The Perils of Private Infrastructure

It is becoming increasingly obvious that the Trump Administration is incapable of pursuing any coherent, sustained legislative strategy. The Administration was unable to play any useful role in fashioning a viable “repeal and replace” health care bill, and it seems equally clueless on the other big agenda item, tax reform. Seeing the Republican legislative machine stall out on those two priority items does not auger well for a third Trump initiative that was once thought to hold some bipartisan appeal: infrastructure spending. That is probably just as well, since any wide-ranging infrastructure bill coming from this Administration and Republican congress would likely be an ideological monstrosity that would entice little Democratic support.

An infrastructure program is, however, more suitable to a piecemeal approach than is health care or tax reform, so it is likely that some sort of  new infrastructure policy emerges over the next eighteen months. Trump’s first budget programmed $200 billion over ten years to implement his infrastructure program (while cutting the Department of Transportation’s budget for the coming year by 13 percent). A fact sheet outlined some of the principles that will guide infrastructure policy.

The Trump infrastructure program will invariably seek to maximize the private-sector role, although the Administration’s fact sheet only hints at that direction with proposals such as removing the cap on private activity bonds. Administration officials are also touting the concept of “asset recycling,” whereby government agencies sell existing public infrastructure to private operators and use the proceeds to invest in new infrastructure projects.

The notion of private firms providing public infrastructure is polarizing, with conservatives portraying public agencies as inherently corrupt and inefficient and the left portraying private operators as inevitably predatory. In reality, the economic infrastructure of the United States has always been a patchwork of private and public operations and whatever prevails in a particular region tends to be taken by its residents as the natural state of affairs. Most passenger rail transportation, for example, was originally developed by private firms but virtually all of it was eventually taken over by government entities. Similarly for water supply systems, although about one-quarter of the U.S. population is still served by private water. Conversely, about 70 percent of American households buy their electricity from private, investor-owned firms. Roads and highways, and commercial airports, have always been developed and operated primarily by governments.

In recent years governments have explored privatizing, or re-privatizing, some infrastructure or contracting with private firms to operate it. Encouraging privatization appears to be a key part of the Republican infrastructure agenda, and that will be controversial enough. Even more problematic, though, will be efforts to incentivize the private creation of new economic infrastructure. In that regard the development of Florida’s long-distance passenger rail network is instructive, highlighting both the opportunities and perils of relying on private firms to develop new infrastructure.

The Florida High Speed Rail Project

Efforts to reestablish intercity passenger rail links in Florida have a  checkered history reaching back decades. In 2000, Florida voters approved a constitutional amendment mandating the establishment of a high-speed intercity rail system. In order to implement that mandate, the Florida legislature established the Florida High Speed Rail Authority (HSRA) in 2001. However, Florida Governor Jeb Bush was opposed to the idea of a constitutional mandate for transportation infrastructure and was skeptical of the endeavor’s cost. He managed to get the rail mandate repealed in 2004, although the HRSA remained in existence and oversaw the completion in 2005 of an EIS for the Tampa-Orlando segment of a proposed system that was envisioned to eventually run from Tampa to Miami.

The hopes of rail advocates were revived in 2009 when the American Recovery and Reinvestment Act made $8 billion in federal funds available for high speed rail projects and Florida was listed as one of the ten eligible potential rail corridors. The state’s application for federal funding was approved by the Federal Railroad Administration (FRA) and the state was eventually awarded over $2 billion for the project, with another $340 million expected. However, in February 2011 the new Florida Governor Rick Scott rejected the funds and effectively cancelled the project once again.

In 2011 the prospect of high-speed passenger rail between Florida’s major cities was unexpectedly revived when the Florida East Coast Industries (FECI) proposed to build a privately owned and operated passenger line between Miami and Orlando. FECI had a long and storied history of freight and passenger rail operations dating to the 19th Century. The firm was purchased in 2007 by Fortress Investment Group, an investment management and private equity firm headquartered in New York that had $70.2 billion in assets under management through the first quarter of 2017, including $14.2 billion of private equity assets. The private equity assets include traditional real estate, media related assets, leisure and entertainment businesses, and transportation and infrastructure.

To undertake the project FECI created a subsidiary, AAF Holdings LLC, known as All Aboard Florida. AAF proposed creating a 235-mile express passenger railway between Miami and Orlando with stops in West Palm Beach and Fort Lauderdale. The new railway, called The Brightline, would use existing and upgraded freight rail tracks owned by FECI, as well as a new 40-mile line that would run from Cocoa to Orlando along State Road 528. AAF is also building three new passenger train stations in South Florida; the trains will terminate at the Orlando Intermodal Transportation facility now being built by the Greater Orlando Aviation Authority. The company initially pegged its cost for the entire project at $3.5 billion, including $600 million for the purchase of land and easements.

