A grip for the long haul?

Governments around the country are being persuaded to improve the way they tender public works to the private sector, but they face criticism that they are favouring public-private partnerships for ideological reasons and without adequate assessment of their risks. Shaun Drummond reports

The continuing furore over Sydney’s Cross-City Tunnel has again led to questions over how public projects are procured – particularly the use of public-private partnerships (PPPs) where public infrastructure is financed and built by the private sector. But despite the bad headlines, governments are becoming more enamoured of this option, both here and overseas.

Although on average, PPP models of procurement only account for about 10 per cent of new infrastructure, and investment is likely to go no higher than 15 per cent of public capital expenditure, according to the Australian Council for Infrastructure Development (AusCID), like privatisation, the difficulty of reconciling commercial interests with the government’s mandate to provide public services has made PPPs particularly controversial.

Even the Federal Government, which doesn’t have primary responsibility for most public infrastructure, dispensed with its reticence over private partnerships. Last month the Prime Minister announced that Cabinet had decided to require all departments to consider all funding and ownership options, including PPPs. Importantly, agencies would have to provide detailed explanations of why they didn’t choose to involve private financing in major projects.

PPPs would particularly be sought for projects with a ‘whole-of-life’ cost of more than $100 million. John Howard was careful, however, to point out that he remained strongly in favour of PPPs so long as “private financial interests are not unreasonably preferred at the expense of the public and taxpayers”.

So what’s the attraction? A common benefit recognised by many jurisdictions is the ability to allocate risk “to those better able to manage it”. The Commonwealth Policy Principles for the use of Private Financing say PPPs can also provide access to specialist expertise and innovation. As Howard put it, private sector financing could “harness the innovation, financing and marketing skills of the private sector”.

It is also felt that projects are more likely to be built on time and on budget if the private sector is building and financing the project.

A counter argument that has held back many state governments from choosing PPPs is the view that the state has a greater range of options for financing and can procure funding at lower rates of interest than the private sector, or increase taxes to pay for it.

Professor Bob Walker, from Sydney University’s Faculty of Economics and Business, says there are several other political reasons, including the ability to shift liabilities off the government’s books, reducing the apparent government debt. “It’s primarily to keep borrowings off balance sheet, as I see it.”

In one of the few submissions to the ongoing NSW parliamentary inquiry into PPPs, the Combined Pensioners and Superannuants Association of NSW says it is concerned that the difficulties of the Cross-City Tunnel show that the NSW Government’s mandate to provide services to the public is being undermined by the commercial requirements of those building the infrastructure.

It cites a speech given by Christopher Shiel, a senior research fellow at the University of NSW, to the Evatt Foundation in 2002. In it, he mirrors Walker maintaining the main reason the states have become more and more keen on using PPPs is to keep public debt as low as possible. “The contemporary refusal of the states to maintain, let alone increase public borrowing has thus opened up the way for PPPs. Let me stress that the present zero public debt policies are nothing but pure populism, or economic rationalism. There is no economic rationale in any economic theory for our state governments not to borrow.”

Lawyers are always closely involved with the bids for many of these projects, but despite their vested interest most have their own list of concerns about the way PPPs are being approached in Australia.

Christopher Kelly, a partner at Maddocks Lawyers , says regardless of the arguments for and against PPPs, which method of financing and construction is chosen will vary depending on the project, each of which can be hugely different in scope and commercial requirements. He says, however, the decisions on whether to choose PPPs have, in some states, become too “politicised”, and instead of choosing to use or not use PPPs for economic reasons, ideological considerations are coming to the fore.

“This is not a form of procurement the public sector should embrace ideologically. It’s not a cure all for everything, but by the same token it’s not something they should reject ideologically,” he says. “It’s simply another form of procurement, which if conducted efficiently and adequately resourced, should compete on an equal footing with other forms of procurement.”

Value for money

When assessing whether to use a PPP instead of another option such as acquiring the asset directly, according to guidelines now in place in most states, the government agency concerned must formulate what’s known as a public sector comparator (PSC), which provides a benchmark to determine whether the bids offered in the PPP process are providing better value for money.

