Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects (2015)

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28 Funding and Financing Rail Projects 4.1 Funding vs. Financing The terms funding and financing are often confused or used interchangeably. They are in fact very different. Funding refers to the sources of revenue that can be used to pay for a project or service. Sources of funding include but are not limited to future revenue streams from the delivery of rail transportations services (whether freight or passenger services), ancillary revenues, and non- repayable government grants and subsidies. Financing refers to the financial mechanisms or tools used to access money to pay for a project or service—generally before the project generates the necessary revenue to pay for the invest- ments. Financing mechanisms include various forms of debt, equity, and capital leases. Financ- ing is typically used when a project’s revenues do not correspond to the cash needs of the project. For instance, financing mechanisms can be used to raise capital needed for the construction phase of a project, before revenues associated with the project start to flow. The use of financing mechanisms generally creates an obligation to the entity providing the financing. This could include an obligation (debt) to pay the money back with interest or to provide an ownership stake (equity) in the investment and an associated share of profits. C H A P T E R 4 As defined by the AASHTO Center for Excellence in Project Finance, funding mech- anisms are the sources of revenue available to pay for investment in transportation assets or programs. Financing mechanisms are the financial tools or approaches used to leverage project revenues, accelerate project development, and match the costs and benefits of long-lived assets.a aAdapted from the AASHTO Center for Excellence in Project Finance report: “The Forum on Funding and Financing Solutions for Surface Transportation in the Coming Decade: Conference Report,” January 2011, page 9. http://www.transportation-finance.org/pdf/featured_documents/ sep_30_report_final_2011_02_02.pdf (accessed February 1, 2014). Figure 4-1 provides a simplified representation of the funding and financing for a typical commercial rail project. Revenues associated with the service or asset (funding) generally flow only once the project is built and in service. Because project capital costs are generally incurred before revenues start flowing, financing—in one form or another—is used to pay for upfront capital costs.

Funding and Financing Rail Projects 29 When revenues (i.e., funding) associated with a project or service are expected to be sufficient to cover the overall costs of the project or service, financing is relatively easy and can be accessed through commercial financial markets. Simply, the service or asset-related revenues, once they start flowing, are used to cover the project costs, including financing costs. Conversely, it is difficult to access financing when future revenue sources (funding) are not expected to be sufficient to cover the overall cost of a project or service (i.e., when a project has a funding gap). 4.2 Service or Asset-Related Revenues (Funding) A rail project’s costs will be recouped, in full or in part, largely from revenues from rail ser- vices or the assets of the railway. Typical service or asset-related revenue sources are described below. 4.2.1 Freight Rail Revenues In the United States, freight railroads have broad freedom to set their own prices for transport services. Some railroads publish a “tariff” (similar to list prices for many products and services), but most transportation fees are negotiated with individual shippers taking into account the distance from an origin to a destination, type of commodity, volumes, frequency, and other characteristics of the service, specified in (generally confidential) contracts between the railroad and a shipper. Generally, railroads set rates so that total revenues cover capital and operating costs and provide a positive return on capital (i.e., profit). Individual rates vary all the way from marginal cost (where the railroad company is already committed to operate and maintain the railroad network, but can make extra income from additional traffic) to multiples of marginal cost depending on demand and competition. Freight services can be provided on the basis of a “take-or-pay” contract whereby a shipper agrees to give the railroad a minimum level of cargo for shipment or pay the railroad even if they do not provide the cargo. This model provides railroads with some longer term revenues against which to secure financing for any investments that might be needed to provide the specified services. Freight railroads also earn revenue from ancillary freight rail services and surcharges (e.g., on fuel), on access provided to shippers or to other train companies operating over their tracks, and from the sale or lease of rights to use their property (e.g., air rights over rail infrastructure, access to railway rights of way for utilities and fiber-optics companies, and development rights to land and stations for things like office buildings and cell towers). Source: CPCS Project Capital Costs Operaons and Maintenance (O&M) Service or Asset-Related Revenues (Funding) Net Profit (?) Financing Figure 4-1. Simplified representation of rail project funding and financing.

