Megabang for megabucks: driving ‘better value’ on megaprojects

The Grattan Institute’s most recent report on the transport sector Megabang for megabucks: Driving a harder bargain on megaprojects caused quite a stir when it was released two months ago – mostly because of its opening sentence:

Taxpayers end up paying too much for major road and rail projects in Australia because governments don’t drive a hard bargain on contracts with the big construction firms.

The controversy was not around the suggestion that taxpayers end up paying to much.  Most industry participants accept this part of the proposition, even those responsible for ensuring taxpayer money is spent wisely.  

Rather the controversy lay in the suggestion that this was because governments don’t drive a hard bargain on contracts with the big construction firms. 

The controversy is useful because of the interest it generates in the Grattan Institute’s recommendations, most of which I fully support.  The purpose of this article is to express my alternative views on why Australian taxpayers are paying too much for major transport infrastructure and why Australian governments should adopt the Grattan Institute’s recommendations (subject to some minor adjustments).

Competitive tender processes

Most government contracts for infrastructure projects are ‘fixed price’ contracts that are competitively tendered.  The Grattan Institute isn’t suggesting that the tender processes that governments run aren’t leveraging the competitive process to get the best possible bargains.  Rather, it’s suggesting that governments allow these bargains to unravel by not enforcing the contract.  This is controversial, and I’ll return to it shortly.

The Grattan Institute also suggesting that governments could get better bargains by ceasing the practice of awarding some contracts without a competitive tender process, or without one that it open to all.  This is less controversial.

Not enforcing contracts

The Grattan Institute’s suggestion that there is a culture within governments of not enforcing contracts is unfair.  In my experience, there is no such culture (although I have seen isolated instances).  Rather, my experience is that government contract managers often apply a completely inflexible approach to enforcement and compliance when a more flexible, nuanced approach would deliver a better long-term outcome for government.  Often, this is because they don’t have the authority, experience or confidence needed to adopt a more sophisticated ‘give and take’ approach.

The true nature of a ‘fixed price’ construction contract is often misunderstood.  In reality, the fixed price in a construction contract is never 100% fixed – there are always circumstances that will entitle a contractor to an adjustment to the initial contract price, such as:

  • a failure by the government to provide timely site access, or to fulfil another of its obligations; or
  • variations requested by the government.

The main reason why approximately 25% of projects end up costing taxpayers more than government promised when the contract was signed is because the contractor was legally entitled to an increase to the contract price under the terms of its ‘fixed price’ contract.

Of course, sometimes the final price paid to the contractor exceeds the initial contract price for other reasons, such as:

  • the contractor seeks to renegotiate the contract price after the contract is signed for reasons other than those that entitle it to an increase; or
  • the contractor successfully claims damages from government due to a breach or other wrongful conduct by government in connection with the contract. 

If government agrees to settle a claim for an amount that can’t be justified, or agrees to adjust the contract price by an amount that exceeds the adjustment to which the contractor is entitled, then government can be rightly accused of failing to enforce the contract.  However, damages awarded by a court, arbitration tribunal or independent expert cannot be said to arise from a failure by government to enforce the contract. 

In my view, the Grattan Institute appears to have conflated these two scenarios.

Are competitively tendered fixed price contracts appropriate for mega-projects?

Most industry participants and commentators, including the Grattan Institute, consider that the practice of competitively tendering fixed price contracts places downward pressure on the cost of mega-projects. I think fixed price contracts end up having the opposite effect, and place upward pressure on the cost of mega projects. I recognise this is counter-intuitive, so let me explain why.

There is no doubt that the competitive bidding process by which most contracts for major projects are awarded drives the initial contract price down.  It’s also a very effective tool for transferring risk. 

Government procuring agencies are highly adept at conducting parallel negotiations with two or more competing bidders, as part of the bidding process, to get them to improve their offers, whether that be the price, the risk allocation, or the proposed scope or quality of the works. The pressure on tenderers for mega projects to keep ‘sharpening their pencil’, in order to win the tender, is immense.  Each bidder will have invested millions bidding for the project, and there are no prizes for coming second.

Hard-to-price risks end up under-priced

It’s around the risk allocation that this competitive pressure has the most impact, as the government will typically ask tenderers to accept a bunch of risks that are hard to quantify, such as:

  • unforeseen ground conditions,
  • adjustments to third party utilities where scope, cost or timing of the adjustment works is controlled by the third party; and
  • changes in law.

Providing a single fixed price for these risks is fraught because the costs that the contractor will incur if the risk materialises tend to vary widely depending on the impact the risk has on the works. The best-case scenario might be no or minimal additional cost or delay, but the worst-case scenario could cost hundreds of millions of dollars and/or many weeks of delay. If you fully price for the worst-case scenario you will surely lose the tender. Indeed, if you fully price for the most probable scenario, you probably lose because one of your competitors will under-price the risk in order to win the tender. So, the winning tenderer will almost certainly under-price these risks, and the government has great deal at the time it signs the contract.

