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FUTURE-PROOFING INFRASTRUCTURE ASSETSBuilding capital-efficient infrastructure in the age of austerityA report by The Economist Intelligence Unit

1© The Economist Intelligence Unit Limited 2014

FUTURE-PROOFING INFRASTRUCTURE ASSETS Building capital-efficient infrastructure in the age of austerity

Contents

Introduction 2

Chapter 1: Focus on reducing costs 3

Chapter 2: The perils of cost cutting 6

Conclusion 9

2 © The Economist Intelligence Unit Limited 2014


There was a time when roads, railways, power plants and other forms of infrastructure were paid for straight from the public purse. However, in recent decades, the corporate sector has played an increasingly important role in financing, building and operating these assets—whether through full privatisation or public-private partnerships (PPPs). And since the global financial crisis and the recession that followed in its wake, the role of private capital has expanded further.

In an era of austerity, governments and companies have sought to increase infrastructure’s capital efficiency—that is, the ratio of its output to the capital expenditure needed to operate it. The challenge is to maximise the productivity of assets and minimise the costs associated with building, operating and maintaining infrastructure. This can be done in a variety of ways, including:

l Streamlining infrastructure portfolios with the help of cost-benefit analyses and by looking more broadly at project objectives;

l Building in flexibility of use and dynamic pricing;

l Considering the possibility of multiple-purpose assets;

l Using technology to improve design, planning and performance.

However, while these measures can cut costs and increase capital efficiency, focusing too intensely on cost cutting has its perils. Often, short-term savings can lead to additional costs over the lifetime of assets that may need to be in place for decades.

For this reason, it is critical both to make lifecycle assessments of the cost of operating and maintaining assets and to “future-proof” those assets by anticipating changes in patterns of use or growth in demand, thereby creating flexibility and the potential to add capacity.

This report will examine the tools and techniques that can help drive capital efficiency in infrastructure, as well as the business models and procurement arrangements that create incentives to rein in costs, while maximising performance and operational efficiency.

Introduction



In the US alone, the scale of investment required is daunting. More than 200m trips a day are taken across deficient bridges, according to the American Society of Civil Engineers, while 42% of major urban main roads are congested (costing an estimated US$101bn a year in wasted time and fuel) and much power infrastructure dates back to the 1880s.1 Around the world, as infrastructure-spending needs mount and government budgets and credit remain tight, attention is turning to capital efficiency.

An important part of this is assessing the returns on infrastructure assets. In financial terms, the returns on some assets—such as revenue-generating transport networks or power plants—are easier to measure than others, such as bridges or public roads. However, as well as financial returns, infrastructure assets need to deliver returns to society. Increasing the long-term performance and productivity of infrastructure is, therefore, another important goal of asset owners.

Public-private partnershipsFor governments, however, the first question is where to find the money to make the necessary investments. Public-private partnerships (PPPs) are one route to funding. These have been widely used in the UK. Between 1990 and 2006, for example, the country secured US$50bn for transportation infrastructure through this “best-of-both-worlds” funding model.2

PPPs have sometimes been accused of being far from equal partnerships, with private companies enjoying substantial financial benefits while

Focus on reducing costs 1taxpayers shoulder the burden of cost over-runs, or projects’ net returns failing to offer taxpayers good value for money.

Nevertheless, in an era of tight public finances and government austerity, the role of the private sector in providing infrastructure is widely accepted. “Throughout the West, there are going to be severe constraints on public funding for infrastructure needs,” says Wilson Magee, director of global real estate and infrastructure securities at Franklin Real Asset Advisors. “So, capital efficiency, almost by necessity, involves use of private-sector capital to provide these essential services in an environment where governments are unlikely to be able to.”

Institutional investors, such as pension funds, also play a part in advancing the capital efficiency of infrastructure by selecting the most efficient projects. “They have an influence by what they choose to invest in,” says Richard Robinson, head of civil infrastructure for Europe, the Middle East and Africa at Aecom, which provides technical- and management-support services to sectors ranging from energy to construction. “They are looking for cash flow, rather than rapid equity-value appreciation, so they are certainly a force for long-term thinking.”

Joining the dotsRegardless of the source of funding, companies and governments need to ensure that the design, construction and maintenance of infrastructure assets make the most efficient use of limited resources.

1 American Society of Civil Engineers, 2013 Report Card for America’s Infrastructure.

2 Engel, E., Fischer, R. and Galetovic, A., “Public-Private Partnerships to Revamp U.S. Infrastructure”, Discussion paper 2011-02, The Hamilton Project/Brookings, February 2011.



