause regulatory risks. For example, worried politicians may plead for a maximum for electricity prices, in an attempt to protect residential consumers, but at the same time thwart private investments in new capacity.

Box 3: Regulatory risk Cable networks In the early 1980s, the Dutch national authorities encouraged the construction of cable networks by local governments. By doing so, substantial economies of scale could be realized, negative external effects of ubiquitous antennas would be diminished, and TV pirates would be ousted. As a result of this policy, Dutch cable networks now have a penetration rate of about 90% of households, which is very high by international standards. In the late 1990s, most Dutch local governments sold their cable television networks to private parties, who subsequently invested large sums of money in these networks in order to upgrade them for delivering broadband Internet services and telephony. As a result, the cable sector enjoyed a temporary first mover advantage and (transient) monopoly power in the broadband market. In response to this, pressure groups called for public intervention to mandate third party access to this infrastructure, even though no such arrangements had been stipulated in the sales conditions. Now, a few years later, several local governments consider subsidizing fibre-to-the-home broadband networks, which will be a direct competitor to the cable networks that were sold less than a decade ago.


Apart from the negative effects of regulatory uncertainty, government intervention can give rise to transaction costs that are higher than the efficiency gains of the regulation. In addition, when government intervention involves public funding, these investments are paid from tax revenues. Taxation brings about welfare losses since it changes the way in which people behave. An increase in income tax, for example, makes working less profitable and generally reduces labour supply. Similarly, a sales tax on houses discourages people from moving. Because taxation changes the choices of people, efficiency is no longer realized and a welfare loss occurs. In addition to this, taxation also incurs administration and compliance costs. Government intervention as a remedy to market failure can be worse than the disease. Uncertainty about future regulation hampers private investment in infrastructure, while existing regulation can be an effective means of discouraging competitors to enter a market.

Why would private parties under-invest in new infrastructures? Let us now return to the central question of this section: Why do private companies invest abundantly in some types of infrastructure and not in others? Reviewing our exposition of market and government failure, we sum up the fundamental and practical reasons for a lack of private enthusiasm to invest in infrastructures: - A lack of exclusiveness: Private investment will only occur if it is possible to exclude others from using the infrastructure and hence to recover investment costs by charging a price.

Addressing these issues adequately will spur private investments. Before turning to the question how to do this, we summarize our theoretical framework in Box 4.

Box 4: Situations in which government intervention can be desirable and reasons why private parties may under-invest in new infrastructures General justifications for government intervention Market failure

Non-economic motivations

- A lack of competition - Positive and negative external effects - Public goods - Coordination problems

- Unequal distribution of welfare (universal service obligations) - Paternalistic motives - Social and regional imbalances

Why private parties may under-invest in new infrastructures - A lack of exclusiveness (related to market failure of public goods) - The existence of positive external effects - High regulatory risks (these may be due to political considerations) - (The perceived higher interest rate for private companies when compared to the government)

- Positive external effects which cannot be

internalized: The social benefits of an infrastructure that do not directly accrue to its investors and users, generally lead to under-investment by private parties. - High regulatory risks: The risk that the government regulates profits away after several years or that the government will change the ex ante regulatory framework, will make private parties reluctant to invest. This is especially true for investments in new infrastructures that have long pay-back periods. A more practical reason can be added to this list: - The perceived higher interest rate for companies when compared to the government. Government debt has a very low risk and, hence, a low interest rate. However, this is largely due to the lack of a project-related risk premium, which means that a government may go ahead with a project because the discount rate used is too low. Also, the economic distortions (costs) of raising taxes are usually disregarded.

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3 POLICY ISSUES: IMPROVING THE INVESTMENT CLIMATE In this section we discuss the proper conditions for private investment in new infrastructure. Taking the barriers described in the previous section as a starting point, the following success factors for private initiatives can be determined.

