How can leaders put the capital into cities?

By

George Atalla

EY Global Government & Public Sector Leader

Working with governments to address complex issues and build a better working world.

7 minute read 5 Apr 2019

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Finance for smart urban infrastructure is falling short, and city leaders need creative new ways to bridge the gap.

Most mayors, city planners, citizens and technology experts agree: cities need to get smart and stay smart. If not, they will struggle to cope with challenges like rapidly growing populations, digital disruption and the effects of climate change.

But being smart means having infrastructure that’s connected and enabled by technology. And as 75% of the infrastructure that will exist in 2050 doesn’t exist today, the amount of capital needed will be immense ($94 trillion by 2040, according to forecasts.)

Cities can’t rely upon their own coffers to provide this money. In a 2017 survey, 55% of municipalities identified lack of public funding as a major barrier to sustainable urban growth. And while the private sector is awash with capital looking to find a home in infrastructure, cities often struggle to access it. (We’ll explain why later.)

As a result, the World Bank estimates that less than 2% of the US$106 trillion of private institutional capital in the world today goes to infrastructure. And based on current trends, total funding for infrastructure is predicted to fall around 20% short.

So how can cities bridge this gap? By exploring new and varied ways to secure investment for smart city initiatives.

  • Funding
    Capital the government or another organization provides, usually interest-free, with no expectation of being repaid.

    Financing
    Capital that one or more organizations (usually financial) provide to a project. The recipient repays it along with an agreed amount of interest.

Four approaches that hold promise for the future

Cities can explore alternative models and revenue streams, exploit existing assets and tap into new markets

1. Raising capital for smart city investments

There are two growing areas of interest available to city leaders:

  • Exploiting existing city infrastructure and assets

5G technology depends on broadband fiber-optic cable and small cell wireless networks to deliver its capacity, speed and coverage. Government agencies are increasingly teaming with private partners to design, build and maintain this infrastructure.

For example, New York City’s Metropolitan Transit Authority (MTA) is using existing infrastructure assets to expand its broadband networks. The project will provide cellular and Wi-Fi connectivity for MTA’s transit operations as well as the city’s sensors and mobility networks. The private sector will also be able to lease the network for commercial activities.

  • Tapping into the growing market for green and social impact bonds

Green bonds specifically target climate and environmental projects, and issuance of these bonds grew by 3% in 2018 to US$167.3 billion. In Canada, EY teams have worked with the City of Toronto and the Province of Ontario to finance a portion of the Eglinton Crosstown Light Rail transit project with a $500 million green bond.

There’s also scope for cities to bundle up the financing of several smaller green projects to create a single “securitization” product. They could group projects within their own jurisdiction, or team up with other cities hoping to implement similar projects. The scale of the product this creates could appeal to an institutional investor.

Meanwhile, social impact bonds target projects that aim to achieve specific social outcomes, like reducing the number of people sleeping on the street. As such, they attract investors who may be prepared to receive a slightly lower return in the knowledge that the bond is doing a social good.

2. Accessing private sector capital

Smart city initiatives are complex, involving more parties than a traditional project. Their future revenues are less certain than those from a toll road or a bridge. And the relatively new technologies that underpin them tend to be higher risk.

That said, some new opportunities are emerging.

  • The private sector is increasingly interested in smart city initiatives; a major European pension fund committed US$250 million to a smart infrastructure fund in late 2018. 
  • Private equity is proving to be a valuable first mover, particularly in less developed markets. Impact investing, philanthropy and a blend of both have also become major trends. According to estimates by the Global Impact Investor Network, impact investors now hold more than US$22 billion in assets. 
  • International development partners and public sector organizations are launching smart city funds and initiatives, as well as creating tools to stimulate investment.

Despite these encouraging initiatives, difficulty connecting public and private capital and expertise is still holding up the process. Intergovernmental organizations can help. With their experience of working with an array of cities, organizations like these can also help build relationships between public and private partners.

3. Applying pay-for-success models

One model in particular stands out as addressing the issues we raised in point 2: an “evolved” public private partnership (PPP), based on pay-for-success concepts.