Part of this involves seeing assets as part of a portfolio and prioritising where to invest. Rather than constructing additional main roads, for example, investments in public-transport systems could reduce demand for roads.

A recent study by the McKinsey Global Institute estimated that, of the US$1trn in potential savings to be made in infrastructure globally, US$200bn would come from improved asset selection and streamlining infrastructure portfolios through cost-benefit analyses and by looking more broadly at project objectives.3

“We need to look at infrastructure in its entirety,” says Terry Bennett, a senior infrastructure strategist at Autodesk, which provides software to engineering, construction and other sectors. “One of the best things we could do is to have a single infrastructure vision that doesn’t separate roads and highways from other infrastructure things like water and sewers—because it all has to work together.”

Once infrastructure-asset owners take this joined-up approach, they can adopt another strategy that is critical to increasing cost savings and improving the productivity of their assets—building in flexibility.

For energy infrastructure, this might mean the capacity of a power plant to use several energy sources, whether moving from gas to coal when appropriate or feeding renewable sources, such as solar and wind, into the mix.

Road infrastructure can also incorporate flexibility. Multiple lanes, of different speeds, can be used to manage traffic flows. Dynamic tolling and other forms of flexible road pricing minimise congestion, while also generating revenue. “That makes it much more efficient for consumers and more productive for companies,” says Mr Magee.

In some instances, infrastructure can even be used for multiple purposes: fibre-optic cables can be laid along railway lines, for instance. And because cement plants, with their extremely

high temperatures, can be used as incinerators, municipalities looking for more efficient waste management might consider locating facilities near to cement kilns.

In San Francisco, an investment in energy-efficient street lighting to cut costs has led to a pilot project whereby wirelessly enabled lampposts are creating a communications network that could monitor everything from parking spaces to traffic lights. One futuristic venture, Solar Roadways, is even proposing to cover roads with modular solar panels.4

Technology drives efficiencyIn managing these increasingly complex, multi-purpose infrastructure projects, technology is playing an increasingly important role. First, private investors, such as pension funds, are now able to gain a clearer picture of proposed projects, since 3D-modelling software, such as building information modelling (BIM), can produce a visualised business plan as part of the initial proposal. Technology can then enhance efficiency of assets once they are operational.

“Investing in infrastructure has almost been a blind trust—you throw the money over the wall and hope someone manages it correctly and your project comes in on time and on budget, which often isn’t the case. BIM with associated visualisation, simulation and analysis can reduce that dramatically,” explains Autodesk’s Mr Bennett, a land surveyor and civil designer by training. “Now, with big projects, people can understand what the end result will be—so visualisation has been key.”

For those constructing and managing infrastructure assets, technology can be an effective cost-cutting tool and can improve performance and productivity. For example, according to the McKinsey Global Institute study, intelligent transportation systems for roads, railways, airports and ports can double or triple the use of those assets.5

4 Solar Roadways, www.solarroadways.com.

5 McKinsey, “Infrastructure productivity”, p. 50.

3 McKinsey Global Institute, “Infrastructure productivity: How to save $1 trillion a year”, January 2013, p. 5; www.mckinsey.com/insights/engineering_construction/infrastructure_productivity.



In power infrastructure, smart meters allow utilities to manage energy consumption patterns, cutting back on the use of more expensive “peaker plants”, saving large amounts of money. Lowering the pressure on the network through IT-enabled demand response also increases reliability.

In the US, for example, OG&E’s smart-grid programme—covering a service area of 30,000 sq miles in western Arkansas and Oklahoma—uses dynamic pricing and other tools that allow customers to manage their energy use. This reduces peak demand, deferring the need to build extra fossil-fuel power plants, avoiding associated operating costs of US$250m–US$300m net present value.6

Technology builds greater efficiency by making infrastructure assets more flexible. In the renewable-energy subsector, for example, a wind turbine will be more productive if its blades adjust themselves to changes in wind direction and speed, while solar panels generate more power if their angle shifts in line with the movement of the sun. “Those kind of things are innovative and really important developments, in which the private sector is typically a leader,” says Mr Magee.

Of course, the challenge—particularly in sectors such as power generation—is that, given the age of existing infrastructure, data often exist in siloes in different business units and reside in systems that are not interoperable. In many cases, much work remains to be done in streamlining these data sets, so that information can flow more easily across the enterprise, particularly as power infrastructure needs to accommodate increasingly diverse energy sources, from wind and power to the energy generated by electric vehicles.