30 Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects 4.2.2 Passenger Rail Revenues Passenger railroad revenues largely consist of revenues from the sale of tickets. Different rider- ship revenue models can include different ticket prices based on type of ticket (e.g., economy vs. business class) and yield management models (e.g., higher prices at peak periods). Other rev- enue is also typically generated from the sale of food and drinks in stations and onboard trains, onboard advertising, parking commissions, station property rentals, and other sources, though these generally represent a small fraction of operating revenues. In the United States, no passenger railroads cover their operating and capital costs, and pas- senger rail services must be supported by government.27 On some corridors, passenger revenues may cover operating costs, but very rarely (if ever) do they cover all related infrastructure costs. Passenger railroad operators in the United States (Amtrak and the various commuter authorities and agencies) require funding support from federal, state and/or local funding agencies. 4.3 Financing as a Means of Bridging Timing of Costs and Revenues Financing is relatively straightforward when a rail project’s service or asset-related revenues are expected to be sufficient to cover costs and pay back the financing and associated financing costs. For such projects, there exists a range of financing products, available on commercial markets. Table 4-1 provides a high-level summary of the types of financing used for rail projects. The terms and cost of financing for each of these mechanisms can vary greatly, depending on the creditworthiness of the owner, project proponent, or service provider, and the extent to which the financing has recourse to assets that are fungible (i.e., can be resold). Commercial pricing is a relatively recent development. From the late nineteenth century until the passage of the Staggers Act (1980), rail rates and many condi- tions of service were determined by an independent national authority (the Interstate Commerce Commission [ICC]). The ICC had the power to direct rail- roads to provide loss-making services for the public good and to set the prices for which all rail services would be delivered. Loss-making services had to be cross-subsidized by higher prices for other services. Often prices and services were not well matched to alternatives available in the marketplace. Govern- ment regulation came close to destroying the U.S. freight railroad industry, and by 1975 many railroads were actually in bankruptcy. Some short-line rail- roads still operate at a loss and require financial support in one form or another to remain viable. 27 Operating financial performance for Amtrak’s services varies widely. Acela services and Amtrak services on some other routes earn an operating profit, which is then used to subsidize other services. Some reforms to re-invest these operating profits into their respective services have been proposed. This could strengthen services with high financial performance but increase reliance on public funding sources for services with poor financial performance. Class I freight railroads in the United States are generally able to cover operating and mainte- nance costs and provide for a net return on capital sufficient to justify continuing the business.

Funding and Financing Rail Projects 31 Instrument Descripon Retained Earnings (Cash) Cash available aer operang expenses, debt service, taxes, and dividends to shareholders. Class I railroads pay for much of their investment programs from retained earnings Equity A financial investment represenng an ownership share in the project. This could be in the form of publicly traded stocks or private equity. As an unsecured investment, the return on equity is highest, reflecng its inherent elevated risk. Share issue The public issue of equity through sales of shares in a company via a public stock market (e.g., NYSE). Private equity Private investment in ownership that is not publicly traded on a stock market Debt Debt, in one form or another, is oen used to leverage an equity investment by a project proponent. Debt can be recourse (i.e., backed by collateral) or non- recourse (i.e., not backed by collateral). Loans Short or long-term commercial loans, typically with fixed interest payments Bonds or debentures Debt instruments issued in the capital markets, whereby bond issuer agrees to pay a fixed interest (coupon) rate to bondholders. Equipment trust cer€ficates A debt instrument – similar to a mortgage or lease – where an investor is given use of a par€cular asset (e.g., rolling stock) which they pay for over €me according to specifica€ons of the debt agreement. In the US, equipment trust cer€ficates are bonds issued by the railroad to a financing en€ty (a bank or pension fund). The cer€ficate gives the bondholder the first right to the equipment if scheduled interest and principal are not paid when due. Capital leasing A long-term lease considered by accoun€ng standards to be the economic equivalent of asset ownership. Typically most or all of the useful life of the asset is consumed during the lease and/or the asset is transferred to the lessee at the end of the arrangement. Opera€ons leases A short-term lease for rolling stock, office space, or other assets. Typically, opera€ng leases are usually limited to a term of 10 years but many opera€ng leases are for shorter periods. Lines of credit A revolving line of credit typically for short or intermediate term financing. Source: CPCS Table 4-1. Typical sources of private finance for rail projects. Recourse to Assets and Rail Project Financing One of the challenges railroads often face in raising private finance has to do with the relative attractiveness of fixed rail assets. The extent to which a private financier (e.g., a lender or a bank) can have (and would want) recourse to assets if a project fails is a material consideration. Fixed rail infrastructure (e.g., tracks, wayside equipment, and signals) are immoveable assets with a limited resale market, especially if the transportation services they support are loss making. Bridges, tunnels, and other fixed facilities usually have no potential for resale separate from rail infrastructure. Such facilities can be financed on the basis of

