Skip to Content

PC Productivity Update 2015

3 Improving the efficiency of capital investment in public infrastructure

Investment in infrastructure and other capital assets supports growth in the national economy. As the previous discussion shows (see box 1.3 for instance), capital deepening makes a critical contribution to growth in productivity and living standards. The quality of this capital investment is instrumental in achieving this contribution. Public infrastructure includes capital assets that play a unique role because, unlike other types of capital, it provides services to the community in general. Yet, the efficiency of public infrastructure investment is often under question. Recently, the Commission completed an inquiry on the provision of public infrastructure and found that, among many other things, that the delivery of public infrastructure projects could be improved by the application of more rigorous and transparent cost-benefit analysis (PC 2014). The analysis in this chapter is based on the findings from this inquiry.

3.1 The importance of capital in the Australian economy

As reported in chapter 1, the growth in real capital in the Australian economy has outpaced the growth in labour inputs resulting in more intensive use of capital (known as 'capital deepening'). Capital deepening contributed almost 60 per cent of the growth in national labour productivity with multifactor productivity (MFP) growth contributing the remaining 40 per cent. In 2013-14, there was an estimated $5.1 trillion or more of installed capital that was available for use in the Australian economy — over three times the value of production in that year (figure 3.1, top panel). Over the next 50 year period, the Commission has estimated that new capital investment will be more than five times the cumulative investment made over the last half century to around $38 trillion in today's prices (PC 2013).

The largest component of today's installed capital is in the form of non-dwelling constructions — which consists of non-residential buildings (i.e. buildings other than dwellings, including fixtures, facilities and equipment integral to the structure) and other structures (including streets, sewers, railways and runways) — which amount to over $2 trillion (or 43 per cent of the total). The next single most important component relates to dwellings, amounting to around 35 per cent of the total installed capital (figure 3.1, bottom panel).

Additions to the stock of capital will usually increase output and add to labour productivity. However, for productivity to improve, the growth in output must exceed the growth in inputs. Poorly selected projects can detract from productivity as the resources they use would have delivered a higher output elsewhere in the economy.

Growth in the stock of capital is also important as a source of capital embodied technical change. Over time, technological change embodied in newer units improves the quality of the capital installed and, with it, improvements in the productivity of that capital. The introduction of new generations of capital equipment and general purpose technologies (such as ICTs) may also enable firms to undertake broader technological and organisational change that would enable the more productive utilisation of all factors of production adding to MFP growth.1

  • Figure 3.1 Net capital stocka, as at 30 June 2014

    Aggregate value ($ trillion)

    Figure 3.1 Net capital stock, as at 30 June 2014. This first chart shows that in 2013-14, there was an estimated $5.1 trillion or more of installed capital, compared to the value of production in that year of $1.6 trillion.

    By type of asseta

    Figure 3.1 Net capital stock, as at 30 June 2014. This second chart shows that the largest component of installed capital in 2013-14  is non-dwelling construction which amount to 43 per cent of the total, followed by dwellings (35 per cent), machinery and equipment (12 per cent), and all other (10 per cent).

    a Net capital stock is the stock of produced assets including machinery and equipment, non-dwelling construction, dwellings and other forms of produced capital including ownership transfer costs; weapons systems; cultivated biological resources; research and development; mineral and petroleum exploration; computer software; and artistic originals. The capital stock is 'net' of accumulated depreciation on installed capital.

    Source: ABS (Australian System of National Accounts, 2013-14, Cat. no. 5204.0, October 2014).

3.2 The role of public infrastructure

Public infrastructure is an important part of Australia's total capital stock with available estimates suggesting that it amounts to nearly one fifth of the national stock of capital. According to the Commission's study into Public infrastructure (PC 2014), in 2011-12, Australian governments owned 'infrastructure and other (non-building) construction' assets valued at $614 billion, which comprised economic infrastructure, such as road, rail, energy and water assets. Governments owned a further $263 billion worth of buildings, much of which is social infrastructure, including schools and hospitals.

Efficient provision of public economic infrastructure (such as road, rail, energy and water assets) provides services that support production and consumption activities across the domestic economy and international trade. These services can also generate indirect or flow-on benefits such as through communications network infrastructure that increase the opportunity and capacity for business to collaborate and innovate, leading to technological and organisational change, and ultimately improved productivity.

Efficient provision of public social infrastructure (such as schools and hospitals) provides services that benefit individuals, but can also have broader economic implications. To the extent that public social infrastructure leads to the maintenance and improvement of education and health outcomes, such investment supports workforce participation and productivity, drives economic growth as well as promotes broader community wellbeing.

