Pppreport

CHAPTER 3:

PRIVATE INVESTMENT IN PUBLIC INFRASTRUCTURE IN VICTORIA

Key findings of the Committee: 3.1

A number of the earlier public private partnership (PPP) projects focused excessively on transferring most of the risk to the private sector and on undertaking projects at lowest cost.

3.2

There has been limited independent external scrutiny of PPP projects undertaken to date.

3.3

The Committee considers that the build, own, operate arrangements entered into for the Mildura Hospital and the Melbourne County Court were not in the long term interests of the public, and that no further contracts of this type should be entered into.

3.4

In the absence of an international accounting standard dealing with concession agreements arising from partnership arrangements, reliance has been placed on the AASB117 (Accounting for leases) leasing standard. Under this new standard, various operating lease arrangements will need to be reclassified as finance leases, which form part of government debt.

3.5

The Victorian Government has been paying a high premium for the transfer of risk to the private sector, but as experience has shown large components of this risk have reverted back to the government.

3.6

Government needs to give more attention to evaluating the value of commercial opportunities available to private sector developers from certain categories of PPP arrangements.

3.7

The practice of governments providing private developers with 99 year leases at peppercorn rentals, which extend far beyond concession agreements, needs to be examined and a policy developed.

3.8

Redemption of the concession notes issued by Transurban in relation to CityLink was seen as being on terms very favourable to the company, particularly in view of the discount rate of 9.7 per cent.

3.9

There has been a long history of traditionally procured projects being over budget and not delivered on time.

Chapt er 3: Private investment in public infrastructure in Victoria

3.10

The Gateway Initiative, introduced about three years ago is proving to be of considerable benefit to the government in improving the delivery of new infrastructure. This initiative will help to determine real comparisons between in-house delivery of major projects and the use of PPP arrangements.

3.11

More consideration needs to be given to the long term cost to future budgets and the increasing levels of state debt arising from PPP arrangements compared with those arising from other methods of funding infrastructure.

The inquiry’s first term of reference required the Committee to provide an overview of the major infrastructure projects in Victoria that have involved private sector funding since 1990, with particular emphasis on issues relating to risk allocation and protection of the public interest. The second term of reference required the Committee to review and evaluate the expectations and outcomes of these projects in terms of the benefits and disadvantages to the community.

3.1

Overview of public private projects in Victoria 1990 – 2006

The involvement of the private sector in the funding of public infrastructure emerged as a new development in Victoria in the late 1980s and early 1990s, within a context of substantial budget difficulties and Loan Council borrowing limits.1 The Australian Loan Council was formed in 1928 and its functions included regulating borrowing by the Commonwealth and states, and placing limits on the states’ borrowing powers.

These requirements were eventually removed in 1995 because they were being increasingly avoided by the states through sophisticated financing techniques such as entering into operating leases for public infrastructure built by the private sector.

Over the past decade, investment markets have expanded into new ventures and private sector involvement in the provision of public infrastructure has advanced worldwide. The sophistication of such arrangements has increased, as has the sophistication of the methods for allocating risk.2 Victoria is the dominant jurisdiction in terms of the Australian public private partnership (PPP) experience.3 The Committee established that since 2000, Victoria had entered into contracts for 16 PPP projects; further projects are under consideration. By comparison, New South Wales had entered into eight projects, with the remaining states and territories collectively undertaking six projects.

1 2 3

Victorian Auditor General’s Office, submission no.13, p.1 ibid., p.2 Australian Council for Infrastructure Development (AusCID), submission no.18, p.14

Chapt er 3: Private investment in public infrastructure in Victoria

Private investment in public infrastructure projects has extended across different sectors and has included: • the early Victorian Accelerated Infrastructure Project (1990) – comprising 10 police stations, the Werribee Hospital and the Dandenong Mental Community Centre; • public transport franchise agreements, automated ticketing and the redevelopment of the Spencer Street Station; • the Melbourne Magistrates’ Court and the County Court of Victoria; • the St Vincent’s Hospital redevelopment, the Latrobe Hospital, the Mildura Hospital, and the Berwick Community Hospital; • the Intergraph emergency services system and the more recent mobile data network; • the new prisons project; • Castlemaine Water Reclamation Plant (Coliban Water), the Wodonga Wastewater Treatment Plant (North East Region Water Authority), the Campaspe Water Reclamation Project (Coliban Water), and Enviro Altona (City West Water Ltd); • the CityLink road project; • the Docklands film and television studios; • the Royal Women’s Hospital redevelopment; • EastLink; and • the Melbourne Convention Centre development.

Further projects under consideration or being prepared for market include the Ballarat North Reclamation project, the Royal Children’s Hospital redevelopment, the Melbourne Wholesale Market relocation and the Barwon Water Biosolids management.

CityLink has been the largest infrastructure project completed to date at a cost of around $2.1 billion, with $1.8 billion being financed by a private consortia and $266 million of associated works and other costs being financed by the state.4 Exhibit 3.1 provides details of each project.

4

Victorian Auditor-General’s Office, Report on Public Sector Agencies, June 2002, p.117 It was found that the Government had contributed approximately $346 million or (14.7 per cent) of the total project cost to the CityLink project. Source: E W Russell, E Waterman, and N Seddon, Audit Review of Government Contracts: Contracting, Privatisation, Probity and Disclosure in Victoria 1992-1999, An independent report to Government, Vol.2, May 2000, p.83

Chapt er 3: Private investment in public infrastructure in Victoria

As noted previously, the contribution of PPP projects to the total public infrastructure investment in Victoria is estimated at about 10 per cent of Victoria’s annual capital asset investment.5

5

Office of the Treasurer, Victoria’s PPPs Showcased at Canadian Conference, media release, 29 November 2005

Chapt er 3: Private investment in public infrastructure in Victoria

3.2

Evaluating Victorian projects

3.2.1

Background

An independent external evaluation of eight partnership projects was undertaken in January 2004 by Peter Fitzgerald from the Growth Solutions Group. The review concluded that the eight projects examined (of which two were actually completed), provided tangible evidence of the benefits available from harnessing private sector skills and innovation of design in infrastructure. Other positive aspects were seen as timeliness of delivery, certainty of price, and a whole-of-life approach to maintenance.

The report drew attention to a need to further improve risk identification and evaluation, along with improving the pricing of the transferred market risks. There was a need for a concentrated effort to improve the skills and capabilities of public servants involved in major infrastructure developments undertaken under partnership arrangements.

The Fitzgerald report, probably the most comprehensive review of the outcomes of partnership projects within Victoria, drew heavily on the experiences of the AuditorGeneral in evaluating selected projects.

The Department of Treasury and Finance advised the Committee that in the early years, partnership arrangements focused on transferring most of the risks to the private sector partner. Excessive focus was also placed on projects being undertaken at lowest cost, as evidenced in the projects examined by the Auditor-General: (a)

Latrobe Regional Hospital

The government’s key objective of this project was to deliver improved health services to public patients in the Latrobe Valley through a private sector provider. The successful tenderer (Australian Hospital Care Ltd) was awarded the contract to build, own and operate the new Latrobe Regional Hospital from January 1997. In return for the services delivered, the government paid the company a service fee, inclusive of a facilities component to service the debt incurred by the company in building the facility.6 The company incurred large losses that were attributed to its low bid price for the services together with the inability to achieve efficiency gains it expected from private sector operations. The government was forced to take back the operations for a nominal amount of $1 because a threat to public health and safety was beginning to emerge.7 This example serves to illustrate that: 6 7

Victorian Auditor-General’s Office, Report on Public Sector Agencies, June 2002, pp.75–79 Victorian Auditor-General’s Office, Report on Public Sector Agencies, June 2002, pp.75–79

Chapt er 3: Private investment in public infrastructure in Victoria

• regardless of efforts being made to transfer major risks to the private sector, the ultimate risk (that is, the impact of public health services on the public) was borne by the government; • private sector so called efficiencies compared with the public sector may not materialise; • acceptance of tenders at lowest cost may not ultimately be in the best interests of government; and • more attention needed to be given to all risks borne by both parties. (b)

Casey Hospital

Casey Hospital, formerly known as the Berwick Community Hospital, was the first public hospital to be procured under the government’s Partnerships Victoria policy.

The private sector was responsible for the design, construction, financing and maintenance of the facility. The hospital was completed in 2004 and leased to the state for 25 years, at which time the hospital will be transferred to the state for nil consideration.8 The leasing arrangement was defined as a finance lease on the basis that the key risks associated with the project were to be borne by the state. Accordingly, the hospital was recorded as a state asset with a corresponding liability, reflecting the government’s obligations to finance (over the 25 year period) the capital cost and maintenance of the facility, estimated at $378 million.9 The net present cost of the building and facility services was calculated at $115 million at June 2002, after taking into account a discount factor of 8.65 per cent. According to calculations contained within the public sector comparator (PSC), this value was 9 per cent cheaper than if the project had been undertaken in the public sector.10 The net present value of the hospital building at 30 June 2006 was $84 million.11 The risks assumed by the government included extensive provisions whereby if the contractor defaulted, the state could terminate the contract and pay the developer the market value of the project at the termination date. These provisions were inserted as a result of the Latrobe Regional Hospital experience.