This involves assessing the relative costs and risks of the different procurement options available. As the then Commonwealth Auditor-General, Pat Barrett, pointed out in a 2002 speech on maintaining government accountability when engaging in PPPs, “identifying the most appropriate risk allocation between the parties to a PPP while maximising value for money to the public sector is not, however, at all straightforward”.

Barrett said numerous audits had concluded government departments were often not up to the task of making those assessments and that there were deficiencies in the project management skills of agency decision makers, allied with the fact that some of these projects involve substantial resources and complexity. “As well, similar audits have flagged the need for care in assessing value for money and negotiating, preparing, administering and amending major contracts.

“Contracting can be a high risk and costly exercise for both parties,” Barrett says. “For the private sector, the risks arise from understanding the services to be provided, the attendant obligations and the immediate expense of developing a tender with few guarantees of success. Contractors face the challenge of working in a public sector environment and public servants the challenge of dealing with all aspects of commercial financial viability.”

Despite moves to address these concerns, particularly in Victoria, and at a national level through the National PPP Council, which first met in May 2004, many say reforms have been piecemeal and very slow to emerge.

Kelly says bidders can still be frustrated by the fact that a government agency has not been as thorough as the private sector in assessing the costs and risks of the project when formulating the PSC.

“I’m not convinced that enough resource is being thrown at that appraisal and that it’s not updated,” he says. “When a NSW state government department is formulating the PSC, it might spend $50,000 doing that. But it then goes to the market and asks it to price the project. The market will cost that project and in doing so appraise the PSC, and will spend sometimes as much as a million [dollars] doing that, and will often, and quite justifiably,come up with numbers in excess of the Government’s PSC.

“The Government sometimes offers figures which aren’t as developed and haven’t been as well resourced and the private sector is asked to accept that, when the Government itself is unable to verify them.”

Walker at the University of Sydney agrees with complaints from the private sector that there is a lack of transparency in how the PSC is formulated. However, in NSW he says the guidelines on preparing the PSC “are fundamentally flawed” and are in fact biased against direct service delivery by the Government.

In a report commissioned by Unions NSW to be submitted to the NSW parliamentary inquiry into PPPs, Walker and his wife and co-author Betty Con Walker claim the capacity of the state to borrow at cheaper rates is ignored by the guidelines, leading to incorrect assessments of the relative benefits of different financing options.

He says the guidelines fail to “explore the risks that private sector partners may earn excessive profits which are opportunity costs to the Government, they “disregard the risks to the NSW community of having to pay compensation in the event that there is a need to upgrade public sector infrastructure” and “contain no flexibility for adjusting to changed circumstances during the term of the contracts so the Government of the day may lose control of the standard of service to the community”.

Picking winners

Both critics and proponents of PPPs say systematic monitoring or evaluation of PPPs in Australia has been patchy to date. Kelly at Maddocks says there is a dire need for a national audit of PPPs as was carried out by the National Audit Office in the UK.

To this end, a University of Sydney research group has been given a grant by the Australia Research Council to develop a “post-project evaluation” model for PPPs.

The group, including Professor James Guthrie, Linda English and Associate Professor Sue Newberry, point out in a submission to the NSW parliamentary inquiry that the extent to which PPPs deliver on their promise depends on many factors – including “pre-decision specification criteria, financial modeling, unanticipated future events and the nature of the relationship between the partners”. How successful PPPs are can only be assessed through long-term monitoring, they argue. “The negatives of PPPs are frequently the subject of media coverage. Less is known about successful PPPs and why they are successful,” they say.

Common approach

Working out what has worked and what hasn’t in a PPP is part of the process of developing standard contractual terms for PPPs, which the states have agreed is another important step to improve the efficiency of the PPP market. The preliminary form of standardised terms have been released in Victoria, acknowledged by most as the state which has the most sophisticated treatment of PPPs in the country through its Partnerships Victoria policy.

“Contracts get standardised in the sense that the lawyers look at the previous deals and take the good bits out of them. But there is still a degree of independence exercised by the law firms as well as certainly by the states,” says Geoff Daley, a partner at Blake Dawson Waldron in Melbourne.

