IMPACTS OF CONSTRUCTION EVENTSON THE PROJECT EQUITY VALUE OF THE

CHANNEL TUNNEL PROJECT

ABRAHAM PARK1 and CHEN YU CHANG2

1Graziadio School of Business and Management, Pepperdine University, USA

2Bartlett School of Construction and Project Management, UCL, UK

Introduction

• With the growing strains on public resources, many governments in recent years have turned to the private sector for infrastructure project financing.

• The special purpose vehicles (SPVs) taking such project usually has a 2 stage business model: a construction stage followed by an operating stage.

• However, the project risk in stage 1 is very high, and in most cases, the impacts of specific construction events on project risk and capital cost are unobservable due to lack of informational transparency.

• Eurotunnel (the Channel Tunnel project) is unique in that the share price data for the entire construction period is publicly available.

• The goal of this paper is to contribute to the measurement and assessment of project risk by providing empirical data on the impact of various events that occur during the construction phase of the project finance company’s life.

• Using the event study methodology, our study shows that: (1) during the construction stage, efforts to better manage the interests and incentives of contractors produce more significant positive impact from investors than efforts for cost containment;

• (2) during the construction stage, meeting the project deadline is a higher investor priority than containing construction cost; and

• (3) once the construction phase is complete, the investors’ priority then becomes the overall cost and the impact of construction events on the expected returns from investment.

• Finally, the level of risk and the potential conflicts of interest that arise during the construction phase of a mega infrastructure project are such that turning to IPOs to provide equity capital may not be appropriate.

Background on PPP• A public-private partnership (PPP) is an arrangement

between public sector and private investors and businesses whereby private sector provides a service under a concession for a defined period on a non-recourse or limited recourse basis.

• In the UK, the PPP procurement framework gave rise to Private Finance Initiative (PFI), which is a type of project finance where public infrastructure projects are financed with private sector capital through the use of privately funded Special Purpose Vehicles (SPVs).

Project Finance• Conceptually, there are many benefits to project

finance: a standalone legal entity, access to significant levels of non-recourse or limited recourse debt based on expected cash flows, customizable risk allocations, and asset-specific governance systems.

• Under the umbrella of appropriate strategic alliances with participating governments, project finance with private sector participation allows for the undertaking of many sorely-needed infrastructure projects which otherwise would not be feasible due to size, risk, efficiency and complexity issues.

Project Finance• In practice, however, the analytical effort necessary to

accomplish proper due diligence with respect to a project’s economic viability is vastly underestimated, especially in large infrastructure projects (Flyvbjerget al., 2004).

• Since expectations of cash flows are at the heart of project finance, extensive and accurate feasibility analyses and risk assessment/measurement are critical in determining the project’s economic viability.

• Often, not only are the length and cost of delays underestimated, the revenue expectations are overly optimistic, and changes in project specifications and designs are inadequately taken into account.

Project Finance Risk

• Because project finance involves single project companies, it could potentially provide researchers with valuable insights into the constantly evolving risk profile of projects as well as the financial impacts of various events on the project equity value.

• Although several previous studies have examined the causes and impacts of project delay and post-contract award design changes (Fen et al, 1997; Bordoli and Baldwin, 1998; Cox et al., 1999), there is a gap in empirical research concerning the impact of such construction events on overall project risk and equity value.

Lack of Transparency• The challenge for researchers has consistently been

the lack of informational transparency. • This lack of transparency stems primarily from

concentrated ownership structure of project finance companies.

• Typically, project companies have a few equity shareholders as sponsors with a syndicate of banks as debt investors (Esty, 2004).

• As such, whenever events that affect the expected cash flows and risk of a project occur, the impact of such events on the project value remains undisclosed, except among the few equity and debt investors.

The Channel Tunnel• The Channel Tunnel project is a unique case in project

financing in that the concessionaire of a BOOT project, Eurotunnel, was listed on London Stock Exchange from the very beginning of the project.

• Unlike most other project finance companies, Eurotunnel’s equity capital base included funds raised through an initial public offering, and the historical stock price data is available from the beginning and through the entire construction phase of the project.

• During the period of 1990 to 1994, Eurotunnel suffered several public disputes and construction delays with its construction contractor, Transmanche-Link (TML).

• The Channel Tunnel case provides a unique opportunity in the field of project finance to quantitatively measure the impact of disputes and delays during the construction phase on the market value of the entire project.

• Some of the biggest sources of risk in BOOT structue projects are delays in construction, delays in projected revenue flow, technical failure, poor management, and regulatory changes (Beidleman et al., 1990).

