Thursday, February 21, 2013

CAG and the Delhi Metro Rail

The Times of India reports that the CAG has found fault with the DMRC for causing loss to the public exchequer in the execution of the contract for construction of the Delhi Airport Express Metro Link (DAEML). The project was executed on PPP mode through a consortium of Reliance Infrastructure and  Construccionesy Auxiliar de Ferrocarriles, SA (CAF) of Spain. I have mixed views on the CAG's latest exposure. 

1. The CAG points out instances of non-contract concessions and dilution of statutory regulations in the contract provisions which benefited the concessionaire over and above that allowed in the original tender. For example, it points to the concessionaire benefiting by about Rs 30 Cr through customs duty concessions on capital equipment worth Rs 990 Cr imported for the project. It also points out that the project was awarded despite the concessionaire arranging only 46.17% of the total cost through its equity and debt and the government financing the rest, whereas the PPP guidelines mandate a 40% cap on government spending. 

If, as appears to be the case, these two concessions were given outside the scope of the original tender, then it would constitute a clear financial benefit for the concessionaire. Furthermore, despite the contractual stipulation of 70:30 debt:equity ratio for the concessionaire, the ratio was 4,3218:1, 230,907:1 and 275,205:1 for three financial years between 2009-12. This clearly benefited the concessionaire by boosting its return on equity. More importantly, it leaves the concessionaire with too little skin in the game and sets the conditions for engendering moral hazard, especially when the project runs up against market risks induced commercial viability problems. This moral hazard gets amplified by the fact that most of the lending would have come from public sector banks as project finance loans. 

These findings highlight the moral hazard created by the attraction of non-contractual gains and the possibility of contract re-negotiations in large infrastructure projects. Contractors bid aggressively to bag the project in the firm assurance that they can make handsome profits by using their influence to either skirt around contractual obligations or re-negotiate provisions that adversely affect them. I have blogged about this pernicious trend here, here, here, and here

2. But the CAG's observations about failure to levy penalties (or liquidated damages) for construction delays may be questionable and is certain to contribute towards further policy paralysis. Construction delays, especially those involving short time periods, while theoretically objectionable, most often tends to get condoned due to practical implementation issues. Such delays occur mostly because of site handing over and other problems, which are more likely beyond the control of contractors. 

Further, the execution of any large contract is accompanied by several operational decisions, some of which involve financial implications (though only a minuscule proportion of the contract). Requests for time extensions and non-imposition of liquidated damages for failure to meet pre-defined milestones are commonplace in large contracts. Similarly, all projects involve repeated invocation of cost escalation provisions. All such decisions are judgement calls, made on the basis of appreciation of some evidence which cannot be easily quantified, by field engineers. If we examine all such decisions post-facto from the narrow lens of financial costs and benefits, without appreciating the context in which the decision was taken, most of these decisions will end up as audit objections. 

If this precedent is established, it will adversely affect the progress of all major projects. Engineers and officials will play safe and simply refuse to take operational decisions. This will in turn affect the contractor's commercial viability and create undesirable incentive distortions.

Update 1 (1/7/2013)
The tortured relationship between Reliance Infra's SPV DAMEPL and the DMRC finally ended with the DMRC taking over operational control on the 22.7 km long Delhi Airport metro link. This followed the DAMEPL's unilateral termination of the concession agreement in October 2012 citing the DMRC's failure to repair the substantial defects in the civil structure designed and built by DMRC. 

DAMEPL claims that it had given adequate notice to DMRC to rectify the defects. It argues that the terms of the concession agreement obligates DMRC to pay DAMEPL a termination payment equal to 130% of the adjusted equity and 100% of the debt due for the project, as the termination has arisen owing to DMRC's event of default. This could amount to an estimated Rs 2800 Cr.

1 comment:

KP said...

Dear Gulzar,

Entirely agree with comment 1, as to 2, a reaction to your observations

"But the CAG's observations about failure to levy penalties (or liquidated damages) for construction delays may be questionable and is certain to contribute towards further policy paralysis....if we examine all such decisions post-facto from the narrow lens of financial costs and benefits, without appreciating the context in which the decision was taken, most of these decisions will end up as audit objections.

If this precedent is established, it will adversely affect the progress of all major projects. Engineers and officials will play safe and simply refuse to take operational decisions."

My view and understanding

R1. The CAG can go by the book (applying laws and contractual conditions as stated) or /and make observations within and outside the scope of the stated conditions.

R2. The contractual conditions themselves can be found stifling for the govt or private contractor - or what can also be the case, the parties collude to create generous contractual conditions that defeat the norms of efficiency.

R3. This audit is a review of work - and to expect that it is not post-facto is unreasonable.

Any reasonable judgement of the situation can identify whether the problems are of the kind in response 2 (R2), and assess the situation accordingly.

A summary of critiques of the CAG leads to a situation where the CAG is now criticised both for going by the book as well as going beyond the scope of the book!

It is likely the CAG is swamped having to repeatedly pull up the government. But, considering the state of our governance it is not surprising. However, this is now being politically painted as a problem of CAG extending its mandate / or functioning with a political agenda.

Meanwhile the CAG has articulated the direction of the institutional mandate of the audit institution in government http://www.ndtv.com/article/india/govt-auditor-cag-vinod-rai-s-speech-at-harvard-kennedy-school-327674

I like to reiterate what I may have said in an earlier post - that officers doing their jobs responsibly have no reason to fear an audit - but if we cry wolf about policy paralysis everytime the CAG makes an observation, we may have a larger cause to fear an executive that creates (has nearly created ?) conditions where policy mandates are grandiose but the goals easily perverted.

Policy paralysis is"where we are" with or without the CAG - we cannot confuse the existence of a policy or a stated intent in itself as progress, we have always been stymied by the perversion of its delivery and that is where the CAG's role is vital - as always checks and balances should be welcomed including for the CAG.

regards,KP.