IRF and Roads Australia Regional Conference - Asia and Australasia

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1 IRF and Roads Australia Regional Conference - Asia and Australasia Sydney, 4-6 May 2015 Where to next for road PPPs? Owen Hayford and Marko Misko, Clayton Utz The road PPP model continues to change in response to changing market conditions. The main area of change has been the allocation of traffic /demand risk, in response to the continuing lack of private sector appetite for this risk. Another area of change has been the trend away from 'fully bundled' PPPs, as governments separately tender and contract for services which would previously have been included in a single 'fully bundled' PPP contract. This paper considers these two areas of change and asks "where to next for road PPPs?" Tackling traffic risk The most significant change has been in the area of traffic risk, also known as demand risk or patronage risk. Traffic risk is the risk that the number of motorists using the road, and consequently the amount of toll revenue, is less than forecast. Australian toll road PPPs historically allocated traffic risk to the private sector investors in the road. The investors in some early toll road PPPs, such as the M2 Hills Motorway in Sydney, and the CityLink project in Melbourne, did quite well out of this model. However, investors in later toll roads, in an effort to win bidding competitions for the right to build and operate the toll road, were far more aggressive with their traffic forecasts and, consequently, lost large sums of money when the traffic didn't materialise. Notable examples include the Cross City and Lane Cove Tunnel projects in Sydney, and the Clem 7 and Airport Link projects in Brisbane. Fortunately for taxpayers, the contractual allocation of traffic risk on these deals worked. The losses were borne by those who agreed to take traffic risk, being the private sector equity investors and, in some cases, the debt financiers. In all cases, the roads remained opened to motorists, at toll levels no higher than originally contemplated, and government did not have to bail out the project with additional government funding. However, equity investors and debt financiers lost their appetite for traffic risk and started calling for changes to the allocation of this risk. A new road ahead Availability Payment PPPs Around this time, the Victorian Government tendered its Mornington Peninsula road project as an "availability payment" PPP. Under the Availability Payment PPP model, the project company receives its revenue in the form of a quarterly availability payment from government, in return for making the road available for use by motorists. If any tolls are levied on motorists, the government applies them towards its obligation to pay the availability payments. The availability payment which the project company receives does not depend upon the amount of toll revenue collected. Accordingly, under this model, the risk of toll revenues being less than forecast is borne by government, rather than the private sector. Some in the industry point to the Peninsula Link project as an example of government responding to the calls for change to the traditional allocation of traffic risk. However, the decision to not impose tolls on the Peninsula Link was made for other reasons. Once that decision had been made, the traditional toll road PPP model ceased to be an option for the Peninsula Link project (on which Clayton Utz advised the Government).

2 That said, the use of the Availability Payment model on some other road projects certainly is a response to the private sector's current aversion to traffic risk. Road PPPs that have adopted this model this model include the recently cancelled East West Link project in Victoria, the Toowoomba Second Range Crossing in Queensland, and the Transmission Gully road project in New Zealand. (Clayton Utz advised government on the first two of these projects). The GBTS model Government's response to the change in investor appetite for traffic risk has not been limited to the Availability Payment PPP model. Another model which has emerged in response to the traffic risk issue can be described as the "Government Builds, Tolls then Sells" (GBTS) model. Under this model, government engages private sector contractors to design, build and maintain the road, and to install tolling equipment, under public funded contracts. It retains the tolls collected during the ramp-up periods as the project builds some actual traffic history. Once actual traffic levels have been established, government sells the right to levy and collect future tolls to the private sector. Under the GBTS model, the government bears traffic risk during the ramp up period, and the private sector bears traffic risk after ramp up, when the risk is largely retired. Go between Bridge and Legacy Way Clayton Utz advised the Brisbane City Council on the application of the GBTS model to the Go Between Bridge and Legacy Way projects, both of which have now been sold to Queensland Motorways. The Legacy Way project is a variant on the GBTS model, as the project is still under construction and was sold before the ramp up traffic risk was retired. The arrangements for the payment of the sale price have been structured, however, so that part of the price is only paid after actual ramp up traffic levels have been proven, and the amount is adjusted having regard to any difference between actual and forecast traffic levels during the ramp up period. Accordingly, Council continues to bear the ramp up traffic risk, and the new owner bears the traffic risk thereafter. WestConnex The New South Wales Government is also adopting a variant of the GBTS model for Stage 1 of its WestConnex project. It is proposing to complete Stage 1 of this project in two phases. It will use government funding to pay for the first phase, being the widening of the M4 motorway. Once the widening is completed it will impose a toll on the M4 and collect the toll revenue through a special purpose company owned by the State. Once some actual traffic data is gathered, the Project Company will raise private sector debt against the future toll revenues. This debt will be raised on a non-recourse basis, i.e. the lenders will only be entitled to have recourse to the assets of the Project Company, and not the balance sheet of the State, in the event the loan is not repaid. As such, the debt raised by the State through the Project Company will not affect the State's credit rating. This debt will then be spent on phase 2 of Stage 1, being the extension of the M4 East from Strathfield through to Haberfield. Once phase 2 has some actual traffic history established, the NSW Government proposes to sell its equity in the Project Company and recycle that released capital into subsequent Stages of the WestConnex project. What are the implications of the different approaches? These two quite different responses, to the reduced appetite of private sector investors to traffic risk, have different implications. Government v private sector finance Under an Availability PPP, private sector finance is used to pay for the construction of the new road. Compare this with the Government Builds, Tolls then Sells (GBTS) model, where the government finances the construction of the new road.