32 Alternative Funding and Financing Mechanisms for Passenger and Freight Rail Projects 4.4 How to Realize Rail Projects That Have a Funding Gap? Financing is typically not available to projects or services that have a “funding gap.” Indeed, a funding gap—when revenues are insufficient to cover the cost of a project or service—is a fund- ing, rather than a financing, problem. Short of reducing a project’s costs, there is but one solution to addressing a funding gap: finding other sources of revenue. Specific mechanisms by which a rail project or service provider could increase revenues from its assets or services exist. Many of these asset or service-related mechanisms are described herein (see Chapter 6). When these mechanisms are insufficient, public funding support, in one form or another, is usually required to address a project or service funding gap, as summarized in Figure 4-2. a revenue contract (e.g., a toll bridge). The cost of the financing will be a func- tion of the financing capacity of the entity providing the revenue contract. Land is often the most valuable part of infrastructure assets. Railroads generally have extensive land holdings, some in very valuable urban areas, and others in sub- urban and more rural areas. Rights to the use of railway land are often used in project finance—air rights, development rights for warehousing and manufac- turing facilities, and for many other purposes. In contrast, freight rolling stock is much more easily privately financed because of the diverse resale market. New large locomotives are relatively standardized across freight rail systems. Similarly, freight cars are designed to work freely across all freight rail networks. This common design and cross-system use permits many different types of financing mechanisms—from outright purchase using typical debt instruments to long- and short-term leases and even to rental agreements—because the equipment can be easily moved between users. Thus, if a private financier exercises its recourse to the asset in the event of default, the financier can obtain immediate value from the asset in a resale market relatively easily. Depending on the design, there can also be a good resale or releasing market for passenger rolling stock. Figure 4-2. Simplified representation of rail project funding and financing dynamics when there is a funding gap. Source: CPCS Project Capital Costs Operaons andMaintenance (O&M) Service or Asset Related Revenue (Funding)Financing Public Funding (in one form or another) Funding Gap Funding Gap Public Funding (in one form or another)

Funding and Financing Rail Projects 33 Public funding is used when a rail project or service has a funding gap and that project or service is deemed to provide a net public benefit worthy of public investment. Public funding mechanisms generally include grants or other capital contributions (for capital investments) and/or operating subsidies (for operations and maintenance), although the form and terms of these grants and subsidies can differ. Unlike financing mechanisms, public funding generally does not need to be repaid. Grants from federal, state, and/or local sources, often disbursed on the basis of a competitive, merit-based process, are one source of funding. Many grant funding programs are in place in the United States (see Appendixes A and B). For larger projects involving many parties, funding from multiple funding programs is sometimes used. Notable challenges associated with some grant funding (and other “subsidy” type programs) are that they can be subject to political uncertainty, with funding allocation based on unclear criteria (e.g., with no link to cost-benefit analysis relative to other projects). Public funding for rail projects can also become more complicated when rail projects cross jurisdictional boundaries and require shared funding from multiple jurisdictions. Subsidies to an operator to cover operating losses (which may include interest on debt- financed projects) are another funding source. Most passenger railroads receive government subsidies, in one form or another, to cover operating losses. Amtrak, for example, receives federal funding through appropriations from the federal budget on an annual basis to cover its operat- ing loss and capital costs. With the introduction of Section 209 of the PRIIA of 2008, states also provide subsidies for short-distance Amtrak services within their state in accordance with an established cost method.28 All commuter rail services are also subsidized from some combination of local, state, and federal sources.29 Predictable and stable public funding (subsidies) for passen- ger rail services is needed to effectively plan and sustain these operations. Many public funding models, including federal appropriations for Amtrak, however, are neither predictable nor stable from one year to another. This creates a particular problem for planning and investment. Grant Programs for Freight Rail Projects In the United States, the range of federala and state grant programs for freight rail projects is largely intended to provide financial support to short lines to make capital improvements. Grants in some cases cover up to 100% of project capital costs (e.g., federal – Section 130 Railway-Highway Grade Crossing Program), but more often cover only a share of project costs (e.g., up to 90%). At the state level, grant programs vary widely and often focus on improving safety or separation of road/rail crossings and on broader economic development objectives. a Eligible recipients of federal funding programs are almost always states, although in some cases municipal and transit agencies or private freight railroad companies are eligible for direct grant funding. 28 PRIIA Section 209, Cost Methodology Policy, August 2011, http://www.highspeed-rail.org/Documents/PRIIA%20209%20 Policy%20Final%20Version%20083111.pdf 29 PRIIA (Section 209) requires that states must now pay operating and capital costs on a fully allocated basis for intercity rail service on Amtrak routes either state requested, on designated high-speed rail corridors (outside of the NEC), short-distance corridors, or on routes less than 750 miles.