2. Definitional Issues
2.1 Defining Characteristics of Infrastructure
This report focuses on what is commonly regarded as economic infrastructure (e.g. transport and communications networks, power and water systems), rather than the broader notion of social infrastructure (that includes housing, health and educational facilities). For the purposes of this study the defining characteristics of infrastructure are that it comprises sets of assets that can only be adjusted in large, "lumpy" increments of capacity, with long lead times, risks of asset stranding, high fixed costs and low marginal costs, and diverse users. Infrastructure investment and consumption of infrastructure services have significant implications for achievement of sustainable development objectives, as infrastructure services underpin many aspects of economic and social activity and, as a consequence, infrastructure failures can have widespread impacts across the community. The severity of such failures is reduced by the availability of substitutes for those infrastructure services.
Infrastructure is only useful for the services it provides, and infrastructure as currently known may be rendered obsolete by technological change in delivering desired services. A recurring theme in the economic literature is the shifting boundary of what services are best provided by infrastructure in the face of new technologies, new uses for existing technologies, and changes in the economies of scale and scope of particular types of service provision. This creates investment uncertainty, given the long life-spans of infrastructure, which is another of its key characteristics. It also means that the availability of substitutes will change, sometimes to the extent that the service is no longer tightly associated with the original infrastructure.
Appendix B sets out the definition of infrastructure adopted for this report. For the purpose of this study, "infrastructure" displays the following characteristics:
- Capacity can only be adjusted in large, "lumpy" increments
- There are high initial fixed costs and low marginal costs of supply
- There are high sunk costs and risk of assets stranding as conditions change
- There are multiple users of the services spanning production and final consumption
- There are externalities not reflected in service charges that have attracted regulation
- Scale and regulatory hurdles create long lead times for installing new capacity.
It is also a feature of infrastructure that it is difficult to find substitutes for the services provided, though this is a matter that can change over time with technological advance.
These characteristics confine infrastructure in the scope of this report to:
- All categories of assets for reticulated water supply and wastewater treatment.
- In energy, all categories of gas assets, and all categories for electricity except retailing; but oil distribution assets are excluded.
- In telecommunications, cellular towers, local loops and international connections; but increasing substitutability between landline and cellular services is reducing the disruptive potential of infrastructure failures.
- In transport, airport runways and terminals, dock facilities, roads, rail tracks and inter-modal interchange facilities; but excluding vehicle and vessel fleets.
The precise boundary around infrastructure depends on the degree to which particular assets display all these characteristics. For instance, in the case of telecommunications, which is probably the sector undergoing the most rapid technological change at present, structures like cellular towers have infrastructure characteristics because of the costs and time delays they may incur due to objections and consenting delays in finding appropriate sites and because, once built, they have limited other uses; whereas the equipment that goes into the towers (base stations) is more likely to have a second hand or salvage value at the end of its current life, and its installation or replacement is less likely to attract objection as a change of use under local planning rules. If particular types of equipment replacement or upgrade face sufficient objections, delays and uncertainty of outcome, they too may be regarded as infrastructure. Investment in such sectors therefore has to take account of both normal market risks of competitors or new technologies undermining expected returns, and infrastructure-specific risks that may impede adaptability and uptake of new technologies.
2.2 Economics and Sustainable Development
While this report focuses on economic infrastructure, it has also been prepared in light of Government's objectives for sustainable development, which involve looking after people, taking a long term view, taking account of economic, environmental, social and cultural impacts and encouraging participation and partnerships.1 More recently this has been described as seeking progress across quadruple bottom lines - economic, social, cultural and environmental - in which none takes precedence over any other.2
What those bottom lines might be needs to be interpreted from broad policy directives issued by Government, such as those contained in the Sustainable Development Programme of Action (SDPA), the New Zealand Transport Strategy, and the statements on the Growth and Innovation Framework. These tend to stipulate desired outcomes rather than the policy settings needed to achieve them. Some examples with respect to the infrastructure sectors are briefly outlined in Appendix C.
