The livability and economic prosperity of our cities is underpinned by an array of social and economic infrastructure, and while the social and economic benefits of infrastructure are well known and understood, finding the money to build, operate and maintain this infrastructure can be a daunting task. This post briefly explains some of the key elements of funding urban infrastructure, it begins with an discussion of why the public sector usually provides these services, and then considers whether infrastructure users or society at large should pay for the services. We then finishes with some suggestions to improve infrastructure funding in NSW.

Market Failure
When discussing public infrastructure it's important to understand some of the fundamental economic challenges infrastructure services may face. For example most infrastructure suffers from market failures such as natural monopolies and the free rider problem. These market structures determine whether the public or private sector is best placed to provision these services.

Infrastructure is said to have a natural monopoly because most infrastructure services require high fixed capital costs. For example. it is much cheaper for a community to build and maintain just one electrical network, rather than have multiple energy providers run multiple cables past every home and business. Natural monopolies also occur due to the natural structure of a place. For example a city may only have one suitable location to build a dam or shipping port. When building monopolistic infrastructure services it is essential that the markets are well regulated by government, through mechanisms such as; contestability, breaking up vertical markets, minimum services standards and even price regulation.

Infrastructure services can also suffer from a free rider problem, where metering and measuring can be technically difficult or too expensive. A free rider is someone who takes benefit from a good, but does not pay for the benefit or negative cost they may imposed on others. For example, electrical lighting was not widely adopted until energy providers could meter consumption through the adoption of the electricity meter. Today, it is relatively easy for the market to provide water, electricity and data services due to the consumer being the only beneficiary and the amount of benefit can be easily identified by metering their usage. However, other infrastructure services such as roads have been much slower to adopt ways of metering and measuring consumption. While new GPS and mobile computing technology would allow for accurate time-of-day and location metering of road consumption, public policy has been slow to respond. Transport infrastructure also suffers from a free rider problem in that the benefit (and costs) are not only derived by consumers. For example building a road through an industrial area may increase land values as businesses have improved accessibility, even if the land owner does not use the road the land owner benefits from increased land values. Roads are also notorious bad at imposing costs on others, for example; noise and air pollution, road congestion, barrier effects, even injury and death. It's critical that infrastructure funding considers all the beneficiaries and adopts innovative metering and pricing technology to accurately price benefits and costs.

Beneficiaries Pay
When funding infrastructure it is critical to identify all the beneficiaries of the infrastructure services, and then identify the most appropriate mechanism to pay for infrastructure services. The mechanisms to pay for infrastructure may be social funding, through general tax revenue, or directly charging users through metering usage or special levies related to the nearby infrastructure service.

When using user pays levies or taxes to capture the positive externalities of infrastructure services, it is critical they only capture the incremental benefit derived from the infrastructure service. For the market to function effectively, the timing and value of the levy should be directly linked to the derived benefit. For example, the diagram below illustrates the increase in property values from a range of urban activities, including; rezoning, the construction of local infrastructure (such as streets, utilities, parks, etc), property development (such as building a house), and the construction of strategic infrastructure (such as main roads or a railway station).


In this example, only the value highlighted in blue should be captured by mechanisms such as a special levy or taxes. It is also critical that these levies be charged at the time the value is realised, that would be when the rezoning or infrastructure service is delivered, not before. It is preferable that the value created by the property development activity should not be captured, as this value has been earned in the market and any tax on these activities would only result in higher prices, lower demand and lower supply.

The benefits of most infrastructure services are not completely realised the assets are constructed. While some value is created, the greatest benefit is realised over the useful life of the asset. For this reason it is also reasonable to impose user charges and levies over the useful life of the asset, rather than large upfront levies. For example, a small contribution could be made immediately after the construction of footpaths and street lighting, however the bulk of the value should be captured through smaller ongoing levies over a longer period of time through mechanisms such as council rates or a special levy.

Needed Reform in NSW
Public policy in regards to urban infrastructure in New South Wales is notoriously bad at charging the right beneficiary at the right price and at the right time. For example, most roads in NSW are provided at no cost to road users, and consumption taxes like federal petrol taxes are location and time-of-day agnostic. There are a limited number of roads that are tolled in NSW, however only the harbour crossings have time-of-day pricing, and they are priced at construction/maintenance cost, not the value derived by the benefiting consumer. This leads to congestion on some roads and empty tunnels on others, which in turn has led to massive project failures such as the Land Cove Tunnel, Cross City Tunnel and undoubtedly the future WestConnex project.

These poor pricing mechanisms are also notoriously bad in the housing market. Property developers are often charged local and strategic infrastructure levies before the infrastructure assets are built and the value is created. This adds significant costs to housing supply as prices are inflated; developers add a risk adjusted rate of return to the cost outlay, these costs are then passed onto consumers through increased housing prices, and to society at large for a decrease in the supply of housing. The increase in house prices is also multiplied through increases in stamp duty and other property transaction costs such as real estate agent fees, and the final amount is then financed by the home owner through the private mortgage market adding significant financing costs. A homeowner in NSW could easily end up paying $100K for a $300K levy.

To fix this mess all value capture mechanisms should be separated into small upfront contributions when the assets are constructed and ongoing user charges or levies over the economic life of the asset. Government treasury should be funding the asset construction, which they can finance at no cost to government through infrastructure bonds which would be repaid by levies and consumption charges. If communities are unable to afford essential infrastructure services there may be a case for government grants to fund these projects or provide subsidies for ongoing user charges, however the planning system and development industry should not be used to hide these subsidies. Reforming the funding of infrastructure services would have many benefits, including significant cost reductions to government and consumers, reducing the risk to property developers, and reduce the market price of new housing. We now have the technology to accurately identify beneficiaries and charge them for their benefit, we now need to reform the institutions that deliver these public goods and the mechanisms they use to deliver them.