Wednesday, July 16, 2014

The value capture problem with greenfield projects

The new government in New Delhi has announced an ambitious urban development program, including the establishment of 100 smart cities to be financed mainly through Public Private Partnerships (PPPs). This may be an appropriate time to step back and examine the challenges with such greenfield investments.

Consider the development of a private township in the sparsely inhabited outskirts of a large city. Once the township develops, the positive externalities from the development drives up property prices in the neighborhood. The property owners in the neighborhood capture most of these externalities and reap windfall gains. In contrast, the township developer, despite being responsible for the value creation, gets little or nothing. Worse still, since he makes most of his sales in the initial stages, the developer captures very little of the massive value creation that comes with the development. In simple terms, he creates value, only to be captured by all others.

Econ 101 teaches us that this is true of most positive externalities. It also tells us that, when faced with such a situation, there will be an under-supply of the activities that create the positive externalities. In the instant case, the developers will be loath to invest in such developments, or in any case unwilling to invest substantial amounts in such projects.

In the circumstances, such socially beneficial projects are most unlikely to emerge from predominantly private investments. Governments are best positioned to undertake such activities. This is all the more so since, unlike the private investors, governments can capture a large share of the value from their investments. And it takes time for the valuations to be realized. Such value capture takes place directly through more property tax revenues, levy of impact fees etc, or indirectly in the form of general tax revenues from the economic activities triggered in the neighborhood. In fact, most often, such revenues are large enough to recover the investments within a very short time.

However, this attractive logic conceals one flaw. Governments do a bad job of project execution as well as capturing value. A purely public procurement based execution is generally badly designed, poorly executed, and badly delayed, thereby raising project costs. Weak or inadequate policy frameworks, exacerbated by lax enforcement, severely limits the value capture from such investments. So what is the way out?

There are no easy answers. Among all flawed models - public procurement, private development, and PPPs - an iterative hybrid appears to be the least distortionary. Front-loaded and progressively declining public investments, strategic partnerships with private developers (not the conventional PPPs), enabling policy frameworks and its rigorous enforcement, and a reasonable sharing of value capture between governments and private partners are some principles that should underpin such endeavors. 

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