These policy statements are similar in broad direction, but they are unspecific about the particular policy settings to achieve their desired outcomes. For instance, accessibility and affordability of services is a recurring theme, but there is no indication of what affordability may mean: is it just that prices are to be as low as possible, or is it aiming to restrain prices for services to some ceiling proportion of household expenditure, as some other countries have done in defining inability to afford heating as energy poverty? To progress infrastructure policy on a consistent and effective manner will require some narrowing down of such settings, so as to enable prioritisation of different policy choices.
2.2.1 Addressing Quadruple Bottom Lines
a. Economic
The only bottom line that has been yet articulated into a definite measurable goal is the aim expressed in the Growth and Innovation Framework (GIF) of returning New Zealand's real per capita income to the top half of the OECD and maintaining that standing. This is intended to allow continued provision of first world public health and education services, create competitive opportunities for all New Zealanders, and provide returns which attract further capital to New Zealand. The GIF also talks about improving infrastructure and natural resources by ensuring efficient energy and telecommunications markets and effective regimes and property rights for natural resources that are controlled by the State. This goal statement points to a number of questions for assessing policy settings over infrastructure service markets, e.g. are current settings helping or hindering the attraction of capital to New Zealand, the emergence of competitive opportunities, and the achievement of growth in per capita GDP?
Improving New Zealand's OECD ranking will require sustaining growth in excess of 4% per year, a higher rate than New Zealand has achieved over the past 30 years. Implicit in this requirement is the need for reliable infrastructure services, that minimise the impacts of service disruptions and reduce uncertainty for new investment across the economy. Continuity of quality infrastructure at reasonable cost, with arrangements for managing price volatility, contributes to growing and maintaining an economy's reputation as an attractive location for investment.
b. Social
A social bottom line has not been as tightly defined as yet, but some components can be inferred from documents such as the Energy Policy Framework (2000) which seeks prices as low as possible while still reflecting full costs (including environmental costs), reliable and secure supply of essential services, and fairness in pricing that ensures access for the least advantaged at reasonable prices. These aims leave a number of policy settings unspecified (e.g. what level of reliability and security is the community willing to pay for, what is a reasonable cost and is a cross-subsidy required to ensure it?). However, they point to a social bottom line that might be encapsulated in an objective such as providing infrastructure services in ways that are widely accessible, affordable and do not detract from health, safety and social cohesion of the communities they affect.
c. Cultural
A cultural bottom line does not appear to have been defined so far, but it might be encapsulated in an objective such as providing infrastructure services in ways that protect cultural heritage, give due consideration to customary interests in natural resource use, and allow participation of Māori in decisions regarding natural resources as Treaty partners.
d. Environmental
An environmental bottom line is likely to be closely aligned to sustainable management of natural resources as defined by the Resource Management Act, which involves safe-guarding life-supporting capacities of air, water, soil and ecosystems and avoiding, remedying or mitigating adverse effects of activities on the environment. The environmental bottom line also involves observing other legislative requirements and commitments to international environmental treaties, such as policy towards the Kyoto Protocol and area designations made in support of the International Convention on Biological Diversity.
2.3 Economic Terms Used in Report
In developing the framework for infrastructure policy, it is necessary to distinguish different types of effect that may be associated with infrastructure. The meaning of terms commonly used in this report are as follows.
Externality is an effect caused by an action of one or more parties that is borne by third parties without invitation or compensation. As the effect is not "priced" to the parties to the transaction, there is market failure and hence likelihood of inefficient resource use. They may be either negative externalities that fall on third parties as costs and hence warrant corrective intervention, or positiveexternalities that fall on third parties as benefits (e.g. well-kept houses that enhance neighbourhood property values). As positive externalities arise from actions that will happen anyway, they need not provoke policy intervention, unless it is clear that the effect is a public good or a merit good that should be consumed more than it currently is, and encouraging positive externalities is the best way to do so.
Public goods are goods and services that are characterised by consumption that is non-rival (such that one person's use does not detract from that available to others) and non-excludable (such that once provided to one person, others cannot be excluded from receiving the benefits). Pure public goods with both these characteristics are relatively rare (national defence is a commonly cited example) but there are varying degrees of less than pure public goods, such as those that become congested (rival) beyond some level of use (e.g. roads) and those that are excludable by virtue of location (e.g. local public goods like street lighting). Private suppliers under-provide public goods because they cannot recover their full costs of supply, so public goods are commonly provided by taxing the community that benefits.