New projects face fewer of the challenges posed by integrating technology into legacy systems. From the start of a new project, technology can be used to improve planning and design. BIM technology provides information on which to

base decisions, from construction through to operation and maintenance.

Using Autodesk’s software, for example, clients, contractors, administrators and others working on the expansion of the Panama Canal—designed to double its shipping-traffic capacity—can see the design in three dimensions, assess a range of options and make any changes before construction starts. Through 3D visualisation, companies and governments can cut costs and time spent at various stages of a project. First, with more accurate visual plans being submitted, planning approvals can be secured more quickly.

Moreover, when more efficient and accurate site designs can be created, a greater proportion of a project can be prefabricated. This saves time and generates less waste than building everything onsite.

Meanwhile, data analytics is increasingly being used for everything from highlighting complex risks before construction to helping identify potential weaknesses in aging infrastructure. At Carnegie Mellon University, the Advanced Infrastructure Systems group is researching ways in which computers, networks and sensors can be used to develop information modelling, advanced analytics and visualisation to improve the performance and reduce the lifecycle costs of traditional physical infrastructure.7

Computer modelling more accurately predicts schedules and costs, taking out much of the uncertainty that can deter investors.

Once assets are in place, technology is increasingly being used to track their performance in real time, delivering a picture of components that would otherwise be expensive, time-consuming or impossible to monitor. One example is water-delivery infrastructure. Using web-enabled sensors, companies can track the quality of water—including pH levels, turbidity and temperature—and detect leaks before they become severe, saving money on the repair of pipes and other network infrastructure.

6 VaasaETT for Ventyx and ABB, “Smart Grid: 2013 Global Impact Report”, 2013, https://www.smartgrid.gov/sites/default/files/doc/files/global%20smart%20grid%20impact_report_2013.pdf.

7 Carnegie Mellon University, Advanced Infrastructure Systems, www.cmu.edu/cee/research/ais-research.html [accessed on September 1st 2014].



For investors looking for assets that have attractive annual and long-term returns and relatively low volatility, short-term gains are of less interest than knowing their investments are being managed efficiently for the long term—from planning and construction stages through to operation and maintenance. Hence, despite the benefits of cost cutting highlighted in the previous chapter, an over-reliance on cost cutting to raise efficiency, at the expense of long-term planning, can be counterproductive.

Given the cost of maintaining assets with extremely long lives, Mr Robinson of Aecom stresses the need to consider the full lifecycle of infrastructure at the outset and to make up-front investments that save money later on. He cites the example of road maintenance, where investing in accessible lighting systems makes sense, given the cost of closing off a section of a motorway and installing temporary road signs simply to change a few bulbs. “Those costs are very significant,” he says. “In fact, the costs of the traffic management are probably equal to the costs of the work that’s being done.”

Certainly, cost cuts may look attractive in the short term, particularly if they are part of what is often referred to as “value engineering”—a systematic approach to providing the required functions of a project at the lowest cost. “In a project that’s not done well, cost cutting is sometimes hidden under value engineering,” says Mr Robinson. However, he explains, this approach can also create extra expenses in the long term.

Take power plants, which have to be regularly

The perils of cost cutting2dismantled and reassembled for routine and corrective maintenance. A company or utility might decide to save money on construction by minimising the size of the plot of land designated for the plant. Yet this could make the maintenance more expensive. “There are safety implications when a plant is hard to take apart; it takes longer to do it and you have to use more expensive equipment,” explains Mr Robinson. “So, you have successfully cut a few percent out of the capital cost by minimising the size of the plot, but you’ve built in a huge amount of downstream problems.” Avoiding this scenario means gaining a complete understanding of immediate investments, as well as future capital and operational costs.

The importance of future-proofingIf investors in long-lived assets are seeking reliable returns over a period of many years, it is essential that infrastructure projects can remain efficient and productive over the long term. This means that those assets must be future-proofed by predicting likely increases in demand and or changes in use patterns. “This is extraordinarily important,” says Mr Magee of Franklin Real Asset Advisors. “If you think about utilities alone, in the US, where you still have significant population growth, these utilities are having to build plants that require many years to construct. They need to anticipate demand trends that are well into the future—and these are huge capital investments, so this is a very delicate decision-making process.”

Of course, predicting the future with certainty and in detail is never possible. For this reason,



Mr Robinson again points to the importance of building flexibility into infrastructure assets—in this case, the flexibility to adapt them to shifts in demand or changed patterns of use.