3 Private sector finance comes at a cost, which reflects the risk being taken by the private sector financiers. That means there is an additional cost in the Availability PPP model that is not present in the GBTS model. But this does not necessarily mean that the GBTS model will deliver a better value for money outcome for government than the Availability PPP model. So what is the extra risk transfer that government achieves under the Availability PPP model that justifies the additional cost of private sector finance? It's not the risks associated with the design, construction, operation or maintenance of the road; these risks can be transferred to private sector contractors on an equivalent basis under both models. The key difference is that the Availability PPP model exposes debt and equity to the risk of a default by the contractors, or the insolvency of those contractors. This provides government with a 'buffer' against such risks. Under the GBTS model there is no such buffer. The involvement of private sector debt and equity investors also adds additional rigour to the due diligence and monitoring of projects. This additional rigour, which goes into the planning of the project and the monitoring of its performance, is one of the principal reasons why PPPs have been found to experience lower average construction cost overruns and construction phase delays, compared with traditionally procured projects. That said, in theory, there is no reason why the same level of rigour cannot be applied to the preparation of tender documents and risk and cost assessments, and to the project management of publicly funded construction contracts, under a GBTS model. Who bears traffic risk over time? The other key difference between the two models is the period over which government bears traffic risk. Under the GBTS model the government takes the traffic risk prior to the sale, and then transfers this risk to the private sector through the sale, once it has been largely retired. Under the Availability Payment model, government would ordinarily retain the traffic risk over the life of the PPP. The government could feasibly seek to sell the right to retain future toll revenues at some point during the life of the PPP. However, the contractual interfaces which would apply after the sale as between the new owner, the Availability PPP Project Company and its Operation and Maintenance (O&M) contractor, and government, would need to be very carefully considered when structuring the sale, in order to maximise the number of bidders for the tolling concession. Is one model better than the other? The answer depends on a number of factors and will differ from project to project, as it did on the East West Link and WestConnex. Those factors include: the cost of the private sector finance; government's assessment of the value of the buffer provided by debt and equity against the risk of contractor default or insolvency, and the additional rigour which debt and equity will bring to the assessment and monitoring of the projects; and government's desire the recycle its capital out of the project and into future projects. Changing private sector appetite for traffic risk Not all investors in toll road projects have lost their appetite for traffic risk. The agreement between the NSW Government, Transurban and the Westlink M7 shareholders for the NorthConnex project adopts a more traditional position on traffic risk, with traffic risk being borne by the investors providing the equity for the project. We expect private sector appetite for traffic risk will continue to return, but not to the levels experienced at the beginning of this millennium.

4 Unbundled road PPPs The second area of significant change has been a movement away from 'fully bundled' PPPs to more disaggregated procurement models, on some PPP projects. There are a few forces at play here. One force, as already mentioned, has been the market's response to the aversion of investors to demand risk on toll road deals, which has led to the GBTS model. Another force at play has been a desire to break the civil works on large projects into several packages. This is being driven by a variety of reasons. The North West Rail Link project was broken into 4 packages of civil works. This breakup was driven by a desire to get some construction happening quickly to demonstrate real progress. It was also driven by concerns regarding the market's capacity at the time to finance all of the necessary civil works, as well as concerns about the influence which the D&C contractors would have within the consortium relative to the operator if the civil works component of the PPP was disproportionate in value to the operations component. Another example, although not a PPP, is the Hunter Valley Expressway, where the break up was driven by the nature of the civil works, some of which were much more risky and difficult to price than the rest. The risky, hard to price works were performed under an alliance contract and the balance were performed under a separate traditional D&C contract. Structuring the works in this way delivered a better value for money outcome for government. A third force at pay is a desire to achieve best of class outcomes. On a fully bundled PPP deal, the best technical solution isn't always combined with the best financing solution. Or the best operator may not be teamed up with the best construction contractor. By separately tendering the different components of a project, government can achieve best in class outcomes for each component. However, these disaggregated procurement models can expose government greater risk in connection with the integration of the different components, compared with a fully bundled PPP where all of the necessary components are bid as an integrated package. But if the relevant government agency has the capabilities to manage this risk, it could achieve a better value for money outcome by managing this risk itself, rather than paying the private sector to do so. The Productivity Commission sees the potential for better value for money by unbundling the finance component from the initial bidding process, and allowing the preferred bidder to subsequently seek finance from the full range of potential debt and equity providers. Indeed, the Productivity Commission has recommended that governments undertake a pilot procurement program which trials this approach. Road user charging - more publicly funded road construction contracts? If road user charging is introduced across a broader range of roads, and the revenues raised are hypothecated to fund the development of road and other transport infrastructure and services, then this new source of funding may result in: greater use of publicly funded contract delivery models for the construction of new roads, such a D&C contracts, alliance contracts and the Delivery Partner Model; and consequently, fewer PPPs involving the use of private sector finance. The greater use of publicly funded contract delivery models for the design and construction of better roads would also fit neatly with the use of network wide performance based road maintenance contracts like the Stewardship Maintenance Contracts recently adopted by RMS for the parts of the Sydney metropolitan road network.