Merit goods are those which the State supports because it believes consumption should be greater than is currently observed. Commonly cited examples include cultural events and museums, and in the infrastructure area accessibility to places (as in roads) and information (as provided by broadband services) have merit good characteristics. The problem with merit goods does not lie in production characteristics but in insufficient consumption.
Writings on sustainable development describe the aims of managing trade-offs between the components of the quadruple bottom lines (i.e. advancing one at the expense of another), and complementarities between them (advancing them simultaneously). As described elsewhere, "trade-offs arise when advancing one objective has a detrimental effect on progress towards another goal - for example, protecting a wetland increases the costs of motorway construction, inhibiting economic development. Conversely, complementarities or synergies arise when advancing one goal also contributes positively to another - e.g. extending internet access to rural areas for economic reasons also generates social benefits".3
From this perspective, internalizing externalities will generate complementary benefits, since it will generally lead to resources being used more wisely with environmental, social and cultural effects taken into account. Recognising the impact on environmental, social and cultural outcomes of development options will change resource use decisions to those with lesser impacts and improved outcomes in the non-economic bottom lines. This means that seeking complementarities is a subsidiary aim of internalization rather than a separate goal in itself.
It is important that resource use decisions are made on the basis of the best possible information, and it is notoriously difficult to quantify non-economic outcomes. Complementarities need to be explicitly recognized and taken into account where there is no other means of establishing the relative value of the different bottom line outcomes, but it is only a proxy for explicit valuation of the advances across the different bottom lines. This can be illustrated in the example of the wetland and the motorway quoted above, where protection of the wetland and provision of the motorway may appear as a "win-win" outcome for environment and long term economic development in that it preserves an environmental resource that may become more valuable in future. However, this begs the fundamental question of resource use choice, about whether protecting the wetland was worth the additional costs incurred on motorway construction.
To justify protecting the wetland the benefits of doing so - contribution to biodiversity conservation, opportunities for recreation etc - must be at least as much as the value of additional costs incurred in modifying the motorway. The value of protecting the wetland may be inferred from the marginal cost of securing similar wetland in other places, and if that value is not commensurate it is pertinent to enquire what is so special about that wetland to give it a different value. If the services provided by the wetland - contribution to biodiversity conservation, opportunities for recreation etc - can be provided elsewhere at lower cost than those incurred in motorway modification, both the economic and the environmental bottom lines could be better served by sacrificing the wetland and diverting the savings on motorway construction to restoring other wetlands elsewhere.4
The conclusions to be drawn from this are that complementarities will emerge automatically if externalities are internalised and all resource inputs are properly priced. Acknowledging complementarities may also be a way of scoping the externalities to be included in a policy analysis. But the mere fact of complementarity does not in itself establish the relative values of environmental gains against economic costs. Achievement of complementarity is subsumed in the principle of internalising externalities.
At the policy level trade-offs are virtually inevitable wherever multiple goals are sought, and where their advancement can come into conflict. Such conflicts of goals are resolved within public policy processes all the time - indeed, may be said to be the purpose of such processes. Resolution of such trade-offs reveals an implicit value for the gain in non-economic outcomes, as in the wetland example above. The value of environmental effects implicit in decisions can vary quite widely between apparently similar cases, with the implication that a more standardised set of relative weights - environmental values or prices - could improve environmental outcomes by assisting resources to be diverted from more costly to less costly locations to achieve maximum environmental gain.5
If due weight is given to external effects in policy decision processes, societal well-being is advanced more by allowing trade-offs where benefits are likely to exceed the costs, than by avoiding trade-offs. Once the externality is recognised by internalising into the decision process or some other measure, an incentive is created to find the most net beneficial option across all the bottom lines.
