How Will Upswings in Price Inflation and Interest Rates Change Toll Road Risk Profiles?

How Will Upswings in Price Inflation and
Interest Rates Change Toll Road Risk

Profiles?
A Study of Developing East Asian Economies with
Broader Implications
Richard Di Bona, Hong Kong

rfdibona@yahoo.com
Australasian Transport Research Forum 2011,

Adelaide, 29 September 2011
Contents
1. Background
2. (Business) Environmental Analysis
3. Business Cycles
4. Accuracy and Demand Risk Issues
5. Questionnaire Survey – what do Practitioners Think?
6. Risk Simulation Modelling
7. Conclusions
8. (And a quick Post Script on the Global Economy)
How Will Upswings in Price Inflation and Interest Rates Change Toll Road Risk Profiles?
Background
1980s and 1990s:
• Resurgence in private sector involvement in
infrastructure provision, e.g. toll roads
• Generally declining price inflation and interest
rates
Now:
• Price inflation and interest rates likely to rise
rather than fall
• What impacts (if any) on project risk?
Geographic Scope
Specific Hypothesis
“There is a significant change

in the nature and extent of
project finance risks for private
stakeholders in East Asian toll
roads during a period of
increasing price inflation and
interest rates”
PESTLE Analysis
• Political: Stability concerns – though not necessarily
derailing investment
• Economic: Generally growing, but with income
disparities
• Social: Increasing desire for travel. In some
locations demand substantially suppressed. Varying
nationalism, with impacts on contracts
• Technological: lots of manual tolling
• Legal: wide range of systems, but much corruption
• Environmental: Economic development objectives
predominate
Scope for Toll Roads
• Correlation between roadspace and car ownership:
one can proxy for the other
– Khan, A. and Willumsen, L.G. (1986) “Modelling Car
Ownership and Use in Developing Countries”, Traffic
Engineering and Control, 27(11), pp554-60
• Tested on study countries, plus Mexico, Poland,
South Korea, UK and USA
– Population per km of paved road vs GDP per capita
– Land area (km2) per km of paved road vs GDP per capita
Relationship: Wealth versus Roads per Capita
Relationship: Wealth versus Road Density
Three Groups of Countries
• Relatively developed networks, in countries with
significant prior experience of transport
infrastructure privatisation: China, Indonesia,
Malaysia and Thailand
• Relatively undeveloped networks, correlating to a
relative lack of infrastructure privatisation:
Cambodia, Laos and Myanmar
• Intermediate countries: with some problematic
experience of privatisation (Philippines) or nascent
interest in privatisation (Vietnam)
Weighted Average Cost of Capital (WACC)
• Fisher-Hirshleifer Theorem: Undertake projects if
return is greater than investors’ required return
• Capital Asset Pricing Model (CAPM): return is:
rj = ri + βj (rm – ri)
• Weighted Average Cost of Capital (WACC):
WACC = [(EMV x Ke) + (DMV x Kd)]/(EMV + DMV)
– EMV = total market value of equity employed
– DMV = total market value of debt employed
– Ke = cost of equity: (Dividend/Share Price) + Expected
Dividend Growth
– Kd = cost of debt: (Interest Rate/ Debenture Price (% of
face value)) x (1 - TaxRate)
ri + βj (rm – ri) ≥ [(EMV x Ke) + (DMV x Kd)]/(EMV + DMV)
Business Cycles
Schumpeter (Business Cycles, 1939) brought together
others’ work:
• Kitchin (1923): fluctuations in business inventories
(39 +/- months)
• Juglar (1863): business investment in plant and
equipment (7-11 years)
• Kondratieff (1926): development of new
technologies/ sectors/ markets and impacts of
these changes on socio-economic conditions (48-60
years) (a.k.a. The “K-Wave”)
Nikolai Dmitriyevich Kondratieff (1892-1938)
• Specialist in statistics and agricultural economics