He says contractual terms can be standardised in common areas such as the design/development process, or extensions of time during construction, or how variations or a change in law is dealt with. They could also deal with: “How your default and remedy regime will work, how your [key performance indicator] regime will work.” However, this can only go so far as each project “has such a degree of specificity”, he says.

Minters partner Fred Tingle says his firm did some of the work on the Victorian Government’s “commercial principals for risk”, which he says will possibly lead towards a standardised contract for use around the country. “It’s a halfway house. It deals with the risk that will be documented in a contract and dealt with in some detail, but not fully drafted.”

Daley has worked on several successful PPP bids in Victoria and interstate, including the first ones undertaken by Queensland and Western Australia. He is sceptical, however, that he will find common contractual terms across the states any time soon. “Victoria has done some work on standardisation. Bits of it have been followed in other states, but only relatively small sections. The states have gone their own way in a lot of ways. We don’t have particular standardisation across the states on risk allocation. So if you can’t agree the risk allocation in general terms, you are not going to be able to agree the contractual drafting.”

The private sector has also been pushing hard to get some national coordination of infrastructure projects. Last month, AusCID called for the creation of a National Infrastructure Advisory Council. AusCID CEO Dennis O’Neill said this council would “provide a forum, which also needs to have investor representation, for considering and acting on all critical public private infrastructure frameworks”.

Bid costs

All of the above deficiencies contribute to the costs of the parties bidding, but the way the agencies control the bid process perhaps draws the most ire. Some practices that commonly come in for criticism include ‘best and final offer’ (BAFO) or ‘two-to-the-wire’ bids, where bidders are forced to re-bid several times in order to drive the costs below the PSC.

Kelly argues that the money spent on this process would be better spent on developing a more accurate PSC instead of continuing to drive the price down after it becomes obvious who is actually going to win the bid.

“What is happening is that governments are running two bids down to the wire to ensure that they maintain competitive tension,” he says. “Everyone can see that there is an advantage to that. However, what the private sector is saying is that in circumstances where it is apparent prior to that … process, that one or other of the bidders is clearly superior, is it equitable to compel the other party to make a bid which will cost quite considerable sums of money without a reasonable prospect of that bidder getting it?”

“That’s a very common occurrence, to have a re-bidding process,” says Daley. “They really increase your bid costs. The problem is you’ve spent so much on your bid. If they ask you to bid again, you have to say yes because you’ve already sunk so much into the process, you can’t just walk away and have no prospect of winning.”

Interactive bidding

Some feel governments also get too hung up on probity concerns. Daley says it is important to treat each bidder “fairly” and make sure the parties are free of any conflict of interest, but insists bidders can’t in practice be treated exactly the same. Probity shouldn’t preclude discussions with each bidder so they can get a better understanding of what the agency wants and the agency can understand better the commercial concerns and benefit from the bidders’ expertise.

“To what extent will the state engage with a bidder, before appointing anybody preferred and talk specifically about their bid? Some states have found themselves very bound up by probity in that respect. They take the view that they have to make a decision and then they can negotiate afterwards,” he says.

He says the complexity of the projects and the variation in each bidder’s design will lead to a different “operational solution” and each may have “a completely different construction methodology”.

“And of course there’s your risk allocation in the contractual sense. Between different bids, to compare those two things, you may want to actually drill down into them a bit further.” The state could also indicate to bidders what it definitely won’t accept and could be shown better ways of approaching the project by the bidders.

“If a bidder can’t go away and think about it, then that’s going to count against their bid. But state can’t say the same thing to both bidders, because the other bidder may not have the same issue. And that’s where the probity problems have come for some of the states – they haven’t been able to get their heads around how to have that conversation without breaching probity.”

Victoria is one state where they allow discussions with bidders throughout the bidding process. “There are certain milestones during the bid process where they say: ‘we want you to present your master plan; we want you to come in and tell us your top-10 commercial, financing and legal issues. Come in and let’s talk about them,’” Daley explains.

“It’s really the clarification process. They are very, very complicated projects,” he says, adding that while the state might specify as best it can what it wants, that can be clarified if need be during discussions with the stakeholders.

