01 May 2014

Why the PPP model for roads is alive and well

by Owen Hayford

There are two quite different responses to the reduced appetite of private sector investors to traffic risk, with different implications.

Critics of the Public Private Partnership (PPP) model for road projects have declared it dead, never to be revived. The justification for this view is founded mainly on the financial troubles of various road projects in recent years, which some have attributed wrongly to the PPP model itself. In fact the primary cause of financial troubles of road PPPs has been overly ambitious traffic projections.

Despite the criticism and negative media attention, the road PPP model is far from dead. The PPP model is alive and kicking, having evolved in response to market conditions in several significant ways.

Tackling traffic risk

The most significant change has been in the area of traffic risk, otherwise known as demand risk or patronage risk. Traffic risk is the risk that traffic levels, and consequently toll revenues, will be different to the forecast traffic levels.

Australian toll road PPPs historically allocated traffic risk to the private sector investors in the road. The investors in some early toll road PPPs, such as the M2 Hills Motorway in Sydney, and the CityLink project in Melbourne, did quite well out of this model. However, investors in later toll roads, in an effort to win bidding competitions for the right to build and operate the toll road, were far more aggressive with their traffic forecasts and, consequently, lost large sums of money when the traffic didn't materialise. Notable examples include the Cross City and Lane Cove Tunnel projects in Sydney, the Eastlink project in Melbourne, and the Clem 7 and Airport Link projects in Brisbane.

Fortunately for taxpayers, the contractual allocation of traffic risk on these deals worked. The losses were borne by those who agreed to take traffic risk, being the private sector equity investors and, in some cases, the debt financiers. In all cases, the roads remained opened to motorists, at toll levels no higher than originally contemplated, and government did not have to bail out the project with additional government funding. However, equity investors and debt financiers lost their appetite for traffic risk and started calling for changes to the allocation of this risk.

A new road ahead Availability Payment PPPs

Around this time, the Victorian Government tendered its Mornington Peninsula road project as an "availability payment" PPP.

Under the Availability Payment PPP model, the project company receives its revenue in the form of a quarterly availability payment from government, in return for making the road available for use by motorists. If any tolls are levied on motorists, the government applies them towards its obligation to pay the availability payments. The availability payment which the project company receives does not depend upon the amount of toll revenue collected. Accordingly, under this model, the risk of toll revenues being less than forecast is borne by government, rather than the private sector.

Some in the industry point to the Peninsula Link project as an example of government responding to the calls for change to the traditional allocation of traffic risk. However, the decision to not impose tolls on the Peninsula Link was made for other reasons. Once that decision had been made, the traditional toll road PPP model ceased to be an option for the Peninsula Link project (on which Clayton Utz advised the Government).

That said, the use of the Availability Payment model on some other road projects certainly is a response to the private sector's current aversion to traffic risk. Road projects which are presently being tendered under this model include the Victorian Government's East West Link project (on which Clayton Utz is advising). The Availability Payment PPP model is also being applied by the NZ Government to its Transmission Gully road project.

The GBTS model

Government's response to the change in investor appetite for traffic risk has not been limited to the Availability Payment PPP model. Another model which has emerged in response to the traffic risk issue can be described simply as the "Government Builds, Tolls then Sells" (GBTS) model.

Under this model, government engages private sector contractors to design, build and maintain the road, and to install tolling equipment, under public funded contracts. It retains the tolls collected during the ramp-up periods as the project builds some actual traffic history. Once actual traffic levels have been established, government sells the right to levy and collect future tolls to the private sector.

Under the GBTS model, the government bears the traffic risk during the ramp up period, and the private sector bears the traffic risk after ramp up, when the risk is largely retired.

Go between Bridge and Legacy Way

Clayton Utz advised the Brisbane City Council on the application of the GBTS model to the Go Between Bridge and Legacy Way projects, both of which have now been sold to Queensland Motorways.

The Legacy Way project is a variant on the GBTS model, as the project is still under construction and was sold before the ramp up traffic risk was retired. The arrangements for the payment of the sale price have been structured, however, so that part of the price is only paid after actual ramp up traffic levels have been proven, and the amount is adjusted having regard to any difference between actual and forecast traffic levels during the ramp up period. Accordingly, Council continues to bear the ramp up traffic risk, and the new owner bears the traffic risk thereafter.

