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4. Legal Structures and Frameworks

© New York University/Stern School of Business, CC BY 4.0 http://dx.doi.org/10.11647/OBP.0106.04

Numerous legal and regulatory issues arise in infrastructure finance, often creating barriers to project development. The most important involves securing a grid of space that can support at least the trunk lines for any networked infrastructure. Other issues concern the clear definition of property rights and the enforcement of long-term contracts with constituencies such as customers and organized labor. A diverse range of social concerns also arises, such as privacy for communications network users or safety for residents who live near nuclear power plants.

As discussed earlier with respect to environmental sustainability, non-economic issues are usually reflected in regulation of infrastructure projects. Such issues have become prominent and seem likely to grow further in influence. They help drive not only the sources of financing but also the key risk profiles of projects through completion, operation, and market or off-take conditions.

4.1 Land as a Key Issue in Network Infrastructure

Because a landowner holds a monopoly regarding the land’s use in a grid that passes through the property, neither a government nor a private party that wants to acquire land for grid-based infrastructure can rely on purchases in a competitive market.

In places where private individuals have extensive property rights to land, eminent domain offers a mechanism for acquiring land that is not subject to unlimited monopoly distortions. In places where individuals lack such de jure rights, they may still have de facto rights that present the same impediment to the construction of a new network, and a process analogous to eminent domain may still be necessary. Even in places where the government retains both legal and de facto rights over key uses of land, some compensation system may still be required when a government exercises its right to build a network on specific parcels.

Any such process will be easier to implement if private individuals have not yet made large, site-specific durable capital investments on a parcel of land where a network will be located. For this reason, it is efficient for a government to decide the location of a grid of public space before private-sector development takes place, especially in advance of the extensive capital investments that characterize urban development.

One successful example of this kind of sequencing is the Commissioner’s Plan of 1811 for New York City. It laid out a grid of public space for infrastructure on the undeveloped agricultural land of Manhattan above what is now known as Houston Street. This grid extended all the way up to 155th Street. Without even exercising the right of eminent domain, this plan notified landowners that when the streets and avenues were eventually developed, the landowners would not be compensated for the structures built after the plan was implemented on land where a future street or avenue would be located.

One of the reasons why the Commissioner’s Plan was so successful is that it specified a generous allocation of public space for infrastructure, more than 30% of the surface area of the land (not including land devoted to parks and open space). In addition, the plan allowed for a temporal separation between the specification of the land that would be used for infrastructure and the actual expenditures that would eventually be required to build the infrastructure. In fact, it took nearly 100 years for sidewalks and roads to be built on all of the grid’s streets and avenues.

Public land is essential to the grid of network infrastructure needed to support urban life. Organizations such as the Urbanization Project at NYU Stern are helping fast-growing cities in the developing world follow a version of the planning approach that worked so well in New York City. To make the task more manageable, the process lays out in advance only an arterial grid with a separation between trunk roads of about 1 kilometer. These arteries should allow roads between them wide enough so that, in coming decades, they can support both passenger buses and other vehicles as well as the subsurface locations for water and sewer mains.

Different states vary substantially in their capacity to assemble land for new network infrastructure projects. Compare, for example, two former British colonies: Singapore, which has an unusually aggressive eminent domain law, and India, where historically it has been difficult for the government to use its legal right to eminent domain. Singapore today has perhaps the world’s finest infrastructure, whereas India’s infrastructure remains chronically underdeveloped relative to the country’s needs.

This variation is not highly correlated with the level of development that a country can attain. The major infrastructure projects completed on time and on budget in China or France would be almost unthinkable in the US today, where even the redevelopment of obsolete and even dangerous infrastructure can involve years of debate, approvals, impact statements, legal challenges and appeals, and other blockages. If infrastructure is important, part of the US growth slowdown during the last decade (the slowest economic recovery since 1949) could be attributed to special interests scrapping over slices of a stagnant pizza rather than pouring political and economic effort into baking a larger pie and sharing the gains. American infrastructure development today seems to be decentralized and localized — coupled to federal support and commercial projects in the private sector — with the 1956 Eisenhower-era Interstate Highway System the sole postwar “grand design” initiative.

