Briefing Report: This Is No Way To Run A Railroad

Wednesday, June 1, 2011

"The state High-Speed Rail Authority, made up of politicians and political appointees with side agendas, has supposedly been working on the details [of the state's high-speed rail plan]. But we still don't know how much it would cost, what the ridership would likely be or what would be the sources of construction money." - Dan Walters, Sacramento Bee, May 11, 2011.

"The Emperor has no clothes!"

Since its inception as the brain child of Senator Quentin Kopp and then Governor Pete Wilson, the High-Speed Rail Authority (HSRA) has been a state organization designed to advocate for a high-tech, futuristic transportation system that would simultaneously connect all California's job-centers and assuage the inferiority complex of a generation of civil engineers who have looked across the waters at glitzy trains in other countries and in a fit of Kennedy-era wonder asked, ‘why not?'

On May 10th, the Legislative Analyst's Office (LAO) answered that naïve question with an uncharacteristically harsh dose of reality. In a 28-page, strongly worded vote of no confidence, the LAO delineated a number of problems with the HSRA's business plan, its command structure and its competence. As the report rightly points out, the HSRA's plan today is dramatically different than the one presented to the voters in November of 2008. In fact, the voters agreed to a system that would cost $33 billion to construct, with the state portion being $9 billion in general obligation bonds. For that price tag, the voters were told they would have a system up and running by 2020 that would cost $33 billion, and would provide service between San Francisco and Los Angeles that was both faster and cheaper than what is currently available from the airlines. The voters were promised a system that would make a profit in its first year of operation, and by its completion would have 39 million passengers per year. Today, the HSRA's plan is predicted to cost $43 billion, although the LAO projection sets the number at $67 billion and other analysts predict the final bill will top $100 billion. The one-way ticket that was sold to the voters as costing $55 is now $105 and instead of taking under 2 hours, the estimate has increased to 2 hours and 40 minutes. This is far from competitive with an airline ticket on Southwest, which costs only $70 and takes only 80 minutes. In addition, the HSRA plan calls for significant subsidies in an effort to induce private investment.

Documenting a number of critical problems, including federal funding assumptions that are unrealistic, the potential need for significant subsidies that are specifically precluded in the measure passed by the voters and strict federal guidelines for the use of federal dollars that limit the utility of the initial phases of the project, the LAO provides a list of devastating recommendations: (1) pull all but $7 million in funding to the HSRA; (2) direct the HSRA to renegotiate with the federal government, seeking additional flexibility and time; (3) reevaluate the initial segment to ensure that any construction provide a statewide benefit (i.e. as opposed to a train to and from nowhere); (4) pass legislation shifting the responsibility for day-to-day operation and strategic development to the Department of Transportation (Caltrans); and (5) remove all decision-making authority over the project from the HSRA board to ensure that the state's overall interests are taken into account.1 It is hard to imagine a more glaring indictment of the HSRA's plan or its capabilities. Finally, at long last, an unbiased observer is echoing the chorus of many Republican voices: "The Emperor has no clothes!"

But aside from that Mrs. Lincoln, how did you enjoy the show?

As damning as the LAO's analysis of the HSRA is, it quite literally only scratches the surface. First and foremost, the HSRA has never even pretended to provide the Legislature with credible analysis and has instead focused on being an effective advocate, as evidenced by their significant investment in contracts for public relations and lobbying both in Sacramento and Washington. To date, despite repeated requests from the Legislature, the Authority has failed to provide an investment-grade business plan. At first, HSRA representatives intimated that they were unclear on what such a plan might be. In fact, an investment-grade business plan is a thorough analysis of all points of a proposed project, its viability, the potential risks, best case scenarios and worst case scenarios and the likelihood of the project achieving its goals and providing a financial benefit to the investors. No financial institution would consider investing in a massive infrastructure project before undertaking this form of credible analysis. When asked about this again, the HSRA's Executive Director Roelof van Ark in a hearing on the LAO recommendations, deferred, implying that this level of data analysis is the responsibility of the investors and not the Authority.

This introduces a common theme in the HSRA's relationship with the Legislature. Despite the fact that the HSRA needs legislative appropriation for the funds necessary to undertake the construction of the project, it never concerns itself with providing the Legislature, or the people of California with the information necessary to make informed decisions. In that information vacuum, independent analyses – which provide an increasingly grim picture of the potential impact that undertaking this project would have on California's financial future – pile up.