WestConnex

The New South Wales Government is also adopting a variant of the GBTS model for Stage 1 of its WestConnex project. It is proposing to complete Stage 1 of this project in two phases. It will use government funding to pay for the first phase, being the widening of the M4 motorway. Once the widening is completed it will impose a toll on the M4 and collect the toll revenue through a special purpose company owned by the State.

Once some actual traffic data is gathered, the Project Company will raise private sector debt against the future toll revenues. This debt will be raised on a non-recourse basis, ie. the lenders will only be entitled to have recourse to the assets of the Project Company, and not the balance sheet of the State, in the event the loan is not repaid. As such, the debt raised by the State through the Project Company will not affect the State's credit rating.

This debt will then be spent on phase 2 of Stage 1, being the extension of the M4 East from Strathfield through to Haberfield. Once phase 2 has some actual traffic history established, the NSW Government proposes to sell its equity in the Project Company and recycle that released capital into Stages 2 and 3 of the WestConnex project.

What are the implications of the different approaches?

There are two quite different responses to the reduced appetite of private sector investors to traffic risk, with different implications.

Government v private sector finance

Under an Availability PPP, like that proposed for the East West Link, private sector finance is used to pay for the construction of the new road. Compare this with the Government Builds, Tolls then Sells (GBTS) model, where the government finances the construction of the new road.

Private sector finance comes at a cost, which reflects the risk being taken by the private sector financiers. That means there is an additional cost in the Availability PPP model that is not present in the GBTS model. But this does not necessarily mean that the GBTS model will deliver a better value for money outcome for government than the Availability PPP model.

So what is the extra risk transfer that government achieves under the Availability PPP model that justifies the additional cost of private sector finance? It is not the risks associated with the design, construction, operation or maintenance of the road; these risks can be transferred to private sector contractors on an equivalent basis under both models. The key difference is that the Availability PPP model exposes debt and equity to the risk of a default by the contractors, or the insolvency of those contractors. This provides government with a 'buffer' against such risks. Under the GBTS model there is no such buffer.

The involvement of private sector debt and equity investors also adds additional rigour to the due diligence and monitoring of projects. This additional rigour, which goes into the planning of the project and the monitoring of its performance, is one of the principal reasons why PPPs have been found to experience lower average construction cost overruns and construction phase delays, compared with traditionally procured projects. That said, in theory, there is no reason why the same level of rigour cannot be applied to the preparation of tender documents and risk and cost assessments, and to the project management of publicly funded construction contracts, under a GBTS model.

Who bears traffic risk over time?

The other key difference between the two models is the period over which government bears traffic risk. Under the GBTS model the government takes the traffic risk prior to the sale, and then transfers this risk to the private sector through the sale, once it has been largely retired. Under the Availability Payment model, government would ordinarily retain the traffic risk over the life of the PPP.

The government could feasibly seek to sell the right to retain future toll revenues at some point during the life of the PPP. However, the contractual interfaces which would apply after the sale as between the new owner, the Availability PPP Project Company and its Operation and Maintenance (O&M) contractor, and government, would need to be very carefully considered when structuring the sale, in order to maximise the number of bidders for the tolling concession.

Is one model better than the other?

The answer depends on a number of factors and will differ from project to project, as it has on the East West Link and WestConnex.

Those factors include:

  • the cost of the private sector finance;
  • government's assessment of the value of the buffer provided by debt and equity against the risk of contractor default or insolvency, and the additional rigour which debt and equity will bring to the assessment and monitoring of the projects, and;
  • government's desire the recycle its capital out of the project and into future projects.

The traditional toll road PPP model still works

Not all investors in toll road projects have lost their appetite for traffic risk.

The agreement between the NSW Government, Transurban and the Westlink M7 shareholders for the M1 to M2 Link (now known as NorthConnex) will adopt a traditional position on traffic risk, with traffic risk being borne by the investors providing the equity and debt finance for the project.

Considering this and other recent developments, it seems the traditional toll road PPP model is far from dead and has a new lease on life.

This article was first published in InfraNews online, April 2014

 

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.