2.4 Rationale and Design Principles for Infrastructure Policy
Infrastructure supports growth and sustainable development by providing services as inputs to other productive processes (e.g. energy, transport), and as outputs going direct to final demand consumption (e.g. potable water, sanitation). In the case of telecommunications and transport it also improves the efficiency of markets by reducing transaction costs and extending the area across which goods, ideas, labour and other services can be exchanged. By facilitating specialisation within the economy it raises the productivity of other capital and labour, to the extent these other resources have the capacity to do so. The effectiveness of additional infrastructure investment is dependent on its place in the overall network of infrastructure, the efficiency with which the overall network is operated, and the capability of other factors of production to use infrastructure to raise their productivity.
Government policy is generally about:
- setting the rules within which activities take place across the community, striking a balance between being responsive to perceived problems and avoiding excessive changes that create uncertainty and disincentive to investment for the future;
- correcting inefficiencies that arise from market failures, such as anti-competitive behaviour arising from monopoly or market dominance, and externalities (effects falling on third parties that are not taken into account by those whose actions cause them);
- providing public goods that private suppliers cannot supply in sufficient quantities, because free-rider issues prevent them from recovering their full costs, and merit goods that the state considers more beneficial than is evident in private consumption choices; and
- addressing equity and income distribution concerns.
Each of these is generally applicable to infrastructure policy. A key question for a policy framework is how the characteristics of infrastructure affect the emphasis placed on, and options available under, each of these areas of concern.
2.4.1 Rationale for Infrastructure Policy
The prime rationale for infrastructure policy is enhancing infrastructure's net contribution to improvement in societal well-being over time, or conversely, reducing the expected severity of service failures (i.e. the cost of disruption over time). Failure severity includes not just the disruption incurred at the time, but also the opportunity cost of investment deterred by perceived unreliability of infrastructure services, and impacts on the natural environment and social structures that are significant for sustainable development.
This rationale is consistent with the following desired outcomes from infrastructure, which have been inferred from various government policy documents:
- security and reliability in the provision of infrastructure services;
- provision of services at reasonable cost i.e. one that reflects full input costs (including environmental costs) and provides both competitive prices for consumers and sufficient return to ensure continuing investment; and
- including environmental accountability, so that adverse effects on the natural environment and cultural interests, or the costs of remedying those effects, are reflected in resource input prices, or otherwise taken into account in consumption and investment decisions.
These outcomes support economic development by providing international competitiveness of input costs and encouraging timely investment in new infrastructure capacity. They support the social bottom line by promoting affordability, and the environmental and cultural bottom lines by reflecting expected adverse impacts in the arrangements for using natural resources and the wider environment.
In principle, societal well-being would be a composite measure incorporating income per capita and (currently) less readily measured indicators of environmental, social and cultural "health" within New Zealand. In practice, only income per capita is readily measured, and the non-economic bottom lines must be assessed by other means, such as the development of state of environment reports, satellite accounts, or simply by ensuring that institutions and processes are in place to give due consideration to effects on these bottom lines in each new project.
2.4.2 "Design Principles" for Infrastructure Policy
Enhancing infrastructure's net contribution to improvement in societal well-being over time, or conversely, reducing the expected severity of service failures, implies a number of policy "design principles" for infrastructure policy.
- Internalise externalities associated with infrastructure service provision. This is an objective stressed by literature on both economic efficiency and sustainable development. It entails identifying externalities with rectifiable market failures and ensuring that institutional arrangements incorporate these into decision processes, either through pricing or through other means (e.g. observing environmental standards).
- Overcome financial market failures which may arise if particular types of investment are being hindered for no rational reason. This entails examining the circumstances around investments that appear to face capital shortage to establish if there is a rectifiable cause of capital constraint (e.g. information deficiencies about particular market opportunities).
- Mitigate political and regulatory risk that may be hindering infrastructure investment. This entails examining individual policy settings affecting the infrastructure sectors to establish if all the influences are pulling in the same direction and enabling infrastructure to emerge that supports production and consumption without unduly damaging environmental, social and cultural conditions.
- Redistribute resources to the less well-off through the medium of infrastructure services, where this is effective compared to other possible mechanisms, and does not impose undue costs on the provision of that infrastructure. This entails identifying accessibility of infrastructure services across the community, the causes of any difficulties in accessing services, and ascertaining whether these difficulties can be best remedied through modifying the way infrastructure services are provided or through some other means (e.g. comparing the effects of manipulated prices or direct income supports to assist the less well-off).
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