The Regulatory Asset Baseand Project Finance Models
An Analysis of Incentives for Efficiency

01

Discussion Paper 2016 • 01
Dejan Makovšek andDaniel Veryard

International Transport Forum,
Paris, France

The Regulatory Asset Base and Project Finance Models:
An Analysis of Incentives for Efficiency

Discussion Paper 2016-1

Dejan Makovšek
Daniel Veryard
International Transport Forum
Paris, France

February 2016

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Model

Abstract
Governments world-wide have sought value for money by augmenting the traditional approach to
public infrastructure delivery and management by introducing private capital. Two well establishedplatforms for private capital participation are the Regulatory Asset Base (RAB) Model and the Project
Finance Model (broadly termed PPPs). This paper reviews available evidence on the efficiency indelivery and operation of major infrastructure of each platform relative to the traditional approach.
Overall the basic concern with the RAB model is that its application might lead to excessive capital
expenditures, to strategically inflate the base on which the return is being calculated. By contrast,
given the complexity of PPP projects and the inherent uncertainty associated with such long-lived
contractual commitments, it is questionable whether competition leads to efficient outcomes. Bothapproaches have some potential advantages and this paper investigates, whether it is meaningful tomerge them.

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Model

Table of Contents
Introduction.................................................................................................................................. 6
Methodology ................................................................................................................................. 8
The traditional model baseline ................................................................................................... 9
Infrastructure delivery using the traditional model .................................................................... 9
Quality and delivery approach ................................................................................................ 9
Delivery efficiency ................................................................................................................. 9
Infrastructure operation under the traditional model................................................................ 10
Operational efficiency .......................................................................................................... 10
Operational flexibility........................................................................................................... 10
Assessment of the traditional model ........................................................................................ 11
Towards private participation .................................................................................................. 11
The Regulatory Asset Base model ............................................................................................ 12
Overview of the Regulatory Asset Base model ....................................................................... 12
Infrastructure delivery using the RAB model .......................................................................... 14
Quality and delivery approach .............................................................................................. 14
Delivery efficiency ............................................................................................................... 15
Infrastructure operation under the RAB model ........................................................................ 16
Operational efficiency .......................................................................................................... 16
Operational flexibility........................................................................................................... 18
Other value for money considerations for the RAB model ...................................................... 18
Cost of debt financing........................................................................................................... 18
Estimating the appropriate returns to capital ........................................................................ 19
The Public-Private Partnership model .................................................................................... 21
Overview of the PPP model ..................................................................................................... 21
Infrastructure delivery using the PPP model ............................................................................ 22
Quality and delivery approach .............................................................................................. 22
Delivery efficiency ............................................................................................................... 23
Infrastructure operation under the PPP model ......................................................................... 24
Operational efficiency .......................................................................................................... 24
Operational flexibility........................................................................................................... 24
Other value for money considerations for the PPP model ....................................................... 25
Cost of debt financing........................................................................................................... 25
Risk and return considerations for bidders ........................................................................... 26
Discussion ................................................................................................................................... 28
Project RAB finance ................................................................................................................ 29
Summary .................................................................................................................................. 31
Conclusion .................................................................................................................................. 33
Bibliography ............................................................................................................................... 35

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Boxes
Box 1. Cost of financing in RAB and a PPP ..................................................................................

26

FiguresFigure 1. An Regulatory Asset Base structure example ....................................................................... 13
Figure 2. Cost overruns in electricity transmission projects in the USA in 2013 ................................. 16
Figure 3. An example of a PPP model for infrastructure delivery and operation ................................. 22
Figure 4. An illustration of the Project RAB finance during construction ........................................... 30
TablesTable 1. Characteristics of alternative infrastructure delivery and operation models........................... 31

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Model

Introduction

Investment in infrastructure is important for productivity and growth, for future generations aswell as today. A recent study by McKinsey compiled multiple sources of information on the so called“infrastructure gap”, estimating the needs at USD 57 trillion over the next 30 years (Dobbs et al.
2013). Almost half of this amount is in the transport sector. Despite the inherent difficulties inaccurately estimating it, the infrastructure gap in clearly large.
The traditional approach to investing in infrastructure relies on governments using its revenue(either from taxes or borrowing) to finance the design and construction of new or upgradedinfrastructure. Although the design and construction can be procured through competitive tenders fromprivate firms, the traditional model relies on continued government ownership and operation once
construction is completed.
In recent decades, many governments have responded to limitations of the traditional model by
seeking increased private sector involvement in the funding, financing, delivery and operation of
infrastructure. The two primary challenges with the traditional model driving this change are:•difficulty in finding sufficient government finance, either because of weakness in tax
revenue or a reluctance (or inability) to increase government borrowing•

evidence (or policy preference) that government ownership and operation of infrastructure
assets results in worse price and/or quality outcomes compared with the private sector.

This paper explores the two primary models through which private sector involvement has been
introduced into the financing, delivery and operation of infrastructure: the regulatory asset base model(RAB) and the project finance model (or Public Private Partnerships, PPP).
In the RAB model, private (or corporatised state-owned) companies act as the infrastructure
manager: they own, invest in and operate infrastructure assets. The infrastructure manager receives
charges revenue from users and/or subsidies to fund its operations and recoup investment costs. The
infrastructure manager would behave much like a natural monopoly in the absence of regulation –setting prices too high in an attempt to earn “super normal” profits. An economic regulator is therefore
established to provide efficiency incentives and to cap prices, revenue or rates or return received by
the infrastructure manager to improve social welfare. Efficiency incentives aim to mimic the
incentives that would be faced by the market if it were competitive. The efficiency gains in this casearise primarily through the interaction between the regulator and the infrastructure manager “during
the contract”.
In the PPP model (also termed Private Finance Initiative, PFI, in the UK) of public infrastructuredelivery, the government calls for tenders for a contract for a single infrastructure project. These
contracts commonly take the form of a Design-Build-Finance-Maintain-Operate (DBFMO) contract.
The contract gives the successful private consortium responsibility for all aspects of project financing,delivery and operation for periods often spanning decades. The contract sets out how the consortium
receives revenue: either from the government in the form of a periodic “availability payments”, and/or
direct from users. (The latter case is associated with demand risks that are generally beyond the scopeof this paper.) The efficiency gains in this approach are primarily determined at a single point in time:by competition between the bidders for the contract (ex-ante).

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These two approaches could be considered as two diametrically opposite solutions to the samechallenge of infrastructure financing, delivery and management. The sharp distinction made here
serves to allow analysis. In reality competition between investors in the RAB model also serves toprovide an incentive to efficiency, at least at the outset. Similarly, a DBFMO contract need not be
entirely devoid of incentive regulation1. In between the two basic approaches, there are also otheralternatives, which take various forms, from management contracts to other types of concessions.
These are not discussed in this paper.
The central advantage of RAB is that in developed economies it offers one of the lowest costs offinancing, only marginally above that of government bonds. At the same time, incentive regulation can
provide adjustable high powered incentives for operational efficiency during the life of theinfrastructure. One of the bigger challenges of RAB is incentivising efficient capital expenditures,
which is a problem that appears to be more adequately solved in PPPs. These are well established fordelivering projects on-time and on-budget; however, the cost of financing PPPs is substantially higher
than for RAB, and the PPP contract is considered to be relatively rigid during the operations phase.
The question this paper asks is whether it is feasible and desirable to merge the advantages ofboth approaches – the low cost of finance and continuous incentives for operational efficiency in the
RAB, with efficiency in infrastructure delivery of the PPP – in a single model? To attempt to answer
the question, the paper first reviews the available empirical literature and assesses the infrastructuredelivery and operation performance of the traditional model (section 3), the RAB (section 4) and PPP(section 5) approaches. We then discuss whether there is room to combine any elements of the twomodels, which would lead to an improved infrastructure delivery and management vehicle (section 6).
Section 7 concludes.
This paper was originally published as “The Regulatory Asset Base Model and the Project
Finance Model: A comparative analysis“ (ITF Discussion Paper 2015-5) in February 2015. Feedbackon the complex issues raised in that earlier paper has prompted us to improve and streamline thestructure for enhanced presentation of the material and better accessibility of the conclusions. Daniel
Veryard has been added as co-author to reflect his valuable input. Comments on an earlier version by
Darryl Murphy, Frederic Blanc Brude, Daniel Loschachof, J.L. Guasch and Marian Moszoro are
gratefully appreciated.

