Though most of those that are pushing for HSR along with better transit service are not hypocrites, since they are not against public funding for streets & roads.

After reading this post, I once again notice the suggestion of an alternative formulation of the "full cost" of roads (and other infrastructure). I have encountered this argument in several posts on this blog. Some of the ideas I don't think are correct, and so would like to discuss here.

Thank you for taking the time.  I welcome any input that helps me communicate more accurately and effectively.  I especially appreciate input from knowledgeable, intelligent commenters like you.

The first is the issue of opportunity cost, which you give great prominence to in this post. I think it would be important to first mention in each case whether you are referring to private finance of infrastructure (e.g. roads) or social benefit-cost analysis for public provision, which is much more common.

I am referring to opportunity cost in a strict sense of the term: the value of a choice which is forgone in order to pursue a particular decision.  Before going further, I must confess that prior to your comment, I was not familiar with “social benefit-cost analysis”.  I skimmed the internet and didn’t find too many good resources on the topic.  The concept still sounds a little scary to me, in a Soviet sense.  What insights you can share with us?

The opportunity cost of investment capital is explicit in the case of private finance, it is simply factored into the interest rate.

I think you are oversimplifying quite a bit.  The cost of capital for a particular investment is the weighted average cost of capital for all tranches of that investment.  It includes all forms of equity, as well as debt.  And even for the debt tranche, the opportunity cost of capital is not as simple as a relation to interest rate – although the concept is often incorrectly interchanged.  The opportunity cost of the capital is the returns forgone to pursue a project of the same risk.  Thus, I consider the Opportunity Cost of Capital a much more valid metric than interest rate for projects both public and private.

In the case of private finance, two other factors that you mention, risk of cost overruns/uncertainty and demand uncertainty/bias can also be appropriately factored into an interest rate.

I think likelihood of default, and liquidity are the determining factors for pricing interest rate. And in infrastructure finance there must be some degree of an implied backing by government in the case of default.  The value of that guarantee is huge.

Or sometimes, so-called-private infrastructure even uses government bond financing.  Are these risks even a factor in government bond financing, or are bonds priced merely the risk of that government failing?  And when government can always lean on its citizens to prevent default, is it really baked into the price?

But, regardless, we are not given an interest rate to work with in this example.

The last two factors, legal costs associated with eminent domain and opportunity costs of land, are in fact often included in typical project cost estimates for both public and private projects. The former is fairly straightforward, as it is a project-related cost. The latter, opportunity cost of land, is simply the purchase price of land (assuming it is bought at market rates through an arms-length transaction — this doesn't always happen).

You are absolutely correct, and I am embarrassed for being so sloppy.  Thank you for pointing that out.  I will make the correction to this post accordingly. 

I would like to clarify, that I stand by my posts where I rebut assertions that existing highways “pay for themselves” as we discuss below.

I have also heard some argue that the cost of existing roads should reflect the land it occupies. To me, this raises at least three questions:

1) What value would that land (presumably urban) have were it not made accessible by the provision of infrastructure. Would it have any value at all (above an agricultural use)?

Of course, if there were no infrastructure, the land would have limited value.  Are you suggesting I am against infrastructure or wish to destroy all of it?  I am sure you are not.  I am only suggesting that we take all costs into consideration, including the value of distinct pieces of land the infrastructure uses if that land were put to different use.

2) The land typically occupied by urban infrastructure (especially roads) is not well-suited for development, and hence would have a low opportunity cost. This land often appears in long, narrow parcels, upon which little could be profitably built, especially if confronted with modern land use regulations (e.g. maximum impervious surface requirements).

I don’t think this is anything close to being universally true.  Let’s consider the typical urban expressway, which is the case I consider most in need of opportunity cost consideration.  Most urban expressways displaced existing communities when constructed, and if the expressways were to be demolished, the land would likely return to that use or a similar alternative.  At the same time, nearby property values would increase as the negative externalities of the expressway are alleviated.  Thus, I consider it necessary to at least evaluate the value of the DOT land if it were to be liquidated at values similar to land in nearby neighborhoods.  The actual liquidated values would likely be greater, in consideration of the alleviated externalities.

3) Who is the residual claimant for the payment of the supposed opportunity cost? Local government? How would this enhance social efficiency?