The Committee observed several outcomes from this project: • all the key risks associated with the project remained with the state, whereas one of the key objectives of the partnerships policy is that substantive risks should be borne by the private sector; 8 9 10 11

Victorian Auditor-General’s Office, Report of the Auditor-General on the Finances of the State of Victoria 2002-03, November 2003, pp.104–107 Department of Treasury and Finance, Financial Report for the State of Victoria 2004-05, p.112 P Fitzgerald, Review of Partnerships Victoria Provided Infrastructure – Final Report to the Treasurer, January 2004, p.11 Hon. J Brumby, MP, Treasurer, response to the Committee’s follow-up questions, Inquiry into the 2006-07 Budget Estimates, received 26 July 2006, p.5

Chapt er 3: Private investment in public infrastructure in Victoria

• because of the finance lease arrangement, the state has incurred additional debt of $378 million over the 25 year lease period; • the project proceeded on the basis that to undertake it within the public sector would cost 9 per cent more, but the 9 per cent saving was predicated on discounting the value of the lease payments of $378 million by a factor of 8.65 per cent, a level that appears excessive; • the $115 million net present value of the project at 30 June 2002 did not include an allowance for all the risks borne by the government, that if the contractor defaulted, the government could terminate the contract but would have to pay the contractor the market value of the project at the date of termination.

If for example, a lower discount rate of 5.6 per cent was applied, the supposed savings of 9 per cent would disappear and private sector construction would actually be 6 per cent more expensive. Given that the government was to bear the majority of the risks associated with the project, the discount factor of 8.65 per cent was far too high.

A high discount factor usually reflects the high degree of risk borne by the private sector, which translates to higher borrowing costs for the developers. The government subsequently recognised this deficiency and reduced the discount factor for hospital facilities to 5 per cent in 2003, although it was too late to amend the concession agreement.

The Committee understands that discount rates for partnership projects in the United Kingdom had been reduced from 6 per cent to 3.5 per cent.12 Both of these hospital projects forced the government to recognise that the state was accepting a disproportionate share of the risks involved in PPP projects. It also recognised that use of the public sector comparator needed to be more robust and include consistency of approach across projects. The government acknowledged that tenderers were sometimes submitting low-cost proposals that included overly aggressive assumptions as to the cost efficiencies that could be achieved by private sector operators, which had the potential to lead to financial difficulties.

12

Public Accounts Committee, New South Wales, Inquiry into Public Private Partnerships, June 2006, p.27

Chapt er 3: Private investment in public infrastructure in Victoria

Because of its early experience with partnership projects, the government has issued further policy documents and various advisory notes dealing with matters such as determining inflation rates, managing interest rate risk and disclosure and management of conflict of interest.13 The Committee acknowledges the efforts the government has made to ensure best practice is applied when determining the suitability of projects to be undertaken as PPPs.

3.3

Projects evaluated

3.3.1

Background

The Committee is not aware of any detailed, comprehensive and systematic evaluation of the outcomes of PPP projects in Victoria, with the exception of the review of undertaken by Peter Fitzgerald. This review examined eight projects but as discussed earlier only two of the projects (the County Court and the Wodonga Waste Water Treatment Plan) had actually been completed at the time of the examination. Peter Fitzgerald stated that his review was based on information that was publicly available, and did not necessarily reflect matters of a commercial nature. The Auditor-General has also examined a range of PPP projects since 2001. With some limited exceptions, most of these reviews have concentrated on the contractual arrangements, risk transfers and the rights and obligations of the respective parties rather than on the evaluation of completed projects.

The Committee considers that independent post completion reviews of a selection of major projects should be undertaken, and that the reports should be made publicly available. This process would enhance accountability and enable the government to systematically address any perceived deficiencies.

A major factor in all projects is the use of discount rates. The concept behind the use of discount rates is to quantify the extent to which the value of money diminishes over a long period. For example, $100 today may only be worth $20 in 20 years time. To maintain the real value of the $100 today, it would be necessary to provide for a payment stream of $500 over the 20 years. The discount rate attempts to measure the extent to which the value of the dollar diminishes over time, and is usually based on the cost of capital.

The discount rate is a separate exercise from allowing for inflation, although it may appear similar. Prior to July 2003, most partnership projects used a discount rate of 13

Contract Management Guide (June 2003) – guidance on contract management issues during the life cycle of a partnerships project; Standard Commercial Principles (June 2005) – reflects the government’s position on Partnerships Victoria; Public Sector Comparator Supplementary Technical Note (July 2003) – reflects additional guidance on the use of the comparator following lessons learned from past experience; Use of discount rates in the Partnerships Victoria process (July 2003) – provides specific guidance on determining discount rates following a cash flow analysis for the purpose of evaluating bids and constructing a public sector comparator. In general, where the private sector assumes high risks the discount rate can be as high as 9 per cent. Conversely, where the government assumes most of the risk, the discount rate can be 5 per cent

Chapt er 3: Private investment in public infrastructure in Victoria

8.65 per cent. This incorporated a risk factor of 3 per cent, while the remaining 5.65 per cent represented an allowance for the opportunity cost of capital foregone based on the long term bond rate. The time value of money, including inflation and the opportunity to invest at a risk free rate, is seen by economists as being best captured by the long term Commonwealth bond rate, presently 5.75 per cent. As an example, using the risk free long term bond rate of 5.75 per cent, $100 today would have a value of $32.70 in 20 years time. The Committee understands that a typical calculation of the future cash flows would involve determining the level of annual payments to be made during the concession period in order to equate to the net present value of the contract as of the date it was entered into.

Assuming an annual payment of $10 million is made, for example, this amount would be multiplied by the inflation rate (assume 3 per cent) in one year to arrive at $10.3 million. This amount would then be discounted by 1.0865 to arrive at the present value of the payment of $10 million, which would be $9,479,981. The same process continues each year using the discounted payment from the previous year as the base, until such time as the total of the discounted payments equals the net present value of the project upon completion of construction. The higher the discount rate, the higher the level of payments to be made by the state in return for the private sector expending the money immediately, or borrowing at 5.75 per cent which is deemed as risk free.

As previously stated, the discount factor of 5.75 per cent is normally supplemented by a risk factor of up to 3 per cent, in recognition of the additional risks assumed by the private sector. Retention of these risks can also influence the interest rate to be paid on borrowings by the private sector.

Since the Committee was unable to undertake detailed reviews of specific PPP projects because it did not have access to departmental files, three projects that were examined by the Auditor-General and/or in the report of the review of Partnerships Victoria provided infrastructure are commented on in the following sections. (a)

County Court The new Victorian County Court building is seen as a case study of the timeliness of delivery and the quality of finish that can be obtained from a public private partnership.14

Cabinet approved the development of new facilities for the County Court in June 1997, using a build, own and operate (BOO) model. The estimated capital cost in 1997 under public sector delivery was $113.3 million, compared with private sector delivery of $100 million.15 Following protracted negotiations and various amendments to a government estimate of the project cost, a contract for $193.6 million, inclusive of maintenance 14 15

P Fitzgerald, Review of Partnerships Victoria Provided Infrastructure – Final Report to the Treasurer, January 2004, p.7 Victorian Auditor-General’s Office, Report on the Finances of the State of Victoria 1999-2000, November 2000, p.129

Chapt er 3: Private investment in public infrastructure in Victoria

arrangements, was eventually entered into in June 2000 between the government and the Liberty Group Consortium Pty Ltd, a consortium including ABN Amro Australia Ltd, N M Rothschild & Sons (Australia) Limited, Multiplex Construction Pty Ltd and Honeywell Ltd. At that stage, the project had been placed under the control of Partnerships Victoria.16 The Crown land upon which the building is situated was leased to the consortia for 99 years for a nominal rent of $1 per annum. A proportion of the land not required for the court building was sold to the consortia for $3.5 million, to be developed for commercial purposes.

The contract with the Liberty Group was to design, build, finance and provide specified building management services, security and information systems. The contract is for 20 years and requires the government to make payments of an estimated $532.9 million, including adjustments for inflation. The payment stream was equivalent to a net present value of $195 million at June 2000, discounted by a factor of 8.65 per cent.17 The Liberty Group was to assume the long term ownership risk of the new court facility beyond the 20 year leasing period in line with ‘Partnership Victoria’ policy reissued in 2001, which stated that the government was to provide court services, not infrastructure.18 The residual value of the building after the 20 year lease period was therefore, not a factor, despite the building having an economic life of at least 80 years.

The consortium also retained the ability to re-lease or sell the facility to another party, or to convert the facility for alternative use at the end of the 20 year contract period.