• Involved with early Soviet Five Year Plans
• Investigated nature of capitalist crises
• Discovered periodicity, correlated with long waves
in agricultural price inflation and interest rates
• First gulaged, and subsequently murdered on
Stalin’s orders
• Rehabilitated in the USSR in 1987
The K-Wave: Key Characteristics
• Downswings: price inflation and interest rates
decline (e.g. 1980s, 1990s)
– Corresponds with growth in private investment in
infrastructure
– Refinancing projects cheaper than anticipated during ex
ante evaluation
– Cost of delayed/ incomplete toll adjustment less than
anticipated during ex ante evaluation
• Upswings: economic growth, price inflation and
interest rates increase
– Growth drives demand for goods (price inflation)
– Growth drives demand for capital (interest rates)
– Costs of debt and equity likely to increase
– Refinancing and toll escalation likely to be more critical
The K-Wave: Postulated Position
18 800
16 700
14
Treasury Bill Interest Rates (%)
600
Gold Price (USD per oz)

12
500
10
400
8
300
6
200
4
2 100
0 0
50
55
60
65
70
75
80
85
90
95
00
05
19
19
19
19
19
19
19
19
19
19
20
10 Year T-Bill 3 Month T-Bill Gold(USD/oz) 20 K-Wave

Primacy of Traffic and Revenue Risk
Construction
Delay
Risk (nominal) Change Orders
Construction
Costs
Ramp Up
Traffic &
Revenue
O&M
er
-2
-1
10
0
ov
d
an
H
Willumsen, L. and Russell, C. (1998) “Reducing
Year Revenue Risk”, European
Transport Conference, Loughborough, 14-18 September 1998
Accuracy (or Lack Thereof)
• Average initial year traffic: 70% of forecast
• For lender-commissioned studies: 82%
• For other studies: 66%
– Bain, R. and Wilkins, M. “Credit Implications of Traffic Risk in Start-
Up Toll Facilities”, Standard & Poor’s, September 2002
• Due to Ramp Up?
• Can last 3-5 years
– Streeter, W. and McManus, K. “Challenges of Start-Up Toll Roads”,
Project Finance Special Report, Fitch ICBA, 1999
• Or optimism bias constant in years 2 to 5?
– Bain, R. and Polakovic, L, “Traffic Forecasting Risk Study Update 2005:
Through Ramp-Up and Beyond”, Standard & Poor’s, August 2005
Resources, Psychology, Ethics
• Models’ opaqueness
• Lack of resources (e.g. time, data)
• Ethical factors
– Discrepancy between lenders’ and others’ forecasts
• Modellers delude themselves
– Supposed “neutrality” or “infallibility”
Brinkman, P.A. (2003) The Ethical Challenges and Professional Responses
of Travel Demand Forecasters, PhD Dissertation, University of California at
Berkeley
Kilsby, D. (2004) “Ethical Challenges and Professional Responses of Travel
Demand Forecasters – Review”
• Or cycles?
– More studies during boom times
– Projects open after the boom has ended?”
Price Inflation & Interest Rate Impacts
• Value of Time
– Income and substitution effects – what is the elasticity
– (Negative) savings effects during credit expansion?
• Competing Routes
– Faster network expansion in boom times?
• Toll Increases and Revenue Guarantees
– As price inflation grows, greater potential for loss if
increases not granted/ delayed (or political risk of toll rise
approvals during slumps)
• Construction, Operating & Maintenance Costs
– Price inflation for raw materials & wages
– (Negative) savings effects during credit expansion?
• Toll Leakage
– Greater incentive for malfeasance?
Practitioner Questionnaire Survey
Test views versus literature environmental analysis:
• Scope of project experience
• Relative weightings of macro and micro-level risks
• Data availability and quality
• Accuracy of forecasts and key metrics used
• Market outlook for the 9 Study Area countries
• Expectations for economic parameters
Respondent Experience
100
80 Respondents by
Type
60
40
20
1 to 4
5 to 9 7%
6% 30+
0 26%
Financial, Transport Engineer, Government, Academic Others
Legal, Planner, Architect Aid Agency
Operator Economist
10 to 19
Respondent 31%
Experience (years)
20 to 29
30%
Selected Questionnaire Findings
• Primacy of legal & political factors on viability
• Once modelling commences, economic factors
predominate
• Business cycles deemed unimportant, but:
– A degree of acceptance of increasing price inflation/ fuel
prices
– Some expectation of interest rates increasing (but not
having an impact)
