Combining Private Finance with Collaborative Contracting to deliver the Sydney Metro Northern Beaches!
Infralegal recently organised an IPFA event that explored the potential to combine private finance with collaborative contracting based on a hypothetical project—a new Sydney Metro line to the Northern Beaches!
Below is an overview of the key discussion points and perspectives:
Hypothetical Scenario
The Premier and Transport Minister in our fictitious scenario have just jointly announced, to a room packed with media journalists, a new Metro Line to the Northern Beaches.
There will be 12 stations: Neutral Bay, Mosman, Seaforth, Manly Vale, Narrabeen, Dee Why, Collaroy, Mona Vale, Newport, Avalon Beach, Whale Beach, and Palm Beach.
Bradfield’s vision for rail services to be not only finally realised, but bettered with turn-up-and-go Sydney Metro services!
When asked whether a business case has been prepared, the Transport Minister confirms that it has, that the projected Benefit Cost Ratio (BCR) is 2.0, and that all 300 pages of the business case are available on the Sydney Metro Website — no redactions
The Minister calls Sydney Metro’s new CEO straight after the announcement. She tells the CEO that the business case doesn’t include a procurement strategy because she wants the CEO’s advice on how the line should be procured. The Minister says she doesn’t want a repeat of cost overruns and delays to the opening of the last line. This time she wants a different approach that will deliver a better value for money outcome for the good taxpayers of NSW.
Oh, and just before she hangs up, she mentions one more thing — “Treasury says the State’s current cash flow position is diabolical, so the project can only proceed if it is privately financed. However, given the BCR, Treasury is prepared to sign up to an availability payment PPP, as per Sydney Metro Northwest and Sydney Metro Western Sydney Airport.”
Government Procuring Agency’s perspective
Sydney Metro’s CEO attends the Minister’s office the next morning and proposes testing the following procurement strategy with the market:
The main contract is to be a privately financed PPP contract covering rail systems, station fit-out, trains, operations and maintenance for 15 years, plus the raising of private finance – similar to the PPP package on the Northwest and Western Sydney Airport lines
However, the PPP contract should be more collaborative than those prior PPP contracts. It should incorporate an Incentivised Target Cost (ITC) mechanism where:
each System Provider is reimbursed for its actual costs;
the fee for margin and overheads for each System Provider is based on KPIs for the full PPP package, rather than system-specific KPIs, to encourage collaboration between the various System Providers;
cost overruns and underruns are shared between Sydney Metro, the PPP SPV and the System Providers
the painshare contributions for PPP Co and the System Providers are capped; and
Sydney Metro bears 100% of cost overruns once the caps are reached.
Like the Northwest and Western Sydney Airport metro lines, there will be two further main contracts: a Design & Contract (D&C) contract for the tunnel and another D&C contract for the viaduct and other surface civils. But both will incorporate an Incentivised Target Cost (ITC) payment regime rather than a lump sum price.
The ITC model is proposed for each contract package because it is better suited to complex infrastructure projects involving the integration of multiple systems than a lump sum price.
If each System Provider has agreed to a fixed price, its margin is the difference between its costs and the price, so every dollar it spends on cooperating with other contractors and providers is one dollar less profit.
Whereas under an ITC regime, each System Provider’s costs including cooperation costs are reimbursed, and each System Provider’s margin depends on whole-of-project outcomes, not the difference between its actual costs and its fixed price.
One of the Minister’s clever young advisors suggests that Sydney Metro should consider a Multiparty Cooperation Contract sitting across the top of the three contract packages, that provides for gainshare payments to each of the three package contractors if whole-of-project outcomes are achieved, and painshare payments if they aren’t.
The gainshare payments could be funded in part by the fee covering BAU profit margin that would otherwise be payable to each D&C contractor, after reimbursing their actual costs, under each D&C contract. That will encourage cooperation and collaboration between PPP Co and the two D&C contractors for the other two packages, to achieve the whole of project objectives.
The Minister’s advisor also suggests that the PPP Co should be exposed to a slice of any gainshare or painshare payments. This will cause the return to equity investors to increase if the whole-of-project outcomes are achieved or exceeded or decrease if they are not achieved. It will, therefore, align the interests of the equity investors with the interests of Sydney Metro.