Operating Subsidy

One of the only protections afforded to the taxpayers in the passage of Proposition 1A was that it specifically precluded an operating subsidy. Proposition 1A states "The planned passenger service by the Authority in the corridor or useable segment thereof will not require a local, state, or federal operating subsidy." At a bare minimum, this language requires the HSRA to prove that they have the financing to build any corridor or useable segment and the revenues and costs (operating and financial) before requesting any additional legislative appropriation. To date, the HSRA has not provided the Legislature with any such proof, and instead asserts that it has a legal opinion releasing them from that obligation. It is instructive to note that not a single public transit or passenger rail system in the US operates without a subsidy to its capital development phase and/or operations.2

The Authority has assumed private equity investors would need a pre-tax annual profit of about 21% to participate in the capital development phase or operations. In their 2009 Business Plan, the HSRA states "Never before has there been more interest and more momentum behind building a high-speed train system in the United States . . . tremendous amounts of interest from private companies who work with train technology as well as construction ... " Despite that assertion, to date, no private investor has come forward with any of the $10-12 billion required for the project's capital development. Unless the State and/or Federal governments build or guarantee Phase One's capital construction costs, there will be no project.3

Risk Assessment

The HSRA business plan makes many bold assertions. Not the least galling is its plan for assessing risk. The plan's entire risk management and assessment amounts to monitoring the likelihood of receiving federal and state funds for the project. That is lobbying, not risk assessment. "The Authority puts forward only its best-case scenario in the 2009 Business Plan. Presumably, that case assumes nothing deviates from their assumptions on ridership – which drives their assumptions about revenues and operating expenses – and therefore cash operating surpluses. But the outcomes are based on highly questionable assumptions about ridership, capital construction costs, operating expenses and revenues. And the Authority assumes there are no debt servicing costs from the capital development part of Phase One above the voter-approved $9.95 billion of bonds that the State (not the Authority) will service. In other words, their plan ignores the costs of building the system and simply says what will happen in the subsequent years of operations."4 That would be like passing the state budget by balancing revenues and expenses, but never quantifying interest payments for outstanding debt.

The Business Plan also fails to provide any alternative scenarios to assess potential financial risks for the investors. What happens if ridership fails to achieve the projected 39 million, which all credible analysts have challenged as impossibly optimistic? If only three quarters of the HSRA's forecasted riders show up in 2020 to 2035 (nearly nine of every ten people in California in those years) the cumulative negative cash flow would be $9 billion. What if the system cannot extract full fares from all its customers? If ticket sales' revenues from the 39 million riders are down by a quarter, the peak negative cash flow would be $16 billion. What happens if both those plausible events happen together? The outlook for operating surpluses would disappear, leaving a negative cash flow of $22 billion.5 These are basic risk assessment analyses that any responsible investor would consider prior to putting their capital in the hands of the project managers. It may explain why private capital has failed to materialize, but it should also give any responsible public official pause. If any of these alternative scenarios came to pass, where would California come up with the revenue to support that kind of drain to the general fund?

The Big Picture

To date, the biggest investors in California's high-speed rail dream are the taxpayers. As the elected representatives of the people, it falls upon the Legislature to protect taxpayers, the state and the economy from these kinds of potential liabilities. Every day hundreds of thousands of dollars are wasted funding studies, surveys and public relations efforts, if as the LAO reports, the financial plans for the construction and operation of the HSRA are not realistic.6

Setting aside for a moment the potential benefits or financial costs associated with the proposed high-speed rail system, the Legislature is in the uncomfortable position of having to make a decision, and by so doing let its priorities be known. As the state struggles to close a massive budget gap, every dollar must be accounted for. Just the $9.95 billion in general obligation bonds that constitute the state's down-payment on the system, according to the LAO, represent about $1 billion per year in general fund interest payments.