1

Around the world region specific differences may induce confusion. A concession is a specific term incivil law countries. In common law countries however, projects that refer to discrete pieces ofinfrastructure are also referred to as concessions, although they could be better described as BOT typeprojects.

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Model

Methodology

This paper compares the relative performance of three alternative models for delivering andoperating infrastructure in capital-intensive network industries: 1) traditional procurement, 2)
regulated asset base (RAB) and 3) project finance (PPP). We assess these models by examining andcomparing their performance in the available empirical literature and economic theory.
The paper focuses on capital-intensive network industries (e.g. road, rail, utilities) as they haveelements of natural monopolies that make investments candidates for each of the delivery models ofinterest. An important aspect of these industries is that demand is mainly an exogenous factor for the
infrastructure manager. Nevertheless, the paper assumes the basic incentive structure is the same inany project finance PPP and thus draws on available evidence also from other sectors where relevant.
To demonstrate the scope of the analysis, a project life-cycle can be divided into five stages, eachwith its own considerations:•

Project selection (outside the scope of this study) – which markets should be served? What
service capacity should be built? Which service technologies should be provided to the users(e.g. light rail versus bus rapid transit)?

•

Quality and delivery approach – which materials, techniques and technologies should beapplied in construction? What quality of asset should be built? Will life-cycle costs beminimised (for a given service output)?

•

Delivery efficiency – how well can specified capital projects be delivered, without excessive
cost overruns and delays? How well are the risks of delivery estimated and managed?

•

Operational efficiency – given the assets available, can the operator produce a given output
at low cost? Can the service contract be re-negotiated easily at low cost to government?

•

Operational flexibility – to what extent are prices, quantities and service levels locked in or
flexible? What costs are incurred by governments if they wish to make changes during theoperational period?

Only the first of these life-cycle stages is not considered in this study. This is because in two of
the delivery models under consideration, project selection has generally been decided ex-ante (before
any delivery contracts have been tendered) regardless of whether a project is desirable or not. Only in
the RAB model is project selection within the scope of the delivery framework itself. Infrastructure
managers are involved (with the regulator/state) in the selection and procurement of projects, but this
aspect of the RAB model cannot be compared with the other models which rely purely on government
project selection decisions.
Decisions made during phases two through four determine which party bears the various delivery
and operational risks. This risk allocation in turn influences the incentives for performance and canhave a significant influence on the cost of financing. The assessment of models considers these points
in terms of the returns required by private participants and the resulting value for money forgovernment.

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The traditional model baseline

The term “traditional” describes something that has remained more or less unchanged throughtime as an established method. The dominant method of major infrastructure procurement hasremained unchanged for decades, while the processes and technologies for infrastructure planning anddelivery have progressed. This section explores the traditional approach to delivery and operation ofmajor network infrastructure.
Infrastructure delivery using the traditional model
The traditional model is a contract structure where the phases of design and construction are
tendered to private companies, either separately (Design-Bid-Build or DBB contracts) or bundled (aDesign and Build or DB contract). The spending on public infrastructure is financed with public funds
or through government borrowing.
Quality and delivery approach
The planning, building, and operation phases are commonly each performed by different entities
in the traditional model. In such a setup each actor “leaves the scene” after his engagement iscompleted, hence limiting incentives to consider future consequences of decisions in each of thephases2. This makes the implementation of life-cycle cost optimisation principles difficult.
Equally importantly, the sponsor (the public entity), which should have the incentive to minimise
life cycle costs, is also subject to political short termism. Politicians have an incentive to “cut the
ribbon” for as many projects as possible, without considering future cost of this infrastructure. This
leads to the procurement of lower quality infrastructure than might be suggested by life-cycle
minimisation.
Delivery efficiency
In large projects, traditional procurement involves the public sector entering into a cost-plus
contract3, which has three main consequences for delivery efficiency:•

The public sector retains most of the risks of cost or time overruns.

•

The public sector also retains the possibility of changing the scope of the project during
construction with relatively small transaction costs. This flexibility also creates moral hazard
by making it easier for the public sponsor to conceal the true cost/benefits during the project
selection stage (Flyvbjerg et al. 2002).

2

In traditional procurement the Design and Build procurement resolves part of the problem with regard
to incentives, but it would still be inferior to a contract that also bundles the operations phase.

3

In this paper we apply the term cost-plus contract as opposed to fixed price/fixed date of delivery
contracts. Cost-plus contracts offer a weak guarantee ceteris paribus to the investor that the projectwill be delivered for the contracted value, including the design and build contract. The fixedprice/fixed date of delivery contract involves a TLS (Total Lump Sum)/turnkey contract, with acomparably strong guarantee to the investor, that the contract value will not be exceeded (provided ofcourse, that the investor does not change the content of the project).

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A large number of potential contractors can participate during the bidding stage, including
participants that would be unable to accommodate major risks.

A large body of literature assesses the on-budget cost performance of the traditional infrastructure
project delivery ex post. The relevant part of the literature focuses on construction contract
performance where cost performance is measured against the contract price (Blanc-Brude and
Makovšek 2013 include a literature review). On this measure, systematic cost overruns for roadinfrastructure are found to average below 9% under the traditional approach4.
Infrastructure operation under the traditional model
Operational efficiency
Once infrastructure is delivered, its management and operation is traditionally transferred to astate-owned infrastructure manager. The challenges typically faced in the operation phase include poor
performance incentives and an under-recovery of efficient life-cycle costs.
Infrastructure managers share several characteristics with natural monopolies (sunk costs that
limit new market entrants, economies of scale and scope, etc.). Accordingly, they are not subject toadequate competitive pressures that would provide incentives to innovate or reduce costs. For
example, within large monopolies unions organise more easily and can exert considerable power on
the company and its owner (Salinger 1984, Rose 1987, Hendricks 1977). In a related point, Savedoffand Spiller (1999) explain how the threat of government opportunism leads publicly owned companies
to protect their cash flows against interventions (e.g. by hiring too many employees or granting
excessive benefits).
State-owned infrastructure managers tend to under-recover efficient life-cycle costs due togovernment short-termism or “time inconsistency” (Helm 2009). Government short-termism stems
from voter expectations: voters appreciate a low upfront price with little concern for the consequences
for the distant future generation from running down the asset. Persistent lack of renewals caneventually lead to (non-linear) excess current maintenance requirements, which entail even higher
expenditure than before.
Effectively the incentives for efficiency are dependant solely on how well the state performs its
corporate governance function.
Operational flexibility
The advantage of the traditional model during the operational phase is that the government has
direct (or indirect) control over prices, quantities or service levels. If economic or technologicalconditions differ to those that were expected when an infrastructure investment was made, thegovernment is able to implement changes without any contractual penalties or without costly or time
consuming renegotiation procedures.

4

A related, but separate, part of the literature measures performance against “decision to build”
estimates that are made earlier in the project life-cycle (i.e. during the “project selection” stage, e.g.
Flyvbjerg 2002, 2003; Odeck 2004; Cantarelli 2012a,b; Makovšek et al. 2012). This literature findsthat transport infrastructure costs between 8% and 40% more than is estimated initially.

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An adjustment in the national transport policy for example may require a change in theinfrastructure development plans. In roads or railways for example, demand on each section of the
network affects demand on the other links. If a major part of the network was managed by different
PPPs a more radical change in the network would require a renegotiation with all the PPPs that would
be affected by the new policy.
Assessment of the traditional model
Under government ownership, infrastructure is financed with public funds or through government
borrowing, which has a lower cost than private financing5. The government also has greater flexibility
to respond to changes in future circumstances without contractual penalties and complicatedrenegotiations.
Against these advantages, the main challenges for the traditional model of infrastructure delivery
and management is the weak incentives to maximise a project’s value across delivery and operation(including a lack of certainty of on-going funding).
Towards private participation
In economics it has long been theoretically argued, but only recently empirically established, thatthe performance of the private ownership in a competitive market is superior to public ownership(Meginson and Netter 2001). In recent decades, some countries have aimed to apply this success ofprivate ownership to network industries. However, the natural monopoly characteristics of many
network systems (sunk costs, long lived assets and externalities) mean a simple application of private
ownership would lead to multiple market failures. As such, some form of government intervention
remains necessary to achieve socially optimal outcomes. For instance:•

Setting the appropriate investment allocation – Helm (2009, 321) notes that it is ultimately
the state that decides on the overarching objectives of expenditure programmes, including
public infrastructure.