Initial construction of the less costly Phase I of the project, from Miami to Fort Lauderdale, was privately financed. However, to complete Phase II to Orlando, the company applied to the FRA for a $1.6 billion loan through the Railroad Rehabilitation and Improvement Financing program (RRIF). Concurrently, the company sought alternative public financing by requesting that the U.S. Department of Transportation (DOT) exempt from federal taxation $1.75 billion in private activity bonds that would be issued by the Florida Development Finance Corporation. AAF explained in its application that the bonds would be a crucial factor in ensuring the completion of the project and that the proceeds would be used across the length of the project, including to retire $405 million in high-yield private debt the company had already obtained. DOT provisionally authorized the request in December 2014.

The FRA and AAF conducted an environmental assessment of the Phase I project in 2012-2013, culminating in a Finding of No Significant Impact. FRA released a Draft Environmental Impact Statement (DEIS) covering Phase II in September 2014 and a Final Environmental Impact Statement (FEIS) in August 2015. According to the FEIS, the fully built-out project is projected to remove 1.2 million auto trips per year from the regional road network and to reduce carbon dioxide emissions by 31,477 tons per year by 2030. The railway, according to projections, would capture about 1.2% of short-distance trips between Miami, West Palm Beach and Ft. Lauderdale, and 10.2% of long-distance trips between southeast Florida and Orlando. But there would be a variety of negative environmental effects in traversed communities, including increases in noise, vibration and traffic delays, with typical at-grade crossings closing an average of 54 times each day. There would also be adverse effects on natural ecosystems, such as the loss of 263 acres of wetlands due to filling, excavation and other impacts.

The environmental review was the subject of the most serious legal challenge to AAF’s plan, in which Florida’s Indian River and Martin counties contended that the project does not qualify for tax-exempt financing under the applicable statute. They also contended that the DOT violated the National Environmental Policy Act (NEPA) by authorizing the tax exempt bonds before a FEIS had been prepared. In 2015 Judge Christopher R. Cooper of the United States District Court, District of Columbia denied the counties’ motion for a preliminary injunction against authorization of the bonds, ruling that the counties had not established that the project would not be completed without the tax exempt bonds. After further discovery, the Court found in 2016 that invalidating DOT’s authorization of the bonds would in fact significantly increase the likelihood that AAF would not complete Phase II. It was a Pyrrhic victory for the counties, however, as the Court also dismissed the claim that the project does not qualify for the bonds under the applicable section of the Internal Revenue Code. Then, in October 2016, AAF announced that it was changing its financing plan, and would use $600 million in tax exempt bonds to complete Phase I and apply for a separate allocation of $1.15 billion to complete Phase II. That change led Judge Cooper to dismiss the case in May 2017.

Court documents reveal how difficult it would be for AAF to finance and complete the project through private channels. The company was forced to pay a 12% yield on the original $405 million in private debt it raised, and in fact intends to retire it with some of the proceeds raised through the tax-exempt financing. However, it has had difficulties placing even the tax exempt bonds, trying to market them without success to qualified institutional buyers and accredited investors in late 2015 and again in 2016, according to industry reports. It requested and received two extensions for the deadline to issue the bonds, first to January 1, 2016 and again to January 1, 2017. However, as mentioned, AAF restructured its financing plan and the original approval for the $1.75 billion bond issue was withdrawn, while the company’s $600 million request was approved. I find no evidence that the $600 million bond issue has been placed, and it is still listed as an allocation, rather than as bonds issued, on the DOT’s website.

FECI also released in 2015 a ridership and revenue study prepared by The Louis Berger Group. The study projected that the passenger rail line would realize 2.8 million short-distance trips and 2.5 million long-distance trips once completed and fully operational in 2020. Short-distance trips were projected to generate $64.1 million in annual revenue while long-distance trips  would generate $229.4 million in annual revenue. Total revenue would grow from $283 million in 2020 to about $400 million in 2030. Those projections underscore the difficult financing of the project. If half the $3.5 billion dollar cost of the rail project were financed with 7.5% tax-exempt bonds (a realistic interest rate for a speculative project like this), the annual interest costs would be about $130 million, or close to 40% of the average annual revenue of the project. If the private equity capital for the other half of the project’s cost requires a similar after-tax rate of return, virtually no revenue is left for operating the rail service. Even if real estate development planned by the company around the rail stations is highly lucrative, it is still easy to see why investors might be skeptical of the project.