The budget is a zero-sum game, meaning that every dollar spent here means a dollar that cannot be spent fully funding education, or a host of other vital programs. If all that money was to be taken directly from the schools, that would represent closing a medium-sized primary school every month, adding up to over 100 schools before the system carries its first passenger.7

On the other hand

There has been a great deal of criticism leveled at the HSRA, its management practices and the lack of details associated with its plans. Although these criticisms are valid, there are a number of equally valid explanations. To date, the HSRA argues that it has been hampered by a lack of staff and a lack of funding. Until the passage of the Proposition 1A, the overall goal of the HSRA was to develop a visionary plan and advocate at the Legislature and with the voters to adopt their vision of what the system might look like. At that point, the lack of detail was fundamental to the success of the effort. As the staff of the HSRA has become more professional, and high-speed rail experts like Mr. van Ark have come on board, the mission of the HSRA has been transformed from an advocate into the skeleton of an agency that could effectively see the construction of the system through to its conclusion. The HSRA has argued that it is in the process of finalizing a business plan that will provide valid statistical data on ridership estimates that meet or exceed industry standards, and will identify additional funding sources for the revenues that will be necessary to complete the project. In a hearing on the LAO report, Mr. van Ark, again reiterated the importance of keeping the project moving forward and that any vote of no confidence from the Legislature at this point would virtually assure that the private sector would not invest in the project.

Proponents of the system are asking that the HSRA be given the time it needs to complete a more robust business plan. As the Legislature considers the wisdom of that request, it is important to note that there are significant potential benefits that California might reap from the system. As California contemplates how it will achieve mobility under the rubric of AB 32 and SB 375, where the state effectively has eliminated the possibility of additional road construction, the pent up demand for mobility will require either massive increase in airport capacity or some other system like the high-speed rail to link the major cities throughout the state in a manner consistent with the stated environmental goals adopted by the Legislature. Furthermore, may of the criticisms of the HSRA to date are not unique to the HSRA, but have instead plagued virtually every publicly developed mega-project both in the United States and abroad. These arguments merit additional attention.

Mega-Projects: How the public sector fails to deliver

The sad fact is that mega-projects the world over are plagued with similar problems. What is more, these problems have been extensively analyzed. Danish academic Bent Flyvbjerg is a global leader on mega-projects and the risks associated with their development. In a study that covers 258 highway and rail projects ($90 billion worth) in 20 countries, he came to some startling conclusions. Nearly all (90%) of the projects studied suffered significant cost overruns, with the average rail project costing 45% more than projected. Flyvbjerg concludes that "... the cost estimates used in public debates, media coverage, and decision-making for transport infrastructure are highly, systematically, and significantly deceptive. So are the cost-benefit analyses."8 The study comes to several more conclusions that could have been drawn from a study of the HSRA. "The incentives to produce optimistic estimates of viability are very strong and the disincentives weak... And the reason for that is a lack of accountability of the parties involved, not a lack of technical skills or insufficient data. Another key insight is that risk is simply disregarded in feasibility studies . . . by assuming what the World Bank calls the EGAP principle: Everything Goes According to Plan. But in mega-projects... things seldom go according to plan."9 (emphasis added)

So, at least we can take comfort in the fact that the problems California is having with the HSRA are not unique, but are inherent in government-run mega-projects. Because the track-record for these projects is so well-documented, we can skip to the end and see what the future has in store for California: all the major risks - of cost overruns and of inadequate ridership - will be squarely on the taxpayers' shoulders.10

Conclusion: The future of high-speed rail is with the private-sector

Given the performance to date of the HSRA and how that mirrors the global experience with mega-projects, perhaps it is time for the Legislature to heed the warnings of the LAO and go one step further. It is time for the Legislature to focus what little remains of the general fund on its top priorities and leave the funding and development of untested transportation alternatives to the private sector that has proven far more adept at delivering these projects on-time and within budget than the public sector.

 

1 Legislative Analyst's Office, High-Speed Rail is at a Critical Juncture, May 10, 2011.
2 Seven Deadly Financial Facts for California's High-Speed Rail Authority, January 18, 2011, p2)
3 Ibid, p 3.
4 Ibid, p7
5 Ibid
6 The Financial Risks of California's Proposed High-Speed Rail Project, October 12, 2010, p 34)
7 Ibid, p 4
8 Transportation Mega-Projects & Risk, Reason Foundation, February 2011, p 6
9 Ibid
10 Ibid, pp 6-7

 

For more information on this report or other Transportation issues , contact Ted Morley, Senate Republican Office of Policy at 916/651-1501.