Life-Cycle Project Delivery A Note for Discussion

IndII Round Table

11th December 2012

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Concerns with Conventional Project Delivery

• Government pays for inputs, not outputs

– Incentive for time/cost over-runs

– Difficult to control quality

– No performance standards over project life

– Risk of time/cost over-runs borne by Government

• Separate Design, Construction and O&M contracts: no life-cycle optimization

– eg, contractor bears no consequence for taking short-cuts

• Significant fluctuations in Government expenditure

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Construction O&M Risk

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Concerns with Current PPP Approach

• Objective is to attract additional funds, not to deliver projects in the most efficient way

• Poor project preparation

– Lack of understanding of what drives PPP investors

• Inconsistency, mixed messages and lack of a single institutional point of contact

• No proper specification of performance standards

• Poor risk allocation: developers cannot manage land and toll revenue risks

– Hence delivery costs will be high, relative to public sector alternative

• Project viability too dependent on toll revenues

– Necessitates viability gap funding, which significantly dilutes risk transfer

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Conventional v Life-Cycle Procurement

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Govt Outlays

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Construction O&M Risk

Conventional Procurement: • Government pays for inputs, not outputs • Separate D/C/O/M contracts – no life-cycle optimization • No performance standards over project life • Contractors have incentive to expand their workload • Risk of time/cost over-runs borne by Government • Significant fluctuations in Government expenditure

Life-cycle Procurement: • Concessionaire provides a service over

project’s life • Concessionaire manages D/C/O/M risk through

sub-contracts – over-runs don’t impact on Government

• Life-cycle optimization • Government pays only for what it gets • Concessionaire incentivized by payment

mechanism to maintain high performance standards

• Predicable Government expenditure pushed into the future

Conventional Procurement: Government meets all expenditures when they occur

Life-cycle Procurement: Government pays only for the service provided

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A Better Value-for-Money Alternative

• De-couple tolls and life-cycle delivery

– Tolls are for road pricing: Government should keep control over them

• Pass to the private sector only those risks they can manage

– Government should take land acquisition risk

– Private sector can manage financing, design, construction, materials, O&M and (insurable) force majeure risks

o But not all interface risks (eg, an existing poorly-constructed pavement)

• Pay the private sector a Unitary Charge for providing a road service (once open to traffic) over the life of the agreement

– Deductions for failure to meet KPIs

– Pressure from equity-holders and lenders also encourages optimum life-cycle performance

• Experience elsewhere shows that this solution is cheaper than conventional procurement

– Extra costs of private finance are outweighed by life-cycle economies

– Demonstrated by a VfM comparison (i) on preparation of the business case and (ii) prior to contract-signing with preferred bidder

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MPW

Project Sponsor Equity Shareholders

Other Equity Shareholders (eg SMI)

Bank Lenders

Bond Holders

D&CContractor

O&MContractor

ProjectCompany

Concession Agreement

Shareholder Agreement

Fixed-Price D&C Contract(with full risk pass-through)

Fixed-Price O&M Contract(with full risk pass-through)

Not shown: Performance bonds and guarantees

Typical Structure

Comprehensive risk transfer minimizes

time/cost over-runs

SMI or similar

80/20 or 90/10 gearing. Cost of borrowing much

lower than expected equity

returns

D&C contractor locked in for several years after construction

completion

CA modeled on familiar international banked

projects. No surprises!

Banks pressure Project Company

to perform – they want their

loans repaid

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Dealing with Multi-Year Contracts

Note: IIGF guarantee only permitted for tollroads

(Perpres 13/2010)

Key feature: PIP loan agreement

supports multi-year funding

Credit: Erwin Sukandar, IIGF

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Risk Allocation

Risk Description Private Public

Economic risks Fluctuations in exchange, inflation, interest rates ● ●

Political risks Change of government, change of policy, war, riot, terrorism, expropriation of land etc

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Legal risks Unexpected change in legislation, regulations ●

Force majeure (insurable)

Weather, earthquake, natural disasters and other uncontrollable, insurable risks (relief events allow time but no cost protection)

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Pre-construction risks

Planning and other approvals not achieved in time for work to start; required land, environmental permits, construction permits etc

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Construction risks

CAPEX cost overruns and construction delays ●

O&M risks OPEX cost overruns and road closure ●

Traffic risks Traffic higher/lower than forecast – private risk within band limits ● ●

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Performance-Based Payment

Output Requirements Link to Payment

Safety Deductions when annual Crash Reduction Strategy target is not met

Availability Deductions when any lane is closed

Responsiveness Deductions when Company fails to meet specified response times (eg emergency) and rectification times (eg debris removal)

Road quality & upkeep Deductions when Company fails to meet minimum quality/safety standards for pavement, structures etc

Hand-over Deductions for failing to meet standards for quality and residual life on hand-over at the end of the concession period

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Benefits

• Better value-for-money based on PSC comparison

• No VGF necessary

• Optimal life-cycle management (to minimize Unitary Charge at bidding)

• Higher quality over economic life (reinforced by lenders)

• Full payment only on project opening and satisfactory performance

• Predictable, even cash-flows

• Manageable risks, so low bid price

• Risks managed through in-built incentives:

– Life-cycle performance risk

– Risk of traffic variations

– Truck overloading

– Design & construction risk (eg, pavement thickness/quality)

– Corruption risk

• Opportunities for shared refinancing gains

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Life-Cycle Delivery: Key Messages • Indonesia urgently needs a new approach

– The present PPP situation destroys confidence

• Change thinking: output/performance-based service, not input-based projects

• Focus on life-cycle synergies between design, construction and operation

• Cash-flow advantages of deferring capital expenditure are significant …

• … but private finance is not mainly about funding: it drives efficiency, better quality and innovation – Private equity and lending at risk strongly incentivizes innovation and performance

• For many projects, the higher costs of private finance and the procurement process are outweighed by these efficiency gains

• Privately-financed life-cycle delivery is not ideal for all projects: a VfM comparison has to be carried out

• Private financing capacity and appetite depend on the risk profile – Sovereign risk (a big issue for Indonesia); project risk (resolved by sensible risk

allocation in contract design); risks associated with competing lending/investment opportunities

• Transfer of land and toll revenue risks adds significantly to costs – Private sector cannot control most land and traffic risk factors

• Government should maintain control over infrastructure pricing (tolls)

• Competition in the procurement process is critical to ensuring value-for-money

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Thank you