Time to get moving on productivity
Governments around the world acknowledge that they have fallen behind on infrastructure investment. To support expected economic growth in the next two decades, we estimate that the world needs to more than double its stock of infrastructure. This is such an enormous investment, especially given the fiscal constraints that many nations face, that the all-too-common response has been paralysis – or placing what we believe is far too much faith in the potential for innovative financing schemes involving private capital to come to the rescue. By Nicklas Garemo, director, and Martin Hjerpe, principal, McKinsey & Company and Jan Mischke, senior fellow, McKinsey Global Institute.
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Nations cannot afford to wait any longer to start catching up with infrastructure needs – strained road and rail systems and over-used airports are already slowing commerce, and closing the investment gap could achieve almost half of the growth acceleration aspired by the G20.
To move ahead, governments must address the infrastructure productivity challenge and adopt international best practice for project selection, delivery, and management – practices that the McKinsey Global Institute (MGI) estimates can save as much as 40% of costs. To help governments determine their starting point and what levers to pull, we have created a diagnostic that quickly identifies key capability and process gaps preventing governments from optimising their infrastructure investments.
Using the diagnostic has enabled governments to determine where they stand and how to move forward, and to obtain:
* Quantitative analysis of current infrastructure stock and needs, as well as effectiveness and efficiency in comparison with other countries;
* Delivery system benchmarking against international best practices;
* In-country comparisons, such as progress over time, across sectors and agencies, or across sub-national governments;
* A basis for a structured dialogue across stakeholders;
* Prioritisation of key improvement opportunities; and
* An outline for implementable transformation programmes.
The gap – Filling a US$57trn need
Between 2013 and 2030, the world’s economies will need to invest US$57trn to US$67trn in economic infrastructure (ie, transport, power, water, telecoms) to support expected economic growth – more than the total infrastructure stock today, which is valued at US$50trn. This does not include the additional infrastructure costs related to climate change, such as flood-control systems, or the cost of extending universal access to critical infrastructure (clean drinking water, sanitation) in low-income economies (Exhibit 1).
Sixty per cent of that need will arise in emerging economies. China alone will account for a quarter of total global demand (Exhibit 2).
In most countries, the annual spending needed to bring infrastructure to the level required to support economic growth to 2030 far exceeds what they have spent historically (Exhibit 3). In North America and Western European countries, the gap ranges between 0.5 and 1 percentage point of GDP per year, and rises to 2 to 3 percentage points in economies such as Brazil, Indonesia, and India. Fiscal concerns have only made the infrastructure gap wider. Only a few economies have invested enough – or indeed too much – in infrastructure, including China, which sees infrastructure investment as core to its growth model, and Japan, which may have over-invested as it expanded public works to boost its economy.
In addition to providing a foundation for long-term growth, stepping up investment in infrastructure can have immediate benefits, including creating employment in nations that still struggle with the aftermath of the global financial crisis. It is estimated that an additional investment of 1% of GDP in infrastructure would add around 500,000 jobs in Germany, 1.5m in the US and 3.4m in India1. Over 10 years, such investments also could increase capacity for output by around 1.6 percentage points (Exhibit 4) - or 0.16 percentage points annually, almost half the target the G20 set itself for growth acceleration by 2018.
Innovative finance is only part of the answer
Public finances of both advanced and developing economies are still constrained by the after-effects of the global financial crisis and banks still suffer from weakened balance sheets and operate under tighter post-crisis regulation. As a result, many governments have focused their efforts to bridge the infrastructure funding gap on innovative financing schemes, particularly public-private partnerships (PPPs). No matter how innovative they are, however, alternative financing schemes cannot fill the entire infrastructure funding gap.
Despite high hopes for private investment in public infrastructure, project-specific financings represented only about 20% of total infrastructure investment in the boom year 2008 and collapsed to around half that level a year later. PPPs with private financing are a minor share of that and remain small in comparison with traditional public financings or corporate financing by utilities and other private infrastructure owners.
Nor is the share of infrastructure built with private financing likely to rise rapidly. We estimate that by 2030, institutional investors such as pension funds, insurance companies and sovereign wealth funds, will have about US$100trn in assets, up from close to US$50trn today. These institutions have target allocations to infrastructure of around 3% to 6%, according to Prequin. This implies holdings of up to US$6trn in infrastructure, a small slice of the US$57trn requirement. With the right frameworks in place, countries can increase allocations or capture a disproportionate share of global investments.
Public financing can also provide a lower cost of capital for risky projects or in cases where risk is difficult to measure. In large, high-risk greenfield developments such as high-speed rail networks, public financing may be the only viable option because it offers the risk-absorption capacity of the public sector. Even leaders in PPP investment such as the UK have begun to limit these structures to lower-risk social infrastructure such as schools, which have a correspondingly low private cost of capital, while benefiting from the increased discipline on cost and time that characterise well-structured PPP investments.
