How can Victoria encourage local builders to bid for PPP projects?

Out-Law Analysis | 29 Jul 2020 | 9:35 am | 3 min. read

As Australia turns to infrastructure to boost the Covid-19 economic recovery, the Victorian state government will be looking for ways to keep the profits from major public-private partnership (PPP) contracts within state borders.

The state government has for years bemoaned the barriers to entry for second- and third-tier builders in the PPP market, with major PPPs often awarded to non-Victorian builders and the profits disappearing north of the border or overseas. But there is no need for Australia to go the way of the UK and abolish PPPs: instead, let's fix the procurement model and use infrastructure procurement as a way to stimulate an economy otherwise headed for a deep and prolonged recession.

For the Victorian state government, one option is to finance alliance-style contracts rather than the fixed-price/fixed time contract model traditionally adopted for PPPs. The 'blame culture' encouraged by the use of fixed price/fixed time contracts on massive, complex construction projects have proven themselves to be a cash boon for litigators and almost nobody else. Under an alliance model, stakeholders become motivated to fix problems constructively, as a group, rather than sue each other.

King Jeremy

Jeremy King

Partner

There is no need for Australia to go the way of the UK and abolish PPPs: instead, let's fix the procurement model and use infrastructure procurement as a way to stimulate an economy otherwise headed for a deep and prolonged recession.

Financiers will be able to get their heads around financing alliance contracts: they will simply finance the total outturn cost (TOC). If the TOC is lower than expected, the borrowers will be able to cancel any undrawn commitment and stop incurring commitment fees on that excess debt amount. If the TOC is more than expected, everyone has to come together to get approval for the increased amount.

There is certainly investor appetite for changes to the model. Look at the recommendations of IFM Investors, who recently called for new ways of procuring infrastructure equity in Australia.  And John Manning, senior credit officer at Moody’s, recently told reporters that there is a greater propensity now to use alliance or other non-fixed price contracts to shift some risks off the builder. These contracts usually don’t involve pure private equity investors, but Manning thought that this was a challenge that could be overcome with a new structure.

As an example, let's look at the Suburban Roads Upgrade (SRU) PPP (dollar and other amounts invented by the author) in Victoria. The state recently withdrew from procurement a A$1 billion (US$715bn) PPP with a principal contractor working across 20 sites. Construction, given its intensity, is necessarily more efficient when it is localised. Instead of having a principal contractor, you could put 20 A$50m alliance contracts with second- or third-tier builders in place, each of whom would love two or three A$50m jobs and be able to do them well.

The PPP component could be held back for the operation and maintenance (O&M) contract, over the next 20-30 years. Maintenance, to be more efficient, should be spread across multiple regions. As the quarterly service payment (QSP) moves in accordance with the size of the TOC, the financiers shouldn't have any issues as long as the TOC is within their approved limits. There is less in this for equity investors, but these projects are usually highly leveraged and the state has – justifiably or not – regularly downplayed the value of PPP equity. There is also less of an obsession with 'value for money' in this scenario: a concept which proves to be a total fiction in any event, as soon as a PPP heads towards litigation.

We could take this example a step further, and consider the case of linear infrastructure for broad-acre subdivisions in outer suburbs. Developers only install the necessary roads, water, sewage and power facilities because they need to sell the blocks in order to recoup their investment; but this additional capital expenditure forces up the prices of the blocks, making them less affordable to the very people who are going to buy them.

Instead, the state or a statutory development authority could pay to install roads and utilities and then legislate to apply an annual levy to each block for 20-30 years to recoup the investment via council rates. The legislation could also provide that this levy ranks ahead of mortgagees.

The approach of land value capture – using taxation to fund infrastructure – might seem innovative, and therefore difficult to achieve politically, but it has already been employed multiple times across Australia (including Victoria!), New Zealand, Asia and the United Kingdom. One third of the costs of the Sydney Harbour Bridge (1922-1932) were to be funded through a betterment tax (via council rates) on landholders who benefited from the harbour link. Up to 25% of the Melbourne City Loop was to be funded by a Benefited Area Levy, via Melbourne City Council rates, over 52 years. Perth has had its Metropolitan Region Improvement Tax in place since the 1950s. In New Zealand, Crown Infrastructure Partners uses this approach for its broad-acre subdivisions while, in London, Crossrail applies a levy on local businesses that directly benefit from its infrastructure. Hong Kong's MTR, Tokyo's Metro and Hyderabad's metropolitan rail system all receive a percentage of benefited businesses profits and property development fees in areas surrounding subway stations.

The PPP model in Victoria (and elsewhere in Australia) may be damaged, but it isn't irreparably broken. We shouldn't discard 20 years of expertise in delivering major infrastructure projects because the risk allocation has been skewed to an unsustainable point. Fix the procurement model, and the debt financing component will adapt accordingly.