The bargain achieved at contract award unravels during the delivery phase

If government can hold the successful tenderer to the deal through the contract delivery phase, taxpayers will get outstanding value for money because of the risk transfer achieved.  But this is a big “if”.  Unfortunately for government, the commencement of the contract delivery phase is the point at which competitively tendered fixed price contracts start to work against governments’ interests causing the deal to unravel.  And it’s the commercial incentives that the fixed price contracts create post award that cause the deal to unravel.

Fixed price contracts are not well suited to complex mega projects

Fixed price contracting has many benefits. It’s simple, well understood and provides a higher degree of price certainty at the time a contract is signed compared to other remuneration models. But it is not well suited to mega projects.  Let me explain why.

Obstacle to collaboration

Firstly, fixed price contracts are an obstacle to the cooperation and collaboration that is needed to successfully deliver complex mega projects.

Mega transport projects are inherently complex, due to the need to integrate different systems from different suppliers, in order to make the entire project work.  For example, to make a new Sydney metro line work there is a need to carefully interface many complex systems including:

  • the tunnel systems (fire, lighting, ventilation, hydraulics etc),
  • the track system,
  • the rail systems (signalling, train control),
  • the traction power system,
  • the other electrical supply systems,
  • the trains,
  • the stations and station systems (building management systems, vertical transport, platform screen doors, communication systems, electronic ticketing system),
  • the stabling and maintenance facility, and
  • the security systems. 

Most of these systems are manufactured by different suppliers, and they all need to be installed and integrated with one another and the civil construction works to make the entire metro system work.  This requires the different suppliers and contractors to cooperate and collaborate with one another, to work out who plugs one system into another, and what the other needs to have done to enable the plugging to occur.

The cooperation and collaboration activities cost money and take time.  Under a fixed price contract, every dollar of additional cost means one dollar less profit for the contractor.  Every minute they spend on such activities is one minute less that they have to complete their scope of work on time.  So each contractor and supplier of the different system will want the other interfacing contractors and suppliers to do the cooperating and collaborating.  There is no incentive or reason for any of them to do anything beyond what is contractually required of them, even if doing so will deliver cost savings or other benefits to:

  • the government,
  • the government’s other contractors, or
  • even the relevant contractor’s subcontractors.

Accordingly, when it becomes necessary for interfacing contractors to cooperate and collaborate with one another, each will only do so to the extent necessary to fulfil its contractual obligations.

Of course, government can include in its contracts an obligation on each contractor to cooperate and collaborate with the others, but this doesn’t solve the problem because such an obligation is hard to enforce.  When is the obligation discharged?  How much cooperation is enough?

So, fixed price contracts are an obstacle to the cooperation and collaboration that is needed to successfully deliver complex mega projects.

No incentive to minimise the cost of variations

Fixed price contracts also provide no incentive for non-owner participants to minimise the cost impacts of any government-initiated variations. Rather, they provide an opportunity for the other project participants to charge ‘monopolist’ prices for the additional work, as it is usually impractical for the government to competitively tender the extra work. Indeed, this is the mechanism through which contractors who under-price risks to remain competitive hope to recover their profit margin.

The absence of an incentive on others to minimise the cost of government-initiated variations is not a problem for government if it doesn’t initiate any variations. But for complex infrastructure projects that involve the integration of different systems and third-party interfaces, it is almost inevitable that the government will need to initiate variations in respect of the interfaces to make the project work.

The negative impacts of fixed price contracting are under-appreciated

So, while the practice of competitively tendering fixed price contracts generates great deals for governments at the time they sign the contracts, they create financial disincentives to the behaviour that government needs from the various non-owner participants to make the entire project work, on time and to budget, and minimise the cost of variations.

I think many people within government don’t fully appreciate the negative impacts that fixed price contracts have on complex mega projects. 

The payment regime should be re-wired

What governments need to do to get better value for taxpayers is to develop more sophisticated commercial frameworks that better align the commercial interests of the other project participants with the whole-of-project outcomes that the government is wanting to achieve.

More specifically, governments should rewire the payment regimes in the contracts so that the profit margin that each project participant is entitled to is set by reference to how the project performs against the desired outcomes.

The project outcomes that deliver value to government if done well, or that that destroy value if done poorly, differ from project to project, but commonly include:

  • minimising the costs government incurs in getting to completion or, better still, optimising the costs that government will incur over the life of the project once operating and maintenance costs are accounted for;
  • timely or early completion of construction;
  • happy stakeholders;
  • better than business-as-usual (BAU) sustainability or environmental outcomes;
  • better than BAU training, skills development and diversity outcomes;
  • better than BAU involvement from local industry, or Aboriginal owned businesses.

If you link the contractor’s profit margin to optimising its performance against these outcomes, rather than minimising its costs, then the contractor will be incentivised to do the former.

I say optimise, rather than maximise, because the desired outcomes often compete against one another.  Better performance against a non-cost outcome, is often achieved to the detriment of the cost outcome.  So, the objective for the contractor is work out the overall outcome that will maximise its profit margin and aim for that.