In Boston, US, the regional transit authority used an evolved PPP to implement a next-generation fare collection system. The transit agency didn’t have to start making payments until the system had hit certain operational milestones and met the technical requirements. This had the added advantage of motivating everyone involved to carry out the upfront due diligence that would make the project more likely to succeed.

4. Exploring alternative revenue streams

Some projects offer direct opportunities to deliver returns on digital investments, most likely through advertising revenue. In Auckland, New Zealand, the city council has been exploring a self-sustaining, replicable model for funding infrastructure. The options it’s considered include naming rights, corporate events sponsorships and advertising on bus stops and in train stations.

Bed and travel taxes are also potential sources as global tourism grows, along with the expectation that visitors should contribute to maintaining and developing local facilities. Regional fuel taxes and road tolls are other ideas.

Finally, smart city investments are likely to make areas more desirable and valuable. Cities should regularly review property rates, developer contributions and what they class as non-rateable land.

How cities can speed up the pace of change

In our view, four areas can help city leaders roll out technology-based infrastructure projects faster.

1. Recycling capital

In many cases, cities can adapt existing mechanisms to accommodate smart investments. Agueda in Portugal has used a revolving fund to build a new system for controlling the lights in its stadium. It’s also installed smart meter systems alongside solar panels at municipal buildings. As a revolving fund constantly replenishes itself, the city will plough the expected energy savings (around 20%) back into the fund.

2. Combining sources of capital and expertise

Technology-led investments are complex, so effective investment models need the structure, scale, breadth and financial capacity to succeed. In practice, this means blending several financing options and bringing in specialist expertise.
The European Investment Bank (EIB) has championed this approach by combining EIB products (investment loans and framework loans) with EU grants. It also gives technical advice on issuing equity and finding other sources of capital. On top of this, cities should bring in partners with expertise in technology, procurement, project delivery, finance and managing complex arrangements.

3. Measuring and reporting project-level performance metrics

Investors will always need clear evidence of financial returns to understand the opportunity. But other metrics are becoming increasingly valuable.

Corporate social responsibility (CSR) and environmental, social and governance (ESG) continue to move up the corporate agenda, for example. In a recent EY investor survey, 97% of respondents said that they evaluate a target company’s non-financial disclosures. Smart city projects can contribute to these areas in a meaningful way. But the companies that invest in them need quantifiable metrics to report on.

On the public side, citizens are increasingly interested in knowing how the city spends its capital and the impact it’s having. Reporting project data and results will help to generate goodwill. Effective programs also allow mayors and city leaders to hear back from citizens, helping them to better identify and prioritise new projects.

Finally, measuring and reporting performance metrics will help cities to attract future investment. The World Bank recently announced it will invest US$200 billion between 2021 and 2025 to help countries act against climate change. Recipients will be expected to use a new rating system the bank has developed to track and incentivize progress.

4. Creating legislation that promotes long-term investment

Cities need a regulatory environment that encourages investment, and resilient bodies to oversee it. This will bring consistency and make sure investments survive a change in administration.

For example, in the US State of Pennsylvania, many jurisdictions have their own set of rules around installing the small cell nodes needed for the rollout of 5G. Recognizing how challenging it is to arrange permissions in all jurisdictions, the state is working to implement uniform standards that will streamline the process.

Building a bridge to the future

As cities continue to grow, leaders have a responsibility to make them vibrant, healthy and stimulating places to live and work.

Adopting smart technology will be critical to making this shift. But to do it, mayors and city leaders need to find ways to bridge the gap between what they need and what the providers of capital demand. At the moment, they can wave at each other from across the river, but they don’t have a way of reaching the opposite bank.

There’s no great secret to bridging this gap. Mayors and city leaders need to work with the private sector to create an environment in which mutually beneficial relationships can emerge. Only then will they be able to build cities fit for the future.

Summary

Around the world, cities struggle to finance the smart infrastructure that will make them future-fit. Their leaders need to think creatively and work with the private sector to bridge the gap.

About this article

By

George Atalla

EY Global Government & Public Sector Leader

Working with governments to address complex issues and build a better working world.