In last summer's Donville Kent Asset Management ROE Reporter Jason Donville and Jessie Gamble share Benjamin Graham's insightful quote:
"In the short run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long run, the market is a weighing machine".
How does this apply to investing infrastructure? Is there also a "voting machine" at play in our industry when it comes to picking policies and technologies for flood mitigation? There certainly is. Is there also a "weighing machine" that will ultimately show us the merit of our decision making over time? Yes again.
Jason and Jessie comment how a focus on fundamentals and performance, including return on equity (ROE), 'weighs' value in an investment that in the long run will pay off, regardless of the frustrating volatility of short term 'voting' in the market, where decisions are made based on emotion.
Every stock on the TSX have a ROE value and a price to earnings ratio (PE) so that an investor knows what benefits (annual earnings) come at what cost (stock price). All stocks also have a price to earnings growth (PEG) reflecting the increase in value over time.
The concepts of ROE, PE, or PEG in infrastructure investing (aka city building and remediation) is a little more complex than in the stock market. Price: The price for infrastructure investing is somewhat volatile with construction projects tendered in an open market whereby hundreds of individual tender items that make up an infrastructure project are priced and multiplied by tender quantities and them aggregated into a total project bid price - for example one tender item in a flood remediation project may be 1800 mm diameter concrete pipe, and contractors will bid on that item considering the quantity involved, the environmental conditions for installation (depth, trench shoring requirements, adjacent infrastructure to isolate/protect from damage, etc.), etc.. Earnings: Typically municipal infrastructure does not have earnings - an exception might be privatized toll roads that are build and operated under P3 arrangements.
In the stock market the cost of the investment and benefits (capital gains and distributions) are all assigned to the same investor. In infrastructure investing, cost are borne by municipalities, passed on to taxpayers, and benefits accrue to taxpayers (hopefully in proportion to their funding contributions) and also to others like the insurance industry who can benefit from lower flood claims etc. over time. Sometimes costs are partially funded more widely, such as through the recent federal Clean Water and Wastewater Fund (CWWF) or through the upcoming federal Disaster Mitigation Adaptation Fund (DMAF). In an upcoming paper presented at the Water Environment Association of Ontario's 2019 Annual Conference I'll touch on the principles that have been in place for almost a century when it comes to funding water resource infrastructure projects. Kneese (What Ever Happened to Cost Benefit Analysis?) described the evolution of cost-benefit analysis in the United States dating back to the beginning of the 20th century when the Federal Reclamation Act of 1902 required economic analysis of projects, and 1936 when the Flood Control Act established a welfare economics feasibility test that benefits “to whomsoever they may accrue” must exceed costs.
Some infrastructure investments are mandated through regulation such as in the water supply realm where human health is paramount and even high cost investments are warranted to meet safety goals. ROE, or return on investment (ROI), are not considerations.
In contrast, in the flood control realm, most investment decisions are discretionary and must be justified through public and political will and in most cased be funded locally. In Ontario, the majority of flood mitigation municipal projects, including basement flood risk reduction, are funded through municipal taxes or water rates with some grant offsets. Exceptions include works on municipal drains funded through local Drainage Act assessments of contributing and benefiting properties, or in Markham, Ontario's Flood Control Program where a city-wide Stormwater Fee is dedicated 100% to funding flood mitigation activities. Some cities will offer rebates to property owners on stormwater utility fees who implement on-site measures to provide system benefits (e.g., Kitchener, Mississauga), but there is not a rigorous assessment of benefits achieved relative to rebates provided.
Do flood mitigation projects rigorously consider ROI? - that is, the ratio of deferred flood damages that infrastructure investments achieve relative to the cost on the discretionary infrastructure investment? Typically no. Investment decisions may be based on achieving specific outcomes, like meeting a standard of performance or level of service, regardless of the investment cost. Typically, in Ontario, the Environmental Assessment process guide infrastructure investment decisions such that preferred solutions to a 'Problem Statement' are evaluated qualitatively based on performance (i.e., how well is the problem addressed or solved by an alternative solution) and on capital and long term operating costs. However, the relationship between costs and performance benefits is not typically evaluated and decisions to implement a particular solution are not tied quantitatively to ROI. Where costs or other impacts are excessive relative to the benefits, the mandatory "Do Nothing Alternative" may be selected as the preferred solution, essentially stating that the ROI of potential solutions is inadequate.
Sometimes an infrastructure investment to achieve flood risk reduction is a 'no-brainer'. Examples include the Lower Don River landform to protect the West Don Lands from Don River flooding. In that case a berm and bridge upgrades with costs in the tens of millions of dollars freed up land development worth a billion. The Environmental Assessment did not even have to do economic cost-benefit analysis to settle on that solution. Opportunities for such "10-baggers" investments with benefits an order of magnitude greater than costs are rare. What is more typical is that the high ROI is not so obvious. For example in the case of Calgary's Springbank Off-Stream Flood Storage reservoir the benefit-cost analysis shows benefit cost ratios between 1.32 and 2.07 depending on the damage estimate and proposed level of service (IBI Group, 2015). And then where benefits are limited, meaning the flood risks are marginal, and mitigation costs are high, there may be no positive return at all - benefits may be less than costs. This range of benefit-cost ratio was explored on a sewershed-by-sewershed basis in the City of Stratford City-wide Storm System Master Plan in 2004 - but that is perhaps a very rare example of rigorous benefit cost analysis for local infratructure investments.
Because of the qualitative nature of the alternative evaluation in Ontario's Environmental Assessment process it can be considered to be part voting machine and part weighing machine, that is, there is some 'weighing' of alternative value but the decision is a qualitative 'vote' when it comes to ROI. For many small infrastructure investments this approach is reasonable. For high cost challenges facing municipalities, like those related to flood control, a more rigorous ROI assessment is required - why? - because there is an apparent risk of over-investing in low ROI solutions and under-investing in high-performance solutions with high long term value.
Enter Infrastructure Canada's DMAF. This $2 billion federal fund targets projects valued at over $20 million that will be implemented over the next 10 years. Unlike other funding programs like CWWF, DMAF applications will have to assess the ROI (benefits/costs) of the project and achieve a minimum ratio of 2:1. The benefits may be direct flood damage reduction values over the service life of the project, as well as other non-commensurate benefits (environmental benefits). The costs are the infrastructure investment capital and operating cost.
A focus on cost effectiveness is welcome in the realm of infrastructure policy setting, planning and funding. The is a healthy debate around policies for traditional grey and emerging green infrastructure investment, for example. As proposed in the WEAO 2019 paper noted above, and in the upcoming article in WEAO Influent's magazine, cost effectiveness screening is essential for given limited resources and the need to prioritize infrastructure investments to get the most bang for the buck. Unfortunately there appears to be a lot of 'voting machine' behaviour promoting technologies that have uncertain performance, high cost, but strong emotional drivers.
As noted in the Made-in-Ontario Environment Plan, "When the government does invest in environmental programs, taxpayers should not have to watch their hard-earned dollars be diverted towards expensive, ineffective policies and programs that do not deliver results." - that means we need a Benjamin Graham weighing machine, carefully assessing costs and benefits of policies and programs, as opposed to a voting machine fed by emotion and ideology. Ontarian's should demand the same careful focus on ROE or ROI for their infrastructure investments that Donville Kent has embraced in their equity investments.