•

Externalities – It is impossible for the investor to directly capture positive externalities and tomonetise them and he will not voluntarily be held liable for the negative externalities.
Addressing both would be in the interests of society.

•Sunk costs – because investments in large physical infrastructure are sunk, it is unlikely thatprivate investors would commit to investments where there is a risk of expropriation.
Participation of private capital in infrastructure delivery and management in suchcircumstances is not possible in the long run. To make it possible, a credible commitment by
the government is necessary.

The next two sections present two approaches that have evolved to introduce more private sector
involvement in network infrastructure development – the RAB under incentive based regulation and
the PPP. A brief description of each approach is followed by the analysis of the delivery and operation
dimensions as above.

5

This issue is partly addressed in the PPP section. However, an in-depth discussion of whether this isultimately the case is outside the scope of this paper.

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The Regulatory Asset Base model

The previous section summarised that capital-intensive network industries have many
characteristics of natural monopolies, which imply that the development of fully fledged competition
is not possible. While the traditional approach to this challenge is government ownership and control,
many countries have introduced various types of economic regulation with the aim of improving theefficiency of this form of delivery, an d in some cases, to enable greater private sector involvement.
Ex-ante price controls are considered the strongest form of economic regulation as it presumes
some form of market failure exists.6 Ex-ante price controls have been introduced into a range ofcapital-intensive network industries, such as railways, electricity transmission, water supply andtreatment. These are industries where natural monopoly characteristics are strongest, so fullcompetition is unlikely to ever emerge.
There are three main types of ex-ante price controls – price caps, revenue caps and rate of return
regulation. With the price and revenue caps, the regulator must estimate the efficient cost of providing
a service for the next regulatory period (price review period) and allow the regulated company torecover that cost through user charges, if it meets the efficiency target. Similarly, rate of return
regulation allows the infrastructure manager to collect revenues that allow it to earn a return on its
assets up to a designated cap.
All of the ex-ante price control approaches rely on being able to determine the capital andoperating costs that the infrastructure manager is allowed to recover from its customers. There are twomain approaches to calculating this efficient cost of service provision. One is the regulated asset base
(RAB) or building block approach, and the other is a forward looking approach (e.g. Long Run
Incremental Cost, commonly applied in telecommunications). This paper focuses on the RAB
approach as representative of the economic regulation approach to infrastructure delivery andoperation.
Overview of the Regulatory Asset Base model
The Regulatory Asset Base (RAB) concept emerged in UK to provide assurance to investors inprivatised network utilities by setting out the principles for the calculation of price caps (Stern 2013).
The RAB model was developed to value existing assets as a part of the privatisation process in the UK(rather than the delivery of stand-alone major investments). The RAB model itself does not preclude
any particular form of ownership for the infrastructure company – its assets can in principle beprivatised or remain in public ownership. The RAB simply assesses the value of the assets used in theperformance of a regulated function. In practice, it is an accounting number that reflects the value ofpast investments into network infrastructure.
An economic regulator aims to set the RAB such that financial capital values are maintained7(and current cost accounting is applied where sensible). More specifically, financial capital
6

Other “lighter” forms of economic regulation involve pricing rules (preventing the dominant operator
from abusing its market power, as for example in telecommunications or postal services) or an
application of transitory measures (e.g. non-discrimination clauses, price monitoring), where themarket is deemed competitive, but one operator still has significant market power.

7

An alternative is physical capital maintenance (maintaining the productive capacity of assets).

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maintenance requires that the monetary or market value assets be preserved through time (taking into
account price growth over time). Current cost accounting ensures that a realistic replacement value istaken into account in estimating the current value of long-lived infrastructure. Together, the twoconcepts are applied to guard against hidden expropriation. The regulator must also allow theinfrastructure manager to recoup other legitimate costs. Regulated revenue should therefore allow therecovery of:•

New investments into new infrastructure (investments that increase the RAB).

•

Depreciation (loss of value of existing assets).

•

Operating and maintenance costs (costs of running and preserving the assets).

•

Financing cost (the cost of equity and debt, including an appropriate reward or return).

The regulated return to investors is based on the value of RAB (the value of “investment” on which
the return is made) and WACC (the combined rate of return on equity and debt), while the operating
costs are recouped on a pay-as-you-go basis. In terms of legal execution, the RAB model involves the
granting of a license to the infrastructure manager that specifies its rights and obligations. On a basic
level, the regulator accepts the duty to fund the infrastructure manager (directly or through user
charges), provided the latter delivers the services agreed. An example of the model is presented in the
figure below.
Figure 1. An Regulatory Asset Base structure example
Dedicated funding(if necessary)
Budgetrevenue

Strategic
policydevelopment

Economic regulator(independent agency)

Duty to fundinfra.
manager

License fee(Financingof theregulator)
Payment

State

Users

Infrastructure Manager
Services

Expenditures

Regulatory framework•
Incentives for efficient operation•
Monitoring•
Legal duty to finance activities

Source: Authors.

The RAB is a concept that can be embedded in different regulatory frameworks, with more orless powerful incentive regimes. The incentive regimes are the subject of a vast theoretical andempirical literature covering generic as well as sector specific contributions issues. Joskow (2008)
provides a good overview of the economic theory principles behind incentive regulation. These

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Modelprinciples have been embodied in different regulatory traditions in different geographical locations(e.g. in Australia, continental Europe, UK, US).
We next compare the implications of the RAB model with the traditional model in terms ofdelivery and operations.
Infrastructure delivery using the RAB model
The RAB approach generally allows all capital expenditure to be recovered (Frontier Economics
2010). This might suggest there are challenges to the efficiency of the RAB model of infrastructuredelivery with respect to getting the investment quality and delivery right. The next subsections explore
the evidence.
Quality and delivery approach
Under incentive based regulation, the investment plans (and the revenue required to finance thoseinvestments) are negotiated between the regulator and the network manager. (Alternatively, theinvestment plans can be seen as the result of an iterative game between the regulated company’s idea
and the regulators perception of the actual needs). In any case, it is the information asymmetries
between the two parties that make it very difficult for the regulator to establish with any precision theamount of investment needed to deliver a given output.
This arrangement can result in “capex bias” where the regulated infrastructure manager prefers acapital expenditure solution to an operating expenditure one8. This is because the regulated entity
gains more financially from pursuing capex solutions (where it is able to earn a rate of return) thanopex ones (where it recoups only the original expenditure). The bias can also result from the opex
regulation (benchmarking) regime being perceived as “tougher” than the capex regulation regime. This
problem has been identified by the stakeholders in the regulatory process (including the regulatedcompanies themselves (OfWatt 2011)). However, to date, no empirical evidence has been found tosupport the claim9.
The perception of a capex bias has prompted regulators to consider adjustments to regulation
frameworks. For instance, the UK has considered “totex” regulation, where the capex and opex are
targeted as single category, as well as 11 other options (OfWat 2011, 46). However, it is not clear
whether the incentive of capex bias can be fully removed.
The RAB model is likely to deliver superior life-cycle investments compared with the traditionalmodel. In the RAB model with incentive based regulation, design, construction, and operation are8

For example, investing in a campaign to raise the awareness of consumers with regard to waterpollution instead of building a new water treatment plant. The former would be recorded as operating
expenditure and the later as capital expenditure.

9

The concept is similar to the commonly known Averch-Johnson-Welisz effect, which suggested an
incentive to invest excessively in the capital assets as well. Its primary proposition states, that if aregulated firm is required to choose an output price to earn no more than an allowed rate of return,based on the level of installed capital, the firm will choose a capital-labour ratio which is higher at agiven output level, than it would have been the case without regulation. However, a recent review offound there is no or very little evidence to support its existence either (Law 2014). If these results are
accepted and one also accepts that a capex overspending incentive nevertheless exists, then a potential
explanation would be that there must be other incentives present, which offset the capex bias.