• In particular, the main sources of financial risk in major transportation infrastructure project are cost overruns (especially in the construction phase), increased financing costs due to delays, and lower than expected revenues (Flyvbjerg et al., 2004).

• At any time during the life of the project, events that affect the risk profile of the project, therefore, have a direct impact on the overall value and the financial viability of the project.

• From the lenders perspective, unexpected events may jeopardize the completion of the project and timely repayment of debt, which is substantially larger in proportion than equity investment in project finance companies.

Management of Risks• The main elements of project risk management include

the identification, the measurement/assessment, and the process of prioritizing and responding to various project risks (Thomas et al., 2006).

• Among these elements, risk measurement/assessment is the most difficult task, which involves evaluation of the probability of occurrence of risk events and their impact on the project (Thomas et al., 2006).

• This paper is an attempt to clarify the dynamics of project risk by providing empirical evidence on the impact of construction events on the overall risk profile of the project finance company, which can help to better quantify financial risk factors for the purposes of assessment and measurement.

Research Methodology

• According to finance theory, when a specific event occurs during the construction phase of a project which affects the risk level of equity investors, there should be a significant impact on the project’s market equity value as a result of the change in the cost of equity.

• Since the Eurotunnel project is unique in that the market price data for the entire construction period are available, we can use the event study methodology to test and observe the impact of occurrences of specific construction events on the project equity value.

Event Study• Our hypothesis is that when events occur which

impact the SPV’s risk level either positively or negatively, the impacts should be observable through significant abnormal returns as well as through changes in the direction of the volatility measure.

• An event study is a widely used methodology in the fields of economics and finance for measuring the impact in share prices as a result of an announcement event.

• Brown and Warner (1985), Mackinlay (1997), and Binder (1998) provide for comprehensive descriptions of the procedures in the event study methodology.

Step 1

• The first task of conducting an event study is to identify the event(s) of interest.

• Due the public nature of the project, the news surrounding the various disputes and resolutions of Eurotunnel construction as described in the previous section were covered extensively by the media.

• We reviewed and identified from LexisNexis database the following seven important announcement events during the Eurotunnel construction period of 1988 to 1994:

Dispute EventsTable 1: Disputeevent chronology

Event Dates Title of Announcement Source Disputes

(1) 12 Jan. 1990 “Deal Cuts Risk of Channel Tunnel Overruns” Financial Times Event #1

(2) 10 Feb.1991 “Eurotunnel Costs Set to Soar After Ruling” Independent Event #2

(3) 30 Mar. 1992 “Dispute Panel Rules Eurotunnel Should Treble Monthly Payment to Meet TML’s Expenses”

Evening Standard Event #3

(4) 5 Oct. 1992 “Opening Date Delay Adds to Worries” Evening Standard Event #4

(5) 29 Mar. 1993 “1bn Shortfall as Tunnel Hits New Delay” The Guardian Event #5

(6) 28 Jul. 1993 “Eurotunnel and TML Reached Agreement about Interim Payment”

The Times Event #6

(7) 6 Apr. 1994 “Settlement of £1.14bn Payment from Eurotunnel to TML”

Financial Times Evening Standard

Event #7

Event Study Steps• Event Study Step 2: Event Window• Event Study Step 3: Estimation Window• Event Study Step 4: Measuring Normal Returns

1. Market Model2. Capital Asset Pricing Model (CAPM)3. Intertemporal CAPM (ICAPM) 4. Asset Pricing Theory (APT)

• Event Study Step 5: Measuring Abnormal Returns• Event Study Step 6: Testing for Significance of

Cumulative Abnormal Returns

Results

• Seven events• All four models showed consistency in producing

significant results for all seven events. • Both the market model and the CAPM showed

almost identical results, while all four models produced the same order of ranking for the degree of impact among the seven events.

• The signs were also consistent for all four models

Event 1• The event Deal Cuts Risk of Channel Tunnel Overrun (Event #1)

was a public dispute that came to an agreement on January 12th of 1990.

• This event produced the highest positive cumulative abnormal return.

• The agreement contained three main components: (1) increase in total construction cost from £5 billion to £7.2 billion; (2) TML to bear 30% of all cost overruns, rather than 6% as originally agreed; and (3) a stronger incentive upon TML to complete the project on time through bonuses and more severe penalties.

• Even though there was an increase in total construction cost, better alignment of incentives by TML clearly outweighed the negative factor generated by cost overruns.

