Market failures and political economy distortions in infrastructure sector

Private investment in infrastructure faces two important challenges. One, it demands large upfront investments which will have to be recovered over several years, often decades. Second, the project has to be operated and maintained (O&M) over its long-life cycle. 

This means that not only do the private investors have to mobilise the long-term financing required, but also, they should have the capacity and risk appetite to manage the project over its life cycle. The life cycle management challenge is compounded by the inherent nature of infrastructure projects with their deep political economy connections. This includes the site or right-of-way acquisition problems, politics of tariffs or user fees and their periodic revisions, management of the local stakeholders including unions, fending off rent seeking by entrenched local interests etc. In other words, in addition to the financing and O&M, the investors must manage the political economy too. 

This applies to any infrastructure sector – power plants, ports, airports, highways, gas pipelines, power transmission lines, metro railways etc. These challenges, formidable as they are with existing sectors, are amplified manifold in case of emerging sectors like city gas distribution or electric vehicles (EVs). These sectors face the additional co-ordination challenge required to create the eco-system to sustain the sector. They require someone to play the catalytic role. For example, EVs require complementary investments in charging infrastructure. Or city gas networks require gas supply and associated transmission pipes. 

All this introduce an interesting dynamic, which favours incumbent large companies. Who else can manage the funding, O&M, and stakeholders management of such assets? Who else have the appetite to assume such risks? Who else have the political influence to be able to keep entrenched local interests at bay?

In other words, just as platforms and network effects in technology sectors favours the big firms, similarly with long-term contracting and political economy in infrastructure. There is a clearly observed market failure in infrastructure in terms of the natural course of market dynamics resulting in the preference for big companies. 

This inherent bias towards large incumbents brings its set of problems – business concentration and private monopolies, crony capitalism and rent-seeking, political influence peddling and regulatory capture, etc. 

It also presents a difficult public policy dilemma. On the one hand, large businesses are likely to be more efficient and also more effective in overcoming the various challenges of constructing and crowding in infrastructure. But on the other hand, the inherent bias towards large firms threatens to subvert the market and corrupt the political economy. 

How can public policy respond to this problem? More specifically, how can it straddle the middle path of harnessing the efficiency of large firms without allowing it to weaken the market and destabilise the political economy? Is this an impossible dilemma – you can either have large infrastructure firms or efficient markets, but not both?

A recent welcome development in this area is the emergence of infrastructure funds as important financiers of infrastructure projects. Their very nature addresses the financing challenge. And they can outsource the management to well-suited locally relevant O&M operators. One would therefore imagine they would be agnostic to the operators and their funding would help generate a diverse supply side for infrastructure services. However, their share in the private financing of infrastructure is still a very small share. Further, these funds too are vulnerable to the same market failures and political economy risks.