The AAF project has also experienced legislative, as well as legal and financial, hurdles. For example, a bill in the Florida legislature this year would have established safety standards on high-speed passenger rail systems operating in Florida exceeding those required by federal regulations. However, after an intensive lobbying campaign by AAF, the bill died in committee. Interestingly, the bill’s two sponsors in the Florida Senate and two in the House are all Republicans, proving that regulatory obstruction of private business investment is not something that only Democrats specialize in.

Despite the roadblocks, initial passenger service was scheduled to begin in July between Fort Lauderdale and West Palm Beach, and to extend to Miami in August (that schedule has not been met and the company has made no announcement yet fixing the inaugural run). Completion of Phase II of the project, with service to Orlando, is not scheduled to begin until 2019, and there remain skeptics who believe Phase II will never be built.

All Aboard the Private Infrastructure Train?

If All Aboard Florida is able to develop and operate profitably passenger rail service between Florida’s major cities, while complying with applicable–and hopefully appropriate–environmental and safety standards, only the most doctrinaire skeptics of private enterprise should complain. Transportation is a good thing, and from a social equity, safety and environmental viewpoint, rail transportation is an especially good thing.

To be sure, there will be environmental gains and damages from this project. However, a full environmental review was conducted and the FEIS, issued August 2015, concluded that there would be no significant adverse environmental impacts if certain mitigation measures were undertaken, which AAF has agreed to. For our purposes, we can accept those conclusions at face value.

More germane to the question of private provision of critical transportation infrastructure is whether the dictates of corporate profitability, appropriately regulated, will distribute social benefits and costs differently than if the project were undertaken by a public agency. If the project were undertaken by a public agency, it is likely that political pressure would result in more extensive mitigation measures, perhaps including those included in the Florida High-speed Passenger Rail bill, which would undoubtedly raise project costs. Some of that additional cost might be absorbed from profits, which would not be required by a public project, and some by subsidy. To the degree that additional mitigation is subsidized through taxation, the costs of the project are distributed more broadly among the public, which does not strike me as a bad outcome. One reason that Nimbyism is such an obstacle to infrastructure development is that the environmental costs are borne disproportionately by those unfortunate enough to have the project located in their backyard.

Some critics of the project see it as, essentially, a private equity grab at public subsidy dollars.  Aside from the subsidies associated with the private activity bonds, they foresee operating deficits that will ultimately suck in the State or local governments if a user constituency for the rail service is developed. If they are right that the project is not financially self-sustaining, however, another outcome could be the eventual public purchase of the assets. If history repeats and public agencies are able to purchase the assets at a discounted price, that too would not necessarily be a bad thing. However, that raises the issue of how this privately-conceived project fits into the State’s long-term transportation planning. There is already a commuter rail line known as Tri-Rail serving the Miami-West Palm Beach corridor, operated by the South Florida Regional Transportation Authority (SFRTA).  Tri-Rail has 18 stations and serves about 14,000 daily weekday passengers. All Aboard Florida is not conceived to complement Tri-Rail, but rather to compete with it. Would comprehensively-planned rail service in South Florida establish two parallel rail lines, or concentrate resources on service delivery on the existing line (which also links to Amtrak)?

Recent developments also raise the question of whether the modern corporate sector has the patience and institutional longevity to undertake and operate public infrastructure of this type. In February 2017 Fortress Investment Group was sold to Softbank, the Japanese technology conglomerate run by Masayoshi Son, for $3.3 billion. Work on the rail line appears to be proceeding but Softbank hasn’t made any public recommitment to the project. Furthermore, in March 2017, Fortress sold Florida East Coast Railway Holdings Corp., its freight rail operation, to Grupo Mexico SAB for $2.1 billion. According to a spokesperson for All Aboard Florida, the sale will not affect the Brightline, which has dual ownership of the corridor and the right to operate passenger service. That may be for now, but as we know, in the world of private equity everything is negotiable, and the Brightline project will only be completed and operated if it remains in the interests of Softbank and Grupo Mexico that it does.

In many ways it is remarkable that FECI has come this far and is on the cusp of beginning service on Phase I of its rail line. Nevertheless, the private activity bonds have not been placed and the financial viability of the project remains murky.  At the same time, the company is pressing ahead with related real estate development projects, including several rental apartment buildings, and has recently announced the creation of a new real estate development subsidiary. It would not surprise me if, a decade from now, FECI has already off-loaded a struggling passenger rail operation to a public agency but is spearheading lucrative redevelopment of the Miami, Fort Lauderdale and West Palm Beach downtowns. If such a scenario comes to pass it would be history repeating itself, but not necessarily in a way that would be cause for regret.