Equity interest in the project has subsequently been sold and the Liberty Group is now a wholly owned subsidiary of Challenger Financial Services Group, an Australian property and funds management company.

Because the project commenced prior to the formation of Partnerships Victoria, it was not subject to comparison with the public sector comparator. Instead, reliance was placed on a financial benchmark developed by the government. When the benchmark was not bettered, the ultimate choice of contractor was on the basis of the best and final offer received. No attempt was apparently made to determine the cost of undertaking the project within the public sector, despite the existence of a recently constructed nearby Federal Court, which could have served as a benchmark.

The new facility opened on 31 May 2002, on time and on budget. The Committee acknowledges that regardless of the financial provisions, by comparison with the previous court facilities, the new facility provided a range of social and economic benefits to the community, including reduced waiting times for court appearances,

16 17 18

ibid, p.133 P Fitzgerald, Review of Partnerships Victoria Provided Infrastructure – Final Report to the Treasurer, January 2004, p.8 Partnerships Victoria, Department of Treasury and Finance, Use of Discount Rates in the Partnerships Victoria Process – Technical Note, July 2003, p.44

Chapt er 3: Private investment in public infrastructure in Victoria

better security, reduced court costs, and improved facilities for jurors, victims, the public and the legal community.

The court building consists of ten floors, of which the County Court occupies seven.

Two floors are vacant, and the remaining floor provides services to the building. The vacant floors for which no accommodation expenses are charged could provide for the future expansion of the facility, although such use remains at the option of the Liberty Group as owner. Should the Department of Justice decide to occupy the floors, it is understood that the contracts include a formula for determining the accommodation charge.

The Auditor-General considered that although the government in leasing the building retained a range of risks and obligations (mainly relating to cost escalation associated with service delivery), the Liberty Group had assumed the majority of the risks associated with the construction, financing and operation of the facility.19 The contractual arrangements inclusive of the discount factor of 8.65 per cent, commits the government to make payments of $532.9 million over a 20 year period.

These arrangements, adjusted for inflation, provided for an operating lease for the accommodation and a commitment by the Liberty Group to provide maintenance and other services. The payment stream covers the Liberty Group’s borrowing costs, maintenance commitments, construction outlays and a return on capital. After recouping all costs and a return on capital the ownership of the building remains with the Liberty Group for the lifetime of the 99 year lease, unless sold to another party.

When the contract period of 20 year contract period expires, what is the future of this purpose built building containing the County Court, which the government has effectively paid for, but did not want ownership thereof? Because of the purpose built nature of the building the lease could be renewed, albeit on terms more favourable to the owner or: • the government could relocate the County Court, which is highly unlikely (unless it was forced to do so) because of the expense involved; • the owner could refuse to renew the lease and renovate the building for alternative use; • the building could be sold to a private buyer; • the lease could be renewed on condition that the building is refurbished by the government.

The Auditor-General stated in his November 2000 report that because the Liberty Group had assumed the majority of the risks associated with the County Court project, it was appropriate to recognise the 20 year lease as an operating lease. Recognition of the operating lease did not occur until 2004-05. Prior to this date, the total 19

Victorian Auditor-General’s Office, Report of the Auditor-General on the Finances of the State of Victoria, 1999-2000, November 2000, p.136

Chapt er 3: Private investment in public infrastructure in Victoria

commitments under the 20 year contract ($532.9 million) were disclosed in the annual financial report of the state as ‘other commitments’, which are not recorded as liabilities on the state’s balance sheet.

The accounting treatment for the court was changed in 2004-05. Although the contract amount was still recorded under ‘commitments’, in the annual financial report, the accommodation component of the agreement was aggregated in an amount of $2,893 million described as ‘other’ operating and lease commitments.20 The change was on the basis that the accommodation charge was now recognised as an operating lease.

This change also had the impact of reducing an amount of $436.6 million previously described as ‘other commitments’ in 2003-04 to $64.3 million in 2004-05, representing the component of the contract relating to maintenance of the building.

The Committee finds it interesting that the material change in the accounting treatment of the contract in 2004-05 was not accompanied by a note to the financial report outlining the reason for the material variance from the previous year.

Subsequent to Victoria adopting the Australian equivalents of the International Financial Reporting Standards in 2004-05, the definition of a finance lease has been broadened. AASB117–‘Accounting for leases’, in addition to defining a finance lease as one where the lessee assumes all the risks and benefits incidental to ownership, now includes the following criteria to determine whether a finance lease exists: • ‘the lease term is for the major part of the economic life of the asset even if the title is not transferred’ and • ‘the leased assets are of such a specialised nature that only the lessee can use them without major modifications’.

Under this criteria, the operating lease arrangement should be treated as a finance lease on the basis that: • the 20 year lease, which may be extended upon expiry, represents a major part of the economic life of the County Court building. Further, the land upon which it is located is Crown land, despite being leased for 99 years; and • the County Court is a purpose built building containing special features unique to a court building. Although capable of modification to a standard office building, this would be an expensive exercise.

Reclassification of the operating lease to a finance lease means that the County Court is valued and recorded as an asset in the annual financial report, offset by a liability representing the finance lease, which now forms part of state debt.

The reclassification of the operating lease on the County Court to a finance lease will effectively increase state debt by about $140 million. The Committee noted that with this reclassification, similar situations will apply to a range of other PPP projects 20

Department of Treasury and Finance, Financial Report for the State of Victoria 2004-05, p.112

Chapt er 3: Private investment in public infrastructure in Victoria

involving purpose built facilities where the ownership of those facilities has remained with the contractor.

An example would be the construction of private prisons, currently under operating lease arrangements with the government. Another example can be found with the Mildura Hospital, which was built in 2000 on Crown land which had been leased to the developer for 99 years at a peppercorn rent. The hospital was built at a cost of $26.3 million. The developer entered into an agreement with the state to maintain the building and provide hospital services for a minimum period of 15 years, over which time it will receive $211.3 million, inclusive of recouping construction costs and a return on capital.21 At the expiration of the 15 year agreement period, the lease may or may not be renewed as the private developer has ownership of the hospital (paid for by the government) for the remaining 84 years of the lease.

As noted, the Auditor-General determined in 2000 that the majority of the risks were borne by the Liberty Group. Accordingly, it was appropriate at the time for the contractual arrangements involving the accommodation charge to be regarded as an operating lease. The changes to the leasing standard arising from the adoption of A-IFRS reflects a greater focus on the substance of leasing arrangements as distinct from their legal form. In this instance although the private sector developer owns the County Court building, the new leasing standards defines the risks and benefits incidental to ownership as remaining with the State. The Committee understands that at the suggestion of the Auditor–General’s Office, the Department of Justice has since reclassified the former operating lease on the County Court to a finance lease.

The reclassification of the operating lease to a finance lease effectively negates the government’s initial intention that the Liberty Group was to assume the ownership risk of the Court facility. In addition, the entering into of an operating lease avoided disclosure of the arrangements as state debt in the form of a finance lease.

In view of the change in the risk structure leading to the reclassification of the lease, the Committee draws attention to the contract which allows the Liberty Group to recoup about $533 million over 20 years inclusive of maintenance costs, for a building that cost about $135 million to construct, with ownership remaining with the private company at the end of the lease period. At the end of the lease period the building is estimated to have a further 60 years of economic life remaining. The calculation was based on a discount rate of 8.65 per cent over the period, thereby allowing the Liberty Group to receive a premium of 3 per cent inclusive in the discount rate which in hindsight should have been closer to 5.4 per cent, which is approximately the long term bond rate at which governments can borrow.

The extra 3 per cent was predicated on the basis of the market risk being transferred to the developer. In view of the new accounting standard for leases recognising substance over legal form (and leading to a clearer definition of when a lease should be regarded as a finance lease) it could be argued that a real transfer of risk did not 21

Victorian Auditor-General’s Office, Report of the Auditor-General on the Finances of the State of Victoria, 1999-2000, November 2000, p.127

Chapt er 3: Private investment in public infrastructure in Victoria

occur, and that the government is locked into paying a very large premium for risks that do not exist.

The government has since recognised that the premium for risk paid to the developer was excessive. Guidance material issued by Partnerships Victoria in July 2003 – ‘Use of discount rates in the Partnerships Victoria Process – Technical Note’ – stated that a discount rate of 5 per cent was appropriate for very low risk projects involving accommodation, such as the County Court. By this stage however, the lease had been entered into and could not be amended.

With the exception of the 2006-07 infrastructure program, government borrowing over recent years has been very limited. Infrastructure programs have been funded from surpluses and the cash equivalent of non-cash expenditure, such as depreciation under Victoria’s accrual accounting framework.

