Tag: east west link

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.

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.

The real sovereign risk is that people are no longer sovereign

Until the mining tax debacle of 2010/11, the term sovereign risk was used in Australian political discourse very sparingly. The term traditionally refers to a government not paying back a loan, but now is used for all sorts of situations where government is a risk to someone’s business.

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Source: Google trends

Now “Sovereign Risk” is not applied to Africa or Greece, but has become a political weapon to be wielded on policies – or indeed entire governments – with which one is unhappy. For example:

“BHP Billiton, Rio Tinto and most other world minerals and energy groups have now concluded that Australia is one if the most dangerous places in the world to invest. We are going to see a capital strike of immense proportions, which will take a long time and much effort to reverse. And when it is reversed miners will still require much greater returns from Australia because of the demonstrated sovereign risk of investing here.”

and

Most recently, the concept of Sovereign Risk has been used in a debate over whether contracts for a big road tunnel called east-west link can be torn up. This is a specific kind of sovereign risk, unlike the mining tax issue, where the sovereign is also party to your contract.

But the way governments work these days is in partnership with companies. From welfare to infrastructure via defence and health, government has become more and more entwined with private sector suppliers and implementers.

Governments should avoid flip-flopping, because it will raise the cost of contracting. But where policy change is desirable, changing contracts is also desirable. To fetishise sovereign risk is in many cases to say that policy change cannot happen.

If we make sovereign risk our key yardstick, a horrible political trick will become possible.

Say Labor is about to lose an election and the Libs are promising some expensive policy. All Labor has to do is enter into an expensive contract the Liberals have to honour. Then the Libs can’t implement their promise without going into debt. Liberals look bad, Labor gets back into power.

The Age has found experts who say tearing up the contract for the east-west link would not be a big issue: “Labor could tear up East West Link contract if it wins election”

To me that is obvious. There’s a big difference between cancelling a contract before any work has been done, and reneging on paying a bill after the fact. The latter is clearly bad for a state’s reputation. The former should be acceptable, given some compensation for preparatory work.

The Greens say they’d tear up contracts. Labor says that even though it opposes building the $8 billion road, it would honour the contracts. (The latter position is seen by some as a way of Labor eating their cake and having it too. They don’t actually want to be seen to deprive people of a new road.)

Sovereign risk in contracting with the government is one thing. But blaming the government for changing laws that hurt your business is another.

Anyone doing business in a democracy should know the law is fluid. A smart person can tell what laws might be about to change. (Tobacco supply laws – likely. Tariffs on textiles and clothing – unlikely).

Just as people manage their lives through changes to road rules and tax laws, so companies must manage their business around possible law changes. If a business exists to exploit one small loophole, like selling fireworks in the ACT, then their cost of capital should be higher than a business like Woolworths that will be more resilient to any single legal change.

Of course, changes to law can make investments worthless.

Of course prospective changes to law raise companies’ risk, and thereby their cost of capital.

Of course companies will try to make the legal environment as stable as possible –  that delivers the biggest bump to their bottom line.

So of course they want to make the concept of sovereign risk current and valid.

We see this most vividly in the provisions of the trans-pacific partnership, a proposed trade deal that could let multinational entities sue the states in which they operate for any law change that hurts their investments.

But these companies should remember why they are headquartered in New York and Sydney, not in Beijing, or Havana. In the long run, a functioning democracy is the best environment for stable investments, and in a fast-changing world, policy change needs to be rapid too.

The real sovereign risk is that people are no longer sovereign.