1. Allow private companies to earn a decentprofit According to the traditional dogma of welfare economics, monopoly rents have to be avoided, since they occur when a monopolist exploits his market power by reducing supply and raising prices. The reduced supply constitutes a welfare loss and monopoly rents raise distributional concerns. Moreover, monopolies are traditionally considered as inefficient and not inclined to innovate. Such observations seem to be the guiding principle for many governments and regulators in their attitude towards monopolies. However, modern research shows that this position needs some serious qualifications, especially in a rapidly innovating environment. Not all profits that a monopolist makes, constitute a welfare loss. Without some prospect of a considerable rate of return, private investments in infrastructure will be discouraged. Large profits, which the public will easily perceive as “monopoly rents”, are required to cover both the high fixed cost of investments in infrastructures and the risks, which can be particularly high for investments in innovative infrastructures. Moreover, a monopoly or market leader has a greater incentive than any other firm to carry out a lot of research, to keep innovating and thus stay on top. Drug patents and copyright protection, although not entirely undisputed, tend to protect a monopolist for decades, whereas in infrastructures, particularly those for telecom, politicians can hardly bear the idea of a monopolist making large profits for more than one year. In order to show the need for “monopoly profits” in some cases, we will now present a finer breakdown into Ricardian rents and Schumpetarian rents. Ricardian rents play a role when dealing with scarcity issues (we will come back to these when discussing the fourth success factor). Schumpeterian (entrepreneurial) rents come about because imitation does not occur instantaneously, even though imitators may well “swarm” around the innovators’ key technologies and products. Both are benign sources of rent from an antitrust perspective, as they encourage investment in valuable knowledge assets and in innovation. Therefore, Schumpeterian (and Ricardian) rents should not be regulated away. What is the lesson to be drawn from all this? Monopolies (and monopolistic competition) are not always bad when it comes to investing large amounts of money in new infrastructure. There is a clear difference between protecting the public from monopoly rents of individual companies 60

on the one hand, and stimulating private investment by allowing companies a sufficiently long pay-back period on the other hand. In addition, monopolies themselves face contradicting incentives as a result of their market power. Both empirical and theoretical analyses indicate that the incentives for innovation follow an inverted u-shaped curve with respect to market power. In other words: a moderate instead of a maximum level of competition gives a private company the largest incentives to invest in innovation. Regulating away what is perceived by the public as “monopoly profits” tends to increase effi-ciency in the short run, but particularly in a dynamic environment it may take away the incentives for both the monopolist and possible contestants to invest in new infrastructures. Hence, longterm innovation and infrastructure competition may suffer from over-regulation. This may be the major dilemma for unleashing private investments in infrastructure.

2. Create political stability and certainty for companies It is often argued that private companies will not invest in projects with large pay-back times. This argument is flawed, however. An example showing that private parties can indeed be interested in projects with long pay-back periods are the French motorways. Some of these roads are privately built, maintained and financed, despite the fact that the pay-back period for these projects through toll collection is 30 years or more. The crucial condition for private investment here is not the pay-back period, but the reliance on the government throughout those years to keep its word not to tamper with the agreements about the toll-setting or to build a free alternative. Given the proper circumstances, private companies have no problem with long pay-back times. What matters is that policy-makers provide stability of two kinds: Regulatory stability (i.e., no unexpected access regulation or expropriation, commitment to non-intervention). Stability in planning (i.e., no building of publicly-financed alternatives that compete head-on with private initiatives). Box 5 gives two examples of regulatory risks that may hamper private incentives to invest (also see Box 3 for an example related to cable networks).


Box 5: Regulatory distortion of a private innovation Digital hourly metering systems in the electricity sector Market power plays a very important role in the electricity sector. For example, a main issue in electricity market design is how to control the ability of powergenerating firms to raise prices. One possibility is to increase the price responsiveness of demand by implementing digital hourly metering for (residential) customers. On the one hand, digital hourly metering brings about benefits for the network operators (a longer lifespan, no necessity to drive around and take meter readings, illegal consumers can be detected more easily and switched off, consumption by defaulters can be limited to a minimum). There are social benefits as well. The meters send real-time user data digitally via de network. In times of scarcity, the operator could influence power consumption – following government rules – by limiting the use by some parties in favour of other parties (such as hospitals). The costs to the network operators consist of investing in and placing the new meters (€ 100 ~ 175 per meter, depending on the number of power points). The benefits for users are obvious: consumers can respond, for example, by switching to interval metering. At the moment most residential and small business consumers receive a final payment only once a year and larger business consumers are invoiced every month. In both cases, the relation between demand and price does not play an important role. Digital hourly metering has drawbacks for the power generators, as they will lose part of their market power: all suppliers are faced with a more elastic residual demand curve and, therefore, competition will intensify. Italy is the leader when it comes to actually implementing the digital hourly meters. The Italian power company Enel has already replaced two-thirds of the total of 30 million meters. Enel, the former state monopolist, was privatized in 1999 and cooperates with IBM in this large-scale project. The Scandinavian countries will be next. In some countries, like the Netherlands, electricity companies are considering implementation but are weary of new government rules stating that each consumer may choose his own meter. Since the digital meters have a higher purchase price than the traditional mechanical meters, and the companies expect consumers to focus on this short term expenditure instead

A related aspect is that it is important for the government to manage possible expectations of private parties concerning the future role of the government. Under these conditions, private companies will have no problems deal-

ing with long pay-back times and will use lower discount rates for their investments, thus enhancing the financial viability of projects. The risks that do remain are of a more fundamental nature, such as the risk Motorola took when investing in the Iridium satellite network (Box 6).

