Friday, June 13, 2014

Construction risks and Thames Tideway

I have blogged many times about the challenges posed by construction risks with complex infrastructure projects. London has two of the most complex of such projects - the Crossrail, under execution, and the Thames Tideway (or "super sewer"), being planned. Like with all such mega-projects, both have been at the center of controversies over its economic benefits, financing sources, ownership structure, and so on.

The super-sewer project is a £4.2 bn project involving a 16 mile (25 km) long tunnel, mostly running about 30-70 m under Thames River, intended to provide storage and conveyance of 39 mt of combined raw sewage and rain water discharge that currently flow untreated into Thames. The 7.2 m diameter tunnel will collect combined sewer overflows from 34 discharge points and convey it to a treatment facility before its release. Its construction is expected to start in 2016 and be completed by 2023. 
London's 20000 mile sewerage network, mostly constructed in 1860s by Sir Joseph Bazalgette following a series of cholera outbreaks, is managed by Thames Water, owned by a consortium led by Macquarie. The super-sewer will be the largest addition to the network since. The entire cost of construction is proposed to be ultimately collected by progressively raising the sewerage tariffs on Thames Water's existing 14 million customers. 

The standard approach to building such massive and complex utilities projects has been through public procurement. However, since this project would have to be integrated with the Thames Water's ongoing contract, it was proposed to keep them closely involved. Therefore Thames Water was entrusted with its execution.  

Since it had limited construction experience, Thames Water has proposed an innovative financing plan. Instead of balance sheet financing, Thames Water proposes to set up a company that will own the tunnel and receive a license from the water regulator, Ofwat. Thames Water will contribute £1.4 bn towards the cost of the project while the rest is being sought from pension, insurance, and sovereign funds. The company will be responsible for overseeing procurement and raising bank debt. As aforementioned, the investors will be repaid by the incremental tariffs collected from existing customers. 

Construction risks are considerable with such projects. Apart from engineering risks associated with drilling under the river, there are the always present time and cost over-run risks. Already the cost of the project has risen from £1.7 bn in 2004 to £4.2 bn today. And this estimate is most likely to be revised upwards when the contract is finally bid out, and repeatedly revised during construction phase due to unexpected contingencies. 

The risks associated with a complicated construction phase and its seven year duration are being sought to be mitigated through a couple of ways. One, the investors will receive earnings from the beginning, even as construction starts. Their payment will be made from an 11 percent increase in customer bills - upto £80 a year - over the rest of the decade. Two, though details are not clear, the investors are sought to be compensated with a 12-13% IRR. Three, the UK government will act as a backstop or insurer to the project, bearing the brunt of any exceptional cost overruns or incidents during the construction. 

This financing pattern naturally raises several questions. One, since Thames Water is only a procurer of construction contracts, it has limited incentive to undertake the most efficient design to keep the price and life-cycle costs down. Two, the massive construction risks, even with the government backstop, would obviously raise the cost of capital, as demanded by private creditors. Three, the near certainty of cost overruns means that the construction cost will be higher and most likely to vest on the government. 

In addition to all these risks, there are doubts about whether the project is necessary at all. Its economic benefits are estimated at £3 bn. However, a recent estimated by the same engineer who recommended its construction in a 2005 report, has put it at just £180 m. Two observations on the project

1. A more practical approach to risk mitigation in such projects would be to do a scenario analysis. Different scenarios, based on a few construction/engineering risk materialization, can be modeled. This is a more realistic strategy to assessing the spectrum of risks associated with such complex projects. It would help all stakeholders to better prepare for the materialization of those risks.  

2. The major reason for private financing of infrastructure projects, despite its higher cost of capital, is that it enables incentive compatibility between the construction and O&M contractors and thereby allows for minimizing life-cycle costs. The proposed financing pattern and structuring of the project does not appear to achieve this objective. It effectively uses private finance to construct the project and then transfer its operation to the incumbent private provider. This results in not only a higher cost of capital but also does not align the incentives of the construction contractor with that of the O&M contractor. A more prudent approach in the circumstances would have been to use public procurement and then transfer it to the O&M contractor, Thames Water. 

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