Investing in toll roads Magellan Asset Management November 2023 |
While we tend to think of toll roads as a recent phenomenon, they have been around for thousands of years. Toll roads today are a popular way for cash-strapped governments to raise money and improve the quality of, and reduce the congestion on road networks. Given the huge capital costs (toll roads often cost billions of dollars to build), for most investors the listed market is the only way to gain access to these assets. Types of toll roadsThere are two main types of toll roads; inter-urban toll roads (those between cities); and intra-urban toll roads (those within cities), which can be further be divided into radial, orbital and high-occupancy toll (HOT) lanes. Each road varies in terms of its dynamics but, in general, this difference stems from the types of users and the trips undertaken. Intra-urban toll roads typically host a higher proportion of cars - with a significant part of this related to people traveling to and from work and going about their daily lives. Consequently, in an economic downturn, while some traffic will divert to the alternative free route, as long as people have jobs to go to or errands to run, the diversion is likely to be minimal. By contrast, roads between cities tend to have higher proportions of commercial traffic and discretionary trips, which are more economically sensitive.
As is generally the case for transport infrastructure, the revenue for a toll road is a function of volume and price. In the case of toll roads, this can be put simply as: Toll road revenue = Traffic volume x toll price Pricing Mechanism for toll roads?The typical business model for a toll road is that a government agency enters into a concession agreement (contract) that entitles a toll-road operator to collect tolls for a defined period and increase those tolls on a regular basis in a defined way. The basis on which tolls are increased is controlled by the terms of the concession agreement and the level of tolls is generally linked to inflation. Table 2 shows how contracts differ. In Canada, the owner of the 407 ETR tollway can raise tolls with minimal constraints, while in Australia toll increases are linked to the consumer price index, the rate of inflation or 1 per cent per quarter. The pricing mechanism for these toll roads generally tracks increases in inflation with minimal lag. Consequently, most toll-road owners have the ability to respond quickly to any rise in inflation.
As tolls increase, there is generally a temporary switching effect where some users shift to the toll-free alternative. This causes competing routes to get more congested, which boosts the attractiveness of the tolled route. This results in an increase in total revenue, all things being equal, as the toll increase more than offsets the temporary decline in traffic. This can be seen from the below case study 1, that shows traffic on Sydney's Eastern Distributor, which grew 118% over 18 years despite tolls increasing 151% over the same period.
Three main factors affect the volume of traffic on toll roads. Case Study 2 below, shows the number of cars per thousand people in different countries around the world. It shows that as countries become wealthier, the demand for transport and mobility leads to increases in car ownership. The direct relationship between the demand for transport and economic development underpins the need for transport infrastructure.
1. Misalignment of incentives This is one of the reasons Magellan places so much emphasis on the governance or agency risk of these businesses. Incentives drive behaviour. A management team with incentives that align with the needs of long-term asset owners is less prone to such errors. 2. Congestion charges A congestion charge increases the cost of a trip into the charged area, which would be expected to shift people to other modes of transport; in particular, public transport. Other solutions such as Washington DC's dynamic pricing on parking meters may also reduce traffic at the margins. 3. Technological disruption Toll roads today typically can handle about 2,200 vehicles per lane per hour. A study by the University of California1 concluded that full penetration of self-driving cars could double this capacity. This is because computer-driven vehicles will be able to travel much closer together, at much higher speeds and in much thinner lanes. The long-term impact on toll roads will depend on the balance between additional trips created by driverless cars minus the additional capacity that is created on the free roads 4. Working from Home 5. Declining licence uptake among younger adults An Australian study into the same phenomenon2 suggested a range of explanations. Potential causes included increasingly restrictive access to learners and full licensing requirements along with lifestyle factors - increased tertiary education, staying at home longer and delaying working and having children, and the reduced status symbol of a car. The study found that young people who maintain frequent contact with friends through technology are more, not less, likely to see their friends in person. Toll roads can generate growing and inflation-protected income streams for long-term investors. While the risks are low compared with most equities, the risks of these assets are nonetheless real - particularly when they pertain to agency risk. In-depth research and a good understanding of the drivers of the business and incentives of management teams should allow investors to reap the benefits of these largely misunderstood assets. |
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