However, not all public infrastructure supports productivity and generates economic growth and wellbeing. Poorly selected public infrastructure investment can impede the efficient provision of public infrastructure services, crowd out private investment and reduce productivity, economic growth and wellbeing.

3.3 Governments play an important role

Whilst governments are often major providers of infrastructure, even where they do not have a funding and finance role, their general powers in relation to land use mean they are usually involved in long-term planning which gives them a role in project selection. This is particularly the case in areas of economic infrastructure, such as transport (such as road, railways and airports and bridges), utilities (such as electricity network, dams and waterways), and telecommunications. Governments are also often involved in the economic, environmental and safety regulation of economic infrastructure. In many areas of investment in social infrastructure (such as public schools and hospitals), governments are likely to be the dominant funders (box 3.1).

The increasing trend towards private involvement in the delivery of public infrastructure has changed the balance between government as the primary provider and government as a regulator of infrastructure services. Where the private sector is involved, governments may choose to shape provision directly by setting and enforcing construction and service delivery standards, imposing planning and zoning restrictions, or imposing other conditions and, in some cases, regulating prices. Alternatively, government may influence private investment indirectly through financial incentives such as tax arrangements and capital market interventions. Governments can also seek to purchase particular outcomes from the private providers, which can form part of a public private partnership arrangement, or be transacted under a purchase of service contract.

Box 3.1 Reasons for government involvement in the provision of public infrastructure

  • The basic reason for government involvement in the provision of public infrastructure is to address market failures that may lead to the under provision of infrastructure services if left entirely to the private sector. There are three main forms of market failure.

    • Natural monopolies exist where it is more efficient for one business to supply the entire economy or a segment of the market under prevailing technologies than it would be for two or more businesses. Conditions of natural monopoly create the potential for a firm to exercise its market power by setting prices higher and the level of output lower, than would occur in a competitive market. This leads to a loss in benefit to the community.
    • Externalities exist when the action of an individual or firm creates a benefit or a cost for others who are not a party to the transaction, and these benefits or costs are not fully reflected in market prices. Firms tend to underproduce goods with positive externalities (such as education) and overproduce goods associated with negative externalities (such as pollution).
    • Public goods exist where consumption by one person of a particular product does not diminish consumption by others and it is hard to exclude others from materially benefitting from the consumption of the product. As a result, firms are likely to underprovide the supply of this type of product. Public goods are a special case of externalities.

    Community service obligations (CSOs) are imposed by governments on infrastructure service providers to meet a social or other needs that the government views to be important. CSOs can be imposed through regulation, purchased by governments, or make up part of a package of commitments required by government before they authorise the investment. Without such intervention, markets may not provide access to basic levels or quality of service to groups that are less able to pay for such services or which are more costly to supply to. Supply of water, sewerage, roads, rail and telecommunications to certain rural communities are good examples.

3.4 Improving the assessment and selection of public infrastructure investment

In its recent report on Public infrastructure, the Commission assessed that there is considerable scope to improve the quality and efficiency of government investment in public infrastructure investment in Australia. In its report, the Commission presented a wide range of issues and made recommendations to improve the processes for selecting projects, financing initial capital commitments, and funding ongoing operations. Also included were recommendations to overhaul institutional governance to inject greater rigour into project evaluation and decision making, including more transparent and accountable processes and a more efficient regulatory environment (figure 3.2).

Most relevant to enhancing the efficiency of the provision of public infrastructure is improving project selection processes. Australia's cities and towns generally function adequately and assets undergo usual maintenance, although problems have emerged in some major cities. Nevertheless, the Commission found numerous examples of poor value for money arising from inadequate project selection and prioritisation. In particular, there was a bias toward large investments despite the returns to public investment often being higher for smaller, more incremental investments. In part, this was because the private sector is more interested in financing large investments (due to the costs involved), and governments have increasingly seen public private partnerships (PPPs) as a way of harnessing not just finance, but expertise in project delivery and operation.

Private investors need a return on their investment and, in a fully private venture, will carefully assess the cost-benefit ratio of projects under consideration. While they should apply the same discipline in PPPs, the involvement of government and the complex relationship between the initial financiers of a project and the long term investors can make this assessment difficult. As a result, it behoves government to ensure that the project, and the revenue streams it will generate either directly in user fees, and/or through government purchasing arrangements, will provide a return that is competitive for the investor's dollar. Where the government is the sole investor, they should be accountable to the taxpayer for ensuring value for money.