5 Industry Context A discussion of the delivery partner model (DPM) is highly timely in the current infrastructure climate, given: the state of the PPP market (as discussed so eloquently by Owen); industry concerns about pipeline and ensuring the ongoing utilisation of its available resources on major projects; and the awarding in the last week of preferred delivery partner (DP) status on Australia's first DPM project. In particular, this discussion reinvigorates the old 'broader church' chestnut, about whether a PPP (in its purest sense) is automatically synonymous with private finance, or whether it can extend to other forms of partnership under which public finance is used. Woolgoolga to Ballina Upgrade The DPM is presently being used for the first time in Australia by NSW Roads & Maritime Services (RMS) on the Woolgoolga to Ballina Upgrade. Previously, the DPM has been used in the UK, most notably on the 2012 London Olympics Project. In a joint media statement on 28 April 2015, the Australian and NSW Governments announced Pacific Complete (a consortium of Laing O'Rourke and Parsons Brinckerhoff) as the preferred DP for this project. The project will deliver the 155 kilometre upgrade of the final section of the Pacific Highway to receive full duplication between Hexham (near Newcastle) and the Queensland border. The project will be funded by an 80:20 split of Australian and NSW Government finance. The project cost is estimated to be in the order of $2b. To give an indication of the scale of the role, the DP is expected to employ over 200 people, to be based in a regional project office at Grafton. Overall, the project will employ over 4,000 people directly (and a further 12,000 people indirectly). The Acting Prime Minister and Minister for Infrastructure and Regional Development (Warren Truss) made the following observations: Using a delivery partner is globally recognised as an innovative and effective way to get the best results for major infrastructure projects and has been used on large-scale projects such as the 2012 London Olympic Games. The model has been tailored to meet specific needs of the Woolgoolga to Ballina section of highway, combining the knowledge and expertise of government in areas such as engineering and planning with that of the private industry. Expressions of interest were sought last year, with three major consortia shortlisted for the final stages of the competitive process. Pacific Complete has been chosen as the preferred delivery partner for their design, building and management expertise, and will oversee the 155km upgrade. As the procurement process for this project is extant, this paper will not discuss the specifics of the project; rather, it will outline - in a helicoptorial way - the key features of the DPM.

6 Procurement of DP Issue invitation to submit an EOI EOI briefing EOI Closing Participants announced Issue IPD Complete IPD process Issue Tender Documents Responses Selected preferred tenderer & execute agreement EOI Phase (~8 weeks) IPD Phase (~ 6 8 weeks) Tender Phase (~ 6-8 weeks) Given that the focus of the DPM is to obtain the best resources possible from the private sector, to assist in the management of the procurement/ design/ construction of the relevant project, the procurement process for the DP is critical. The process used by RMS has involved three phases: EOI phase: this involved the submission of EOIs to culminate in the selection of suitable applicants to proceed to the next phase; and the EOI was evaluated on the basis of team / consortium, delivery strategy, experience, key people and management systems; Invitation to participate in dialogue (IPD) phase: this was an interactive phase involving briefings, individual interactions (for different work streams) and scenario based interactions; and Tender phase - the tenderers submitted tenders comprising: commercial issues (eg entity details and insurances etc); DP team (including organisation structure, nominated key people and CVs); delivery strategy (including initial project management plan, cost plan, program and packaging and procurement plan); performance and payment (including payment schedule and proposed incentive regime); and options and innovation. Key features of DPM Generally The key features of the DPM are best considered by reference to: procurement and engagement of designers and constructors; project objectives and project governance; duality of functions (at both the program and individual project management levels); management of program budget; management of program schedule; design management and construction quality/defects; and remuneration and incentive structure.