Since the land is probably owned by the DOT or some other government agency, that is the entity which I assume would receive funds from the hypothetical liquidation.  To take that to it’s logical conclusion, the taxpayers who’s incomes were originally appropriated to fund the DOT would be the rightful claimants.  (but we know that is impossible to expect from government)

And you’ll have to define “social efficiency”, as it’s a foreign concept to me.  What is the metric of measurement of “social efficiency”?

Lastly, how do you arrive at an interest rate of 15 percent? This just sounds absurd. Most of the privately financed roads and other infrastructure projects I've seen recently have not faced interest rates remotely close to this level, even the risky ones. Heck, even the Channel Tunnel project did not face rates this high.

Again, opportunity cost of capital is neither an interest rate or cost of debt.  The Channel Tunnel’s original projected IRRs estimated as high as 18% in this source, so I’d peg it’s OCC in the mid teens.  What was the OCC of the privately financed roads and infrastructure projects you’ve seen recently? 

Let me also add that I guessed 15% for pre-stabilization and 8-10% post-stabilization, so it’d be much lower than 15% if you blended them,  Maybe infrastructure isn’t analyzed in phases like that, but that’s me thinking like a developer.  Your insight would be valuable.

As a real estate developer, have you ever been charged a rate this high for long-term debt?

Yes, of course I’ve been involved with projects that paid more than 15% for Mezz. debt.  In fact, as high as 25%.

But, we’re talking about Opportunity Costs of Capital, not debt.  So, taking into consideration equity, debt, and mezz., most projects I work on have an OCC from 12% to 20%.  But, of course, none of my projects are nearly as risky as a unique, multi-billion dollar high-speed rail project subject to budget overruns, vast political interference, 10+ year time horizon, and little residual value in the case of failure.

My final point would be this: there are things we could do to better discipline infrastructure investment, but they must be tempered with realism. Even if it were possible to calculate a socially optimal cost for road users (hint: it isn't), could we actually do it? I haven't even touched on transaction costs, which become an important matter when talking about things like externality pricing or toll collection. Politically and practically, we cannot achieve social optimality.

I agree, and I wouldn’t tolerate a world where every action would be coerced for the sake of “social optimality.”

The first is the issue of opportunity cost, which you give great prominence to in this post. I think it would be important to first mention in each case whether you are referring to private finance of infrastructure (e.g. roads) or social benefit-cost analysis for public provision, which is much more common. In both cases interest rates figure prominently, but are treated slightly different. The opportunity cost of investment capital is explicit in the case of private finance, it is simply factored into the interest rate. It is more difficult for social BCA. since the objective is to determine the appropriate opportunity cost. Most recent textbooks I've seen on the subject do not assume a priori that public projects simply displace private capital investment, but rather some combination of private capital and private consumption, the latter having a lower marginal rate of time preference (and hence discount rate). Since this issue is not 100% settled, the best course of action in the case of social BCA is to use sensitivity analysis for a range of values, assuming different types of discount rates.

In the case of private finance, two other factors that you mention, risk of cost overruns/uncertainty and demand uncertainty/bias can also be appropriately factored into an interest rate. In principle, the same could be done for the discount rate in social BCA, but in practice is rarely employed.

The last two factors, legal costs associated with eminent domain and opportunity costs of land, are in fact often included in typical project cost estimates for both public and private projects. The former is fairly straightforward, as it is a project-related cost. The latter, opportunity cost of land, is simply the purchase price of land (assuming it is bought at market rates through an arms-length transaction — this doesn't always happen). I have also heard some argue that the cost of existing roads should reflect the land it occupies. To me, this raises at least three questions:

1) What value would that land (presumably urban) have were it not made accessible by the provision of infrastructure. Would it have any value at all (above an agricultural use)?

2) The land typically occupied by urban infrastructure (especially roads) is not well-suited for development, and hence would have a low opportunity cost. This land often appears in long, narrow parcels, upon which little could be profitably built, especially if confronted with modern land use regulations (e.g. maximum impervious surface requirements).

3) Who is the residual claimant for the payment of the supposed opportunity cost? Local government? How would this enhance social efficiency?

Lastly, how do you arrive at an interest rate of 15 percent? This just sounds absurd. Most of the privately financed roads and other infrastructure projects I've seen recently have not faced interest rates remotely close to this level, even the risky ones. Heck, even the Channel Tunnel project did not face rates this high. As a real estate developer, have you ever been charged a rate this high for long-term debt?