The Minister is delighted! She has just one concern — will the banks be on board with the strategy?
Project Financier’s Perspective
The project financier has some concerns:
Project financiers provide limited recourse finance, which means they can only have recourse to the borrower, in this case, PPP Co, and its assets. They typically want PPP Co to transfer all risks associated with the design and construction of the project to its D&C contractor under a lump sum contract, with limited compensation events. For each compensation event, they want the PPP Co to have a back-to-back entitlement to compensation from someone of financial substance, in this case, Sydney Metro.
The proposal that construction cost overruns and underruns would be shared between Sydney Metro, the PPP Co and the System Providers under the PPP contract causes concern because the PPP Co doesn’t usually share in that risk. It usually transfers that risk to its D&C contractor or, in the case of compensation events, to Sydney Metro.
Whilst the North East Link PPP package was project financed with an Incentivised Target Cost payment regime, PPP Co didn’t share any of the cost overrun risk on that project. The cost overrun risk was shared only between the Government and the D&C JV. On the North East Link PPP package, the PPP Co and, hence, its equity investors don’t share any of the pain associated with construction cost overruns, not even a few cents in every dollar.
Another concern is PPP Co’s ability to manage the interface risks between the various system providers and contractors. Usually, a D&C JV with a significant collective balance sheet would jointly and severally wrap all of the construction works required to complete the project and generate revenue. By doing so, the D&C JV takes the integration risk and provides the PPP Co with a single point of accountability.
PPP Co will have to make promises to each System Provider about the work that the other system providers will perform at the interface. If another System Provider runs late or doesn’t deliver the work to specification, PPP Co will have to compensate the affected System Provider and seek to recover the compensation from the defaulting System Provider. If it can’t fully recover, PPP Co will need to fund the difference, so the project financiers will want to see additional equity in PPP Co to cover this.
Also, if the project's operational performance is poor due to design or construction issues, PPP Co will need to be able to determine which of its system providers is at fault. The faults are usually at the interfaces between systems, and each relevant System Provider will blame the others for the faults. This makes it hard and expensive for PPP Co to enforce its system warranties and again leaves it with a funding gap that its equity investors will need to fill.
D&C Contractor’s Perspective
Our hypothetical D&C contractor is interested in the D&C role within the PPP package, in particular the line-wide works. It considers the proposed contracting strategy to be a step in the right direction, for the following reasons:
The problem with the traditional PPP model for D&C contractors is that the PPP Co’s equity investors want a ‘single D&C wrap’, i.e. a single D&C contract covering all D&C works within the PPP package. On a project such as this, that requires several tier 1 D&C contractors to form an unincorporated joint venture under which each D&C contractor is jointly and severally liable to the PPP Co for all obligations under the D&C contract for the PPP package. The individual D&C contractors can’t cap their liability to PPP Co by reference to the value of the D&C works for which each is responsible. Instead, each must put its balance sheet on the line for 100% of the D&C obligations. Each D&C contractor should be able to cap its exposure to PPP Co by reference to the value of the D&C works for which it is responsible.
The integration risk should be shared between PPP Co and the members of the D&C JV. PPP Co should have skin in the game on the integration risk, rather than transferring 100% of that risk to each member of the D&C JV, and leaving each JV member to sort it out with the other members of the D&C JV.
The proposed ITC regime would extend to the integration work, and protect the D&C contractor against the risk of cost blow-outs. But D&C contractors are not in the business of simply recovering costs — they need to make a reasonable margin. The D&C contractor’s margin will depend on how the actual construction costs compare to the target cost. Accordingly, the contractor wants the target cost to be increased for cost events that are outside its control, to protect its margin.
An aspect of the proposed contracting strategy that concerns the D&C contractor is its margin being dependent on whole-of-project outcomes, which depend on the performance of other contractors. If the D&C contractor’s margin will turn on how other contractors manage their scope and associated risks, the D&C contractor will want a say in managing those risks. This has been a problem with some collaborative contracting models where the project owner has sought to retain a right of veto, or the right to unilaterally make various decisions that can significantly impact project outcomes. So perhaps key decisions regarding the management of package risks should be made by consensus between all parties that share the financial rewards or pain of the decision, until such time as painshare caps have been reached.