4.2 Ownership

A central legal issue in infrastructure development concerns the choice of ownership. Classically, infrastructure projects have been owned and financed by governments, at either the national or municipal level. In the past 30 years, however, privatization and investor ownership have emerged as a strong worldwide trend in projects as diverse as water systems, toll roads, tunnels, and power generation. Some projects use a mix of public and private partnerships (PPPs), indirect subsidies such as land grants, or the award of long-term franchise rights to a private operating company.

Private infrastructure ownership creates moral hazard problems related to long-term maintenance and risk taking. Private owners also benefit from a “holdup” problem, because they know that governments will provide bailouts for troubled entities as a result of their enormous positive externalities.

At the same time, private equity capital tends to view infrastructure projects as poor collateral, because such projects usually cannot be relocated or repurposed. Private owners put little value on residual claims. Some of the most spectacular financial infrastructure failures in advanced economies, such as Enron in the US or the Eurotunnel in Britain and France, can be attributed to high-risk, short-term infrastructure management strategies by private operators.

Although ownership choice can be viewed as a purely economic problem, in practice it is often clouded by political considerations. Two of the most obvious are nationalism and homeland security. Many countries require local ownership of infrastructure as a platform for showcasing the society’s achievements whilst also providing employment opportunities for construction trades, engineers, professional managers and the politically connected.

Moreover, assets such as ports and electrical grids are deemed “strategic” and ruled off-limits to foreign ownership. For example, the US refused to allow Dubai’s sovereign wealth fund to invest in American East Coast ports in 2006, and Greece strongly resisted control of its Piraeus cargo facilities by the Chinese state-own shipping giant COSCO until there was no longer a realistic alternative. Even when international or domestic private ownership is permitted, expropriation risk of infrastructure remains a clear issue. There is a long history of nationalizations and expropriations in sectors such as energy and transportation around the world.

The communications infrastructure industry has become an interesting focus of increased public oversight in the emerging era of “big data”. Telephonic and computer networks’ potential for use in government surveillance has stimulated debates about tradeoffs between privacy and law enforcement, especially in the advanced Western democracies.

In an age of terrorism, the potential value of surveillance and deterrence is unknowable, and people differ widely in the value they place on privacy versus security. So classic cost-benefit analysis is hard to apply. Both government and private communications infrastructure operators, who may have little business interest in these issues, find that complying with politically driven information-access regulation can become costly and raises difficult reputational questions, especially when human lives are at stake.

4.3 Regulation of Pricing

Many infrastructure projects become monopolists in a market for public necessities, and as a result they tend to face rate-of-return regulation. The pitfalls of the regulatory process almost certainly deter private investors from committing capital to long-term infrastructure projects. Modern pricing and monitoring systems, such as variable intraday pricing for electrical use or congestion-based highway tolls, offer great promise in this area, but politicians and the public often resist them. People do not like to pay market prices for infrastructure services, preferring to pass the true cost to others through the fiscal system. Some countries have overcome this blockage much better than others.

Regulators’ goals can be complex and change often, as tradeoffs occur between delivering acceptable risk-adjusted rates of return to investors and affordable services to the public. Often this process is compromised by political gatekeepers who see an opportunity for graft, as well as labor unions that have the power to alter consumer pricing by threatening to shut down infrastructure that provides key public goods.

Infrastructure operators’ ability to enforce contracts in order to collect revenue from their customers is often dubious. For example, theft of electrical power is an endemic problem for utilities worldwide, because of the ease with which customers can splice into a system as well as the difficulty for operators of identifying the perpetrators and beneficiaries. In impoverished cities and states, governments are loath to allow utilities to disconnect water or electricity for citizens who cannot pay their bills — in the US this was a major issue in the municipal bankruptcy of Detroit, to cite one well-known example.

