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Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects (2015)

Chapter: Chapter 5 - Key Considerations in Rail Funding and Financing Decisions

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Suggested Citation:"Chapter 5 - Key Considerations in Rail Funding and Financing Decisions." National Academies of Sciences, Engineering, and Medicine. 2015. Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects. Washington, DC: The National Academies Press. doi: 10.17226/22149.
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Suggested Citation:"Chapter 5 - Key Considerations in Rail Funding and Financing Decisions." National Academies of Sciences, Engineering, and Medicine. 2015. Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects. Washington, DC: The National Academies Press. doi: 10.17226/22149.
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Suggested Citation:"Chapter 5 - Key Considerations in Rail Funding and Financing Decisions." National Academies of Sciences, Engineering, and Medicine. 2015. Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects. Washington, DC: The National Academies Press. doi: 10.17226/22149.
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Suggested Citation:"Chapter 5 - Key Considerations in Rail Funding and Financing Decisions." National Academies of Sciences, Engineering, and Medicine. 2015. Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects. Washington, DC: The National Academies Press. doi: 10.17226/22149.
×
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Suggested Citation:"Chapter 5 - Key Considerations in Rail Funding and Financing Decisions." National Academies of Sciences, Engineering, and Medicine. 2015. Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects. Washington, DC: The National Academies Press. doi: 10.17226/22149.
×
Page 38
Page 39
Suggested Citation:"Chapter 5 - Key Considerations in Rail Funding and Financing Decisions." National Academies of Sciences, Engineering, and Medicine. 2015. Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects. Washington, DC: The National Academies Press. doi: 10.17226/22149.
×
Page 39

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34 Key Considerations in Rail Funding and Financing Decisions C H A P T E R 5 5.1 Public Benefits vs. Private (Financial) Return Every rail project is unique, and so too are the financial dynamics and associated funding and financing needs. Nevertheless, principles can inform rail funding and financing decisions and the associated funding and financing mechanisms that can be used. Perhaps most significant among these is the project’s intended purpose. The public and private sectors have very different motivations for undertaking rail projects. Generally speaking, the former is focused on enabling public benefits and minimizing negative externalities, while the latter is focused more strictly on private (financial) returns. Figure 5-1 helps illustrate this point. In considering the funding and financing needs of a particular rail project, a useful first question is the following: Is the rail project and/or service driven primarily by a public benefit rationale, a private (financial) return rationale, or a combination of the two? The extent to which a rail project is driven primarily by a public or private rationale will, in many respects, pre-define the project’s funding and financing requirements and the associated motivations of those making financial contributions. For example, given that most passenger rail operations in the United States do not generate sufficient revenue to cover their operating costs, the public agencies that support these services make funding decisions based on an assess- ment of the public benefits these operations generate, as well as other considerations. Private freight railroads, on the other hand, make financing decisions based on the anticipated financial returns of a project given the estimated risk for a project and the company’s financing capacity and overall strategy. The public benefits vs. private (financial) returns rationale for a rail project can be summa- rized in a Public/Private Return on Investment Continuum, as represented by the vertical arrow in Figure 5-2. This provides a simplified depiction of what public vs. private sectors typically seek from their rail investments, as well as the associated typical mix of public funding vs. private finance along this continuum. At one extreme, projects with a largely public rationale (e.g., commuter rail service) will be justified on the basis of whether or not the allocation of scarce public resources would yield sufficient public benefit to justify the investment (often assessed on the basis of benefit-cost analysis relative to other public investments of funding demands). At the other extreme of the continuum, projects with a wholly private (financial) rationale (e.g., most freight rail operations) will generally be justified on the basis of whether or not the allocation of private resources would yield sufficient return on investment (often assessed on the basis of financial rate of return rela- tive to other investment opportunities).

Key Considerations in Rail Funding and Financing Decisions 35 Source: CPCS Figure 5-2. Public vs. private return on investment continuum. Figure 5-1. Illustrative examples of public benefits vs. private (financial) returns. Source: CPCS Public Benefits Public benefits - Public service - Mobility/accessibility - Regional economic devt. - Regional compeveness - Job creaon, etc. Negave externalies - Road congeson - Emissions - Road maintenance - Other social costs, etc. Private (Financial) Returns Return Risk Adequate Return on Investment Given Level of Risk Risk/Return Profile

36 Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects Funding and financing decisions become more complex when there is both a public and private rationale or interest for a project and related expected returns from the investment in question (overlap area along the Public-Private Return on Investment Continuum), but where neither public nor private sectors, on their own, can justify the investment strictly in terms of either public benefits or financial returns, respectively. A shared passenger and freight corridor project is an example of a project with the potential for both public and private benefits. Another is a grade separation project, which will improve the fluidity of freight operations and minimize disruptions to road users simultaneously. Like- wise, where projects may be paid for with a combination of public and private money (e.g., PPPs) there must be an appropriate balance of public and private risks and benefits. 5.2 Other Motivations and Interests in Funding and Financing Rail Projects Other factors, beyond a strict consideration of public cost-benefit analysis or risk/return, contribute to rail financing decisions. Rail project financing is also driven by the institutional, commercial, and sometimes personal motivations and interests of project decisionmakers. These motivations and interests in turn influence if, how, and under what conditions a rail project pro- ceeds, including whether or not it can be funded. For a rail project or service to proceed and succeed, the motivations and interests of all key actors involved must be substantially satisfied. Table 5-1 provides a summary of key actors involved in or otherwise influencing the feasibility of financing rail projects generally, along with their respective motivations and interests. Private-Sector Rate of Return Expectations for Rail Projects Generally, private rail entities look for project investments to generate returns of 15% or more and the cost of financing such projects is typically less than this. Class I railroads have a computed regulatory cost of capitala of about 11%. Private investors usually insist on a higher return than the cost of capital, because of the risk that the project costs will turn out to be higher or the returns less than expectations. Most U.S. Class I railroads have internal rate-of-return hurdle rates (the projected return on investment that a project must earn to be included in the railroad’s discretionary investment program) in excess of 15 to 20%. When projects offer a lower return, they are typically deferred or cancelled in favor of other projects offering higher returns. In some cases, rail investments may not have an internal rate of return but are required to meet regulatory requirements to remain in business. a The regulatory cost of capital is computed each year for U.S. Class I railroads using specified regu- latory accounting standards. For 2010, the regulatory cost of capital was 11.03% and included an average cost of debt of 4.61% and an average cost of equity of 12.99% with an industry capital structure of 23.38% debt and 76.62% equity. This compares to a rate of return on net investment of 10.36% based on the same regulatory accounting standards. This difference indicates that, from a regulatory point of view, U.S. Class I railroads earn less on their investments than their cost of capital.