Event 1• Some of the increase in construction cost must have been

anticipated, but the sign of a greater certainty of construction completion produced an overwhelmingly positive impact on the returns.

• This event shows the importance of having a construction contract that focuses on the alignment of interest rather than simply low cost.

• This result also shows that the concept of transferring construction risk to contractors through a set of legal contracts may not be so straightforward in infrastructure projects with highly specific assets.

• In particular, deals that focus on the management and alignment of interests in a dynamic way, especially during the initial stages of construction, could result in superior results.

Event 2• The event Eurotunnel Costs Set to Soar After Ruling (Event

#2) was a ruling from the arbitration panel on February 10th of 1991 concerning two main issues.

• The first issue was a ruling in favour of the contractor, TML, that Eurotunnel was responsible for cost increases (as indicated in Eurotunnel’s annual report in May of 1991).

• The second issue was a ruling in favour of Eurotunnel, indicating that TML was denied a time extension of 55 weeks.

• Surprisingly, this ruling produced the second highest positive cumulative abnormal return. This result suggests that construction delay was a bigger risk issue to equity investors at this junction than potential cost increases.

Event 2

• Even though the increase in cost would have resulted in a lower IRR for investors, it appears that a greater certainty of project completion is a more significant issue for equity investors, especially at the beginning of the construction phase.

• The implication is that the reduction of overall project completion risk as a result of achieving a more definite completion deadline is a more important factor to equity investors than a limited increase in the level of construction cost.

Event 3• In the event Dispute Panel Rules Eurotunnel

Should Treble Monthly Payment to Meet TML’s Expenses, 30 March 1992 (Event #3), Eurotunnel was ordered to treble its monthly interim funding payments to TML from £25m to £75m.

• This event produced the lowest negative impact and the third highest absolute impact among all the events. In October of 1991, the progress payments from Eurotunnel to TML did not reflect the cost increases and TML faced negative cash flows and threatened to suspend work due to negative cash flows.

Event 3

• The matter was taken to the Disputes Panel and in March of 1992, the panel ruled in favour of TML, and ordered an additional £50 million (from original £25 million) to be paid to TML each month. This event had a double negative impact for Eurotunnel: first, the negative cash flows by TML were a serious threat to the overall project completion and second, the additional payments represented over £1.2 billion for Eurotunnel.

Event 4• The event Opening Date Delay Adds to Worries (Event #4)

had two main negative implications for Eurotunnel. After the previous ruling on the interim payments, Eurotunnel took the matter to the Court of Appeals, which the investors knew was going to be a lengthy legal battle with a potential for a major delay or suspension of work.

• On October 5th of 1992, the London Evening Standard published an article indicating two main negative news for Eurotunnel investors: first, a delay in the construction completion date and second, a sharply lower revenue forecasts for the first year as a result of Eurotunnel missing the summer peak season.

• This news produced a negative cumulative abnormal return.

Event 5

• The event ’1bn Shortfall’ as Tunnel Hits New Delay, 29 March 1993 (Dispute #5) produced a significant negative cumulative abnormal return as a result of the final verdict by the International Chamber of Commerce that the disputed issues had to be resolved claim by claim.

• This ruling essentially represented a tedious and costly process of itemising each claim to recover payments which meant the project was faced with worries over additional delays.

• Once again, a potential delay resulted in a strong negative impact on the returns.

Event 6

• On the other hand, a protocol of agreement that was reached in July 1993 (Dispute #6) produced positive abnormal returns primarily because of TML’s commitment on setting a hand-over date of 1 December 1993.

• This agreement gave a definite hand-over date which put a limit on the construction delay.

Event 7

• Finally, the resolution of the drawn out dispute regarding payments was reached in April 1994 (Dispute #7). TML had made a final claim submission seeking £1.980 billion, but both sides reached a final agreement of Eurotunnel having to pay TML £1.14 billion in cash.

• This event produced the second lowest negative cumulative abnormal return. Once the construction was finally complete, the issue turned to the final cost of construction, and the ruling that Eurotunnel, rather than the contractor, had to bear the cost produced a significantly negative reaction from the equity investors.

Discussion• It is a common practice in project financing that the

sources of finance change over the project’s life cycle to match the evolving pattern of risks and incentives.

• During the constructional phase, the expenditures are financed with sponsor equity and bank loans.

• Because construction is subject to significant uncertainty and risk, there is plenty of room for moral hazard, and it is appropriate that that the banks perform a monitoring role at this stage.