Even allowing for the supposed extra cost for the public sector to build the County Court project using traditional procurement methods, the extra cost of construction and the potential use of accumulated funds instead of borrowings to finance the project would have been far less than the extra $300 million plus payable by the government under the existing arrangements. The state would also have retained ownership of the asset and the savings to the budget could have been used for other priorities. Under the ‘Partnerships’ policy, the government argues that the cost of capital is not the important factor; the most important factor is who is bearing the market risk. Under the new accounting standard for leases, the market risk is seen as being borne by the government, not the private sector as was intended. The Committee considers that this policy needs to be reviewed, as the cost of capital is a very important factor which must be given proper consideration.

The Committee does not consider that the County Court project provided a good financial outcome for the government, particularly in the longer term. The Committee acknowledges that this project was one of the first projects undertaken in accordance with Partnerships Victoria policy guidelines and that lessons learned have influenced amendments. Nevertheless, the policy which led to the above situation still remains as part of the government’s partnerships policy. Specific issues arising from this project include: • more attention must be given to whether there is a true transfer of risk to the private sector; • the appropriateness of entering into BOO contracts whereby the residual value of the asset and ownership remains with the private sector must be evaluated; • the real risk transferred to the private sector compared with the notional risk equating to 3 per cent (resulting in excessive amounts paid by the government under lease arrangements) must be re–assessed; • the assigning of peppercorn leases of Crown land to the private sector for up to 99 years when the intended government use of the site is only for a portion of this period must be considered;

Chapt er 3: Private investment in public infrastructure in Victoria

• whether market rentals should be paid by the private sector for leases of land no longer required for public purposes; • all PPP arrangements involving leases must be reviewed to determine whether such leases comply with A-IFRS requirements; • irrespective of any perceived short term gain from undertaking a project in the private sector rather than in the public sector, this gain or otherwise must be measured against the long term implications and costs to future budgets of such arrangements. (b)

Southern Cross Station (formerly Spencer Street Station)

The redevelopment of Spencer Street Station formed part of the government’s Linking Victoria initiative launched in 2000. The key objectives of the project included ‘obtaining a world class transport interchange facility providing high quality services for passengers and transport operators’ and to transfer the risk to the private sector where it was appropriate to do so.

The contract was let to Civic Nexus Pty Ltd on 27 August 2002 for $341 million (net present value June 2002).22 This figure was inclusive of capital, operating costs and insurance costs over the life of the agreement. Civic Nexus was a consortium consisting of ABN Amro, Leightons Contractors, Daryl Jackson Architecture, Nicholas Grimshaw and Partners, Honeywell Ltd and Delaware North Australia.

The public sector comparator for this project was $294.4 million in 2002. Following worldwide concern with terrorist attacks at that time, the preferred developer was not prepared to take on the full insurance risk. Part of this risk (amounting to $7 million) was transferred to the government, resulting in the public sector comparator increasing to $301.4 million. The winning consortium’s adjusted bid was $286 million or 5.3 per cent less than the PSC. The government had previously been advised by PricewaterhouseCoopers that the private sector could undertake the project for $234 million due to a range of efficiencies deemed to exist with private sector involvement. As this example illustrates, the estimate fell far short of the private sector final bid of $286 million, which raises concern as to the quality of advice provided to the government on major projects of this nature.

The actual cost of constructing and maintaining this facility was $341 million, after transferring $11 million of additional risk to the state (mainly in relation to the insurance premiums). When comparing the private sector bid to the PSC, however, recognition was made that Civic Nexus estimated it would receive $68.6 million for the rights to commercial development on the site, which would be paid to the state.

This amount was subsequently deducted from the bid.

22

Department of Infrastructure, Infrastructure Projects Division, Contract Details, www.tenders.vic.gov.au, accessed 22 June 2006

Chapt er 3: Private investment in public infrastructure in Victoria

The actual cost of constructing the interchange facility and rail modifications was $313.9 million, substantially more than the PSC of $296.7 million. The deciding factor that eventually resulted in the contract being awarded to Civic Nexus was that if the construction was undertaken in the public sector, the building would be more conservative and would only attract commercial development rights of $39.9 million to offset the construction costs, as compared to the $68.6 million offered.

The contract provided for Civic Nexus to design, construct, finance, maintain and operate the transport interchange for 30 years, after which the facility is to be returned to the state. In a separate transaction, Civic Nexus paid $66 million to the government, via the Southern Cross Station Authority, for the right to undertake commercial operations within the interchange facility over the 30 year period of the contract.

These rights will commence upon final completion of the interchange facility and will involve Civic Nexus entering into a 30 year lease agreement for a nominal $10 per annum, plus outgoings.

The $66 million payment also granted ABN Amro, which was part of the Civic Nexus consortium, commercial development rights in neighbouring properties that are owned by the state. The Committee understands that these properties (in three locations) are actually the air rights for construction on top of a concrete slab adjacent to the Southern Cross Station roof. Commercial development rights could include projects such as an office complex, a retail precinct, residential towers or a hotel. Upon completion of each development, ABN Amro was to be granted a lease until 2100 for a nominal rental of $10 per annum, plus outgoings. The Committee now understands that ABN Amro has sold its interest in the project to an industry superannuation fund, Industry Funds Management Pty Ltd. The land and the commercial developments will revert back to the state in 2100.

The contract specified that Civic Nexus was to design, construct and commission the transport interchange facility including rail modifications and a signalling upgrade.

The developer was also required to meet design and construction milestones, including a final construction completion date. These major risks that were to be borne

by Civic Nexus were reflected in the 3 per cent premium for risk transfer paid by the government. Where the construction milestones were not achieved, Civic Nexus was to pay liquidated damages of $10,000 per day.23 If final completion was not achieved by the scheduled final completion date (mid July 2005) the firm was to be liable for liquidated damages of $25,000 per day until the final completion date.24 Conversely, the developer could also claim any costs associated with delays or disruption to the construction caused by government actions.

Despite the above arrangements, the state settled claims for compensation lodged in 2003 by Civic Nexus, paying the developer an additional $3.05 million for the completion of certain extra works.25 It also either modified or cancelled the 23 24 25

Victorian Auditor-General’s Office, Report of the Auditor-General on the Finances of the State of Victoria, 2003-04, November 2004, p.95 ibid. ibid.

Chapt er 3: Private investment in public infrastructure in Victoria

construction milestones initially agreed to in the contract, completion milestones were changed and the state reviewed its right to seek compensation of $25,000 per day if the scheduled completion date was not achieved. In essence, the state settled the dispute by waiving its rights to be compensated for construction delays.26 At 30 June 2005, Leightons Contractors (the builder of the Southern Cross Station) announced a forecast loss of $122.6 million on the project. At the same time various components of the project were well behind schedule. Construction of the main interchange facility was 307 days behind schedule, for example, and contractual completion of the project, which was originally projected in mid 2005,27 occurred on 2 August 2006, 434 calendar days late. The Committee understands the project was delayed for a number of reasons, including access to the site while the rail services were maintained, difficulties with the design, and industrial practices and disputes.

Leightons Contractors subsequently lodged a counter claim of $54.1 million against the government, mainly in relation to inadequate access to the works and contamination of the site. This claim was settled for $32.5 million, inclusive of certain contract variations requested by the government, and compensation for other unforeseen risks on the site such as removal of contamination. The settlement was seen by the government as a pragmatic outcome to avoid costly and protracted litigation within the courts.28 The Southern Cross Station Authority Chief Executive was quoted as saying: It’s an example of how PPPs work, with all parties coming together and resolving their issues in a very pragmatic and efficient way.

The Committee considers that the settlement reflected the fact that despite financial and construction risks being transferred to the private sector, in return for a premium to be paid by the government, the ultimate financial risk came back to the government.

The Committee does not comment on the merits or otherwise of the legal actions that are common with large projects, but acknowledges that the design of the Southern Cross Station is iconic and presented challenging and unique construction techniques.

The basic concept of most PPP arrangements is that in return for a premium allowing for an adequate return on capital, the private sector accepts all design, construction, financial and operating risks. The state waived its right to be compensated for extended construction delays with this project, and ended up paying compensation to Leighton Contractors for their loss. It could be argued that the $122.6 million loss incurred by Leighton Contractors provided evidence of the success of the transfer of risk to the private sector. This situation is, however, similar to that which occurs with contractual arrangements undertaken under traditional procurement methods, where 26 27 28

ibid.

Victorian Auditor-General’s Office, Report of the Auditor-General on the Finances of the State of Victoria, 2003-04, November 2004, p.102 F Tomazin and R Myer, ‘Spencer St dispute leads to $33m bill’, The Age newspaper, 4 August 2006

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losses incurred by contractors in undertaking government projects also occur and are borne by the contractor.

The main difference between partnerships arrangements and the traditional approach is that under the traditional approach the government contract is with the construction company. Under partnership arrangements such as this agreement, the contract is between the government and Civic Nexus, which in turn entered into a contract with the construction company (Leightons Contractors).

It is common for a special purpose vehicle (consortium) to be created specifically for large projects.