There are probably a laundry list of issues one could discuss on this matter, and I've just touched on a few that caught my eye. My final point would be this: there are things we could do to better discipline infrastructure investment, but they must be tempered with realism. Even if it were possible to calculate a socially optimal cost for road users (hint: it isn't), could we actually do it? I haven't even touched on transaction costs, which become an important matter when talking about things like externality pricing or toll collection. Politically and practically, we cannot achieve social optimality. It's just not a Pareto efficient world. We should probably content ourselves with doing things that push us in the right direction and that we know will work.

My issue with the whole debate is that the cost/benefit analysis is way to hard to crunch for such a huge, complex program that will be implemented over the course of decades.

If it's too hard to quantify, then its not reasonable to expect people to pay for it. But, it's not too hard to quantify. Private companies make multi-billion dollar investments every day and they you'd better believe they do extensive due diligence to quantify the cost/benefit. They'd spend millions on research, designs, and studies and run hundreds of scenarios and sensitivities. But, what does it tell us that no private investors have already jumped in and built high-speed rail (or highways) if there are ones that “pay for itself”? It tells us that only government will get into these kind of projects without proper due diligence.

But, you say maybe the private sector doesn't have that kind of patience?

So, in my opinion, a large-scale HSR might be able to pay for itself in the long-term (20 – 30 years down the road). Since this is a longer time horizon than most private capital is willing to wait, the federal government seems like the appropriate body to carry out a vast intercity network.

To look at this more carefully we need to understand what is different about government and private sector that would make this true?

First of all, being in the real estate development business, I know that decisions are often made for the long run. There is plenty of patient capital that looks for long holding periods of 30 yrs+. The biggest of these is pension funds, which try to match the duration of time until pensioners retirement to the duration of investments. If there was a viable high speed rail project, you can bet pension funds would want a piece of it.

The thing is according to modern finance theory, which applies to the public sector the same as the private sector, the present value of cash flow 20 years into the future is pretty small relative to the nominal amount of future cash flow. So, the longer the term, the more the present value converges. Financial always analysis takes this long-term-effect into account even if their holding period is a few years because they will want to have something valuable to sell at the end of the day. Now, if someone in government plays the trick of saying the sum of future cash flows (instead of discounted cash flow) pays for the investment, they are defying modern finance theory, and purposely (or naively) deceiving you. (this is why I encourage planning students to take at least one course in finance theory and microeconomics)

Now, let's compare that with the “patience” of government capital. Politicians don't even care about recouping the investment, because their term is only a few years, and it's likely voters 30 years from now will not care about the boondoggles of the past – like Eisenhower who is considered a hero for his highway waste. And when voters are able to rationally see the failures, the politician has probably retired already. So politicians and bureaucrats love to be the one spending on huge capital projects they can put their name on, but hate paying for maintaining past politicians' trophies. (airports are a different story because they are huge political patronage machines over the entire life-cycle of the investment) So, do you think any politician even gives a damn about whether or not a project “pays for itself” after 30 years? No, but a private company will go under if they made the decisions politicians jump on. More more importantly, private enterprise wouldn't even be able to raise the capital needed for a boondoggle, while the public sector has the ability to just tax the public more and more to pay for the failures.

but it's not necessarily unreasonable to hold O'Toole accountable to his own principles without agreeing 100% with those principles oneself.

Sure. Then, they should either drop the “pays for itself” talk or lay off of O'Toole.

My issue with the whole debate is that the cost/benefit analysis is way to hard to crunch for such a huge, complex program that will be implemented over the course of decades. There are simply too many factors to have a quantifiable analysis of this. Glaeser clearly acknowledges this fact, but goes ahead and runs the numbers speculatively anyway (the problem is that not everyone knows he is speculating) in his series on the NyTimes blog.

So, in my opinion, a large-scale HSR might be able to pay for itself in the long-term (20 – 30 years down the road). Since this is a longer time horizon than most private capital is willing to wait, the federal government seems like the appropriate body to carry out a vast intercity network. Alternatively, the system could be built piece-meal by private actors, but in the case of HSR it seems the system may be more efficiently built from the top-down than the bottom-up. There are just too many interlocking parts.