An example is the construction of expansion options on a railway line to allow for any new lines that might need to run off the main line in the future. This means that, instead of having to shut the whole line down when modifying it—causing extensive disruption—operators can simply connect the new line to that spur. “That usually entails a bit of extra capital cost and, during the value engineering phase, those things can fall victim to the cost-cutting knife,” Mr Robinson says. “But that can be short-sighted because it can make it very expensive to modify that infrastructure in the future.”

Setting the right incentivesWhile using technology and making the right investments are critical to future-proofing infrastructure assets, so is developing procurement and ownership models that create incentives for companies to engage in long-term planning and investment. “Owner-operators, such as power companies, are more clearly incentivised to understand the balance of operating and maintenance costs versus capital costs, whereas a contractor might be asked to build a bridge at the lowest cost possible and then it’s handed over to a separate company to operate and maintain,” explains Mr Robinson.

One way of aligning incentives is through a public-private partnership (PPP) contract known as the design, build, finance and operate (DBFO) model. Here, the focus is on providing an operating service, rather than building an asset. In the UK, DBFO arrangements have been used extensively by the government’s Highways Agency. Contracts typically run for 30 years, with private-sector enterprises assuming responsibility for operating and maintaining a length of existing road and for building specified improvement schemes over the contract’s life.8

Another model—design, build and operate (DBO) —creates procurement arrangements, whereby a single enterprise designs, constructs and operates a facility (or makes improvements to an existing asset), while its ownership remains with a municipal water utility, for example.

Mr Robinson argues that these kinds of contracts create incentives to focus on efficiency and productivity. “It’s a push to bring those areas together and get companies to think about lifetime costs,” he says.

Environmental sustainabilityIn recent years, the environmental-sustainability agenda has also started to drive capital efficiency in infrastructure. With increasing stress on global water systems and pressure to reduce carbon emissions and waste, the owners and operators of everything from power stations to water-treatment plants are starting to look at efficiency through an environmental lens.

In the energy sector, government pressure to reduce use of fossil fuels and introduce more renewable energy into the power mix has led to the creation of regulatory carrots and sticks that influence the construction of power-generation infrastructure.

Meanwhile, pension funds and other institutional investors are becoming more keenly focused on the sustainability credentials of the companies and assets in which they invest. For example, more than 760 institutional investors, with more than US$92trn in assets now work with CDP, an investor-engagement non-profit organisation that measures companies’ environmental performance.9

While some might argue that the sustainability agenda adds a new layer of cost to the construction and maintenance of infrastructure, this is not necessarily the case. Companies participating in the CDP’s Carbon Action initiative found that carbon-reduction and energy-efficiency measures were generating an average

8 Highways Agency, UK Department of Transport, www.highways.gov.uk/our-road-network/managing-our-roads/operating-our-network/how-we-manage-our-roads/private-finance-initiatives-design-build-finance-and-operate-dbfo/about-design-build-finance-and-operate-dbfo-contracts/ [accessed on September 1st 2014].

9 CDP investor initiatives, https://www.cdp.net/en-us/whatwedo/pages/investors.aspx [accessed on September 1st 2014].



internal rate of return of 33%, or payback within three years.10

For Mr Robinson, resource and energy efficiency are simply part of effective infrastructure management. “Optimisation and efficiency

improvement is always something good engineers have done,” he says. “But, if the focus on the green agenda brings more opportunity for industry to do better, that’s got to be a good thing.”

10 CDP, Carbon Action, www.cdp.net/en-us/programmes/pages/initiatives-cdp-carbon-action.aspx [accessed on September 1st 2014].



Conclusion

Taking the long view

With governments and companies under pressure to make the best use of their limited resources, the temptation is to prioritise cost reduction. Certainly, optimising the capital efficiency of infrastructure assets—whether through use of technology or of integrated procurement models—will remain critical in an era of continued austerity and poor access to credit.

However, cost cutting has its perils if it creates increased expenditure down the line. And, while future-proofing infrastructure may require larger investments up front, a combination of pressures means this makes good business sense for both policymakers and companies.

First, demand for everything from energy to public transport is rising as the global population expands. Second, investors want greater certainty over their returns, as well as viability and environmental sustainability of their investments in the long term.

When put together, these pressures should focus attention on the right way to increase the capital efficiency of infrastructure—by taking into account costs over the lifecycle of an asset and making up-front investments that build in flexibility and future-proof that asset for growth.

While every effort has been taken to verify the accuracy of this information, The Economist Intelligence Unit Ltd. and HSBC Bank Plc cannot accept any responsibility or liability for reliance by any person on this report or any of the information, opinions or conclusions set out in this report.

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