Box 6: A private company accepting astronomical risks Motorola came upon the idea of combining the two technologies of cellular phones and small satellite communications systems. In this project, later to be named “Iridium”, the company proposed launching 77 small communications satellites, and to route cellular telephone traffic over them. (The atomic number for the element iridium is 77, hence the name of the project.) Ground users would communicate directly with the satellites, instead of with a local transmitter, which would later pipe the communications through existing land-line systems. The project turned out to be a commercial mistake, however, because of the faster-thanexpected uptake of mobile telephony, even in emerging economies that were the target area for Iridium. A mere 50,000 Iridium phones were sold, instead of the hundreds of thousands that had been expected. This example proves that private companies are willing to accept astronomical risks, as long as there is a prospect of huge profits to justify the risk.

Such stability may be harder to provide than it would seem, in particular as a newly elected gov-ernment may strongly disagree with the policies of its predecessor. However, long-term continuity with respect to agreements reached with private infrastructure investors is critical. Enhanced accountability for policy changes that violate such agreements could improve the investment climate.

3. Stimulate innovative financing structures In some cases, allowing companies to capture social rents (positive external effects), for example by allowing real estate development, is a way of making a project’s ends meet. Traditionally, governments prefer to grant a subsidy when positive external effects occur, for fear of losing control if a private party manages to capture social rents by itself. This may, however, lead to a loss of synergy: the infrastructure investor loses the incentive to maximize these rents. In Japan, for example the high-speed rail connections are privately financed. Losses on these lines are compensated for by the exploitation of the buildings around the stations, which are in the hands of the railway investor. Another example was the Dutch Maglev proposal, by a private consortium of ABN Amro, Ballast Nedam, HBG and Siemens, to invest a large amount of money in exchange for real estate developments and ownership of the railways. Apart from this private funding, the Dutch government would be willing to invest € 2,73 billion. 61


The consortium was abolished due to the long and insecure waiting period before the government cut the Gordian knot. By opting for subsidy instead of synergy, governments can enhance the incentive to create spillovers through a voucher system giving purchasing power to the target customer group. This could very well be a more direct way of reaching the social target group than through public service obligations. Another example of innovative subsidies to private parties are shadow tolls. Shadow tolls are paid not by the users but by a third party (such as a sponsoring governmental body) to the facility operator. Like regular tolls, they can be based on the type of vehicle and the distance travelled. Shadow tolls can be an element of a highway finance approach whereby a public or private sector developer/operator accepts certain obligations and risks and in return receives periodic shadow toll payments instead of, or in addition to, real or explicit tolls paid by users.

4. Allow money to flow Sometimes, political ambitions follow country borders that economic efficiency is inclined to ignore. Targets for pollution, CO2 emissions and renewable energy, for example, serve an international or global purpose but are often translated into national targets. However, a 10% renewable energy target may be harder and more expensive to achieve in some countries than in others. This may be due to external effects (e.g. horizon pollution) that are larger in densely populated countries, or to natural resources such as sufficient wind or flowing water. Private investors will look at the overall internal rate of return, and the result may be that private investment will be viable in some countries only. Making such policy targets tradable at a European scale, as has been done with CO2 emissions, will allow the Euros to flow to where they can earn the highest rate of return. This will serve both the economy and the environment well. Allowing money to flow means allowing Ricardian rents to be reaped, even though it may not be within the national borders (when discussing the first success factor we already stated that Schumpeterian or entrepreneurial rents should not be regulated away). In the context of innovation, Ricardian rents reflect a scarcity of a unique input (e.g., a unique engineering skill). If the input is necessary to produce the output, the firm could be a (transitory) “monopolist” in the output market. While the firm could be thought of as a monopolist, its profits are scarcity rents, properly attributed to the scarce input. Note that it is precisely the existence of scarcity rents that engenders the expansion of output through replication of the underlying skills.

rents may be looked upon with jealousy, but should be accepted for the fact that the overall outcome will be more efficient.

