How to dodge a big payout on cancelling a road contract AND avoid creating sovereign risk

The government of the state where this blog is produced is in a pickle.

Prior to an election last November the then Opposition promised to cancel or defeat in court a contract for a big controversial road tunnel. The tunnel, worth perhaps $6 to $10 billion dollars, has not been built yet. Nothing beyond planning has commenced

Now the former Opposition are in power, they are finding that the old government left them a poison pill. 

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If the road is not built for any reason, the government must pay the company that would have built it $1.1 billion. This clause was added by the previous government. The companies might have done only $50 million of preparatory work – being generous here – but they get paid $1.1 billion simply for missing out on finishing the job.

Ignoring for a moment the morality of inserting such a clause into a contract (it’s vile, wasteful, ridiculous, and would in a better world result in a range of senior bureaucrats and politicians going to jail), we turn our minds to how the present government can deal with it.

There are three main options.

1. Avoid the payment and make the road. This would involve reneging on a major election promise, but you don’t waste the money.

2. Avoid the road and make the payment. This would gift a billion dollars from an indebted state government to a consortium of companies including Lend Lease Group, worth $9 billion, Acciona, worth €3.6 billion and Bouygues SA, worth €10 billion.  It would probably be politically convenient too.

3. Avoid both the road and the payment. The government has one big advantage. It makes laws. It can write legislation that annuls the offending contract. But the big risk in such a course of action is that it establishes an extremely unwelcome precedent that promised payments can be cancelled at whim by the government, and valid questions being raised about sovereign risk.

I want to look more closely at option three. Is there a way a law could be drafted that gets a just result and avoids sovereign risk? I think there might be.

Any law to cancel the payment provisions in the east-west link should:

1. Make it clear that this is a once-off by raising the hurdle for ever cancelling this kind of contract again.

For example, the Government could include a clause requiring that in future passing legislation that annuls any contract above a multi-billion dollar value threshold requires a supermajority in parliament, e.g. two-thirds of votes. The requirement for a super-majority should not apply to contracts where the cancellation provisions are substantially greater than the cost of the work done.

Sovereign risk only applies if a company can genuinely fear its contract provisions may be changed by legislative fiat. If they fear risk, they will raise prices.

Reducing the risk of such legislative action should attenuate the real costs of sovereign risk (although it won’t prevent the political costs of big companies mouthing off about it.)

2. Legislate against any future government ever introducing “poison pill” contract clauses into infrastructure contracts. (Part of me wonders if this law could apply retrospectively?)

3. Legislate that any large contract signed during the “caretaker period” in the lead-up to an election should be agreed upon by the leader of the Opposition as well as the Government, in order to prevent sneaky surprises. Part of the problem with the east-west link project was that it was never an election pledge, was controversial for 3.5 years, and with weeks before the election it looked set to lose, the government signed a contract.

Transport
We’re in a tangled mess.

Now. Could the state government of Victoria pass such legislation? It has a lower house majority, so it could pass it there, no problem. In the Upper house it holds just 14 of 40 seats. But The Greens have five, and they are likely to support such a plan. Then the government needs just a couple more, drawn from The Democratic Labour Party, the Sex Party, Shooters and Fishers, and Vote 1 Local Jobs. It might require some side promises, but it may be possible.

I welcome your thoughts and comments on this idea. Please leave a comment below, or hit me up on Twitter.

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thomasthethinkengine

Thomas the Think Engine is the blog of a trained economist. It comes to you from Melbourne Australia.

5 thoughts on “How to dodge a big payout on cancelling a road contract AND avoid creating sovereign risk”

  1. A few flaws here:
    1) $50m would not even cover the cost of tendering, let alone the work done since or the financial agreements entered into. $300m could be a more reasonable figure.
    2) The contract was not signed during the caretaker period. Protocols already exist to cover this, as they do for disclosure of cabinet-in-confidence documents (since broken by Labor).
    3) What is there to stop another government legislating a way around this? Any legislation to breach a contract would leave a stain on the reputation of the State and make future major projects, such as Melbourne Metro, either more difficult or more expensive to procure. Potentially there are situations where there is a legitimate (rather than political) reason for terminating a contract. Regardless, there must always be compensation for terminating a contract.
    4) The “poison pill” only confirmed the provisions of the contract. It did not add any new rights or remedies.

    Finally, the fact remains that Labor’s election commitment and decision was political. It was not based on full knowledge of the business case for the project or of the contract. It was not even based on any ideological opposition to the project, which was originally conceived under Labor. Rather, it was purely an election tactic to win inner Melbourne seats.

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    1. Another tenderer got $12million in compo for their failed tender, and they were knocked out of the bidding in June. I doubt another $290 million of work went on between then and the election?

      http://www.theage.com.au/victoria/leighton-to-be-reimbursed-up-to-12m-for-failed-east-west-link-bid-20140623-zsj2m.html

      2. I take your point on the caretaker period and will change that, thanks.

      On point 3. You’re right that another government could always legislate to change the legislation. I guess this is always a risk in any jurisdiction and why the state government is keen to find an alternative to legislating.

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  2. I don’t know whether this would help make a difference in this context, but one option could be to legislate to make clear that the State Government will only honour compensation on infrastructure contracts when there has been a business case published by Infrastructure Australia (or it’s Victorian equivalent that I believe Labor has committed to?).
    At least that way it creates a kind of “buyer beware” effect for the contractors that if they secure a poison pill in a politicised project that hasn’t been validate by an independent authority, they’re aware of the risk under a change of government.
    On the other hand, the parliament has sent a positive signal the market that it will absolutely honour contracts that have had the indepenemt eye cast over them.

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  3. Option 1 – build the road and “you don’t waste the money” – sure, you don’t pay the compo, but you waste a heck of a lot of other money – way more than the compo amount.

    I’m currently reading a book about US transport debate – the authors bemoan that many major public transport projects seem to require a local referendum, but major roads don’t.

    If EWLink had ever gone to an election, it appears it would have failed – surveys consistently ranked it below public transport projects. It’s damning that the Coalition wanted to ram it through anyway.

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  4. The $12m paid to unsuccessful tenderers was an amount offered by the government, not cost recovery

    I was told by a reliable source that Transurban spent $20m in legal and engineering fees on the CityLink tender 20 years ago. That did not include their own internal staff costs. The detail of the tender design and complexity of legal issues were no match for East West Link.

    If tender costs were 1% on a $6b contract, that would be $60m. My guess is they spent more on the tender, plus more on post tender clarifications and negotiations. Once awarded, East West Connect had hundreds of engineers on the job and rumour has it that orders were placed for the two TBMs ($100m each)..

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