Institutional Equity Investor’s Perspective
The institutional equity investor is excited by the opportunity but also has some reservations about the contracting strategy:
There could be a role in certain circumstances for PPP Co/equity to take a share in integration risk or even share in cost outcomes as a means of promoting an alignment of interests. However, for the project to remain bankable with gearing levels close to those typically seen on a PPP, the risks would need to be subject to appropriately sized caps. Equity investors would also need to convince their internal investment committees, and the project financiers, that these were risks that PPP Co is in a position to effectively manage. It would likely mean a bigger PPP Co, as it would need the expertise in the structure responsible for managing those outcomes.
The PPP Co may be able to share a “slice” of these cost overruns, subject to an appropriately sized cap. In this context, it is worth noting a couple of points:
In a highly geared PPP with government contributions, equity typically represents a very small portion of the capital stack, and so it is not sized to absorb every issue that arises in delivery. So, the portion of the risk that equity could be exposed to could be sufficient to promote an alignment of interest, but it won’t substantively take the risk out of the hands of the government and the D&C contractor.
Equity will assess its returns for an investment on a risk-adjusted basis, and any risk that is accepted — even if capped — needs to be priced such that the investment proposition still stacks up. Here, you are passing risk to a party that is not as well equipped to manage the risk as others (as equity is not delivering the scope), so there is also a question of value for money if investors require higher returns, in addition to bigger SPVs.
None of this means PPP Co/equity shouldn’t take risk — it absolutely should! But where equity’s role in a PPP structure is to manage the contractors and contracts, not to deliver scope, exposing the equity investors to significant cost overrun risks may not be the best way to ensure equity performs its role from a value-for-money perspective. There may be better ways to incentivise the right behaviours so that equity is an active partner for government.
Technology Supplier’s Perspective
Technology suppliers usually feature lower down in the contracting chain, usually as subcontractors to the D&C JV. This can create unique challenges, particularly when it comes to integrating technology systems from different suppliers. The usual challenges for the technology supplier to a privately financed project include the following:
The gearing levels required to make these projects work as PPPs—that is, to make them bankable—mean that the risk profile must be well within the project parties’ areas of expertise to a high degree of reliability. This applies not just to the project’s financial and operating models but also to the level of technical/solution risk and project delivery risk involved in delivering against the project specifications and delivery requirements.
Just as these projects work well when the business model is well understood and can be constructed with a very high degree of reliability, so are they dependent on understanding the technical and project delivery risk with a high degree of reliability before project documents are finalised and executed and the parties are committed. This means some projects lend themselves well to limited-recourse project finance and a PPP-style structure, while others are better suited to full-recourse corporate finance. It’s less about whether technology projects are well suited to private finance and more about making sure that your particular technology requirements match the risk profile that makes sense for your financing arrangement.
Ultimately, the project requirements are set by the party seeking the project solution in the first place — in this case, the Sydney Metro. This means that if the customer’s technology system requirements aren’t vanilla, and the technology supplier’s solution won’t meet those needs out of the box, then the technology supplier’s team will need to be able to work closely with the customer’s team to develop and agree a more detailed requirements specification that does, and then design, build, and commission a solution that meets them. A PPP-style contract structure doesn’t facilitate any of these processes; it actively works against them.
Contemporary government customers are increasingly looking to PPP Co to actively deliver the project by, for example, making these kinds of decisions. However, PPP Co’s horizons are set by the PPP contract and its specifications, and they’re not the author or owner of these documents.
Project owners have found, time and again, that it is challenging to accurately forecast their technology needs, and so the delivery of technology scope tends to start with a kind of discovery phase, where the customer’s requirements and the contractor’s expertise come together. Usually, the parties end up with a refined version of the Project Scope & Delivery Requirements as the outcome. This is very hard to do in an infrastructure project, so a direct relationship with the ultimate customer is always one of the technology supplier’s primary objectives when structuring these projects.
