Engineering Finance: South Mountain Freeway vs Tempe Streetcar
Understanding the costs and benefits of civil engineering investments
Right now, there are two interesting civil engineering projects taking place in my home metropolitan area (Phoenix AZ, including Tempe, Mesa, Gilbert and other cities in the Valley of the Sun). The first is a very expensive extension of a highway 202, which will route westbound traffic from Texas on its way to Los Angeles, without driving through downtown Phoenix. According to the Arizona Department of Transportation, the South Mountain Freeway is called the “largest project in State history.”
The freeway is estimated to cost almost $2 billion, and according to the 2012 economic impact report, the new highway will save motorists a present value exceeding $3 billion in reduced travel congestion. (At a 5% discount rate, the $3B present value equates to about $150 million/year).
The present value of travel time savings for each action alternative between 2020 and 2035 would be between $3 billion and $3.4 billion. These benefits compare favorably with the estimated total project cost of $1.9 billion. — Economic Impact Report, South Mountain Transportation Corridor in Maricopa County Arizona (2012).
A billion dollars over about 25 years sounds like a tidy profit for Phoenix area motorists. In a state that features massive civil infrastructure investments like the Central Arizona Project (336 miles of canals and aqueducts that extract water from the Colorado River and delivers it as far away as Tuscon), the Hoover Dam, and the Palo Verde Nuclear Generating Station, calling the South Mountain Freeway the “largest project in State history,” seems a bit hyperbolic. But it is big.
The other is more modest, and might be more interesting. It’s called the Tempe Streetcar. (I’d prefer they call it the Tempe Trolley, which has the advantage of charm and alliteration, but the project might not live up to such a charismatic moniker). The cost of the streetcar project is estimated to be under $200 million. It will open in 2021, and the benefits are expected to be similar to the South Mountain Freeway: reduced traffic delays, reduced emissions from idling vehicles, increased mobility.
The Streetcar will run over 3 miles (total) of track and service 14 stations. It is expected to cost $4 million/year to operate and carry 800 passengers a day when it opens, and 1700 passengers a day by 2035.
I think of the both projects as enormous and expensive experiments in public policy.The economic impact reports might not be very credible. If you read these reports, you won’t find an analysis of the critical uncertainties, because that might undermine political support for the expenditures, and there are lots of reasons that the consultant who create these economic analyses want them to look favorable — including the prospect of getting more consulting work for new economic analyses.
Here’s an excerpt the Tempe Streetcar environmental assessment that discusses some of the economic impacts:
Where a sustained transit investment is provided, observations indicate that local economies generally benefit according to the following trends:
- A sustained investment in transit has the potential to generate an increase of $2 million in business output and $0.8 million in personal income for every $10 million in the short run (during year one);
- In the long run (during year 20), these benefits increase to $31 million and $18 million respectively, for business output and personal income.
Because I teach engineering finance, it’s my job to equip students with the tools they need to evaluate claims like those made in this report. Here’s how Iinstruct my students to do it, on the basis of the project internal rate of return:
- Draw cash flow diagrams that represent the expected expenditures and revenues over the period of analysis. For the Tempe Streetcar project, that means drawing the diagram to show the construction and operating costs with downward arrows, and the expected benefits (e.g., increased business output and personal income) as upwards arrows.
- Write an equality for the present value of the costs and present value of the benefits, and solve for the discount rate that satisfies the equation. The discount rate that satisfies the equality is the same as the project internal rate of return, and it represents the borrowing costs that the project could bear without losing money. For example, if the discount rate that makes costs = benefits is 20%, then the City could afford to borrow money at an interest rate of 20% and society as a whole would still break even on the project. (This says nothing about how the loans would be repaid — whether from transit fares, sales taxes, or gasoline taxes. It matters how the revenues are generated when considering the distribution of benefits throughout different sectors of the economy, or different types of consumers. But for the purpose of evaluating the project as a whole, it is irrelevant). The solution of this equality is not a trivial problem for most engineering students, because the terms for present value on either side of the equation are rarely reducible to something that can be input to a programmable calculator. Rather, it’s often that a spreadsheet is required, and the solution will be found graphically, or using guess and check.
- Compare the discount rate above to typical borrowing costs available to the entities funding the project. If borrowing costs are typically below the break even discount rate, then an argument could be made that the project is economically justifiable. However, it’s typical in civil engineering to apply a factor of safety. (“Really, just a factor of ignorance,” my Father the Professor of Education once told me). In structural engineering, for example, we might multiple the loads expected a structure to carry by 1.4 or more, just to ensure that an incorrect guess or estimate on our part will not result in a catastrophic failure of the structure. When all the factors of safety (ignorance) are accounted for, a building might wind up being constructed to standards that are several times the stresses it actually experiences. And yet, there are still sometimes structural failures. because the consequences of economic failure are not so acute — they are dispersed in time and distributed over a much larger population — the factors of safety that apply to structural engineering might not apply. Nonetheless, it is sensible to insist on a better than break-even rate to be compensated for the risk of such large investments.
There are other ways to compare or evaluate civil engineering investments, including benefit/cost ratios, simple payback period (the number of years of net benefits required to recover expenses), and net present value. The advantage of the internal rate of return is that it allows comparison of many different types of projects, including those with different analysis periods, and it is independent of the size of the project. That is, both the South Mountain Freeway and the Tempe Streetcar project can be evaluated on the same, internal rate of return basis, despite their different scope and analysis period. The disadvantages are that it can be difficult to calculate, and because it ignores the initial capital outlay, it does not acknowledge that there may be limitations on the borrowing capacity of the funding agency.
Based upon the internal rate of return calculations above, and using the data from the economic analyses provided, it would be interesting to compare which project is a more worthwhile investment. This week, I’ll have my students of Civil Engineering at Arizona State University do exactly that.