Dealing with a consortium rather than directly with the construction company is seen as providing an extra level of protection for the government. Conversely, the creation of a special purpose vehicle specific to a project means that the government incurs a risk in that it has no historical record of previous financial and operating performance from which a consortium’s likely performance could be assessed. A common outcome under the traditional approach is that government will vary the contract price to ensure construction of public infrastructure is completed. In this project, the government has agreed to compensate (in part) the construction company for its loss, to avoid costly legal action and to finalise the contract.

Although the financing of the project was arranged by the private sector, the cost of $341 million cost to construct and maintain the Southern Cross Station will be repaid over the next 30 years. The state is committed to total repayments of $1,840 million over this period. The repayments will probably be regarded as a finance lease, as recommended by the Auditor-General, and will form part of state debt. Of the $1,840 million, repayment of the capital component is approximately $1,162 million; with the remainder representing the cost of operations and maintenance and a return on capital.

The $1,840 million includes the anticipated inflation rate over the 30 year period. The annual payments over this period are also discounted by a factor of 8.65 per cent, which represents the risks assumed by the developer (estimated at 3 per cent), along with an allowance for the opportunity cost of capital foregone (because of the developer being repaid the cost of construction over the 30 year period), thereby diminishing the real value of payments received. The ultimate aim of the arrangement is to guarantee that the developer, over time, will receive the margin of 8.65 per cent built into the tender bid.

The transferring of the construction risk associated with this project to the private sector proved to be of considerable benefit to the state in view of the $122.6 million loss on construction (borne by Leightons Contractors), before taking into account the $32.5 million the government recently agreed to pay. Further, the state has received a building with very distinctive design features that it most likely would not have received had the state undertaken the construction.

Chapt er 3: Private investment in public infrastructure in Victoria

The main building, on which the public sector comparator was based, could have been built at less cost using traditional public sector processes. The ultimate deciding factor was the value of the commercial rights, which the private sector estimated at $68 million, as compared with the state’s estimate of $40 million. Based on this outcome, the potential for commercial developments in future PPP arrangements probably needs to be explored further when developing public sector comparators, to reflect the net cost to government of private sector and government proposals. (c)

Melbourne CityLink

This project was not subject to the Partnerships Victoria policy introduced by the current government, but is similar to Partnerships Victoria projects such as EastLink, in that the cost of the project and the return on capital is recouped from motorists using the facility.

The project provides an example of the risks to the government that are involved in such projects. At the time the contract was entered into (in 1995), it was one of the largest infrastructure projects ever undertaken in Australia. The contract was awarded to Transurban, a consortium comprising Transfield Holdings Pty Ltd and Obayashi Corporation. The CityLink project involved the linking of three major freeways in Melbourne, leading to the construction of 22 kilometres of road, tunnel and bridge works as well as other related works.

A statutory authority – the Melbourne CityLink Authority – was established to manage the contract on behalf of the government. The total value of the project was estimated in 1996 at about $1.8 billion; with finance arranged by Transurban. The government commitment included leasing Crown land to Transurban until 2034 and the construction of associated works valued at $346 million. The majority of the risks associated with the tollway were seen as being transferred to Transurban, including the design, cost of construction, financing, maintenance and operation, with recoupment of costs and return on capital dependent on toll revenue derived from traffic flows. The project was completed in December 2000. The Melbourne CityLink Authority ceased operations in February 2002, and the management of the arrangements are now undertaken within the Department of Infrastructure.

Construction of the project was characterised by a series of disputes between the state and Transurban, and between Transurban and its sub-contractors. The state paid Transurban $10 million in 1999 as full settlement of all claims up to August of that year. A further $500,000 was agreed to by the state in March 2000 because of alleged delays due to industrial action and modifications to the project demanded by the state.

Further claims against the state involved Transurban claiming $37 million because of a new public road leading to a decrease in customers and subsequent financial loss.

The government also lodged a $3 million claim in 2003 against Transurban alleging negligence in certain works undertaken. Other multimillion dollar claims were also lodged by Baulderstone Hornibrook against Transfield Obayashi Joint Venture (as builders), alleging a breach of contract involving $200 million mainly in relation to

Chapt er 3: Private investment in public infrastructure in Victoria

water leaks in the Burnley tunnel. Transurban also initiated legal action against Transfield Obayashi Joint Venture and eventually received settlements in excess of $200 million.29 The above disputes highlight the considerable risks to all parties from very large and complex construction projects. In this example, the majority of the risks were transferred to Transurban, which in turn sought compensation from its private subcontractors and from the tollway construction company. However, the state government was also liable for certain risks that apparently were not fully transferred to Transurban. The example illustrates the extreme importance of defining all risks, and the extent to which each of the parties assumes these risks, prior to contracts being entered into. Risks assumed by the government should also be disclosed as contingent liabilities in the Annual Financial Report of the state.

The main contractual document for the arrangements was the ‘Concession Deed’ entered into in October 1995, which detailed the risk sharing arrangements, toll levels, control of the property, rights to cash flows, concession fees, and the length of the concession period (34 years). The concession period could be extended or reduced, depending on the profitability of the arrangement, which apparently was anticipated to provide a net return to CityLink shareholders of 17.5 per cent per annum.

The ‘concession fees’ represented a return to the state to compensate for the cost of acquiring the tollway land and the undertaking of associated works, costing around $365 million relative to the tollway. Under the terms of the Concession Deed, Transurban was to pay these fees on the basis of $95.6 million per annum for the first 25 years, $45.2 million per annum for years 26 to 34 and $1 million per annum for the remaining three years. The total concession fees payable were valued at $2.8 billion.

An arrangement was negotiated with the government in 1996 whereby the right of the government to receive the fees annually was waived. Instead, Transurban issued concession notes each year, which represented promises to pay the government the annual fee either at the completion of the concession period (in 2034), or when certain profitability levels were achieved. The Committee understands that the profitability level was deemed as a net 10 per cent return, which the company estimated could be achieved by 2013, or at the latest in 2017, with payment of the concession notes commencing at that stage. A further option was that the concession notes could be redeemed by the government if Transurban achieved an after tax return of 17.5 per cent and had repaid all its borrowings for the project. The concession notes were non-interest bearing, which meant that their real value decreased each year in line with inflation.

These arrangements virtually guaranteed the profitability of the venture through the concessions agreed to by the government. Allowing the company to defer its obligations to the state also allowed the company to more readily meet its commitments to its financiers, in the knowledge that it would not have to repay its 29

G Hodge, The risky business of public private partnerships, National Council of the Institute of Public Administration, Australia, 2004

Chapt er 3: Private investment in public infrastructure in Victoria

debt to the government until all loans had been repaid and an adequate return to shareholders had been achieved. Conversely, the state was foregoing revenue of $95.6 million per annum excluding interest, which could have been applied to other government priorities. Although not calculated, the above arrangement represented a substantial boost to the value of the company, at the expense of the state accepting further market risks, which were meant to be borne by Transurban.

Although these arrangements were entered into by the previous government, and with the benefit of hindsight, would probably not be acceptable under current partnerships policies, the Concession Deed has led to further controversy in terms of the benefits provided to Transurban by the government.

The Auditor General reported that in November 2005 that in June of that year, the government and Transurban had entered into an arrangement to upgrade the Tullamarine and Calder Freeways interchange.30 The works were to be funded through the redemption of concession notes already held, which had a nominal value of $344.5 million and a net present value of $153.7 million. Transurban was to pay the government the net present value of the concession notes over a two year period, along with $11 million to be paid up-front. Any extra net revenue accruing to CityLink as a result of the works was to be shared with the government on a 50/50 basis. The Auditor-General did not provide any evaluative comment on the arrangement.

Since that agreement, the government subsequently entered into a further arrangement whereby upgrades to the Monash Freeway between Dandenong and Kooyong, to CityLink between Kooyong and the Burnley Tunnel, widening of the West Gate Freeway and creating an extra lane on the West Gate Bridge are to be financed in a similar manner. The total cost of the project is estimated at $903 million, with a contribution from Transurban of $166 million. The contribution from Transurban was seen as appropriate given that it will directly benefit from increased traffic on CityLink due to these works.

In return for the contribution of $166 million, Transurban will share the increased revenue from tolls on a 50/50 basis with the government, but only after Transurban has recouped its $166 million contribution from the increased tolls. The sharing arrangement provides for a one-off payment to be made to the state three years after the construction completion date. In its statement to the Australian Stock Exchange the company stated ‘the deal is a clear demonstration of Transurban’s focus on long term concession management and our ability to extract maximum value from portfolio assets’.

The government’s share of the works of about $737 million will be predominately financed through the redemption of the remaining concession notes. In lieu of the total liability of Transurban to the government over the 34 year concession period (estimated at between $2.8 billion, or $2.9 billion according to media articles), the 30

Victorian Auditor-General’s Office, Report of the Auditor-General on the Finances of the State of Victoria, 2003-04, November 2004, pp.104–105

Chapt er 3: Private investment in public infrastructure in Victoria

government will redeem these notes at a net present value of $614 million. The $614 million represents a discount to Transurban of 9.7 per cent over the concession period. Media articles stated that Transurban would borrow money at 6.8 per cent interest to fund its commitment, representing a net saving to the company of 2.9 per cent or about $18 million per annum. The $614 million is payable to the government over four years.