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bundled, so gains from building high quality infrastructure upfront would accrue to the regulatedcompany itself.10
Delivery efficiency
The procurement of new or improved infrastructure in the context of regulated network industries
is normally subject to general competition legislation. In practice, traditional procurement models (theDesign-Bid-Build contracts) or more advanced approaches, such as performance contracting or
alliancing may be employed. Current procurement practices and approaches of regulated companies in
network industries are not extensively surveyed in the literature. However, NERA (2004) reports mostutility companies in the past in the UK relied on subcontracting and/or in-house provision.
A central part of the economic regulation framework is ensuring that network manager’s capital
works are delivered at efficient costs. To target capital cost efficiency, regulators employ targets thatmean the regulated company earns rewards for meeting/undershooting the investment target at a given
level of output, or is penalised for missing the target.11 To assess the efficiency of expenditure,
regulators have at their disposal a number of tools, from benchmarking analysis, historical trends, tocost modelling techniques, among others. Full scrutiny of the capital spending (e.g. detailed
engineering audit on most projects) is generally not applied, due to the regulatory burden it would
imply, but regulators do track asset quality measures.
The regulator’s oversight of capital cost efficiency has its limitations. For instance, regulators arenever able to determine what part of any cost overruns, measured against the contract price orcompared to earlier estimates, was efficient or justified. Costs for benchmark projects can vary
substantially. To illustrate, Bain (2010) notes that for the road sector notes that outturn costs forresurfacing a dual 3-lane motorway by the British Highway Agency varied from £0.24 million to£0.70 million per km. Thus, while the instruments mentioned above are helpful, they neverthelesscannot completely address the information asymmetry between the regulator and the regulatedcompany.
Moreover, the risk of capital spending being adjudged to be excluded from the RAB might beperceived as a disincentive to investment from the private owners. It would therefore not be surprising
if a strong safety margin were applied to the regulator’s efficiency targets (in the past a pass-throughmodel was in place in the UK, where all capex cost was included in the RAB; NERA 2004). Thiserring on the side of cost inclusion provides further potential arguments against the cost efficiency
achievable under the RAB model.

10

Some potential caveats to this finding are: 1) that the interest of current investors might also be ofshort duration; 2) buyers of existing assets might have difficulty assessing the quality of past
investments and their influence on future operating cost; and 3) the regulator should not set the capex
efficiency (savings) target too low, or else the regulated company would invest insufficiently in theinfrastructure and substitute the meeting of current regulatory capex targets (avoiding the penalties)
for lack of operational efficiency in the future.

11

Menus of options may be applied. For example the regulated company may choose between a higher
capex allowance with lower retention rate and a lower capex allowances with higher retention rates. In
effect, companies, that believe they will have higher capex requirements that the regulator forecasted,
can choose a higher capex allowance, but the penalty for overspending above the allowance – i.e.
overshooting the target will be higher.

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Unfortunately, the paucity of publicly available data12 limits our ability to assess the extent towhich the argued limitations of the RAB model actually inhibit infrastructure investment delivery
performance in regulated industries. A rare example for the regulated sector is the study of Sovacool etal. (2014), which provides some data for the electricity transmission sector in terms of on time and on
budget delivery (Figure 2)13. They found cost overruns reported on 40% of the 40 surveyed projects,
which gives an average systematic cost overrun of 2.2%, or a total impact of USD 162 million, against
the estimated spend of USD 4.174 million.14 The performance of the RAB in this context compares
favourably with findings in the transport sector under traditional procurement, where the averageoverruns were 9% (Blanc-Brude & Makovsek 2013).
Figure 2. Cost overruns in electricity transmission projects in the USA in 2013

No. of projects

20
15
10
5
0
-40 ≥ -30 -30 ≥ -20 -20 ≥ -10 -10 > 00

0 ≥ 1010 ≥ 20 20 ≥ -30 30 ≥ -40

Project cost performance countSource: Sovacool et al., 2014.

Infrastructure operation under the RAB model
Operational efficiency under incentive based regulation is generally considered to be superior tostate owned companies without regulation. Privatisation under regulation can still further lead toefficiency improvements. However, challenges can arise in translating cost savings into improvedsocial welfare and in adapting infrastructure to changing market conditions.
Operational efficiency
Under the RAB incentive regulation framework, the approach towards operational expenditure
efficiency incentives is similar to those for capex expenditures (setting of targets, with penalties orrewards for meeting them) but more straightforward.
12

The lack of data is perhaps surprising given there should not be any business confidentiality
considerations, public money is implicitly involved, and the depth of the literature on traditional
public procurement (see section 2).

13

We note that the data set involves measuring a cost overrun against the budget as opposed tomeasuring against the procurement contract. In terms of construction risk, what is more relevant is thecost overrun, measured against the winning bid, which is a strongly related but different measure.

14

If the penalty for missing the capex target were very strong and the regulated company would incur asignificant cost overrun on some projects, it could attempt to reduce spending on the others, in spite ofpossible life cycle costing inefficiencies in the future, to avoid being penalised immediately.

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelIn the UK and elsewhere, the RAB is embedded in an RPI-X price cap regulation. The “X”
reflects a measure of inefficiency, which the regulator determines and applies on the annual allowed
price growth (RPI). The inefficiency adjustment is reset in regular price review periods, which
typically last five years or more. This adjustment for inefficiency also introduces a risk that theregulated company will not be able to recover its full operating costs if it does not perform its function
efficiently.
The determination of the X-factor for opex is in principle subject to the same caveat as
incentivising the efficiency of capex (i.e. a safety margin in setting targets), though the consequencesof inadequate incentives are more immediate and obvious than in the case of capex (e.g. a drop inservice quality or eroded financial results of the company). For the same reason the information
asymmetry challenges in this case are potentially smaller.
Operational efficiency is related to ownership, and there is a substantial volume of literature
available on the effects or privatisation, which focuses predominantly on performance of utilities(electricity distribution, water supply and sanitation), and less on transport. Gassner et al. (2009)
provide a literature review for industrialised and developing countries, which shows increases in
efficiency, work reduction and other measures of better performance. Under what circumstances these
improvements translate into better social welfare outcomes is not fully resolved, particularly fordeveloping and post-transition economies (Estache and Rossi 2002; Andres et al 2006; Andres et al2013).
The question of better social welfare outcomes, however, may be critically related to having aproper regulatory regime in place. More recent studies, such as Estache and Rossi (2010) explored a
representative sample of 220 electric utilities from 51 development and transition countries andshowed that the establishment of a regulatory agency did contribute to the increases of efficiency (andhence social welfare outcomes) and was robust to the effects of firm ownership. In addition, theperformance of private regulated companies was superior to the performance of state owned regulatedcompanies.
In the specific context of the RAB in an incentive based regulation framework, Parker (2004)
notes that regulation and privatisation in the UK, led to increased efficiency and reduced customer
prices as shown in the table below, with two controversial exceptions: the water and rail sectors.15

15

In the water sector the regulatory system was considered lax until 1999. After 1999 many regulatorychanges took place that led to a significant increase in the efficiency of water supply companies(Erbetta and Cave 2007). Certain water supply firms faced financial exhaustion, in part due toinappropriate regulation (Helm 2008). In the railway sector the results are also unclear. A study of arailway infrastructure manager Railtrack painted a mostly positive picture of the system’s efficiency
up until the period between 1999 and 2001, when three railway accidents happened (Pollitt and Smith
2002). Later research seemed to show that, statistically, the safety standards did not decrease as aresult of privatisation (Evans 2007). However, in reality there was no RAB, an insufficient overview
over the condition of the assets, and inadequate management within Railtrack, which prompted therailway regulator to write an almost a thousand page report on deficiencies with recommendations,just before the accidents. The government called for a strong tightening of safety, imposing hugefinancial burdens on the company which led to its bankruptcy and return to de facto state ownership.

