Motorway concessions: excess profitability?

August 14, 2018: the point of no return in the history of Italian infrastructure. With the collapse of the Morandi Bridge in Genoa, the issue of motorway concessions was thrust center stage in the public debate. Beyond discovering who was responsible for the tragedy, one of the central points in the discussion was the level of profits that concessionaires manage to extract from Public-Private Partnerships (PPP).

PPP contracts and/or concessions allow central and local administrations to resort to private capital and competencies to carry out projects that serve the public interest. The advantage of this type of contract for public bodies often lies in the opportunity to make sizeable investments without racking up more public debt. And for private investors, PPPs are particularly attractive given the long-term low-risk profile, and the anti-cyclical nature of the investment.

However, as studies on PPPs in other sectors have shown (e.g. the UK’s National Health Service), these contracts can generate exorbitant earnings for concessionaires. The reasons for this are high entrance barriers, due to the investment volumes such projects require, and more importantly the lack of adequate financial competency in the public sector.

In motorway concession contracts, the concessionaire is responsible for maintaining, expanding, modernizing and operating the infrastructure; in Italy, compensation comes in the form of tolls paid by motorists. Moreover, regulators can opt to allocate extra ad hoc funds if additional investments are deemed necessary. Since demand is largely rigid, profitability reaches excessive levels when tariffs are high and/or when insufficient resources are reinvested in the infrastructure for maintenance and improvements.

To verify the actual profitability of motorway concessions in Italy, we conducted a study on 23 such contracts beginning in 2007. This marks the date when, following the approval of a series of legislative measures, the contractual framework for these concessions was reformed and a cost remuneration mechanism was introduced based on the weighted average cost of capital (WACC).

We started by analyzing data on PPP contracts, and then calculated project IRR and equity IRR (Internal Rate of Return) in relation to the WACC and the expected return on invested equity, respectively. What emerged from our investigation is that a positive difference between IRR and the cost of capital implies a level of profitability which is inconsistent with the risk that investors are subject to.

We focused particular attention on Autostrade, the private concessionaire that controls that biggest share of Italy’s motorway network (over 40%). In this case, we compared revenues and dividends that were forecasted in the financial plan of the concession (later revised in 2013), and the data actually reported in the company’s annual financial statements from 2007 to 2017.

The Autostrade data reveal that in the first few years after the financial plan (2007-2009) and the subsequent revision (2013), projected revenues and corporate performance actually came into alignment. But after that, in the years following both periods (2010-2011 and 2014-2017 respectively), the company’s revenues far outpaced projections. Even with a steady decline in motorway traffic from 2007 to 2013 (post economic crisis), revenues for the concessionaire continued to climb until 2011 thanks to higher tolls. In fact, from 2007 to 2017 total tolls collected by Autostrade ballooned by 41%, while at the same overall traffic registered a dip of 3%. Further proof of excessive profitability can be found in real dividends, which consistently outperformed financial-plan forecasts: a total of 7.67 billion euro from 2007 to 2017, compared to a projected 4.85 billion.

So the Autostrade experience provides irrefutable evidence that the concessionaire earned excessive profits, mainly due to a badly-designed tariff system, which actually ended up over-compensating for lower traffic flows following the financial crisis.

Our study shows that excess profitability impacts concessions awarded not only to private operators, but to players with public participation as well. Our work also provides a methodology that regulators can use to set levels for tariffs and investments accurately. This will ensure value for money and sustainability of concession contracts, seeing as they represent a very common model used all over the world to realize and/or manage economic infrastructures, to include motorways. Other essential elements in preventing excess profitability are competitive procedures to follow when awarding concessions and the length of these contracts.

As the Italian case shows, it’s impossible for regulators to design concession contracts without conducting a meticulous and insightful analysis of the economic and financial aspects of the project in question. As of 2007, concessionaires were required to submit financial plans when contracts were awarded or renegotiated, but this measure did not go far enough to prevent excess profitability. In fact, there was lack of accurate information in the financial plans that were presented, and a lack of financial competencies within the PA to correctly interpret these documents (so-called honest incompetence). As a result, the requirement to produce a financial plan has become little more than a formal obligation for concessionaires. So for the public, concession contracts are not particularly advantageous, as they guarantee excessive returns on investments for private players.

Studies on regulatory disasters demonstrate that, in the long-term, adopting inconsistent strategies and a lack of competency among regulators can make effective risk management impossible, potentially leading to disaster. With regard to Italian motorway concessions, experience sadly seems to confirm a similar dynamic. However, the solution to this type of problem can’t simply be to reverse course and return to public management of infrastructure. In fact, when concessions are well-structured and monitored by a competent regulator, the results can be optimal on both microeconomic (greater efficiency) and macroeconomic terms (more investments in a context of high public debt, while offering an attractive investment class for long-term investors).