A key recommendation of the report was that governments should undertake a comprehensive and rigorous social cost—benefit analysis to all public infrastructure investment projects above $50 million. Such analyses should be publicly released during the commitment phase and be made available for due diligence. In general, cost-benefit analyses should be done prior to any in-principle commitment to a project or as soon as practicable thereafter.

  • Figure 3.2 Key components to improving the efficiency of public infrastructure investment and service provision

    Text alternative of table follows

    Text alternative for the table in Figure 3.2

    Table for figure 3.2 Key components to improving the efficiency of public infrastructure investment and service provision
    Governance arrangements Appropriate governance arrangements to provide an efficient regulatory environment, evaluation and decision making capabilities, and transparent and accountability processes
    Key components Project selection Development and financing of project Funding ongoing operations
    Recommended approach Undertake rigorous cost benefit analysis that enables sound project selection of the option(s) that maximise(s) public benefit and economic efficiency.

    Provide enhanced opportunities for private sector involvement to:

    • access wider range of funding sources;
    • increase project cost discipline; and
    • better manage project risks.
    Use, wherever possible, efficient pricing mechanisms based on direct user charges.
  • Figure 3.3 Benefit—cost ratios versus cost
    Projects submitted to Infrastructure Australiaa

    Figure 3.3 Benefit-cost ratios versus cost for projects submitted to Infrastructure Australia. This chart shows that the benefit-cost ratio has generally been lower for large projects, and many of these are typically only marginally above the acceptable threshold of 1.

    a Includes project proposals that are submitted by State Governments for inclusion on Infrastructure Australia's priority list that are 'ready to proceed' (those with strong strategic and economic merit that have met all of Infrastructure Australia's criteria) or 'threshold' projects (those that are well developed and present a detailed preferred option). Other projects that are early stage or approved by State Governments are not included.

    Source: Infrastructure Australia (2011, 2012a, 2013a).

Why a cost-benefit analysis is important

Although under-provision of infrastructure can have negative effects on the community, so too can over-provision with infrastructure that is too large, poorly matched to the needs of the community, or unnecessary. Proceeding with major infrastructure projects entails large resource costs that are only worth incurring if they are outweighed by the benefits of the services that they provide.

The economic efficiency of proposed public infrastructure projects can be assessed by conducting thorough and transparent social cost-benefit analysis. This analysis can examine if a project has a positive net benefit to the community, and whether proceeding with it will improve economic efficiency. A comprehensive analysis would consider feasible alternative projects to inform decision makers of the option with the greatest net benefits. This might be to address a particular problem, such as security of an urban water supply in the face of falling dam levels, or as part of prioritising enhancements, such as addressing the congestion points or 'black spots' in an urban transport network.

The value of retaining the flexibility to defer, modify or cancel projects can also be assessed through this process. Governments should select projects that have the highest return to the community as a whole. Social cost-benefit takes into account benefits other than the revenue stream that the project generates to include any positive or negative effects on economic activity, social activities, and the environment.

In Australia, rigorous analysis focusing on the community-wide costs and benefits is particularly important for large infrastructure projects. This is because, the benefit-cost ratio (BCR) is generally lower for large projects due to their large construction costs and rising utilisation rates over time, and many are typically only marginally above the acceptable threshold of 1 (figure 3.3). Rigorous analysis of large projects is also important as there is likely to be a large number of small unfunded projects with high benefit to cost ratios that could be completed instead.

How does cost-benefit analysis help selecting public infrastructure projects?

Community-wide (social) cost-benefit analysis involves aggregating the impacts on all members of the community and appropriately taking account of risks. It allows information to be analysed in a logical and consistent way and encourages decision makers to take into consideration all costs and benefits of a project, rather than making decisions based on selected impacts only. It should consider all, although may only be able to quantify some, economic, social and environmental outcomes to provide a reliable guide to what is in the overall interest of the community.

For example, benefits from a new toll road might include the value of travel-time savings on both the toll road and the wider transport network, reductions in accidents, and effects on pollution. Benefits that take the form of productivity improvements (such as reduced travel time for transporting goods) would be assessed alongside other types of benefits (such as reduced travel time for commuting or recreational trips).

The standard decision rule is that projects with positive net social benefits should be accepted for further assessment and compared with other project proposals. However, at any time, there is always a budget constraint and always an opportunity cost — so transparent ranking of options based on economic, social and environmental impacts is essential. Where there are mutually exclusive projects and a binding budget constraint, the project with the highest net benefits should normally be preferred.