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Table 1. Employment in price changes in Great Britain network industries around privatisation
Industry

AT privatisation
Number of employees, (year)

AFTER privatisation Number of
employees, (year)

Change in user prices% real1(time of study)

Electric power distribution

127 300(1990/1991)

66 000(1996/1997)-25 to -34%
(1990-1999)2

Telecommunications (British
Telecom)

238 000(1979/1980)

124 700(1999)-48%(1984-1999)3

Gas distribution

92 000(1986)

70 000(1994)-26%(1986-1997)4

Notes: (1) The figure is relative to the general price level, meaning the nominal drop was even greater.
(2) Measured in England and Wales.
(3) The decrease can also be attributed to technological progress and, indirectly, an increase in competition as aresult of privatisation.
(4) In the original text, ‟2.6% per year,” which would amount to 26.6% in 11 years; rounded down.
Source: Parker, 2004.

The evidence regarding privatisation of regulated network industries is not as clear cut as in thecase of competitive markets in the overview of studies in Meginson and Netter (2001). But the studies
that are available suggest that privatisation on a platform of effective regulation can have superiorsocial welfare outcomes when compared to state-owned enterprises.
Operational flexibility
An element of the RAB model that is implicit in the traditional model is the flexibility of thecontractual framework to negotiated changes. The RAB model under price cap regulation essentiallyrepresents a regulatory contract in the form of a licence – with a string of renegotiations (pricereviews).
A former chairman of the UK rail regulator, Chris Bolt argued that in terms of practical legal
execution, a licence allows for greater possibilities for modification than a formal contract (Bolt 2007,19). In practice there is a possibility for the regulator to refer a case to the Competition Commission ifchanges to the licence cannot be agreed. An essential part of the apparent adequacy of the process isthat it is clearly defined what is repaid and what is put at risk and in principle and the organisations
involved are independent from the government. The credibility of this process depends on thegovernment’s capacity to respect their independence.
Other value for money considerations for the RAB model
The financing cost at which the infrastructure manager can borrow money is suggested as one of
the advantages of this approach. On the other hand the returns or the reward of the investors has facedmuch scrutiny and has attracted considerable academic and consulting attention.
Cost of debt financing
The cost of debt financing under the RAB model appears to be higher than under the traditionalmodel, though not substantially. For instance, in the UK regulated utilities incur costs of debt
financing only slightly above the cost of government bonds. Recent estimates put this cost at around18

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1 percentage point above 10 year government bonds (see Box 5.1 in the next section). The low cost offinancing also implies that credibility (or indeed predictability) of contracts between governments andthe infrastructure managers is relatively good in the UK16.
When the RAB is an effective commitment device, renegotiations of regulatory contracts seemnot to have immediately obvious adverse effects (such as the ex-post higher costs of finance, which
would signal some kind of expropriation).
Estimating the appropriate returns to capital
Another central tenet of the RAB model is application of an appropriate overall rate of return on
capital that the network manager is allowed to make, i.e. the weighted average cost of capital(WACC). This part of the regulatory process is also typically negotiated between the network manager
and regulator, with estimates made by the regulator typically covering a range of values.
The importance of “getting the WACC right” lies in the incentives that come with this number. If
the regulatory allowed rate of return is greater than the company’s true cost of capital, then the firm
will substitute capital for the other factor of production and vice versa.
Regulators in the UK and Australia, for example, acknowledge their inability to accurately
estimate this parameter, and in practice tend to err on the upside and apply WACC values substantiallyabove the midpoint estimate of the range (Frontier Economics 2014). The reason for this is that thesocial welfare cost of underestimation of this parameter is argued to be greater than theoverestimation, as applying a WACC that is too low could lead to underinvestment (Dobbs 2011). The
recent UK experience gives some evidence of this bias in practice: for the Bristol Water determination,a range of 3.8% to 5.0% was estimated, and 5.0% was adopted; for water networks in England andWales, the range was 2.9% to 5.4%, with 4.3% adopted; for Stansted Airport, the range was 5.2% to
7.5%, with 7.1% adopted (Frontier Economics 2014).
An alternative solution to the risks of underinvestment from underestimating the WACC is to
apply a two-tiered WACC (“the split cost of capital”) (Helm 2008, 2009). This approach recognisesthat different components of investment (capex that is already there versus new capex) may havematerially different risks17. Separate returns for the existing RAB and for major new capital projects
could lead to a more efficient allocation of risks among investors, customers, and tax payers (e.g. ahigher WACC for new investment). The concept is not without challenges (QCA 2014; Cooper 2012;
NERA 2013), but some regulators are investigating whether it is possible to make use of it in moreaccurately determining the single WACC (which implicitly blends the risks related to existing RAB
and new infrastructure projects).
16

Compare this with the example of the French gas industry: “in September 2012, the Frenchgovernment announced that retail gas prices to individuals and small businesses would rise by 2%,even though CRE, the French energy regulator had stressed in the Journal Officiel that the increase
was insufficient and the increase to individuals to ensure cost recovery should have been 6.1%. GdFSuez may have a RAB, but it clearly did not act as an effective commitment device in this case” (Stern2013).

17

Helm (2008, 2009) has also argued that a single WACC potentially over compensates investors for therisks associated with the RAB. Due to the way the WACC is estimated by some regulators, it cancreate room for arbitrage. In the past this enabled owners of the infrastructure companies to extract
value from the companies, by increasing the gearing of the company through financial engineering.
The actual returns were thus (for a time) over and above the “allowed” revenue. This was not an
insurmountable regulatory problem; however, its current status is outside the scope of this paper.

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelAt present it is not immediately clear what the net effect of the incentives outlined above is forcapital expenditure, i.e. whether there is a bias for too high or too low investment, nor is there any
empirical evidence available to support either view.

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The Public-Private Partnership model

The previous section illustrated the workings of an approach where a monopoly infrastructure
provider faces incentives from an economic regulator, which mimics competition. Improvements ofoperational efficiency, compared to the traditional model are well established. The outcomes of
incentives in capital expenditure efficiency are however less clear. The Public-Private Partnership(PPP) model has a higher cost of financing and aims to achieve efficiency improvements throughcompetition for the contract. This section reviews the workings and evidence on the efficiency
performance of the Public-Private Partnership (PPP) model for infrastructure delivery and operation.
Overview of the PPP model
PPPs involve the financing of long-term infrastructure, industrial projects and public services
using a financial structure where project-specific debt and equity are paid back from the cash flow
generated by the project. PPPs can cover a wide range of other arrangements, including management
infrastructure concessions, though our paper covers only infrastructure project delivery and subsequent
infrastructure operation in network industries.
The essential feature of the PPP is the creation of a project company – a Special Purpose Entity(SPE). The SPE enters a long-term contract with the procuring entity to deliver and operate theinfrastructure. We focus here on the specific case where the SPE is a private company. The projectcompany is almost exclusively financed with debt, with equity of the shareholders representing aminor part (commonly around 10%). The shareholders may include financial investors and also firms
involved in project delivery and operation, as in the example in figure 3 below.
The main features that distinguish PPPs for infrastructure project delivery and operation fromtraditional infrastructure procurement can be summarised as:•

Service focus: the public-private agreement defines an output specification, i.e. what service
the project is meant to deliver, as opposed to what the project is (the input). PPPs commit the
public sector to pay the SPE a pre-agreed income, provided the required service delivery andquality criteria are met. Alternatively the public sector can commit by granting the SPE theright to collect revenues from the use of infrastructure .

•Bundling: all procurement phases from design to operations are bundled in one long-term
contract (e.g. the Design Build Finance Maintain Operate contract), which reduces the public
sector’s coordination role.

•

Risk transfer: lenders typically require a fixed-price and date-certain turnkey construction
contract. The public sector therefore effectively transfers the majority of the risks to theconstruction contractor.

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Figure 3. An example of a PPP model for infrastructure delivery and operation

Owner (developer)

SPE
Availability
payment/user charge

Equity investor
EquityTurnkey
contract(Potential) incentives ofcommon ownership

CLIENT

Construction
contractor
Debt
Lender-comfort
measuresService

Lenders

Source: Authors.