Finally, even with high public debt levels, governments continue to borrow at very low rates – well below 3% for US or UK 10-year government bonds. And, if they could leverage their balance sheets the way businesses do, national governments also could tap greater borrowing capacity.
Because nations do not pay significant attention to separate capital accounts, all borrowing looks the same in accounting terms – the debt issued to cover government operating deficits is not differentiated from debt used to build long-term infrastructure assets. So, in times of large deficits, infrastructure gets squeezed out. US public investment in 2013 was 10% lower than in 2007, measured in constant 2010 dollars, even as government consumption rose by 2%. In the eurozone, government consumption rose by 5% over that period, while investment fell by a startling 20%.
The US$1trn a year productivity opportunity
The challenge on which governments can focus most profitably, then, is improving infrastructure productivity. While comprehensive direct measurements of infrastructure productivity are not available, we do have some data. In construction, which typically accounts for a large share of project costs, there has been scant improvement in productivity. For example, while labour productivity in Germany and the US rose by more than 40% (measured in constant currency) from 1989 to 2009, in construction, productivity actually fell (Exhibit 5).
Larger companies typically have shown improvements and in technology-heavy segments such as power plants, projects benefit from the productivity increases of equipment suppliers. Overall, however, the global construction industry has not yet fully experienced the waves of productivity improvements seen in sectors such as manufacturing and retail from technology, automation, and new approaches (such as big-box stores).
Our research, based on 400 case studies around the world, suggests that governments could boost infrastructure productivity by 60%, saving 40% of cost or US$1trn a year, in three ways: improved project selection, streamlined delivery, and making the most of existing investments (rather than building from scratch). None of these initiatives requires radical change and all of them are being applied successfully somewhere in the world (Exhibit 6).
These approaches also can accelerate the timelines for infrastructure investment and make crucial improvements available to the public sooner. In our research, we find that a delay of 10 years for a major project, which is unfortunately not uncommon, can come at an economic cost of between 15% and 60% of initial investment outlays.
* Improved project selection – Globally, this could save an average of 8% of investment costs. Even in the face of increasing fiscal constraints, governments continue to choose infrastructure investments without setting clear priorities for projects with the greatest potential impact; Spain appears to have over-invested in solar power and regional airports; many citizens consider France’s motorways to be under-used, etc.
To optimise project selection, the process must be rigorous, transparent and fact-based. Governments need to use precise selection criteria that ensure proposed projects meet specific goals. This requires thorough evaluation methods to determine costs and benefits and a systematic way of prioritising projects.
A number of governments have initiated important improvements in project selection. South Korea’s Public and Private Infrastructure Investment Management Center (PIMAC) has saved 35% on the nation’s infrastructure budget by rejecting 46% of projects that it reviews compared with the 3% that were rejected before its establishment. The UK set up a cost review programme that identified 40 major projects for prioritisation, reformed overall planning processes, and then created a cabinet sub-committee to oversee and ensure quicker delivery of projects. These measures reduced spending by as much as 15%.
* Streamlining project delivery – Governments can save 15% of investment costs by accelerating permitting and land acquisition processes and by adopting more efficient tendering and construction methods. The time it takes to obtain approvals and acquire land is a major reason for time over-runs. Successful governments take a comprehensive approach to develop their construction and supply markets and promote domestic and international competition. They also heavily invest in project preparation and value assurance, including stage gate processes, stringent project maturity assessments, and business case, concept, and design optimisation teams.
Governments can encourage cost savings by using multi-rounded tendering and optimising design and specifications for maximum value, prefabrication, and modularisation. And they improve their selection and management of contractors, rigorously managing and keeping track of performance as well as claims. One Scandinavian road authority reduced overall spending by 15% by changing standards of road design, using lean construction techniques, and using bundled and international sourcing.
* Making the most of existing infrastructure – Too often, governments rush to build new infrastructure instead of using what they have more effectively. One way is to manage demand to better fit capacity. “Intelligent” transportation systems, which use advanced signalling systems to squeeze more capacity out of existing roads and rail lines, can double asset utilisation, typically at a fraction of the cost of adding equivalent physical capacity.
Demand management through congestion pricing – which has been adopted in London and some other large cities – has already proven effective and emerging traffic-monitoring technology could generate even better results. In London, congestion has been reduced by about 30% in the target areas since congestion pricing was adopted in 2003. The city has also improved the speed of buses during peak traffic periods by up to 20%. Also in the UK, an intelligent transportation system that directs and controls the flow of traffic on the M42 motorway has reduced journey times by 25%, accidents by 50%, pollution by 10%, and fuel consumption by 4%.