As infrastructure investment usually involves a significant amount of money, it is important that the options considered include deferring the investment. Delaying an investment has a considerable saving. Just in time investment raises productivity as the average utilisation rates are higher. Similarly, options for repair and enhancement should be considered if they can delay a major investment. In these cases an options approach to the cost-benefit analysis would allow different packages of investment that deliver slightly different service flows, but at different costs, to be compared. For example, demand management for urban water could delay a major investment in a new dam for a lower net cost and little reduction in benefits if the population is happier with restrictions than with higher water prices. Moreover, comprehensive analysis would consider the ongoing maintenance and operating costs of an infrastructure project along with construction costs to identify the most cost-effective design in the longer term.

Cost-benefit analysis that distinguishes between the impacts of a project on particular groups, such as regional communities and low-income households allows decision makers to form judgements about whether distributional or equity issues should be addressed. Ideally, such issues would be addressed through a transparent public process.

Governments may sometimes have legitimate reasons to make project selection decisions that run contrary to the rankings suggested by a cost-benefit analysis. For example, some aspects of a project that are not quantifiable in monetary terms may be considered important. There also may be a network effect that is hard to quantify. The reasons for such decisions should be clearly explained and scrutinized.

What may impede the effectiveness of a cost-benefit analysis?

For cost-benefit analysis to play a useful role in guiding project selection, it needs to be rigorous and consistently applied. In its inquiry, the Commission outlined three key factors that have the potential to reduce the effectiveness of cost-benefit analysis.

  • Optimism bias. There is a systematic tendency for project appraisers conducting cost-benefit analysis to be overly optimistic — the bias is toward overstating benefits, and understating timings and costs, both with respect to initial capital commitment and operation costs. Over estimates of traffic forecasts on toll roads and tunnels are a particular problem. Optimism bias can be countered by rigorous analysis of plausible outcomes for the project and by using reference class forecasting. The latter does not attempt to forecast the specific uncertain events that may affect a particular project, but instead predicts outcomes based on those actually achieved for a set of similar past projects.
  • Treatment of risk and uncertainty. Costs and benefits are expected values based on the probability of different outcomes. Cost-benefit ratios may be sensitive to certain assumptions which have to be made without sufficient evidential support. For example, inappropriate assumptions about allowance for project risk in the discount rate (that is, the risk premium) may alter the ranking of projects and lead to suboptimal project selection. More commonly, the interaction between the different parameters used to estimate the costs and benefits is ignored despite the potential for these relationships to have compounding impacts.
  • Treatment of 'wider economic benefits'. Infrastructure projects create direct benefits for users of the resulting service provided by public infrastructure. Where cost-benefit analysis is done, such benefits are routinely estimated and included. However, projects can also create wider economic benefits and costs. For example, investment in transportation infrastructure brings consumers closer to more businesses, potentially facilitating greater competition and leading to a more innovative and a dynamic economy. However, such wider economic benefits are hard to quantify and their inclusion in a cost-benefit analysis has the potential to show one project to be superior to another purely because of differences in the way such benefits are defined and estimated. Cautious and consistent treatment across options of wider economic benefits is warranted.

There is also the possibility of double counting of benefits. For example, new transport infrastructure may reduce commuting times, and also increase the value of housing close to the infrastructure. However, if the latter has arisen because of reduced commuting times, then it is double counting to include both as separate benefits.

Any cost-benefit analysis should be conducted by independent analysts and be subject to public scrutiny.

Transparency in the process of cost-benefit analysis

A transparent cost-benefit analysis can play a critical role in project selection, particularly where all the benefits and costs are not internal to the investor, that is, the decisions rest with government. Making cost-benefit analyses public for both projects that have been selected, and those that have not been selected can improve the transparency of decision making. Such transparency strengthens the incentives for decision makers to focus on the overall net benefits of projects from a community wide perspective. It also allows particular estimates, such as construction costs or patronage, to be scrutinized and testing to be done on how the use of different estimates would affect a project's net benefits. Transparency can help to improve the quality of analysis because proponents and practitioners know that any flaws are likely to be exposed.

References

  • Infrastructure Australia 2011, Communicating the Imperative for Action: June 2011 Report to COAG, Canberra.
  • Infrastructure Australia 2012, Australian Infrastructure — Progress and Action: June 2012 Report to COAG, Canberra.
  • Infrastructure Australia 2013, National Infrastructure Plan: June 2013 Report to COAG, Canberra.
  • PC (Productivity Commission) 2013, An Ageing Australia: Preparing for the Future, Commission Research Paper Overview, Canberra.
  • PC (Productivity Commission) 2014, Public Infrastructure, Inquiry Report No. 71, Canberra.

Footnote

1 As MFP growth is measured as a residual, it may also include the effects of other factors such as changes in capital utilisation and measurement issues.

Update homeChapter 4