Governments have pursued the expected competition and efficiency incentives that flow fromthese main features of PPPs. The expectations above are also in line with the theoretical models (e.g.
Iossa and Matrimort 2012). The remainder of this section assesses whether the expected advantages
have been observed in practice and whether any weaknesses have emerged.
Infrastructure delivery using the PPP model
A central challenge in assessing the performance of the PPP model is the bundled nature of theoverall contract. This makes it difficult to compare the single price (or stream of cash flows) paid
under a PPP contract with the costs of a series of unbundled contracts (and on-going operating
performance) under the traditional model. Limited accessibility of data (in traditional or PPP
procurement) further hampers the comparison. The remainder of this section considers the available
evidence.
Quality and delivery approach
Blanc-Brude et al. (2006) found that for 227 road projects in the EU, the ex-ante construction
cost of PPP-contracted roads were substantially above the cost of those procured traditionally.
Makovšek (2013) showed that the costs for PPP-contracted road projects are actually also substantiallyabove those under traditional procurement, even when cost overruns are accounted for: an indicative
19% cost premium for PPPs was estimated. Daito and Gifford (2014) show, that the same costpremium in the US road projects is 64%.18
18This point is usually ignored in Value for Money assessments, when comparing the cost of the public
and the private alternative.

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The higher construction cost of PPP-contracted roads compared to traditional procurement could
be explained by the PPP partner choosing to invest in higher quality infrastructure. This decision
would be efficient if it reduced future maintenance costs and so optimised the lifecycle cost of the
project. However, this explanation does not account for the premium in the US being so much greaterthan in the EU (given that the nature of road construction cannot be substantially different on the tworegions). Moreover, there is little evidence to support the notion that PPP companies actually do invest
in more expensive infrastructure to optimise life cycle costs (or conversely, that this is systematicallynot the case in traditional procurement). On a declarative level there is a widespread embrace of lifecycle cost optimisation principles in PPPs in UK (Meng and Harshaw 2013), but there are practicalobstacles to its execution19. In an ex-post engineering study, the UK National Audit Office found that
PPP hospitals were not built to a higher standard than traditionally procured hospitals (NAO 2007) andthese would be subject to the same expected incentives as any other PPP.
Therefore, the higher ex-ante construction cost under PPP infrastructure contracts is not
explainable only by higher quality infrastructure that might be predicted from incentives for life-cycle
cost optimisation. We return to this issue in section below.
Delivery efficiency
Once a contract has been signed between the government and the SPE, PPPs have generally beenfound to outperform traditional procurement models for on-time performance in Great Britain (NAO
2003; NAO 2009) and Australia (Allen Consulting Group et al. 2007).
Relatively few studies have directly examined the on-budget construction cost performance of
PPPs. One study reports an average performance of on-budget delivery of a 4.3% overrun measured
against the “contractual commitment” estimate (Duffield et al. 2008). But this in itself is not
surprising, since the public sector still predominantly relies on “low powered” cost-plus contracts,
while the PPP model relies on (fixed date, fixed cost) turn-key contracts. That cost-plus contracts with
few incentives to reduce cost will be outperformed by turn-key contracts is consistent with economic
theory (Laffont and Tirole 1993).
There is no large volume of traditionally financed infrastructure procured through turn-key
contracts, so as to compare the PPP performance with the public sector procurement on a level playing
field. There is evidence that the cost performance of the traditionally financed Design & Build contract(where the two phases are bundled) can display superior performance in terms of on budget delivery(whereby the DB contract form still involves less powerful incentives than the turn-key form), whencompared to separate traditional DBB contracts (Ellis et al. 2007).

19

The study inferred the critical success factors from a survey with 52 responses (1) contractual
obligation and client driven optimisation; (2) good awareness and understanding of LLC; (3)encouragement of LLC through competitive bidding; (4) integration of all key stakeholders into WLC;
(5) early involvement of construction and FM teams in the design process; (6) well-establishedprocedures and methodologies; (7) reliability and accuracy of data; and (8) regular monitoring theimplementation of LLC. In the study lack of data and contractual incentives were also often cited as acause for the failure of the LCC

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Infrastructure operation under the PPP model
The PPP model is argued to deliver cost and quality advantages the traditional model during
operation through competition between bids before the start of the project.
Operational efficiency
For most infrastructure PPPs, prices are locked in with the contractual arrangement that wassealed, when the winning bidder was selected. Other than through the initial competitive process, there
is no in-depth scrutiny of the operating costs of the PPP.20
There is no research available that assesses the operational performance of PPP infrastructure
projects against a privatised regulated network industry operator or a state owned operator. But
because the private partner is profit driven, it is reasonable to assume that these projects areoperationally efficient.
The relevant question is whether this efficiency is necessarily passed to the users, i.e. whether
superior social-welfare outcomes are achieved relative to government operation. This question will be
unresolved until a sufficient number of PPP projects run their course and an ex-post analysis of theirlife-cycle cost (and benefits) will be possible.
In principle, an availability payment PPP model (where SPE revenue from the government issubject only to meeting service availability and quality measures) is very similar to incentive
regulation (where the regulated company’s revenue from users is subject to meeting the targets ofefficiency and service quality). However, a weakness of PPPs compared to the RAB approach is thelack of tools for the public sector to share gains from efficiency savings during the operational phaseof the project.
Operational flexibility
Long-term contracts are by their nature incomplete. Thus renegotiations may be an inherent
component of any long-term contract, including PPPs. In infrastructure PPPs, renegotiations have beenfound to be widespread (Makovšek et al. 2015).
Economists have not reached a consensus on the net impact of contract renegotiations in PPPs onvalue for money. The literature can be broadly split into two main positions. In one, the renegotiations
are viewed as having a negative impact by reducing the ex-ante efficiency gains from the bidding
process. Guasch (2004) reports that the majority of PPP contracts in developing nations (managed by
the World Bank) had been renegotiated within two years of the contract signing, predominantly to thebenefit of the private partner. Conversely, opportunistic behaviour by the public party is also possible,
which induces the risk of expropriation and increases the cost (due to the risk premium for
expropriation) for future projects. The second position is that renegotiations are a helpful mechanism
to respond to a changing environment under incomplete contracts (Saussier, 2014). It is impossible toforesee every eventuality over the next 20 years, so having this flexibility is valuable particularly if it

20

By contrast, some UK PFI contracts include a mechanism that gives the public and private participants
the opportunity after five or so years to renegotiate the prices of services relative to observed market
rates (NAO 2007). This approach is typically only applied to services that can be expressed in simple
terms, such as cleaning or catering. Core services, such as infrastructure maintenance in network
industries, are more complex and cannot be simply “market tested”.

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does not weaken the ex-ante commitment of the bidders or influence the future expectations ofinvestors.
A recent review of the causes and incidence of renegotiations around the world (Makovšek et al.
2015) found that renegotiations are not limited to countries with weaker institutional structures.
Predominantly, renegotiations result from the strategic behaviour of the public or the private
contractual partner or both. Governments have considered and put in place a number of measures toaddress renegotiations that undermine the economic purpose of the PPP. Some measures involve thedistancing of the PPP contract management from the government and the introduction of an
independent PPP regulator, which could deal with contract renegotiations in a transparent andsystematic manner. However, in a country with a large PPP portfolio the diversity of contracts andcontracted entities in a given country are likely to make the information, skill requirements and costsof a PPP regulator prohibitive.
Part of the problem of renegotiations is that public authorities have tended to prefer overly
detailed and prescriptive contracts to attempt to reduce the potential consequences of unexpected
events or behaviour of contractual parties (House of Commons 2012). Nevertheless, some PPP
contracts in the UK have proven to be moderately flexible, with some renegotiations being executedNAO (2008). More recently, modest savings have been achieved by the public partner in renegotiated
PPP contracts (NAO 2013). However, these savings are normally not the result of changes in coreservices and do not resolve the challenge of not being able to scrutinise operating costs, as described in
the paragraphs above. That being said, contract renegotiations are generally not seen as a problem in
the UK to the same extent as elsewhere (Makovšek et al. 2015).
Renegotiations of a PPP contract are invariably less structured than in a RAB model, primarily
because there is no economic regulator directing the process. Contract adjustments may be perceived
by the investors as an additional risk to be accounted for in future bid prices. As such, the possibilityof renegotiations can affect the cost of financing, depending on the ex-ante bargaining power of theinvestors, and the derived expectation that the contract will be upheld, renegotiated to their benefit orloss.
Other value for money considerations for the PPP model
Cost of debt financing
Debt makes up the large majority of the financing of most infrastructure PPPs (Yescombe 2014).
The financing cost of PPPs in UK is substantially above the cost of the government debt and thecompanies operating under the RAB model. Although estimates vary, an 8.5% cost of PPP financing
was illustratively estimated in 2011 by the House of Commons (2011, 16), when the government costof borrowing in the UK was 4%. Before the financial crisis, PPP financing was estimated at 2.4
percentage points above government costs (PWC & Franks, 2002). These estimates are relevant for
UK PFI models, which do not involve demand risk. Where demand risk was included, the additional
financing cost would be substantially higher.
Box 1 uses recent market data to compare the cost of finance across three infrastructure delivery
and operating models.