5. Refrain from making technological choices Governments can be useful by playing a coordinating role in the process of reaching industry standards. Such standards can be efficient in maximizing the network effects that users experi-ence. For example, the EU-involvement in the adoption of the GSM standard allows EU citizens to roam all over Europe while using the same mobile phone handset. But, standardization can have negative effects as well. A widely accepted standard tends to create lock-in, which means that a shift to a new and superior technology or standard will be made too late or not at all. Moreover, prescribing a sub-optimal standard or dictating a standard too early in the life-cycle of a product may frustrate private entrepreneurship or the natural selection of standards. In the case of GSM, the bureaucrats have operated wisely. In the case of UMTS, however, their choice for the W-CDMA standard seems to have been less fortunate. At this moment, operators in Japan, Korea and the United States have been more successful at launching 3G mobile networks using a rival technology (CDMA2000). In technological choices, governments should generally not try to lead the way.

6. Allow contractual freedom Governments often try to protect consumers by prohibiting certain arrangements in contracts offered by suppliers. For example, a contract that binds a household to an energy supplier for more than a year may be deemed illegitimate. Such government action may serve the purpose of short-term competition but it can reduce incentives for suppliers to invest in customers or in new technology. Consider, for example, the investment in digital metering systems discussed in Box 5, or innova-tive battery systems that may enable households to use cheap night-time energy during the day. The costs of such new technologies are often so high that households are not interested, even though the investments may be profitable in the long run. Electricity suppliers have a scale advantage to take the lead in such innovations and, hence, they may want to speed up the adoption of such technology by renting it to households. A policy aimed at reducing switching costs for households by prohibiting long-term contracts can be a serious threat to such investments, however, just as health insurers have few incentives to invest in prevention (like losing weight, or quitting smoking) when people can easily switch between insurers.

7. Reduce the administrative burden Returning to the example of investment in renewable energy, one can envisage that tradable policy targets lead to Ricardian rents for countries that have a natural advantage because of mountains, fjords, or wind. These 62

Finally, governments can stimulate private investment by reducing administrative burdens that cause companies serious loss of time and money. Excessive administrative


burdens and “red tape” are generally considered to be a negative determinant of a country’s investment climate. In Denmark, investments in wind power are larger than in the other European countries; Spain and Germany take second and third place, respectively. The better Danish investment climate may be interesting for other countries to learn from (the Danes may well have Ricardian rents). Differences are also likely to be found in the legal and administrative procedures.

4 CONCLUSIONS The Lisbon Strategy touches upon almost all of the EU’s economic, social, and environmental activities. The European Union has been implementing the Strategy for four years now, and progress has been considerable. One of the reasons for the low growth in overall productivity in Europe is the inadequate level of investment. For example, the contribution of information technologies to productivity growth is less than half of that found in the United States. This situation works to the detriment of the priority areas identified by the Lisbon Strategy. In this respect, the European Growth Initiative and the Quick Start Programme, adopted by the European Council in December of 2003, are a major source of leverage to unlock investments in the infrastructure and knowledge sectors. The focus should be on investment, thereby strengthening both the demand and the supply side of the economy, and with particular emphasis on the introduction of new environmental-friendly technologies, enhanced funding of research and development, and the completion of the enlarged EU’s trans-European infrastructure networks. However, European and national public funds for the required investments in infrastructure are scarce in the current economic climate. In addition, there is an increasing awareness that governments should not always be held responsible for infrastructure investment. This paper has formulated seven imperatives to stimulate private investment in innovative infra-structures. They are summarized in Box 7. Although these recommendations should be borne in mind by policy-makers wanting their private sectors to take the risk neck and invest in innovative infrastructures, many of them also contain dilemmas for which there are no one-size-fits-all solutions. Allowing or regulating away monopoly profits may be the most important of them all. In general, it seems justified in this respect to argue that the more innovative a new infrastructure, and the more it creates its own market, the larger the risks involved for private investors. This warrants transient monopoly profits in case of success, and it requires policy-makers not to yield to public and media pressure to keep monopolies on too tight a reign for the sake of short-term benefits.

Box 7: Improving the investment climate 1. Allow private companies to earn a decent profit Without some prospect of large profits, private investment in infrastructure will be discouraged. Regulating away those profits tends to increase efficiency in the short run, but particularly in a dynamic environment it may take away the incentives of both the monopolist and other firms to invest in new infrastructures.

2. Create political stability and certainty for companies Investments in infrastructures have long pay-back times. Contrary to popular belief, this in itself is not a problem for private parties, so long as the regulatory and political environment is sufficiently stable. To provide such stability may be harder than it seems, in particular as a newly-elected government may strongly disagree with the policies of its predecessor. Enhanced accountability for policy changes that violate such agreements could improve the investment climate.