The $614 million was also conditional on Transurban winning a High Court challenge by the Australian Taxation Office. Transurban treated the annual concession fees as an expense, given that they were akin to paying rental on the freeway land owned by the government, and had claimed the expense as a tax deduction. Although not actually paid by the company, the concession fees would be regarded as an expense under accrual accounting, offset by a liability to the government.

An earlier Federal Court challenge by the Australian Taxation Office to the deductibility of the concession fees was unsuccessful. The Australian Taxation Office subsequently appealed the Federal Court decision to the High Court of Australia but lost on the basis that the concession fees were not capital payments because Transurban did not have ownership of the road. Had the appeal been successful, the $614 million contribution from Transurban would have been reduced to $567 million, thereby requiring a further contribution of $47 million from the government.

The main criticism in the media revolved around the savings that could have been achieved by the government had it borrowed the $614 million at about 5.7 per cent (which is the long term bond rate), saving several millions of dollars per year compared with the discount of 9.7 per cent granted to Transurban. Although it was anticipated that Transurban would have commenced paying the concession fees somewhere between 2013 and 2017, there was considerable uncertainty around these dates. The company could in fact have deferred payment until 2034.

If payments had commenced between 2013 and 2017, the net present value of the notes would have been about $1 billion. Because of the discount rate of 9.7 per cent granted to Transurban, the government, in accepting $614 million now, will have effectively foregone about $400 million.

The Committee sought to discuss the arrangements with the Treasurer but was advised that external advice on the transactions provided to the government could not be provided to the Committee due to ‘commercial in confidence’ considerations, including Transurban’s share price. Subsequent to this assertion, Transurban informed the Australian Stock Exchange of the arrangement and its expected return of 11.1 per cent on its capital investment.31 The Committee was very concerned that while public disclosure was inhibited, the shareholders were provided with full details.

The Committee accepts that upgrading the roads in the immediate future will generate large savings for businesses and the public through reduced travel times and other factors. Further, the cost of the project to government will eventually be offset by a 31

Australian Stock Exchange, release from Transurban, 17 May 2006

Chapt er 3: Private investment in public infrastructure in Victoria

share of the increased tolls to be collected by Transurban, but only after the company has recouped its contribution of $166 million and received compensation for any loss of toll revenue that can be attributed to the pending roadworks. The Committee considers that the arrangement is very beneficial to Transurban, particularly in view of the generous discount rate and the increased tolls.

The Committee draws attention to the arrangement negotiated by the previous government whereby Transurban was allowed to defer its obligations to the state for up to 34 years, thereby depriving the state of considerable revenue and transferring financial risk back to the state. The current arrangement has had the effect of recouping the debt owed to the state, albeit at a heavily discounted rate, in order to make further improvements to major Victorian roads. This is a benefit to the state, but at a high price compared with alternatives.

This project illustrates the risks involved in PPPs, particularly when: • governments are prepared to negotiate very generous terms with private sector developers to provide public infrastructure financed from tollways; • contracts are entered into without due regard to long term implications; • there is an ongoing reluctance of government to enter into debt for major infrastructure works, despite private financing of such works being more expensive; • despite claims that all the risks associated with design, construction and maintenance are transferred to the private sector, legal actions illustrate that some of this risk reverts back to the public sector; • governments are guaranteeing private sector developers a high return on capital, and are prepared to offer concessions to ensure this occurs; • many of the arrangements negotiated are not readily transparent to the public, who ultimately bear the costs of such arrangements; • taxation arrangements entered into by developers could result in additional liabilities to the state; and • a serious lack of accountability occurs, for example, where the Australian Stock Exchange is informed by the private sector of commercial arrangements entered into by the government, but public scrutiny is avoided by deeming such arrangements to be ‘commercial in confidence’. (d)

Undertaking infrastructure projects within government

Theoretically, with all factors being equal, the government should be able to undertake major infrastructure projects at less cost than projects undertaken under PPP arrangements because: • governments can borrow money cheaper than the private sector;

Chapt er 3: Private investment in public infrastructure in Victoria

• projects are undertaken at cost only, with no profit component, which is critical to the private sector in terms of achieving a good return on capital for its shareholders; • on occasions, the same firms entering into PPP arrangements will also be engaged under contract to undertake major projects under traditional government procurement methods; • the land may be already owned by the government.

There are also suggestions that the private sector places more emphasis on the accuracy of tenders for partnership projects because it will bear any losses on the projects. Such tenders are no different from tenders submitted under traditional arrangements because any losses incurred as a result of inadequate tenders will still have to be borne by the contractors.

Despite the benefits available under traditional procurement methods, experience over many years has seen traditional methods resulting in major cost blowouts, frequent changes to the scope of a project, failure to deliver projects on time, and design faults.

The Treasurer has acknowledged these problems, which he has attributed to the ‘failure to identify and manage project risks at all stages of a project’s life cycle’.32 In contrast, one of the major benefits of partnership arrangements has been the very sophisticated risk assessment and subsequent risk allocation to those parties best suited to managing the risk.

Examples of poorly managed traditionally procured public sector projects include: • Regional Fast Rail – initial first year cost estimated at $80 million in 1999.

The project was intended to be a PPP project with finance to be provided by the private sector. The private sector did not bid for the project. The current budget is now $750.6 million and is three and half years behind schedule; • State Library redevelopment – cost estimated at $190.7 million in 2003.

Current budget is $238.1 million and the project is six years behind schedule; and • Dandenong Hospital Redevelopment Stage 2 – costed at $24 million in 2002.

Current budget is $34 million.

The government has repeatedly failed to capitalise on its competitive advantage in undertaking major infrastructure projects. While arguments are often put forward that the government prefers major infrastructure works to be undertaken under PPP arrangements, where finance is provided by the private sector as opposed to government borrowing, this is only partly correct.

Projects self funded through revenue streams such as tolls provide a distinct advantage to the government. Where the private sector finances the development and is repaid by 32

Hon. J Brumby, MP, Treasurer, address to the Australian Council for Infrastructure Development (AusCID), 3 July 2003

Chapt er 3: Private investment in public infrastructure in Victoria

the government through service charges over a period of many years, these arrangements (under current accounting standards) will be classified as finance leases and will form part of state debt. There are also long term implications arising from such arrangements in that the commitment to the repayments will, to a degree, inhibit the budget flexibility of future governments.

Apart from the capital component, one of the other advantages of PPP arrangements has been the commitment of the private sector developer to maintain the infrastructure over the concession period. The government undertakes the maintenance under traditional arrangements, and there are many examples, including government schools, where maintenance levels have been sub-standard. The primary reason for this situation has been that the level of maintenance undertaken depends on budget allocations, which compete with other demands. Although the government should theoretically be able to undertake maintenance cheaper than the private sector because of the absence of the profit component and the economies of scale that could be achieved, in practice this has not materialised.

Another major problem for the government that has contributed to these problems has been the lack of internal expertise in project management, contract negotiation and financial evaluation and costing of projects. The lack of skills continue to be supplemented by the use of external consultants, often of variable value. The engagement of additional full-time staff in these areas is difficult for a number of reasons, including the government’s inability to offer competitive packages to attract the best staff, and ongoing criticism of increasing public servant numbers. These factors need to be balanced against the long term financial benefits of better managing government projects.

Although the long term cost effectiveness of entering into PPP arrangements remains open to debate, these options will remain attractive until such time as the government can better manage infrastructure projects in-house.

The government has recognised these problems and has implemented the Gateway Initiative, which is intended to bring greater rigour to project assessment and management across government. The initiative is based on a similar program used in the United Kingdom. The Committee requested feedback from the Treasurer on the status of the Gateway Review Process as part of its review of the 2006-07 Budget Estimates. The Treasurer advised the Committee that:33 The Gateway Initiative has been in place for only three years and yet the initiative is widely perceived to be promoting efficient asset planning and investment in Victoria. Overall, Gateway Initiative Users report that each of the four components is evolving as a useful tool for investment performance assessment and planning and delivery. Since the Initiative’s introduction both the average project delay and the number of projects exceeding budget has decreased. Whether this is a result of the Gateway 33

Hon. J Brumby, MP, Treasurer, response to the Committee’s follow-up questions, Inquiry into the 2006-07 Budget Estimates, received 26 July 2006, p.6

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Initiative is difficult to determine at this stage, due to variables relating to length of implementation time and external developments.