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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance ModelBox 1. Cost of financing in RAB and a PPP
To give a sense of magnitude, a regulated utility in the UK would typically have a rating of A and PPPs are
typically structured to achieve BB+ or BBB- (EIB 2012) or BBB (Yescombe 2014) on the Standard & Poor's
rating scale. Damodaran (www.stern.nyu.edu/~adamodar/pc/ratings.xls; accessed 7 May 2014) suggests A rated
debt attracts a spread above a 10 year government bond of 1.00% points. In comparison, a BB+ rating would
require a spread of 2.75% points and a BBB rating 1.75% points. Experience suggests that PPPs only achieve an
A rating 10 years after financial close (Moody's 2014).

Risk and return considerations for bidders
The PPP derives its efficiency in construction and operations through the competition for thecontract. However, the transfer of risk can be expected to decrease the number of potential bidders forthe construction and delivery of a given project. Lenders require strong insurance against construction
risks taken on by the SPE/construction contractor. These lender comfort measures include liquidated
damages for delay and performance, a full completion guarantee, and retainage.
Big projects and large risk transfers can only be accommodated by firms that can manage them(Blanc-Brude 2013). Evidence from 86 PPPs in the UK suggested that on average there were threebidders for each contract, and in a quarter of the sample, there were fewer than three bidders (Zitron2006). This relatively low number suggests that the risk transfer and/or contracting complexity may
limit the number of bidders participating in PPP processes.
PPP bidders essentially compete over the pricing of the risks to be accepted through the contract(as well as construction costs and techniques). To the extent that bidders do not have perfect
information on what is involved in the construction of the project or what will happen in the next 20 ormore years of its operation, bids will include a risk (aversion) premium. Competition among bidders is
supposed to reduce this risk adjustment to an efficient level. However, some recent research suggests
this is not necessarily the case.
High ex-post returns to PPPs, as well as the high ex-ante construction costs observed, provide
evidence against the argued efficiency of PPPs in terms of risk pricing. The UK NAO (2012) showedthat expected blended equity IRRs21 are substantially above those agreed at financial close in twothirds of the 118 surveyed PFI contracts. Vecchi et al. (2013) showed a similar finding for PFI
hospitals in the UK, where on average the blended equity IRR was 9.3% points (with min 4.5% andmax 17.4%) above the average financing cost for these kinds of projects (i.e. the WACC). Theysuggest that the main reasons for the higher ex-post IRR is the use of cover rates22 and lack ofcompetition in the bidding phase.
21

The equity stakes plus the subordinated portion of debt in the SPE end up in each sponsor’s balance
sheet. The remuneration for these investments is represented by the blended IRR of the SPE. Since
sponsors must assess whether or not the project will increase the wealth of their shareholders, they
will compare the blended equity IRR with their respective WACC (in simplified terms, WACC is an
opportunity cost for an investor for a given type of project/industry). If this difference is positive, theproject is economically attractive for each of the sponsors (Vecchi et al 2013, 248), with the expected
earnings above average.

22

Cover rates refer to internal corporate hurdle rates, which are higher than those that would be derived
from capital benchmarks and are reflective of the company’s (manager’s) risk aversion andinvestment policy.

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This “excess return” made by SPEs in PPPs compared to a traditional model could reflect theconstruction risks borne by the construction company, the risks borne by the SPE during theoperational phase of the project over several decades, or both. A further challenge is establishingwhether these excess returns to SPEs are reflective of additional risks borne (i.e. a “fair” risk
premium) or whether they reflect supernormal returns. The supernormal returns could be due to a lackof bidder competition and/or alternatively due to bidders attempting to price unquantifiable risk
(uncertainty) inherent in the structure of the PPP contract.

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Discussion

The RAB and the PPP models both employ a contractual structure that helps resolve the timeinconsistency problem with regard to infrastructure investment. A potential weakness of the RAB
based approach is the difficulty in establishing proper benchmarks and incentives for an efficientdelivery of infrastructure. There is also a need for an economic regulator. The challenge of the PPP
model is that it faces fewer incentives to deliver efficient social welfare outcomes and is potentiallyless flexible during the operational phase. In addition, PPPs have a much higher cost of finance thanthe RAB.
Overall the basic concern with regard to RAB in this paper is that the approach might lead toexcessive capital expenditures, thus slowly increasing the base on which the return is being calculated.
In the case of the PPP, the complexity of the projects and the long-period of contractual commitment
and uncertainty mean that it is doubtful whether competition will deliver efficient and low costinvestments. Put differently, in the case of the PPP, the basic concern is the required returns, andpotentially the base.
Currently available evidence seems to suggest that the concern relating to the PPP returns andcapex risk premiums by the construction companies are of a much greater magnitude than theperceived capex bias in the case of the RAB model. This capex premium in a PPP arises due to risk
aversion and transfer of construction risk through fixed price/date contracts. If a regulated company
were to use the same contracting approach, the same capex premium would be expected (for thetransferred construction risk).
The capex bias in the RAB model results from the regulated company trying to construct assets toa quality standard above that suggested by life-cycle costing optimisation or with cost overruns. The
role of the economic regulator is to attempt to curtail such excesses. An additional function of theregulator in the RAB model is to provide operational efficiency incentives to the infrastructure
manager. PPPs lack such operational efficiency incentives during the long lives of the assets, with
contractual changes generally only coming at a price to government.
In general, although it is clear in terms of efficiency that both approaches can outperform thetraditional model (primarily through the reduction of excessive employment), there is no researchavailable that directly compares the ex-post performance of the RAB model against the PPP.
Some researchers have considered how to expand the application of RAB principles in thefinancing of infrastructure, or how to combine the strengths of the RAB and the PPP models. For
example, Helm (2009, 2010, House of Commons, 2011) discusses the idea of “RAB finance”, where
the SPE would build the project, i.e. the construction phase would be delivered as a PPP, and atcompletion the regulator would decide which part of the cost is “efficient” and accept the asset into the
RAB. This would enable the refinancing of the construction phase loan with the (much lower) required
return on the RAB.
Under such a model, one way to help start the construction and execute the refinancing would bethrough the establishment of a national infrastructure bank23 that would channel the funds from23

The bank’s role would be to match savings (largely pension and life funds) with investments ininfrastructure projects such as those currently included in the PPP (PFI) contracts. The bank would

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institutional investors. This logic could actually extend to a range of projects or a network, which
would allow cross subsidisation across projects, and regulation during their operation, but that is
actually rephrasing what the RAB model already is. A (regulated) company is a multitude of projects,
running simultaneously, cross-subsidising each other and diversifying risk internally.
Suggestions made to date primarily focus on the RAB as a vehicle to lower the cost of financing,and do not go into greater detail with regard to incentives in either approach. A slightly adjusted
approach, could introduce the efficiency of infrastructure delivery from PPP into the regulated RAB,
without losing the efficiency incentives during operation.
Project RAB finance
It was noted in previous sections that in the infrastructure delivery phase within a PPP framework
one of the key determinants of good delivery performance is that the construction risk is fullytransferred via the fixed price/fixed date contract:•

There are multiple lender protection measures overlapping with ownership (money at risk)
incentives.

•

The due diligence of lenders potentially has a beneficial effect on the quality of projectdelivery and management (but there is no empirical evidence to support the necessity of this
aspect in light of other incentives for delivery efficiency).

