Is $340 million a good price for cancelling a road?

The Victorian government today cancelled the contract for a road, and agreed to pay the winning bidder $340 million for their trouble. Is that a good deal?

Prima facie, $340 million seems a lot.

Despite that the reaction to the deal has been positive, with people describing the deal as a good one.

I remember writing a piece back in September, joking that the compensation could be as much as $500 million!

“I can imagine Lend Lease and the infrastructure minister sitting in a room right now, amending the cancellation provisions. $100 million? Why not $500 million? … We rely on their good citizenship not to do so. A flimsy protection indeed.

At that stage a payout of several hundred million dollars seemed ludicrous. The reason it now doesn’t is due to a psychological effect called framing.

Framing is why restaurants put a $50 steak on their menu, why apartment developers put a $2 million penthouse atop their building, and why TV marketing channels say their $9.99 item is a $20 item at 50 per cent off.

In each case, the context of a higher price makes the smaller sum you are about to pay more palatable. Some excellent work on framing has been done by Nobel winning economist Daniel Kahneman.

The former state government, by including in the contract a kill clause providing for a payout of over $1 billion, made the eventual payout look small.

$340 million could pay for a lot of trams
$340 million could pay for a lot of trams

If we try to analyse the $340 million payout without $1 billion ringing in our ears, how does it seem?

The Sydney metro cost the NSW government $130 million to cancel. But that’s a different kettle of fish. They got further down the track, including buying up property.

Melbourne’s contracts existed for only a month before the government changed and the future of the project was put at risk. If the consortium spent a third of a billion dollars in that month I am impressed at their efficiency.  If they spent it after the election, I am shocked at their boldness.

As for bid costs? One failed bidder, Leighton was reimbursed $12 million. In the Sydney Metro, one bidder spent $22 million and described that as “really big.”

So the $340 million dollars is probably not all costs. More likely, most is compensation – probably dressed up as costs plus a “fair markup”.

The reason it is not called compensation is that suits both sides. Labor leader Daniel Andrews looks like a master negotiator, and the companies – at risk of seeming to be blackmailing the state – look reasonable.

bike freeway
The Eastern Freeway running smoothly.

We should be angry at paying so much. The payout goes straight to the consortium’s bottom line. The longer the project ran, the higher the chance that the consortium made a loss. Cutting out early guarantees that won’t happen. Despite the high volume whining, this outcome has its upsides for the consortium – it banks a profit and puts its engineers onto another project.

Is this good bargaining by the state Government? I don’t know. The consortium seemed to have a great legal position. But the state government actually holds a pretty big stick. They could whisper that companies involved in demanding compensation will never win a bid in this state again unless they pull their heads in. Hopefully they bargained hard, but we shall never know.

Emphasising that these public monies have been wasted – ultimately our money that we paid in GST – is not an exercise in blaming the current government.

Their efforts – however imperfect – are absolutely glowing examples of good policy compared to the previous administration’s deliberate sabotaging of the state of Victoria. Including the kill clause is a stain on their legacy that should be remembered for a long time, and they must bear the blame for the size of today’s compensation package.

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thomasthethinkengine

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

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