* Strong infrastructure governance and capabilities – To adopt infrastructure investment best practices requires an overhaul of infrastructure governance to make management more systematic, professional, transparent, and collaborative (Exhibit 7). Government departments responsible for water, land, or transport need to work closely together. Politicians need to set the strategic objectives and direction of investment in infrastructure, but execution should be the work of professionals, preferably independent ones. Governments need to engage stakeholders early on. In Stockholm, for example, the government introduced congestion charging as a test at first, then briefly revoked the programme to assess the effects, and asked citizens to vote on its introduction – the test changed the tide of opinions resulting in a strong “yes” to congestion charges in the referendum.
* Robust funding and finance framework – Even the most productively planned and delivered infrastructure comes at a cost that often exceeds current investment rates. Appropriate funding and finance is crucial for public, private and PPP infrastructure assets. In terms of public finance, capital recycling frees up funds for risky major greenfield projects by selling off established brownfield assets to private investors, as in the Queensland state divestiture programme.
Several schemes allow governments to capture the property value gains associated with infrastructure investments – eg, the sale and rental of real estate in the vicinity of railway stations in Hong Kong, or various forms of betterment levies, impact fees, or developer exactions. Governments also need to provide certainty on infrastructure budgets beyond annual budgeting or electoral cycles, such as Sweden’s 10-year master plans for transportation infrastructure with associated budgets.
For privatised infrastructure assets, beyond an overall attractive investment climate and mature financial markets, governments need to establish a framework of competition and credible regulation allowing appropriate risk-adjusted returns. For PPP investments, successful governments increase investments in project preparation, sometimes through dedicated funds, and establish transparent project pipelines.
They also establish robust PPP and contractual frameworks and build capabilities to structure risk-sharing to the party that can best control, mitigate, or absorb risks. Finally, they ensure that PPP investments are governed by the same budgeting and decision-making frameworks as public procurement, and assess value for money against a full set of contractual options, including operating leases or design-build-operate contracts.
A new measurement
Many indices – such as the Word Economic Forum competitiveness rankings or the IMD world competitiveness rankings – measure the availability of infrastructure based on surveys and simple ratios of infrastructure penetration (such as household penetration of landlines). The Construction Sector Transparency initiative (CoST) and one-off country- and sector-specific benchmarks, such as the UK Cost Review, measure costs. The International Monetary Fund’s proposed Index of Public Investment Effectiveness aims to measure investment governance.
Each of these metrics is useful, but none captures the full breadth of infrastructure productivity. The McKinsey Infrastructure Diagnostic aims to provide a comprehensive assessment of a government’s infrastructure delivery system. The diagnostic first establishes a baseline view and a balance sheet of available infrastructure assets and future needs. It then measures performance in five areas: fact-based project selection; sufficiency of funding and finance; streamlined delivery; making the most out of existing assets; and strong governance and capabilities, and compares processes and practices with global best practices in these five areas. It finally aggregates quantitative indicators on availability, cost, and time outcomes (Exhibit 8).
To capture effectiveness and productivity of the infrastructure delivery system in detail, the diagnostic breaks the five assessment dimensions into 29 levers and 78 sub-levers – each representing global best practice according to our research. For each lever we also codify average and low performance against a set of clear criteria, providing a basis for scoring each government’s performance (Exhibit 9).
Our results from using the diagnostic so far indicate that even the most advanced economies have significant opportunities to raise their performance. These countries have scored on average 3.8 on a scale of 1 to 5. In transportation, for example, common weaknesses include a lack of structured demand management, insufficient capabilities in infrastructure organisations, and use of price-based procurement approaches that allow little opportunity for the government to work with vendors to optimise engineering and performance.
Momentum is building to capture the infrastructure productivity opportunity. In 2013, the B20 coalition of companies and business organisations from G20 nations recommended to G20 leaders that they establish a global infrastructure productivity institute and international network to exchange best practices.
Still, many countries, states, and municipalities are standing on the sidelines. They acknowledge the importance of infrastructure productivity, but most actual initiatives seem to focus on private-sector finance as the only solution to filling the funding gap, often assuming that private-sector involvement will guarantee high productivity without improvements in public-sector planning, delivery, and governance. This attitude fails to recognise the efforts required to deliver complex PPP projects successfully and results in missing opportunities to raise infrastructure productivity.
Increasing the productivity of infrastructure investment is an imperative for government leaders, private sector leaders, and taxpayers. Without it, nations, states, cities, and regions will not have the roads, ports, railways, water and sanitation systems that their citizens and companies need and deserve.
1 - In gross terms, ie, before considering alternative demand for those workers or alternative uses of funds.