Generally, the users feel that: • the initiative’s first component, the Gateway Review Process, has helped to identify project issues at key decision points by independent review teams. More than 80 per cent of the government’s High Risk Asset Investment projects have now undergone one or more Gateway Reviews. However, due to the long delivery time of high risk projects, no project has progressed through all six gates in the Gateway Review Process; • the initiative’s second component, the Multi-Year Strategy, has improved the alignment of asset projects with government strategic objectives and departmental plans; • the initiative’s third component is project lifecycle guidance material.

Business case guidance was the first material to be developed. The Gateway Initiative Business Case Development Guidelines are now widely used by all Departments and are seen as a useful decisionmaking tool for both Departmental Secretaries and ERC [Expenditure Review Committee] in determining how asset procurement should best occur. Other guidance material is in preparation; and • the initiative’s fourth component, Asset Investment Reporting provides for quarterly reporting on all projects over $10 million and identified high risk projects. Presently Asset Investment Reporting indicates the health of current asset procurement projects. It is now being modified so that it also indicates the capacity of departments to implement planned projects.

There is a strong sense from Gateway Initiative Users across government that the Gateway Initiative has positively influenced the way their Department and Agencies plan and manage their asset projects. The majority of users agree that a greater proportion of government capital projects will be delivered on time, on budget and within scope as a result of the introduction of the Gateway Initiative. Similarly, most users agree that the Gateway Initiative has given them a clearer understanding of project risks.

According to the Treasurer, considerable progress has occurred in ensuring that capital projects are delivered on time, on budget and within scope. Project risks are also becoming more readily identified.

The Committee welcomes the use of the Gateway initiative because it should ultimately enable better decision making about whether major projects can be managed by the public sector on a comparable basis with projects managed by the

Chapt er 3: Private investment in public infrastructure in Victoria

private sector under PPP arrangements. This should lead to better value for money in infrastructure development.

The challenge for the government now is that while project delivery is apparently improving, attention must be given to improving programmed maintenance over the lifetime of new infrastructure. The importance of maintaining assets over their lifetime has been recognised under the ‘Partnerships Victoria’ policy. When ownership of assets reverts back to the government at the end of the concession periods, invariably such arrangements also provide for maintenance over this period. The government must apply the same requirements to major assets delivered under traditional procurement methods as it demands from the private sector when undertaking partnerships projects.

3.4

Summary of conclusions

The Committee acknowledges that restricting its review of PPP arrangements to the three projects outlined does not highlight other PPP projects that may have been successful. Because each project tends to have unique characteristics, it becomes difficult to generalise on the overall success or otherwise of the public private partnership arrangements in Victoria.

However, based on the projects examined, upon which considerable reliance was placed on material provided by the Victorian Auditor-General and the findings of the Fitzgerald report, the Committee reached a number of conclusions.

3.4.1

Post project reviews

Apart from the Fitzgerald report, post project reviews have not been conducted on the outcomes obtained from PPP projects. Although opportunities exist for the Auditor-General to undertake such a function, reviews undertaken have tended to concentrate on the contractual arrangements including the respective rights and obligations of the respective parties, sharing of risks, and updates on the progress of major projects. The Auditor-General is prevented under the Audit Act from commenting on government policy as it applies to such arrangements.

The Fitzgerald report was seen by the government as ‘providing tangible evidence of the benefits that flowed from harnessing private sector skills and innovation in infrastructure’. What was not referred to was that the review was highly critical of the discount rate of 8.65 per cent applied to the eight projects reviewed. This rate effectively represented an additional $350 million commitment from the government on the basis of the risks supposedly assumed by the private sector. It could hardly be stated that the payment of this amount represented value for money, particularly given that the discount rate in the United Kingdom has now been reduced to 3.5 per cent, in recognition of the very low market risk associated with public sector projects. The government also acknowledged in July 2003 that with accommodation projects, such as the County Court, Casey Hospital and the Mildura Hospital, there is a low market

Chapt er 3: Private investment in public infrastructure in Victoria

risk and the discount rate should have been 5 per cent. The government’s long term leasing arrangements for these projects are providing a high return to the developers as compensation for risks that were inflated.

The Committee seeks to demonstrate the importance of having ongoing, independent, post project reviews to highlight any deficiencies in contractual arrangements.

Deficiencies highlighted can be then systematically addressed and the same mistakes avoided in further projects.

3.4.2

Build, own and operate arrangements

As outlined, build, own, operate (BOO) arrangements to provide public infrastructure and services such as the County Court and the Mildura hospital are inappropriate and do not provide value for money.

The Committee fails to understand the logic of the state providing a private developer with a 99 year lease on Crown land at a nominal amount of $10 per annum, entering into an arrangement for the developer to design, finance, build and operate a purpose built facility, undertaking to lease the facility for a period of 15 to 20 years in which time the developer recoups the construction and operating costs plus a premium, and allowing ownership of the facility to remain with the developer upon expiry of the operating lease for a futher 79 years.

Unless the government can justify to Parliament that such arrangements are in the public interest and there were no viable alternatives, no further arrangements of this nature should be contemplated. The ‘Partnerships Victoria’ policy should be amended accordingly.

3.4.3

Government debt

With the exception of self funding arrangements such as tollways, most of the PPP arrangements provide for private sector financing of the facility, with the debt repaid by the government over periods ranging from 15 to 35 years. The early contracts usually provided for operating leases, which meant that the debt was not recorded as a liability in the government’s financial report.

Several of these arrangements have subsequently been reclassified to finance leases, or will need to be reclassified to finance leases with the advent of the new accounting standard on leases. Finance leases are regarded as government debt. The Committee is concerned that the increasing level of debt arising from PPP arrangements will continue to be met from public sector budgets many years into the future and could restrict future budget flexibility for alternative expenditure unless firmly controlled at this stage.

The Committee accepts that PPP’s can be an appropriate form of funding public sector infrastructure in certain circumstances. More attention, however, needs to be given to

Chapt er 3: Private investment in public infrastructure in Victoria

improving public sector delivery of major projects, which has the inherent advantage of obtaining cheaper finance and avoiding long term debt. There is also some concern that whereas the cost of private sector provision of infrastructure may initially appear cheaper than public sector provision (according to the public sector comparator), the short term advantage disappears when the payment schedules are analysed over the long term period of the agreements, which inevitably provide a guaranteed real rate of return to the private sector of at least 12 per cent and higher.

The Committee considers that more attention must be given to the long term impact of PPP on state finances.

3.4.4

Transfer of risk

One of the potential advantages of PPP arrangements is the transfer of major risks to the private sector, which in turn adds to the cost of projects. From the limited number of projects examined, however, it is apparent that the government is willing to take back certain risks in the overall interests of having projects completed. Despite, for example, the initial contract to construct the Southern Cross Station providing for penalties where construction milestones were not met and liquidated damages of $25,000 a day for every day the project exceeded the scheduled completion date, these provisions were dropped by the state in order to settle an industrial dispute. In other words, any protection the government had against the risk of the project exceeding timelines was removed, leaving it to bear the risk.

Similarly, although the builder anticipated a $122.6 million loss on the project, part of this risk was transferred back to the government when it agreed to pay an extra $32.5 million to the builder to avoid further litigation. Various other examples have arisen over the years, including the Latrobe Hospital, where the government was forced to take back risks for which it had paid a premium for them to be borne by the private sector.

The Committee acknowledges that the Partnerships Victoria policy has made a considerable effort to identify the various types of risks and which party is best suited to assuming the risks. Partnerships Victoria released the document Standard Commercial Principles in June 2005 which clearly sets out the range of commercial principles to be applied when entering into PPP contracts and the preferred allocation of risks. While this action is commendable, the reality is that ultimately the government is responsible for the delivery of infrastructure assets and services and in extreme circumstances, private sector contractors will walk away if the project cannot provide a return on capital or if the companies are facing bankruptcy or being placed in receivership. The government must then reach a compromise or take back the project and complete it.

The extent to which real risk is transferred to the private sector and the extent to which the government will pay a premium for such risks is an important question.

Chapt er 3: Private investment in public infrastructure in Victoria

Based on the practical experience gained from the 13 partnership contracts executed to date, the Committee considers that more definitive guidance is required in circumstances where transferred risk reverts to the government. The Committee also suggests that where risk is deemed to be transferred to the private sector, the government must be actively involved in monitoring the extent to which the private sector is managing such risks, particularly construction risk. As previously stated, major projects tend to involve legal disputes, especially where consortias are involved.

Despite the supposed transfer of risk to the private sector, some of these disputes do involve government. Active monitoring by government of the risks assumed by the private sector could assist in resolving issues at an early stage without recourse to legal actions.

