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May 1, 2014

Glimmers of Hope for Infrastructure Spending

But the energy boom, innovative financing and project design still won’t close the needs gap

In New York City, officials proposed an ambitious $20 billion plan to protect against hurricanes and rising sea levels. North of the Big Apple, the replacement for the Hudson-spanning Tappan Zee Bridge is well underway at a cost of $3.9 billion. At the other end of the country, Los Angeles is widening the jam-packed San Diego Freeway and building new light rail lines across the congested sprawl, projects that each cost billions. And where federal money is short, rebounding state coffers, local infrastructure banks that use public funds to attract private investment, and other kinds of public-private partnerships are picking up some of the slack.

Ports and waterways are being upgraded. Airports are expanding and modernizing. The national smart electrical grid is beginning to take shape, along with renewable energy projects to feed it. The boom in natural gas and oil has spurred demand for pipes and pipelines, tank trucks and barges. Railcars and upgraded rail lines have become essential to filling the energy transport gap.

 

 

Good Signs for Steel

Steelmakers are cautiously optimistic: The U.S. economy continues to recover, unleashing pent-up demand for steel-heavy products like homes, cars and appliances—all of which need to be transported by truck and rail or fed with fuel drilled with steel pipe.

After plunging to near zero in 2009, housing starts are expected to rise almost 30% this year on their way back to a long-term annual average of 1.5 million. Non-residential construction is rebounding, too, albeit more slowly. U.S. auto sales and North American auto production are both expected to climb by just under 4% this year. After falling during the recession and stumbling again in 2011 and 2012, appliances and water heater shipments should grow 7% in 2014. The forecasted production growth of tractor-trailers is 11.5%.

“Our outlook and the steel industry’s outlook … starts with the automotive and energy segments as strong drivers for the next several years,” says Charles Schmitt, who runs Western Hemisphere operations for Swedish steelmaker SSAB. Wind power, electrical transmission towers, barges and tanker railcars are all driving demand for SSAB’s high-strength and abrasion-resistant steel products, Schmitt says. But so are construction and broader trends toward more resilient, lightweight designs in autos. The company is in the final stages of commissioning a state-of-the-art quench-and-temper line at its Mobile, Ala., facility, a $220 million bet on a rebounding economy and a turn toward stronger, more durable products.

With oil and gas coming out of and going to parts of the United States that don’t have enough pipelines, railcars have become a favored, though increasingly scrutinized, mode of transport. Rail shipments of petroleum products shot up almost 50% in 2013. New tank cars rose in tandem, up 36% last year. Though modest declines are foreseen in the years ahead, overall shipments of new railcars should rise 12% in 2014. Demand for pipe used in drilling is expected to jump 15% this year.

“Major steel-consuming markets will continue to recover,” wrote ArcelorMittal in a presentation to the Federal Reserve Bank of Chicago’s Annual Economic Outlook Symposium in December 2013. “However, the pace of recovery for the U.S. economy is still very slow.”

 

Still, a Shortage of Guts as Well as Money

A slow U.S. recovery is one cause for concern. But look closer at the state of American infrastructure and you find another: In terms of investing for the future, the United States still lags badly behind where it needs to be, and a deficit of guts, not greenbacks, appears to be the main culprit.

Though still enormous in absolute terms, U.S. spending on infrastructure is shrinking in relation to the economy and is clearly insufficient to meet future needs

In 2013, the United States fell one spot to 15th in global infrastructure quality, behind Spain and Canada, according to the World Economic Forum’s annual “Global Competitiveness Report.” Many big projects happening today are triumphs not of will, but of waiting. Los Angeles is so traffic-choked that it almost has no choice but to invest in mass transit. Crumbling bridges eventually collapse, as several prominent ones have in recent years. Big spending remains contentious, as does the subject of taxes to fund it.

“America’s infrastructure is not improving at a pace to keep up with the needs of business,” says the National Association of Manufacturers in its 2013 report, “Infrastructure: Essential to Manufacturing Competitiveness.” 

Though still enormous in absolute terms, U.S. spending on infrastructure is shrinking in relation to the economy and is clearly insufficient to meet future needs. Spending on surface transportation (roads, mass transit, waterways) and water projects has shrunk from more than 3% of gross domestic product in the 1960s to 2.4% today, according to the Congressional Budget Office. Just as troubling, state and local governments are responsible for three quarters of those dollars, while the federal government contributes the rest. This is a recent historical trend that seems to be continuing with a stingy, paralyzed Congress.