But linking the profit margin of each project participant to how the participant performs against these outcomes in relation to its scope of work, rather than the entire project, will only incentivise each participant to optimise performance in relation to the scope of work it is responsible for.  The optimal outcomes for one contract package, may cause sub-optimal outcomes (e.g., additional cost or delay) for other packages, leading to a sub-optimal outcome for the project as a whole.

To incentivise each participant to optimise the performance of the entire project across the outcomes that government is seeking to achieve, government needs to link the profit margin of each project participant, not to how that participant performs in respect of its contract package, but rather how the project as a whole performs against the whole-of-project outcomes government is seeking.  Only by doing this will government get each participant to make ‘best for project’ decisions. 

Each participant can be trusted to make ‘best for me’ decisions, so by linking each participant’s profit margin to the whole-of-project outcomes government is seeking, government can financially incentivise them to do what’s best for the project and thereby achieve better value for taxpayers.

Are Australian governments engaging in ‘corporate welfare’?

The Grattan Institute says Australian governments are too sensitive to the concerns of the engineering construction sector regarding low profitability, and that it is difficult to see why governments should be contemplating ‘corporate welfare’ to the sector.

The Grattan Institute is rightly sceptical about industry claims of a ‘profitless boom’, given to low level of transparency around the profit levels that contractors generate on particular contracts or projects.  Private sector industry participants are always looking for ways by which they can increase their profits. If they can do so by convincing governments to pay more than is necessary for a project, then they will.

But the Grattan Institute’s suggestion that governments are wanting to pay more for projects then they should, as a form of ‘corporate welfare’, is off the mark. Governments want an industry that can deliver government’s infrastructure needs efficiently and economically. Governments understand that private sector firms need to make an adequate return on their shareholders’ equity to remain in business. The industry is asserting that governments’ practice of competitively tendering fixed price contracts for mega-projects with unquantifiable risks is unsustainable because it encourages tenderers to under-price the unquantifiable risks, resulting in unsustainably low levels of profitability.

Whether profit levels are unsustainably low hard to tell, given the level of transparency that firms provide on the profitability of individual contracts.  Ordinarily, one would expect the shareholders of firms that continually tender unsustainably low prices would eventually stop them from doing, but there’s not a lot of evidence of this happening. Perhaps that’s because profit levels aren’t as low as contractors suggest?  If profit levels are unsustainably low, should governments simply allow market forces to correct the issue?  Or would the failure of one of our top tier contractors cause so much disruption that governments are justified in taking other action to address the issue?

The economist in me agrees with the Grattan Institute’s suggestion that governments should let market forces correct the problem and allow individual firms to become insolvent.  But the political observer in me says governments will want to do what they sensibly and justifiably can to reduce the risk of one of our top tier contractors becoming insolvent.  The actions that the NSW and Victorian Governments are taking or proposing to improve the engineering construction sector suggests that the politicians will prevail over the economists on this issue.  But such actions need not, and should not, include ‘corporate welfare’.

Recommendations

Although I take issue with some of the reasoning supporting the Grattan Institute’s recommendations, I nonetheless support all of them, subject to the following:

  • First, and most importantly, I would add to the Grattan Institute’s recommendations regarding more systematic approaches to determining the optimal bundling of work packages and selecting the contract type for each package.  In my view, governments also develop more detailed guidance on:
    • the downsides of fixed price contracts for complex mega-projects; and
    • how to develop payment regimes that better align the commercial interests of all key project participants around the project objectives that government is seeking to achieve.

  • Second, the Grattan Institute has wrongly conflated:
    • claims made by contractors in accordance with the contract for an increase to the contract price and/or an extension of time due to the occurrence of an event that entitles them to make such claims; with
    • requests by the contractor to renegotiate the contract price after the contract is signed for reasons other than those that entitle it to an increase; and
    • claims by the contractor for damages arising from a breach of contract or other wrongful conduct by government in connection with the contract.

Accordingly, I suggest that governments should only implement the Grattan Institute’s recommendation regarding the involvement of state auditors-general in the latter two scenarios.

  • Third, the Grattan Institute recommends that governments should coordinate their own schedules and collaborate with neighbouring states to minimise costly bottlenecks.  But it concedes that more coordination and cooperation across state lines is unlikely for so long as project selection remains so highly politicised.  I agree.  Mechanisms are needed to help de-politicise the project selection process.  The Grattan Institute previously recommended, in an earlier report, that governments should refine the legislated role of their infrastructure advisory bodies so that, before funds are committed to a project valued at $100 million or more, the infrastructure body assesses the quality of the business case and publishes its assessment on its website.  Such a mechanism would be a good start.

Conclusion

Rather than drive a harder bargain by trying to hold contractors on transport mega-projects to their competitively tendered fixed prices, governments should instead drive better value by adopting more collaborative forms of contract that, amongst other things, replace the fixed prices with payment regimes that better align the commercial interests of all key project participants to the government’s project objectives.

 

 

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Owen Hayford

Infrastructure lawyer

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