3.4.5

Length of concession arrangements

With major projects such as the Southern Cross Station, the consortia will recoup the cost of construction, inclusive of the risk premium, opportunity cost of capital, and profit margins over many years. To allow for the diminishing value of money over an extended period of years in order to preserve the real return on the investment, however, payments are structured so that the total cash flow over the concession period will be sufficiently large enough to compensate for this factor. In the case of the Southern Cross Station, the total repayment of the capital cost over the 30 year period will be $1.162 billion, to repay the cost of construction of $313.9 million. The longer the concession period, the higher the final cost to the state. With repayments being met from future budgets, the extent of these repayments will ultimately restrict budget flexibility for alternative expenditure, and increase government debt. Were projects to be undertaken within government, even after allowing for lower, equivalent tenders from the private sector, in the longer term with cheaper government borrowings or the funding of projects from budget surpluses, the government will tend to achieve substantial savings.

The Committee considers that the long term financial implications of entering into PPP arrangements should be determined and made publicly available. In forming this view, the Committee acknowledges that there are limitations on the amount of money available for infrastructure needs from state budgets, supplemented by grants from the Commonwealth and that private sector financing of infrastructure projects (with the exception of tollways), provides a viable alternative to traditional arrangements. These arrangements still create public debt in the form of finance leases, and ultimately may be more expensive than projects financed from traditional sources. PPP arrangements should not be regarded as a preferred method of constructing state assets.

3.4.6

Commercial arrangements

A limited number of PPP arrangements create opportunities for commercial development by the private sector. The extent to which the public sector can benefit from such arrangements is a complex issue, but warrants detailed examination and

Chapt er 3: Private investment in public infrastructure in Victoria

policy development. Obviously, revenue received by the government from such arrangements should be maximised where possible, depending on a range of factors.

The Committee observed from a financial analysis of the Southern Cross Station project undertaken in 2001 that the preferred developer was willing to pay the state $68.6 million for the commercial rights to the interchange facility and adjoining properties. Under the public sector comparator, these rights were estimated to be worth $39.9 million, a variance of $28.7 million or 72 per cent less than the Civic Nexus offer. Civic Nexus eventually paid $66 million for the rights, a factor that substantially influenced its winning bid.

The Committee makes the further observation that given such a large under-estimation of the worth of the commercial rights, more attention and expertise should be directed towards identifying and valuing commercial rights in any future projects.

The $66 million paid for the commercial rights allowed for commercial development within the interchange building for a period of 30 years for a nominal $10 per annum plus outgoings. With the purchase of air-rights on the land adjacent to the building, however, the leases for any major development on these sites (for example office complexes or hotels) will also be on the basis of $10 per annum, but for 99 years.

The Committee acknowledges that leasing of the air-rights will also bring other benefits to the state, such as stimulating the economy and the receipt of land tax. But it could also be argued that the lease of Crown land in prime locations should be at commercial rents based on property values. Even allowing for the $66 million payment up-front, the leasing agreements are seen by the Committee as a significant concession to the developers. Similar opportunities will also exist for the County Court property once the existing 20 year tenancy arrangement expires.

The Committee acknowledges the complexity of this issue, but considers a policy should be developed on the exploitation of commercial rights. Such a policy should form part of the Standard Commercial Principles, issued by Partnerships Victoria in June 2005.

3.4.7

Incentives to private sector

From its limited examination of the three projects detailed in this report, the Committee notes that all projects contained additional benefits for the private sector developer, which were not initially identified. In the case of: • the County Court −

a peppercorn lease was granted to private sector for 99 years for a CBD property leased to the government for 20 years, and paid for by the government over this period;

• CityLink −

revenue from concession fees was foregone for 34 years;

Chapt er 3: Private investment in public infrastructure in Victoria

−

concession notes were redeemed at a large discount; and

−

additional toll revenue attributed to works undertaken by the government will not be shared by the government until the developer has recouped all costs;

• the Southern Cross Station −

the government decided to forgo penalty provisions for project delays; and

−

compensated the builder for losses incurred on the project in order to avoid expensive legal action.

The Committee acknowledges that the additional incentives and concessions provided by the government to developers are designed to encourage private sector participation in major projects, with a view to enabling an adequate return to investors. Evidence provided to the Committee by a large developer stated that the average investor’s return from PPP projects was between 11 and 13 per cent. The Committee accepts that in order to attract private sector developers, an adequate return on capital must be available. What is of concern to the Committee is that while the government maintains that the design, construction and financing risks are transferred to the private sector in return for a premium, when unanticipated events occur, governments are prepared to offer incentives and to take back some of risks so that projects remain profitable. Ideally the merits of such decisions involving millions of dollars of public funds should be discussed in Parliament, without breaching commercial confidentiality, where possible, before proceeding.

The Committee recommends that: Recommendation 1:

All public private partnership arrangements be subject to independent post-project reviews at the completion of the construction phase and during the operational phase to measure the degree to which agreed outcomes are met. All results to be periodically reported to Parliament.

Recommendation 2:

The Victorian Government not enter into any further public private partnerships involving build, own and operate arrangements with the private sector, unless it can be clearly demonstrated that there are long term public benefits.

Recommendation 3:

Long term peppercorn leases extending beyond the concession period should not be given to a

Chapt er 3: Private investment in public infrastructure in Victoria

private consortium, unless it can be clearly demonstrated that there is a public benefit.

Recommendation 4:

All existing public private partnership projects involving operating leases be reviewed to determine whether they should be reclassified to finance leases under current accounting standards.

Recommendation 5:

Public private partnership contracts should include schedules of payments outlining the total government commitment and the impact on state debt. This information should be published on the Partnerships Victoria website, with summary information included in the state budget papers.

Recommendation 6:

Where, during the course of the public private partnership contract transferred risk reverts back to the Victorian Government, further guidance material be developed to cover this situation.

Recommendation 7:

As part of contractual arrangements, the Victorian Government regularly monitor the extent to which private developers are controlling the risks transferred to them.

Recommendation 8:

Timeframes should be reduced, where possible, for the period of concession agreements extending beyond 12 years.

Recommendation 9:

The Victorian Government develop a policy on maximising the benefits to the state from commercial opportunities arising from public private partnership arrangements.

Recommendation 10:

Parliament be advised when significant additional benefits are provided to a public private partnership consortium, beyond the initial contractual arrangements.

C hapter 3: Private investment in public infrastructure in Victoria

Chapter 3: Private investment in public infrastructure in Victoria

Exhibit 3.1:

Public private partnerships – Project details, 1999 – 2006 Type

Completion date

OF

1999

Castlemaine Wastewater Project

BOOT

Ballarat North Water Reclamation Project

Project Public transport franchise agreements

Mildura Hospital CityLink Victorian County Court Automated ticketing

Responsible Minister

Portfolio Transport

Minister for Transport

Commissioned 2000

Essential Services

Minister for Water

BOOT

Contract let 22 May 2006

Essential Services

Minister for Water

BOO

2000

Health

Minister for Health

BOOT

2000

Roads

Minister for Transport and Minister for Major Projects

BOO

2000

Justice

Attorney-General

DBOO

2001

Public Transport Corporation

Minister for Transport

DBFO(T)

2002

Environment

n/a

Coliban Water Treatment Project (Aqua 2000)

BOOT

2005

Essential Services

Minister for Water and Minister for Environment

Wodonga Wastewater Treatment Plant

(DBO)

2003

Essential Services

Minister for Water and Minister for Environment

Casey Community Hospital

DBFM

2004

Health

Minister for Health

Docklands film and television complex

BOOT

2004

Innovation, Industry and Regional Development

Minister for Major Projects and Minister for Innovation

Echuca/Rochester Wastewater Treatment Plant

BOOT

May 2005

Essential Services

Minister for Water and Minister for Environment

Mobile Data Network

DBFO

Operational 2006

Justice

Minister for Police and Emergency Services

Southern Cross Station Redevelopment

BOOT

August 2006

Transport

Minister for Transport and Minister for Major Projects

Seal Rocks

Chapter 3: Private investment in public infrastructure in Victoria

Exhibit 3.1:

Public private partnerships – Project details, 1999 – 2006 (continued)

Project

Type

Completion date

Portfolio

Responsible Minister

Victorian correctional facilities

DBFO

Early 2006

Justice

Minister for Corrections

Emergency Alerting System

DBFM

Operational by 2005-06

Justice

Minister for Police and Emergency Services

Metropolitan Mobile Radio

DBFO

2006

Justice

Minister for Police and Emergency Services

Royal Women’s Hospital Redevelopment Project

DBFO

Estimated June 2008

Human Services

Minister for Health

Royal Melbourne Showgrounds Redevelopment

DBFM

Completion estimated in 2006

Major Projects

Minister for Agriculture

EastLink

BOOT

Completion estimated in 2008

Infrastructure

Minister for Transport

Melbourne Convention Centre

DBFM

Completion estimated by 2008

Innovation, Industry and Regional Development

Minister for Innovation, Industry and Regional Development; Minister for Major Projects

Note:

BOO

Build-Own-Operate

BOOT Build-Own-Operate-Transfer DBOL Design-Build-Own-Lease DBFO Design-Build-Finance-Operate OF

Operations Franchise

n/a

Information not included in inquiry submissions

DBFM Design-Build-Finance-Maintain