Tag: #ewlink

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. 

Screen Shot 2015-02-06 at 1.07.08 pm

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.

“Tearing up the contracts” for the road tunnel means there is an actual difference between the political parties. Wow!

The state opposition here in Victoria has just announced it will cancel the contracts for an $8 billion tunnel if it wins the election in November. (While it’s true there’s often a big traffic jam on the road in question, the tunnel fails both cost-benefit analysis and any assessment of what sort of infrastructure the city will need in the future).

THE POLITICS

Deciding to cancel the contract is a bold call, and I suspect, the result of intensive polling. Of course, the government saw this coming, and has a strong line of attack running, calling opposition leader Daniel Andrews an economic “vandal.”

In pledging to cancel the contract, Andrews leaves open the question of what he might do instead, and he doesn’t seem to have much of an answer.

Of course Labor doesn’t want to make new giant policy pledges, before the election. The end of the road project would mean, however, that some money becomes free.

 

Labor still has as part of its election platform the construction of a major rail tunnel – “Melbourne Metro”. Both parties are pretending these two mega-projects are not alternatives, with the coalition government pretending to progress the rail project alongside its favourite road. But realistically, the expense and trouble means the projects are an either/or. Cancelling the road contract is an essential input to building the rail project, it’s just that Labor can’t really admit it.

Assuming the “vandal, Naysayer” tags don’t stick, and the lack of a clearly defined alternative doesn’t hurt Andrews much, I think this is smart politics. Voters like a clear choice and the sniff of real leadership.

The seats that would benefit from the tunnel are mainly Liberal strongholds, and I think if Labor focuses on talking about health and education for the rest of the campaign (and especially if Tony Abbott pops his head up) Labor will win the election.

THE ECONOMICS

Promising to tear up the contracts, before they’ve been signed, is a big risk on the part of Labor. 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? Protecting the project and/or hamstringing Labor could both be achieved in the stroke of a pen.

We rely on their good citizenship not to do so. A flimsy protection indeed.

Of course there should be some cancellation provision. A lot of money has already been spent on this project. But from an economy-wide perspective those are sunk costs and we ought to ignore them.

The companies that are selected to build the tunnels will seek sympathy. They will talk a lot about all the investments they have made – hiring people, doing mapping, buying diggers, etc. But we should not listen too closely:

  1. Until just this week there were two bidders in the running for the project. Each of them faced a chance of missing out even if the project went ahead.
  2. The prospect of the project being cancelled was obvious. I bet they haven’t actually made a dedicated unilateral investment in this project for months. Anything they have bought will probably be able to be sold or moved to other projects.
  3. Generous contract cancellation provisions arguably makes this money for jam. When you start building a project, there’s risk of making a loss. When it gets cancelled before you begin, any compensation is pure profit.

The real impact of this cancellation will be felt in future projects. Political parties will have similar incentives to infrastructure companies. Both have incentives to prevent the opposition cancelling the contracts.

If Lend Lease offers Labor a contract for the rail tunnel that includes a slightly lower total cost but enormous contract cancellation provisions, Labor will leap at the chance to protect their project from the whims of future administrations.

There’s game theory at work, and this might be the last chance we have to cost-effectively vote out a project of this kind.