Without these discussions, Daley says, the state may prematurely appoint a preferred bidder, when in fact another bidder may have been found, after some negotiation, to have been better.

Lack of consultation may also lead to more requests for revised bids. “It may manifest itself in the way the state treats you in a more formal way and so they will write to you and say ‘here are the following things that need to be fixed in your bid – can you put in a revised bid’. So then you go through a revised bidding process, so you go and do the bid again.”

Deal flow

One of the ultimate aims of the reforms being called for is to make it more attractive for the private sector to make bids, which it is felt will lead to more competition and better value for money in the long run for the public sector. “At the moment it is very dominated by the big bidders. Which means Leightons, including Thiess and John Holland, Baulderstone, Multiplex, Lend Lease,” says Daley.

“It’s a question of confidence that there is going to be a flow of deals keeping people busy, keeping your teams busy to justify the fact that you’re bidding for projects that one in three, one in four times you might win, the rest you’ll lose,” explains Minters partner Fred Tingle, a specialist in project finance. “Some of these transactions have got bid costs north of $2 million per bidder.”

“It’s certainly been recognised, certainly by Victoria, that their needs to be a substantial deal pipeline,” he says.

At present these high bid costs, including the investment in the expertise necessary, discourage smaller players from making bids, says Daley, and the lack of further deals round the corner mean for most it is not economically viable to spend so much on one or two bids.

However, the lobbying appears to be paying off, with a steady increase in the number of states using PPPs. The current list of projects contracted around the country, produced for the National PPP Forum meeting held last month, is now 29, with another 18 potential projects. It is estimated there are more than $4 billion worth of PPS “in the market” and more than $6 billion worth of projects being considered as PPPs.

Although a much bigger market, Kelly claims by comparison that the UK still proportionally has more projects. As of December 2004, there were more than 670 signed private finance initiative (PFI) deals since 1987 in the UK with a capital worth of £42.69 ($101) billion . Last year there were 45 signed PFI deals, with the peak so far at 108 signed in 2000. “That excludes a lot of PPPs, [but] the point about that market is that it is a big part of the UK economy,” says Kelly.

“The importance of deal flow … is to increase the expertise in all aspects of the people who deal with these projects. But also to get into the market and be able to take a portfolio approach,” says Daley.

“If you are going to spend several million dollars on a bid, and you might lose, you want to know that there are sufficient bids so that you are spending that money but you are recovering it because you have bid on six, but you win three. If there is only one in your state, or maybe there’s two that you can bid on, it’s much harder to make those decisions as a bidder.”

The UK has also led the way in addressing ways to improve the flow of deals and reduce bid costs, according to Kelly, including setting up a separate government agency, Partnerships UK, with the necessary expertise to develop policy and provide assistance to agencies on how to forge good PPPs. The UK has also set standardised policy and contract terms for both national government departments and local governments.

Daley cautions, however, that Australia cannot be directly compared with the UK due to our federal system of government, which adds to the limit that the small size of the local market places on the number of deals available. “They are a single jurisdiction. In the UK, Treasury can influence those outcomes … at a national level. We can’t do that here. The Commonwealth Government has no power to influence the way the state governments implement PPPs.”

Although more difficult to implement here, Kelly says the states and the Commonwealth have to go further, embrace “cooperative federalism” and ensure the key reforms in the UK are duplicated here soon.

“I would like to see this product commoditised. So standardisation to me is a way to commoditise it. That is something that I think has been achieved elsewhere,” says Kelly.

By contrast, in his report for Unions NSW, Walker at the University of Sydney says instead of looking at the processes surrounding the implementation of current policies, the current NSW parliamentary inquiry should be assessing whether “NSW policy and practice are appropriate and in the interests of the citizens of NSW; and whether continuation of those policies is likely to have adverse effects on current and future generations”.

Following the fallout from the Cross-City Tunnel, the NSW Government appears to be shifting towards this view with the Premier, Morris Iemma, telling Sydney’s The Daily Telegraph this week there was now a review being conducted of the state’s infrastructure program and there could be scope for more government borrowing to fund infrastructure.

11-Nov-2005

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