– Stronger economic growth expected (but this perhaps
due to adaptive expectations – survey in 2006)
Risk Simulation Modelling
• Economic, traffic and financial model
– Notional network, using Excel/ Visual Basic
• 3 Cases:
– Conventional – recent interest rates, inflation continue
– Respondents’ – based on questionnaire, with small
increases in fuel prices, general prices, interest rates
– Kondratieff – more substantial price inflation, interest
rate and economic growth
• 33 variables: 27 common for all cases; 6 had values
specified base on case. 10,000 iterations:
– Define random parameters
– Quarterly simulation for 30 years, from construction
– Traffic assignment for each quarter (once road opens)
– Financial analysis (FIRR, NPV, payback)
– Any run with FIRR<0 or payback>120 quarters = failure
Risk Simulation Modelling
Modelling Results (No Risk Simulation)
Results without simulation:
• Conventional Case:
FIRR = 16.8% Payback = 10.73 years NPV (@16%) = $17.9m
• Respondents’ Case:
• Kondratieff Case:
Risk Simulation Modelling Results
• Conventional Case:
Mean FIRR = 17.2% (s.d. = 3.74%)
Mean Payback = 10.83 years (s.d. = 2.32 years)
Mean NPV (@16%) = $28.1m (s.d. = $80.3m)
Financial Failure = 0.6% of runs
• Respondents’ Case:
Mean FIRR = 18.0% (s.d. = 3.77%)
Mean NPV (@16%) = $46.4m (s.d. = $96.3m)
• Kondratieff Case:
Mean FIRR = 17.6% (s.d. = 4.11%)
Mean NPV (@16%) = -$37.7m (s.d. = $308.9m)
Cumulative Probability Distribution:
FIRR (excluding FIRR < 0%)
100%
80%
Cumulative %
60%
40%
20%
0%
5% 10% 15% 20% 25%
Conventional Respondents' Kondratieff
Payback Period (years)
100%
80%
Cumulative %
60%
40%
20%
0%
8 10 12 14 16 18 20 22
NPV (16% discount rate)
100%
80%
Cumulative %
60%
40%
20%
0%
-500 -400 -300 -200 -100 0 100 200 300 400
Analysis of Risk Groups
• Some variables had large but poorly correlated
affect on FIRR. Others had smaller but better
correlated effect. So to assess importance:
– Range (maximum – minimum) calculated
– Range multiplied by coefficient from linear regression
– This impact then multiplied by R2
• Then group simulation variables by category
• Same five groups ranked top in each case, but the
rankings changed
Change in Relative Risk
• There is autocorrelation
• Inflation affects all cost elements
• Interest rates escalate in importance as they
increase, especially when refinancing required
Key Findings
• Impacts of delayed toll increases or refinancing
become greater than anticipated (ex ante) when
interest rates & price inflation increasing
• Mitigating this, increased economic growth (driving
demand for capital and commodities) can increase
demand
• But outcomes likely to be more volatile
• Specific hypothesis is thus supported
• However, the implications of this appear to be
under-estimated
Post Script
• There have been recent issues with economic
growth in many parts of the world, especially the
developed economies – though with countries such
as Australia, New Zealand and Canada relatively
protected by their commodity bases
• These brought about, in my opinion, by excessive
credit expansion which creates distortions to
“natural” economic rhythms
• There is a “debt overhang” suppressing growth in
many countries
• And it could be argued that propping up old firms/
industries has starved the next wave of innovations
of capital to drive the next K-Wave upswing, so it
has not been as pronounced as it would otherwise
have been
In Conclusion
“There is a significant change in the
nature and extent of project finance
risks for private stakeholders in East
Asian toll roads during a period of
increasing price inflation and
interest rates”
– and elsewhere too!
Please feel free to contact me (rfdibona@yahoo.com)
for the full MBA Dissertation on which this is based
Thank You!

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How Will Upswings in Price Inflation and

Interest Rates Change Toll Road Risk

Richard Di Bona, Hong Kong

Australasian Transport Research Forum 2011,

“There is a significant change

• Specialist in statistics and agricultural economics

Gold Price (USD per oz)

10 Year T-Bill 3 Month T-Bill Gold(USD/oz) 20 K-Wave

Risk (nominal) Change Orders

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