7 Procurement and engagement of designers and constructors The DP undertakes all the procurements of the designers and constructors (project contractors) on a transparent, competitive basis. The DP does not self-perform any of the underlying work. The principal enters into all the project contracts. However, they are administered by the DP (as agent on behalf of the principal). This means that the principal has both direct rights against (and direct liabilities) to the project contractors. The project contracts therefore need to be let on terms acceptable to the principal. Project objectives and governance It is critical to identify and clearly articulate the principal's project objectives in adopting the DPM. The DP will then have an express contractual obligation to innovate and provide resources to maximise the achievement of those objectives. The principal establishes a project board to oversee the delivery of the project. The DP is not a member of the project board, but may have a senior representative attend meetings, if requested by the principal. The project board's roles include: to monitor delivery of the project and performance of the DP; to act as a forum for refinement of project requirements; to act as a forum for refinement of processes developed by the DP; and to act as a forum for collaboration as between the principal and the DP. The DP contract may include a dispute avoidance board structure (to assist in resolving disputes or differences between the parties). Duality of functions The DP will act as both overall program manager and individual project manager of each project contract. As a program manager, the DP: has obligations to ensure the entire program is delivered to maximise the principal's project objectives; this includes design management, cost planning and programming obligations; acts as a partner to the principal (and not as a part of the design and construction supply chain); and is accountable to the project board. As a project manager, the DP must administer each project contract in accordance with its terms, as agent on behalf of the principal. This includes enforcing the principal's rights, where required, such as in the event of defective design or construction. The DP has an obligation to provide extensive project plans to the principal setting out how it will deliver the project (which may be substantially developed during the procurement process). Management of budget An initial cost plan is attached to the DP contract, developed during the procurement process (initially by all tenderers during the interactive phase) and then finalised with the preferred DP.

8 The DP is not responsible for cost overruns in the same way as a lump sum contractor. However, the DP must: inform the principal of possible or actual overruns; identify of possible cost savings under the project contracts; and advise the principal on all measures for ensuring that total project cost does not exceed project budget. The DP's performance against budget is also a KPI, which will determine the extent (if any) of the gainshare/ painshare. Management of schedule An initial program is attached to the DP contract, developed during the procurement process (initially by all tenderers during the interactive phase) and then finalised with the preferred DP. The DP is not responsible for delays in the same way as a fixed time contractor. However, the DP must: inform the principal of any matter which will (or is likely) to give rise to a delay (by issuing an "early warning notice"); and actively prevent the cause / minimise the consequences of any delay. The DP's performance against schedule is also a KPI, which will determine the extent (if any) of the gainshare/painshare. Design management and construction quality The DP: provides all co-ordination, design management and construction management of the project contracts; administers the project contracts and performs all functions of the "contract administrator" under those contracts; and uses its best endeavours to ensure that each project contract achieves the relevant milestones by the applicable dates. While the DP must ensure that the works are fit for purpose upon completion, the principal must pursue the relevant project contractor for any defective works or defect rectification (and the DP will - typically - not be legally liable for defective works or defect rectification). Remuneration and incentive structure The DP must use its best endeavours to ensure that project completion is achieved so that the total project cost does not exceed the project budget. The DP is paid the contract price, comprising: direct costs (comprising various direct costs on account of personnel provided by the DP); and margin. A (progressive) painshare / gainshare regime is built into the DP contract (with significant opportunity for DP upside if it performs well against the KPIs).

9 Implications of the Framework So what does the DPM look like? Principal Delivery Agency DP Contract DP Project Contracts Consultants Contractors Supply Contractors FM Contractors? As a new breed of management-style project delivery method, the DPM offers the potential for substantial benefits: decisions will need to be made about which functions remain within the principal / delivery agency and which functions are outsourced to the DP. This has the potential to reshape the role / resources of the delivery agency as agency staff may be embedded in the DP; the principal / delivery agency can use its purchasing power to purchase / hire goods, materials, furniture, fittings, plant and equipment in bulk (for the entire program of work, rather than requiring contractors to do this on an element-by-element basis); the flexibility of the DPM creates an environment conducive to maximising the whole of life benefits of precinct information modelling (PIM)/ building information modelling (BIM), and greater integration with FM contractors; it facilitates cross-fertilisation of innovations / cost saving opportunities across the program of work, rather than quarantining them within each individual project contract; it provides flexibility of resourcing to match fluctuating work volumes over the duration of the program; It is performance-based - and can drive better than business as usual outcomes across an entire program of works - as DP margin is tied to incentives based on KPIs for the entire program; the overall model can leverage an agency's existing processes / standard form tender and contract documents for the project contracts; the bespoke interactive procurement process ensures that the principal/ delivery agency gets the best quality team and smarts for program delivery; and it provides for consistency of design, construction, contract administration, information and other outcomes across the program.