The technology supplier’s time horizon does not end with the completion of construction. In fact, in many ways, that is when its relationship with the project really gets going. The technology supplier is like PPP Co in that sense — the delivery and operations needs come together with it. In PPP Co’s case, it tends to rely on the O&M contractor to bring the operational requirements together with the delivery requirements — but as a contractor providing a service for a fee, the O&M contractor has similar misalignments with the customer’s needs to the other delivery contractors. The technology supplier is one of the few — if not the only — delivery phase contractors that can, and does, balance delivery costs and opportunities against operations costs and opportunities to optimize its risk and return (profit) throughout its relationship with the project.
The technology supplier’s contract also requires it to integrate its equipment with the equipment supplied by other technology providers with whom it has no direct contractual relationship. Again, the D&C contractor expects the technology supplier to communicate with the customer via the D&C contractor, which is suboptimal.
The collaborative PPP model described above is a step in the right direction. North East Link has shown that it’s possible to categorise different kinds of cost risks differently, to refine the allocation of risks that should live with the technology supplier and risks that should live with the customer. This avoids the need to make the same enormous bets that unexpected cost overruns in one area will be (or can be) sufficiently covered by gains — whether of the unexpected or manufactured varieties — in other areas of the technology supplier’s scope.
The collaborative PPP arrangement removes the absolute necessity for Sydney Metro to design and construct the perfect Project Scope & Delivery Requirements for a huge mega-project in advance, and it helps make it possible for us to work collaboratively towards a best-for-project/customer outcome, because the costs are transparent. The technology supplier doesn’t need to bet its profit margin to the same degree. However, an ITC arrangement still means the technology supplier, like the other non-owner participants, is betting some part of its profit margin on things and parties that are outside of its control and area of expertise.
The multiparty cooperation contract proposed between Sydney Metro, PPP Co, the tunnel D&C contractor and the viaduct D&C contractor could be improved by also adding the four system providers for the PPP package as parties to that document, as doing so would provide the technology supplier with a seat at the top table and enable it to communicate directly with the O&M contractor and Sydney Metro. In fact, if you want the technology supplier to buy into an “everyone wins or loses together” arrangement, then this is necessary. It’s less about the other D&C contractors and more about the customer.
Summary
The push for more collaborative contracts has been driven by the D&C contract market. A joint and several D&C wrap on a project like this is very expensive in the current market. On a systems integration project such as a metro line, the integration task is also a very risky proposition for the D&C JV because many of the systems fall outside their core competency.
Collaborative contracts can be combined with private finance, so long as the risks to the borrower (i.e PPP Co) continue to fit within the project financier’s risk/reward framework.
This means PPP Co’s ability to take the integration risk that the D&C JV is no longer prepared to wrap is quite limited — perhaps a few cents in the dollar. So the integration risks need to be shared between government and the various system providers and contractors.
System providers and contractors are prepared to share in these risks subject to painshare caps, which means government ends up bearing the residual cost overrun risks.
As such, the integration risk once taken by D&C JV would be shared, but mostly underwritten by government. Government agencies have shown they prepared to take cost overrun risk on numerous ITC contracts in the market, so this is doable.
Once government recognises it can’t transfer the integration risk to a D&C JV, it should focus on working with the system providers and contractors to remove/reduce risks.
Finally, the relationship between governance and risk sharing needs to be addressed. When parties share risk, one party can’t expect to be in the driver’s seat to the exclusion of the others. Each risk sharer wants to be a co-pilot.
Next step?
NEC has indicated that it would like to add the “F” (for Finance) to its DBO(M) contract to create an NEC PPP contract — it just needs an actual project to do it on. This is a great opportunity for a PPP project owner.
Acknowledgement
We gratefully acknowledge the contributions of those who participated in the hypothetical - Louise Hart, Independent Infrastructure Advisor; Tarek El-Rakshy, SMBC; Jarrod Woodward, Director; John Laing, Andrew Jeffrey, Laing O’Rourke; Damian Morris, MOSO Corporation and Peter Colacino, Mott McDonald.
The hypothetical scenario described above is fictitious. Any resemblance to actual people or events is coincidental.
