How Hong Kong made mass transit profitable (could your city do the same?)

Wed, 2014-08-06 06:00 -- SCC Staff

By Brian Cotton

Hong Kong’s Mass Transit Railway (MTR) is regarded as one of the world’s premiere urban transit systems.  It is also one of the most profitable in an industry where profit is an exception and not the rule. Powering this system is a distinctive business model that monetizes real estate assets adjacent to the transportation infrastructure to supplement system revenue and reach profitability.

Can we take this idea of creatively monetizing adjacent assets to control some of the financing and implementation risks that hamper many smart city infrastructure initiatives?

Financial risks in smart city infrastructure

Research estimates, including our own at Frost & Sullivan, peg the total potential market value of smart city infrastructure projects at over $1.5 trillion worldwide by 2020, including build, operation and maintenance activities. That’s a lot of opportunity, but not easily realizable through public funding alone.

Traditionally, public infrastructure is envisioned as a common good that is not meant to generate a profit for the city.  In the same vein, smart city infrastructures are generally intended to enable a city to save money by supplying services more efficiently.  In the long term, this helps deliver better economic, environmental and social outcomes, but doesn’t specifically enable a city to make any new money.

In today’s climate of fiscal austerity the path to funding infrastructure, including smart city infrastructure, is fraught with obstacles.  Frequently, long-term planning horizons are overshadowed by short-term considerations, including competing funding priorities.  Even when the infrastructure projects reflect critical economic necessities, planning and finding funding formulas can be a grueling process. Outside investment is often needed, but business models that do not make money are unlikely to attract a lot of investors.

Innovation and smart city infrastructure = implementation risk

For many IT-based smart city infrastructure projects there are other risks in addition to the financial ones. Due to the innovative and often pioneering nature of these complex projects, the risks associated with these types of projects is arguably more profound. Compared to traditional infrastructure initiatives like toll roads or power grids, smart city initiatives carry more uncertainty, as described in a recent piece by Rick Robinson of IBM (see below).  Many investors will avoid these projects because of their elevated implementation risk profiles.

Implementation Risk in Smart Cities

Construction risk:  financial loss caused by cost over runs during construction, driven by things such as integrating incompatible IT systems, working with unfamiliar technology and merging two different cultures – IT and construction – in a complex project.

Operational risk:  costs associated with protecting against failures of IT systems controlling critical systems and adequately mitigating or insuring liability when these failures occur.

Outcomes risk:  the inherent uncertainty in pro forma calculations of the benefits achieved or returns delivered from smart city programs or initiatives.

Wanted:  a new model to attract smart city investors

Because of their relative novelty, elevated risk profiles and a challenging public funding environment, governments need to attract the private sector to engage in public-private partnerships (PPPs) to obtain funding and spread the risk. Incenting smart city investors requires a rethinking of the smart city business model.  This means making the smart city economically sustainable, while still delivering public good. Here’s where the MTR comes into play.  With some creativity, their business model could be used as a template to mitigate risk, generate profit and encourage a return on smart city infrastructure investment.

The R+P model:  successful, sustainable and profitable

The MTR’s distinctive business model is called rail plus property (R+P) and it has successfully navigated some of the infrastructure risks noted above, while demonstrating that infrastructure can be profitable and provide public good.  R+P is an example of creative value capture that relies on the basic principle that improved public transportation increases the value of the real estate adjacent to the transportation infrastructure.  That value can be further enhanced by strategically planned redevelopment of the property. In R+P, the MTR captures the enhanced value of the property above its subway stations by optimizing the synergies between transportation infrastructure and the integrated residential, business and retail communities developed along the transit network. Given the density and demand for space and efficient transportation in Hong Kong, this model is highly sustainable, with no need for direct government subsidies.

The success of the R+P model is partly due to some unique factors in Hong Kong that encourage high usage of the system and of the properties above the stations, such as a very high population density, a highly efficient system and a scarcity of quality real estate. However, there are examples that attest to the R+P model’s success as new transportation and community building works are being implemented in London, Shenzhen and Tianjin.  R+P demonstrates that the financial risks of building transit infrastructure can be mitigated and a profit returned.

Can R+P+D (digital) support a smart city?

Extending the R+P model to the smart city, value can be captured when a digital infrastructure of sensors, actuators and communications is married to the physical transportation infrastructure and adjacent properties. This becomes a smart city infrastructure, creating a foundation for developing a network of interconnected smart communities.  

A version of this was created from the fiber optic network build out of the 1990s. When pipeline companies, utilities and railroads laid optical fiber along their rights of way, it formed high-speed city-to-city connections powering the first generation of the Internet economy.  A renewed build out today connects financial services companies or consortia of hospitals, creating value through high-speed trading and telemedicine. 

In a smart city, the data generated by users of the smart city infrastructure has a value. For instance, the insight gleaned from where people go on a transit system, how long they stay there and what they do when they are there, can be used by city planners, public safety agencies or retailers to create and deliver (or sell) new services to the users. The owners and operators of the smart city infrastructure can capture this value and reinvest it in the infrastructure, return it to the stakeholders or both. Ideally, the R+P+D model could apply to other smart city infrastructures, such as smart water networks or electricity microgrids.  It could also help enhance the existing revenue streams from more common city services such as parking or permitting.

Would R+P+D actually work?

Applying the R+P+D model to the smart city may help alleviate outcomes risk while providing incentive to overcome construction and operational risk. By enabling PPPs to cultivate the value of the physical and digital assets in a smart city infrastructure, the model would encourage sustainable operation and investment in the infrastructure.  Ultimately, the R+P+D model could create a marketplace on the infrastructure that drives usage, innovation and sustainable value in the smart city. 

It may or may not be the MTR itself that someday makes my city smart, but it sure could be a version of their business model that does it.

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Brian Cotton is Vice President, Information and Communications Technologies, at Frost & Sullivan. He has more than 20 years of research and market strategy experience, including 16 years in Information and Communications Technology (ICT).