Though that level of spending may be in line with other developed countries (Germany spends 2.2%; France, 2.3%; and Canada, 2.7%), America’s unique geography and decades of putting off tough choices argue for increasing that percentage. The McKinsey Global Institute, for example, estimates the increase should be at least another 1% of GDP annually, or roughly $150 billion to $180 billion to support current estimates for economic growth and prevent further deterioration of vital networks. “The United States cannot defer hard decisions indefinitely while backbone systems deteriorate,” McKinsey wrote in its report last July.

“We’ve gotten used to a lot of infrastructure that we think is just an entitlement and somebody else should pay for it,” laments Pat Natale, who leads the American Society of Civil Engineers (ASCE). “I understand being fiscally responsible, it’s a really good policy, but you mean to tell me if the roof is leaking in your house, you’re not going to repair it in a timely manner?”

 

Leaks in the Pipes and Holes in the Roads

Water infrastructure is a good example, Natale says. Americans by and large get very clean water delivered to their tap and for very little money, a feat that America’s public water companies boast about. But that ignores the 240,000 water-main breaks a year—roughly one for every four miles of pipe—which crater streets and disrupt business and travel. But suggest raising water prices a few cents per customer to pay for real upgrades, says Natale, and utility managers blanch.

Roads are a particular source of frustration for Americans who drive bone-jarring highways nearly everywhere. The particularly brutal past winter in much of the country only aggravated the problem. The drop-off in spending on surface transportation highlights the fragmented nature of America’s infrastructure planning, financing and operations.

“We have seen some improvement and I would say a rebound in pretty much every mode but pavement and highways,” says Alison Black, chief economist for the American Road & Transportation Builders Association (ARTBA). “The big wild card is the situation with the Highway Trust Fund.”

Fed by a gasoline tax that hasn’t been raised since 1993, and hit by better fuel efficiency and a decline in trucking and other commercial transport activity during the recession, the federal highway fund is slated to run into the red in a matter of months. Even if Congress and the White House agree on a reauthorized transportation bill, it will almost certainly be one that will kick the can down the road instead of putting highway spending on sure financial footing for years to come. Neither President Barack Obama nor congressional Republicans are proposing to raise the gas tax, though many on both sides of the aisle acknowledge that is the most obvious long-term solution.

“Congress has three choices right now: They can raise revenues to the trust fund, borrow money from the general fund or cut programs,” says Black, who’s betting that the pols will favor borrowing over raising taxes or slashing what is already a shrinking level of spending.

 

The High Cost of Broken-Down Roads

In fact, while other sectors of U.S. infrastructure rebound from the downturn and years of neglect, or benefit from private investment, roads are the top trouble spot in many groups’ reckoning. Roads and bridges account for slightly more than two-thirds of the deficit in U.S. infrastructure spending in McKinsey’s estimates. The ASCE estimated that in 2010, poor roads cost Americans $130 billion in vehicle operating costs, travel delays, and safety and environmental expenses. By 2040, that figure will rise to more than half a trillion dollars a year.

Though federal spending provides just a quarter of infrastructure investment, it accounts for more than half of capital investment in roads, says ARTBA’s Black. Declining federal dollars trickle down to the states, counties and cities that are primarily responsible for actually building, widening and fixing roads.

“It’s become the new normal,” says Mike Parker, senior managing director at Ernst & Young Infrastructure Advisors, who consults for government agencies. “You have operating expenses that are growing on an inflation basis. You have less free cash flow you can commit to borrowing. You’re seeing local agencies curtail their borrowing in many cases and start to make plans based on what in real terms would be declining revenue.”

 

Off Road, a Brighter Outlook

The silver lining is that many other aspects of America’s public works are on the upswing and, outside of Washington at least, talk about paying for the nation’s future needs is more frank than it’s been in a long time. Last year, the ASCE upped its grade for the nation’s infrastructure to a D+ (from D in 2009, the last rating period)—not exactly scholarship material, but the overall grade included some improvements. Bridges received a C+, though one in nine spans is still considered structurally deficient. America’s rail system got a $75 billion capital investment shot just as the downturn hit, with both freight and passenger providers taking advantage of lower material and labor costs in the recession.

The main private capital rejoinder to public sector inaction is, of course, in the energy sector, where unconventional gas and oil extraction techniques have led the industry to plow cash into exploration and transportation. The resulting boom in energy production means the United States is likely to surpass Russia and Saudi Arabia as the world’s biggest oil producer by 2015, and North America should become a net exporter by 2030. Since 2007, extraction of shale gas and of tight oil—natural gas and oil trapped in porous rock formations that must be fractured under high pressure—has each risen more than 50% annually. The economic impact is already apparent in drilling regions like North Dakota, Texas and Pennsylvania. Energy companies and their contractors may invest up to $1.4 trillion in the years to come, creating 1.6 million jobs, mainly in construction, according to McKinsey.