3. Stimulate innovative financing structures Allowing companies to capture social rents, for example by allowing real-estate development, is a way of making a project’s ends meet. Traditionally, governments prefer to grant a subsidy instead, for fear of losing control if a private party tries to capture social rents by itself. This may, however, lead to a loss of synergy: the infrastructure investor loses the incentive to maximize these rents.

4. Allow money to flow Making policy targets, e.g. with respect to renewable energy production, “tradable” across internal borders will improve overall efficiency, even though this allows fortunate companies to earn (Ricardian) monopoly profits from their resources.

5. Refrain from making technological choices Governments have a role to play in standardization. In technological choices, however, they should not aim to lead the way. Prescribing a sub-optimal standard may frustrate private entrepreneurship and hamper investments.

6. Allow contractual freedom Governments often try to protect consumers by prohibiting certain arrangements in supplier contracts. Such government action may serve the purpose of short-term competition but can reduce incentives for suppliers to invest in customers or in new technology.

7. Reduce the administrative burden Procedures and “red tape” that are aimed at good governance and careful decision-making, may impose administrative burdens that discourage private parties from investing in infrastructure.

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NOTES I

Commission of the European Communities (2004), Delivering Lisbon. Reforms for the Enlarged Union, COM (2004), 29.

II

Take, for example, the Irish plans. The 2007-2013 National Development Plan aims to provide worldclass public and private transport, energy, telecommunications, and waste infrastructure, in order to retain existing - and attract new - inward investment.

III

The GSM technology itself has also generated innovative spin-offs for other infrastructures. GSM-R, for example, is a GSM-based communications platform currently introduced as the European standard for railway communication. It enables a single international communication standard for railways and it also improves interoperability between the various railway companies at an international level.

IV

John Kay (1996), Pricing the tunnel, in: The business of economics, Oxford University Press.

V

William L. Megginson and Jeffry M. Netter (2001), From State to Market: A Survey of Empirical Studies on Privatization, Journal of Economic Literature, Vol. XXXIX (June), pp. 321–389.

VI

G. Debrezion, E. Pels & P. Rietveld (2003), The Impact of Railway Stations on Residential and Commercial Property Value: A Meta Analysis, Tinbergen Institute, discussion paper 04-023/3, Amsterdam.

VII

World Bank, World Development Report 1994. Infrastructure for development, p. 115.

VIII Baron, D.P. & R.B. Myerson (1982), Regulating a monopolist with unknown costs, in: Econo-metrica, 50, pp. 911-930. IX

Stigler, G.J. (1971), The theory of economic regulation, in: The Bell Journal of Economics and Management Science, 2, (1), pp. 3-21.

X

Federico Etro (2004), Innovation by leaders, The Economic Journal, 114 (April), pp. 281–303.

XI

This paragraph draws on: Teece, D.J., Coleman, M. The meaning of monopoly: Antitrust analysis in high-technology industries, in: Antitrust Bulletin, Volume 43 (Fall-Winter 1998), issue 3-4, pp. 801-57.

XII

Aghion, P. et al. (2003), Competition and Innovation: An inverted U relationship, Ministry of Economic Affairs, The Hague; and: De Bijl, P.W.J., (2 May 2004), Competition, innovation and future-proof policy.

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XIII Economists think of profits in terms of Ricardian and Schumpeterian profits, which they sum-marize in the term normal profits. In plain English “normal profit” means that companies make enough profit to reward the invested capital. Economists also distinguish surplus profits, which are realized due to lack of competition. A monopolist can set really high prices and earn profit exceeding a normal profit. The line between normal and surplus profit is sometimes thin, especially in dynamic markets where innovation creates new markets and (transient) monopolists. XIV This does not mean that tolls on these roads should be left to the discretion of the private investor. Complete private provision without governmental control is only rarely considered. The French government has implemented a financial regulation, i.e., a maximum toll rate indexed to inflation, but apparently this is predictable enough not to hinder investment. See G. Fisher & S. Babbar (1996), Private financing of toll roads, RMC Discussion paper series 117, World Bank, Washington DC. The risk of welfare-reducing profit maximization can be mitigated by a proper design of auctions for concessions of private roads. See B. Ubbels & E. Verhoef (2004), Auctioning concessions for private roads, Tinbergen Institute, discussion paper 2004-008/3, Amsterdam.