Key Decision-Makers Driving Movaons/Interests Rail Project Funding/Financing Decision Criteria Public Sector Government Federal State Municipal/Regional Maximizing public benefits (e.g., improved intercity rail) Minimizing negave externalies (e.g., congeson and emissions) The risk of project success/failure Polical level Funding availability Pricing policy Public benefits (e.g., economic impacts) jusfy investment Priorizaon of project vs. alternaves Project size/risk profile Public support for project (votes) Financing capacity and ability to aract grants, increase taxes Administrave level Budget/funding availability Necessary approvals (e.g., environmental assessment and procurement process) Polical constraints Pricing and regulaon policy Public Railroad Companies (e.g., passenger operators) Achieving mandated public policy objecves Access to funding/level of support provided by public sources Private Sector Private Railroad Companies (typically freight) Growth in profitability Other strategic interests (network expansion) Return on investment (ROI) in line with company expectaons Investment risk profile (e.g., long-term revenue assured) Financing capacity, access to finance/cost of capital Shareholder support Shareholders/capital markets Return on investment (share price, dividends) Large instuonal investor/shareholder Consistency with investment strategy/ horizon ROI in line with fund expectaons Relave aƒracveness of alternave investment opons Retail investors: Passive investors (limited direct influence) Lenders/Banks/Bond market Return on loans Creditworthiness of borrower Securing risks Recourse to assets in event of default Suppliers Business growth, profitability New/expanded business on which margins can be generated Security of and risks associated with revenue stream Assessment of project risks and risk profile of cash flows • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • Availability of alternave growth opportunies Table 5-1. Summary of rail project actors and their primary motivations, interests, and funding/financing decision criteria.

38 Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects 5.3 Funding and Financing Strategies to Achieve Desired Outcomes Notwithstanding the other considerations and motivations that drive rail project funding and financing, the extent to which a rail project or service is expected to have a net public benefit or a net private (financial) return is a useful basis for assessing funding and financing requirements. To illustrate, rail projects and services can be plotted on a simple two-by-two matrix, representing net public benefits on one axis, and private (financial) return on the other (see Figure 5-3). In Figure 5-3, “net” denotes whether the overall public benefits or financial returns for a project are positive or negative. Rail projects or services falling into the bottom left quadrant, with neither a positive public benefit nor a positive private return, do not make any sense to undertake. Generally speaking, these projects should not be funded by the public sector (and will not be financed privately). Projects or services falling into the upper left quadrant could generate net public benefits, but require funding support to be financially viable and will not otherwise be financed. Projects or services falling into the bottom right quadrant, which provide a net private (financial), return are commercially viable and can be financed privately. These projects neither require nor warrant public funding given that their ends are private returns rather than public benefits. At the same time, the net public dis-benefits will need to be compensated for (through taxes or charges) to ensure that the public at least breaks even. Lastly, projects or services falling into the upper right quadrant could generate net public benefits and private (financial) returns. Such projects or services can be financed privately, but can also warrant public funding support or other interven- tion if such support could increase the net public benefits. Figure 5-4 suggests a basis for the use of rail funding and financing mechanisms and provides insights into how certain funding and financing mechanisms could help shift rail projects or services from one quadrant to another to increase public benefits, a project or services financial viability, or both. This framework, though rudimentary, provides useful insights on what kind of alternative funding or financing mechanisms may be most appropriate given where a particular project or service falls in Figure 5-4. Figure 5-3. Net public benefits vs. net private (financial) returns. ( ) Net Financial Returns Net Public Benefits (+) Private financing, against future operang revenues (e.g., U.S. Class 1 Freight Line) Operang revenues insufficient to cover project costs, insufficient public benefits to jusfy public funding support (Project should not go ahead) Can be privately financed, but potenal to increase public benefits further with public funding support Public funding support to address funding gap, realize project and related public benefits (e.g., commuter rail services) ( ) (+) Source: CPCS

Key Considerations in Rail Funding and Financing Decisions 39 Figure 5-4. Use of funding and financing mechanisms to increase public benefits, financial viability, or both. Source: CPCS (-) Net Public Benefits (+) (-) (+) STOP Mechanisms to decrease public costs (e.g., taxing emissions regulang tariffs, safety) Mechanisms to increase financial viability (e.g., grants, subsidies, concessional lending) Mechanisms to increase both public benefits and private returns (e.g., cost sharing corridor improvements, shared corridors) Net Financial Returns

Next: Chapter 6 - Alternative Funding and Financing Mechanisms for Rail Projects and Services »
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TRB’s National Cooperative Rail Research Program (NCRRP) Report 1: Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects identifies alternative funding and financing tools that can be used to realize passenger and freight rail project development, including capital investments, operations, and maintenance. The report summary is available online.

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