 

The New Financing Models

Faced with an uncertain federal partner, states are trying out new models for getting projects financed, built and maintained over their useful lives. Public-private partnerships, where private capital for construction is repaid from user fees or other long-term concessions, were just 2% of highway capital investment since 2008, but they accounted for 11% of investment in new highway capacity in 2011, the most recent numbers available, according to ARTBA. More than half the states now have enabling legislation for P3, as these hybrid deals are called. Federal schemes, like the U.S. Department of Transportation’s Transportation Infrastructure Finance and Innovation Act (TIFIA) loan program, lower the cost of privately raised capital. This has mitigated one of the biggest barriers to P3 adoption in the past since American states and counties get a subsidy on their tax-free debt.

Another tactic local agencies are trying is shaking up how projects are designed, awarded, built and run. Asking teams of designers and contractors to pitch projects for an all-in cost, a process called design-build, is not new but is catching on. It offers far more promising efficiencies than the more traditional process of designing first, then putting the construction out for public bid, a process that all too often produced projects years behind schedule and with millions of dollars in overruns. Like public-private partnerships, design-build is an attempt by state and local transportation agencies to cope with funding uncertainty and a general tightening of economic belts. It allows them to put financing together in discrete packages that focus on single projects. Smarter selection of projects and improved design, sourcing and execution could reduce infrastructure project costs by almost 30%, according to McKinsey.

“Most major projects, especially over $500 million, are at least being considered as design-build, and quite often as P3,” says Ernst & Young’s Parker. “It’s part of the conversation. That is a substantial shift from where we were previously.”

The new Tappan Zee, officially the New NY Bridge, was awarded on a design-build basis, and backers boast of its lower costs, faster turnaround and longer lifespan than originally forecast. In California, a series of design-build pilot projects is nearing completion with promising results, says Raymond Tritt, a supervising engineer with California’s Department of Transportation (Caltrans). Aside from delivering projects faster, the pilot has yielded innovative solutions. One design-build team managed to shave at least $20 million off the cost of a highway interchange in San Bernardino County by reconfiguring the layout.

“You have multiple designer-contractor teams competing against each other to come up with the most innovative solution,” says Tritt.

 

Taxes: Still the Elephant in the Room

Ultimately, though, taxes and taxpayers hold the keys, and there are signs that, where government can show value for money, infrastructure gets the benefit of the doubt.

“[Our members] … are open to putting all options on the table for new revenue so long as they have assurances that the money is spent wisely,” the National Association of Manufacturers said last August in announcing the results of a survey of members’ concerns.

Virginia, for example, earlier this year passed a dramatic overhaul of its road-financing system, replacing a per-gallon gas tax with an inflation-indexed one, higher sales taxes, and money rerouted from education and other sectors. This did not happen, however, without a bitter political fight that angered both liberals and conservatives. Pennsylvania, Texas, Ohio and several other states have funded local infrastructure banks that pair federal money with state funds to attract private capital and guarantee loans. Regional transportation programs—in which multiple projects such as highways and mass transit are packaged together and presented to voters for referendum—have taken off, notes Parker of Ernst & Young, as local agencies have found that linking major change in a community’s infrastructure to a bond issue or tax garners public support more readily than do incremental efforts.

 

Who Will Unclog the Highway?

Awareness of the problem has risen dramatically in the last few election cycles, says Parker, but no matter how soon changes come, in the short-term a gap will remain. “Regardless of what happens on the funding side, it’s not going to be enough. We’ll have to prioritize.”

In this new normal, the federal government’s spending level on roads, waterways and the like will probably change little, but those funds will be less reliable as politics swallows an issue that was once nonpartisan. The result will be more private capital and experimentation by state and local governments keen to bypass Washington gridlock. Optimists say that may unlock the potential of new technologies, new processes and new financial models. Americans stuck on clogged and rutted highways, concerned about deteriorating bridges and antiquated water and sewer systems, can only hope so.


Peter C. Beller is a Los Angeles-based business journalist and editorial director at Ebyline.com. A former staff writer for Forbes and MarketWatch, Peter’s reporting has appeared in The New York TimesNew York magazine, the Jerusalem Post and elsewhere.