• The fact that the initial equity sponsors in project financing are often interested parties (operators or contractors) adds to the responsibility of the banks to provide tight control over the project company and the building contractor’s behaviour.

• One of the ways a project is monitored by the banks is to require a certain level of debt/equity ratio with a certain percentage of the SPV to be financed by the sponsors who are often the contractors and operators. This requirement ensures alignment of interest between the lenders and the sponsors.

• In the case of Eurotunnel, the debt to equity ratio for Eurotunnel remained stable at approximately 80% to 20%.

Debt/Equity

• In September of 1986, Equity 1 of £ 47 million was raised by the founder shareholders/sponsors.

• Equity 2 of £206 million was raised in October of 1986 through private placements.

• Equity 3 was a public issue which raised £770 million in November of 1987 at £3.50 per share.

• Equity 4 was raised through public issue for £568 million in November of 1990 at £2.85 per share.

• The primary reason for the IPOs in both 1987 and 1990 was due to the lenders’ requirement for maintaining debt to equity ratio(total equity was approximately £1.6 billion while total debt was approximately £6.8 billion).

IPO

• This resulted in the majority of the sponsor equity for the construction phase of Eurotunnel coming from passive, small time investors from the IPO.

• This dilution also resulted in the original sponsors to shift their loyalty and incentives towards the contractor side rather than the SPV (Eurotunnel) side.

• This shift left the equity investors from the IPO to be in an unfairly vulnerable position, and the cost of equity was in actuality much higher than originally presented.

• The estimated IRRs included in the prospectus and the 1990 Rights Issue were in the range of 17- 18% considering long term investment horizon.

• However, this type of hurdle rate should only have been appropriate for investors in the operational phase of the project rather than in the construction phase, which contains significant uncertainty and higher risk compared to the operational phase.

• Considering that there were no dividends promised during the construction period and limitations to revenue growth, the government’s position to support the IPO of Eurotunnel to individual investors during the construction period seems unwarranted.

Conclusion• Results provide some clarity as to the dynamics of

project risk during the construction phase of a PPP/PFI project:

• (1) during the construction stage, efforts to better manage the interests and incentives of contractors produce more significant positive impact from investors than efforts for cost containment;

• (2) during the construction stage, meeting the project deadline is a higher investor priority than containing construction cost; and

• (3)once the project is finished, the investors’ focus then turns to the overall cost and the expected returns from investment (adjustments to IRR and investment horizon).

• Collectively, these findings indicate that construction delay poses greater risk to project equity investors at the beginning of the construction phase than cost overruns.

• A possible explanation is that due to the high leverage structure of project finance companies (high level of debt compared to equity), the potential accumulation of finance charges due to delay poses greater financial risk than limited cost overruns.

Implications• At least two practical implications can be extracted: • One, having a construction contract that focuses on the

alignment of interest is critical for project risk management and economic viability of the project; and

• Two, the concept of transferring construction risk to contractors through a set of legal contracts may not be so straightforward in infrastructure projects with highly specific assets.

• Conceptually, the Eurotunnel case has revealed that raising equity capital through IPO during the construction phase can significantly affect the agency structure and the interest alignment among the participants in the project.

• Unlike in other project finance cases, in Eurotunnel the equity ownership percentage of the original sponsors became diluted by passive investors from the IPO.

• As the contractors were also the original sponsors for Eurotunnel, this dilution left the equity investors from the IPO in a vulnerable position.

• Accordingly, we believe this ownership dilution makes the cost of equity for IPO investors in project finance to be significantly higher than equity investors in non-IPO project finance cases.

• For this reason, the level of risk and the potential conflicts of interest that arise during the construction phase of a mega infrastructure project are such that turning to IPOs to provide equity capital may not be appropriate.

• Moreover, although Esty (2004) argues that the most important economic motive for using project finance is the reduction of agency conflicts inside project companies, the Eurotunnel case demonstrates that turning to IPO for equity capital for project finance can increase agency conflicts for project companies.

Limitations• The Eurotunnel case is unique in that its share price data

allows us to empirically measure the impacts of construction events on overall project risk and equity value.

• However, the atypical nature of Eurotunnel ownership structure (dispersed rather than concentrated equity ownership structure of typical project finance companies) also means the implications of this research paper could be limited to project finance cases seeking to raise equity capital through IPO.

• On one hand, the availability of Eurotunnel’s share prices allows us to study the impact of construction events; on the other hand, the unusual change in the ownership structure as a result of the IPO is revealed to add to the overall project risk.