4.4 Labor Relations

Organized labor plays a strong role in operating and maintaining infrastructure, especially in the transportation sector. Unions have been very successful in industries such as air travel and public transit because of relatively inelastic public demand for these services, as well as the fixed nature of many of the facilities (making union organization easier) and regulatory barriers to entry. The public necessity of these services has often created public political pressure to accede to union demands.

Inefficient operating practices and inflated wage structures have often resulted from union power, undermining transit systems’ ability to maintain their capital stock and deliver services. Infrastructure operators may enjoy special legal protections against labor issues, such as bans on the right to strike or the ability to invoke government mediation. Sometimes even these protections are violated. For example, labor disruptions in public transport occur routinely in some European countries including strikes by unions that represent essential professions like air traffic controllers. The resulting revenue shortfalls and operating cost increases cast a shadow over competitive financing in debt and equity capital markets.

Labor relations play much less of a role in other infrastructure sectors such as electrical power and water delivery. These industries are much more capital intensive and in some sectors the role of labor has greatly diminished over time because of technological innovations, such as the containerization of shipping and the automation of highway toll collection.

4.5 Public Health and Safety

Because of their daily impact on the general public, infrastructure operators face some of the strongest public safety regulations of any industry. Active government oversight of the supply of infrastructure services is widely viewed as necessary to ensure the purity of drinking water, the security of transit passengers, and the safety of citizens who live near gas-fired or nuclear power plants. Other controversies, such as the purported dangers of living near high-tension power lines, pose theoretical threats that remain unproven but typically face a high degree of public risk aversion.

The implicit costs of public safety regulation have always affected the calculus of infrastructure projects. In recent years, the increased threat of terrorism has adversely changed the economics of transportation worldwide. Sectors such as water and electric power appear to have suffered less from regulatory drag, although in principle these arenas may be even more inviting for politically-driven disruption.

4.6 Environmental Regulation

Environmental impacts have long affected the economics of infrastructure projects — and hence their financing. Negative environmental externalities of such projects clearly need to be internalized, and these costs will be passed along to end-users and providers of capital. There is no free lunch. Under the well accepted “polluter pays principle”, the resulting price and cost changes associated with environmental policy can lead to structural changes in consumption and resource allocation. How to best implement this principle is arguable, and the options range from physical pollution constraints to markets for environmental permits. But the so-called “general-equilibrium effects” on the economy — working with, not against, market forces — offer the best prospects for achieving optimal solutions.

Problems occur when environmental policies result in changing goalposts, generating additional risks for those providing capital to infrastructure projects and in some cases causing significant delays and cost overruns. Environmental impact assessments, in turn, can be heavily politicized and captured by “not in my backyard” advocates, sometimes blocking infrastructure projects altogether. Such assessments can also differ dramatically among countries, so that major infrastructure projects developed in, for example, France or China might be impossible in the US.

Increasing environmental regulation to address climate change likewise seems poised to become a critical legal problem for both new and existing infrastructure projects. Some facilities, such as coal-fired power plants, may be forced into obsolescence despite their economic viability. Other types of projects, such as those in mass transit or “clean” energy, may benefit from legal and political subsidies that increase their attractiveness to investors and local governments. International treaties and carbon trading schemes may upend the legal and financial basis of many infrastructure activities in coming years.

Developing environmental regulation of infrastructure seems as uncertain as it is important. Regulatory evolution may profoundly affect diverse entities such as water utilities in the southwestern United States and coal-fired power plants in China, whilst also influencing national decisions about the optimal amount of highway construction or commitments to nuclear power. The policy tradeoffs are extremely difficult — likely global warming from CO2 emissions versus extremely low-probability accidents in zero-emissions nuclear facilities.

Taken together, the benchmarks for constructing and operating infrastructure will likely continue to expand the emphasis on environmental impact alongside customer service, public safety, and returns to investors. Assessing the associated benefits, costs, and risks will continue to increase the complexity of access to investable capital.