London's 'Big Dig'

London's 'Big Dig' is about to start, with contracts to be awarded over the coming weeks. The £4.2 bn super-sewer, being build under the Thames river and one of the most complex infrastructure projects in the world, has several unique contracting features. The construction work on the project being built by Thames Water, London's privately owned water utility, through its special purpose vehicle, Thames Tideway Tunnel, is set to start in 2016 and will take seven years to complete. Apart from its sheer size (it is spread over 42 sites), the project has several technical risks including potential threat to Big Ben's foundations and flooding of the London metro network. 

Given the size and risks involved, a novel off-balance sheet financing arrangement has been worked out. Thames Water will finance a third of the cost, through the SPV's balance sheet, and the remaining two-third of £2.8 bn will come from a consortium of financiers, Bazalgette Consortium, which includes Allianz, Swiss Life Capital, and Dalmore Capital. The consortium will own, finance, and manage the project for 125 years. In order to pay for the project, Ofwat, the water regulator, and the Government have estimated that Thames Water's 15 mn consumers may need to pay a surcharge on their water bills, of upto £80 every year almost in perpetuity. Interestingly, the surcharge will become operational from the date construction begins, and the investors will therefore receive income from the beginning. This, coupled with the high tariffs and the long, almost a perpetuity, contract tenure provide the project's financial risk mitigation. Further, construction risks are mitigated by a few government guarantees, including accidents at project sites, meeting the insurance costs not covered by markets and also any "exceptionally large cost over-run". 

As critics have pointed out, the cost of capital for the consortium is certain to be much higher than would have been the case if it were constructed with public borrowing. Given that construction problems cause mega projects to become "over-budget, over-time, over and over again", whether done with public or private financing, the final cost of the project once construction is completed is most certain to be much higher than its current estimates. Would that result in an increase in the surcharge?

Further, the case for public financing followed by contracting out long-term once the construction risks are off-loaded becomes even stronger given that the government is already assuming constructions risks thereby limiting the project developer's incentives for on-time delivery. If the construction contract is given out as an Engineering Procurement Construction (EPC) contract and once constructed given out on a long-term operation and maintenance concession, the private sector efficiency gains could just as well have been captured, and at a lower cost of capital.