Both characteristics of the two points above would be met if existing regulated companies
themselves established an SPE for the delivery of a large new project. It would then be financed by:•a majority of equity from the regulated utility, raised through corporate finance channels(e.g. through corporate bonds)•

debt from lenders to ensure the due diligence as in the PPP•

a small participation of the construction contractor in the SPE’s equity, the same as it would
be the case in the PPP to meet the money at risk criterion (Figure 4).

Once the construction phase is finished, the regulated company would buy out other shareholders
from the SPE and lenders and merge the assets into its existing RAB. The SPE would in this way
become just a temporary vehicle to imitate the incentives from a PPP for the delivery of infrastructure,
and would be re assimilated once the infrastructure is delivered.
The efficiency outcomes of such a setup would be easier to observe for the economic regulator,
since the responsibility for any potential cost overruns (apart from force majeure) could be clearly andtransparently allocated (e.g. scope changes during construction would clearly be the responsibility of
the regulated utility).
Under this arrangement, the incentives for asset life cycle optimisation would still be present andthe cost of finance would be minimised, due to the corporate financing through the RAB.

“buy” completed projects, put a RAB wrapper around them, and then sell them onto the pension andlife funds.
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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Model

Figure 4. An illustration of the Project RAB finance during construction
Owner (developer)

SPE
Equity investor

Equity(Potential)
incentives
common ownershipof

Turnkey
contract

RAB

Corporate financeConstruction
contractor

Lender-comfort
measuresService

Debt
Lenders

Source: Authors.

The structure above assumes a replication of the PPP incentive structure during the construction
phase. It is an open question, if this is actually necessary. As noted above and in our review, theefficiency incentives for the construction contractor are many and overlap. Potentially, a similar risk
transfer to the construction contractor and the use of fixed price/fixed date contract, with anarrangement, where his money would be at risk (e.g. like retainage) could possibly be achieved
without the SPE, with a construction performance contract only. In that way transaction cost would befurther reduced.

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Summary
The main findings of the overview of concepts and empirical literature are summarised below.
Table 1. Characteristics of alternative infrastructure delivery and operation models
Analysis element

Quality and delivery
approach

Delivery efficiency

Operational efficiency

Operational flexibility(renegotiations)

Cost of debt financeCompensation to equity
holders

Financing/management models compared
RAB
Project RAB finance
PPP(Incentive based regulation)(Incentive based regulation)
Project delivery
Challenged
Adequate
regulated company has strong
SPE has a strong incentive to
Challenged
incentive to consider future costconsider the future cost of(same as RAB)
of operation
operationrisk of capex bias
Challenged
Adequaterough target to be achieved inincentive present – if risk interms of on budget/time delivery
project delivery is not efficiently
Adequatesome part of cost overruns
managed, serious cost overrun(same as PPP)
passed on to the user/delay reduces SPE profit (maybecome unviable)
Project operation
Adequate
Challenged
regulator exerts an efficiency
no economic regulator means
incentive on the regulated
that social welfare outcomes are
Adequatecompany through detailed
determined at time of bid, which(same as RAB)
monitoring and periodic price cap
implies some inefficiency overreviews
the long run
Challenged
Adequate
contract renegotiations do not
periodic price reviews are aoccur within a clearly defined
Adequate
series of contract renegotiations
framework(same as RAB)
within a clearly defined
renegotiations typically involve
framework
costs to government
Other value for money considerations
Low
High
Low
Challenged
Challenged
limited risk transfer for
returns possibly too highconstruction allows for a strong(uncertainty, low competition);competition;
full construction risk transfer in
Challenged
performance contracts and fullconjunction with reduced(same as PPP)
risk transfer also possible;
competition between risk averse
over-estimated WACC may givecontractors leads to higher
equity bias
base cost

The Project RAB finance solution proposed above appears to offer superior incentives to the
traditional PPP. No examples of this exact approach have been encountered in practice, though asimilar project is currently in development, The Thames Tideway Tunnel24.

24

The Thames Tideway Tunnel (http://www.thamestidewaytunnel.co.uk/) is a £4.2 billion project inLondon, addressing a growing problem of tens of millions of tonnes a year of sewage spills into theriver. In the project the tunnel would be built as a PPP and placed into a RAB after construction,
becoming the subject of the same incentive regulation as the water utility company (Thames Water
Utilities Ltd), which will charge for it.

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The approach is not without limitations. In the network industries, where the Project RAB financecould generally be regarded as the preferred solution (for example, in utility networks, transport
networks and elsewhere), it might not be applicable to projects of all sizes and complexity. The risk
insulation in the latter case being the primary reason why project finance is used by private companies.
If the new project is very large in size and subject to considerable risk, then it could adversely
impact the investment rating of the company investing in the SPV, which may be unacceptable. This
would have probably been the case for The Thames Tideway Tunnel, which at the estimated £4.2
billion represented almost half of the regulated asset base of the utility company that could havesponsored the project.

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Conclusion

This has reviewed the empirical literature of two approaches to involving private finance ininfrastructure delivery and operation: the RAB (under incentive regulation) and the PPP model. The
area of focus is network industries, with some characteristics of natural monopolies, where the demandis beyond the infrastructure manager’s control. Both approaches were compared against the traditionalmodel, where the state procures and operates the infrastructure. The distinctive difference between
RAB and PPP is that the former derives its efficiency through the competition with the regulator,
while the latter does so through the competition for the contract. Our focus was on incentives andefficiency.
Overall the review finds that private participation has a strong ability to deliver value for money
beyond that delivered by the traditional model. However, there are concerns with respect to eachmodel.
The RAB is argued to lead to excessive capital expenditures (aimed at slowly inefficiently
increasing the asset base on which returns are calculated). The primary challenge is therefore theinformation asymmetry between regulator and infrastructure owner. While this argument istheoretically sound, the empirical evidence suggests this is either of an insignificant magnitude, or atthat regulatory monitoring is effective in curtailing this bias.
PPP contracts that bundle delivery and operations for complex projects over long periods ofcontractual commitment embed considerable uncertainty for prospective bidders and the government
counterpart. While the creation of a “one shot” PPP contract can be seen as a significant advantage forgovernment, it also creates major challenges. The risks and uncertainty transferred to the private sector
can limit bidder numbers and raise the cost of finance (and required rate of return) for those who dobid. PPPs also lack frameworks for encouraging operational efficiency or for renegotiation of changes
later in the contract’s life. Each of these aspects can detract from the value for money for governmentsthat engage in PPPs.
Solving the challenges of the PPP model tends to bring us closer to the RAB model, e.g.
establishing a regulator to manage contract renegotiations and benchmarking performance across a
range of PPPs. But if a country has a large portfolio of PPPs, this would be expensive to implement.
Instead, our findings suggest a relatively simple adjustment of the RAB model that incorporates theadvantages of PPPs in infrastructure delivery. This hybrid approach, which we dub “project RAB
finance”, may offset the vulnerability of the RAB model in the infrastructure delivery phase, while
possibly retaining the benefits in the phase of infrastructure management and the low cost of financeof the RAB model.
For most transport modes, the infrastructure assets are already in place (national road, rail
networks) so an option may be to put the existing network into a RAB under a newly createdinfrastructure manager. Performance/risk sharing contracts could then be used to deliver new
infrastructure, without project finance.
The conclusions from this analysis must be considered to be tentative. This is because there aremajor shortfalls in the data available to support detailed analysis of the effectiveness of the various
aspects of the different models. A basic question that cannot yet be answered definitively is whether
fixed price/fixed date contracts are at all an efficient way of delivering major infrastructure projects:
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Makovšek and Veryard - The Regulatory Asset Base Model and the Project Finance Modeldo the incentives for better management of the construction risk offset the lack of knowledge about therisk, the risk premium and the potential lack of sufficient competition?
At a time when many countries and organisations, including international organisations like theOECD, are promoting and facilitating private sector involvement in infrastructure development, thequestions about what form this involvement should take are critical. While we have been able to draw
some tentative conclusions, improved data and further research is required to better understand how
the preferred balance between the structure of the model, risk allocation, efficiency incentives, cost offinance, and the objectives of the regulator, is influenced by project characteristics.

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