Construction Finance, Accounting, and Risk

| June 13, 2016

Question
Construction Finance, Accounting, and Risk

17. Innovative Project Vehicles More Case Studies

17.1 Resources

Pretorius, Frederik, Paul Lejot, Arthur McInnis, Douglas Arner, and Berry Fong-Chung Hsu. (2008).

Project Finance for Construction and Infrastructure.Blackwell Publishing.

Lecture Notes reference Chapters 8-9 of Pretorius et al 2008

17.2 Dabhol Power Project

17.2.1 Setup

In 1992, Indian public sector entered into an agreement with Enron Corporation to build a gas-fired power plant. This project represented the world’s largest independent power project and the largest single foreign investment in India.

17.2.1.1 India

India instituted self-reliance from foreign influence by restricting foreign investment and imposing high import tariffs in order to protect domestic industries. Due to the political and economic climate of the 1990s, India began considering foreign commercial interests to strengthen the domestic economy. In 1991, a program of liberalization began which relaxed control of industrial licensing and opened the economy to foreign investors.

17.2.1.2 India’s Power Sector

The energy sector became open for private investors without restriction on foreign ownership. The power sector was critical to India’s economic development. At this time, power generation in India was not efficient and not capable of meeting the demand. Additionally, consumers would illegally tap into the grid and steal electricity to avoid paying for it. The government induced foreign investment for 8 power sector projects; Phase I of the Dabhol Power Plant was to be the first project.

17.2.1.3 Enron

Enron sought to move into newly privatized non-US markets in the early 1990s by becoming the largest distributor of liquefied natural gas. This long-term plan would set up two liquefied natural gas terminals and would provide a 15% annual return for Enron. As a result, Enron strove to build, own, and operate the Dabhol Power Project. Enron along with General Electric Corporation and Bechtel Enterprises Inc. formed the Dabhol Power Company to provide the gas turbines, engineering procurement, construction contracts, and operations and maintenance. Almost a decade later, Enron collapsed due to falsification of revenue. Enron eventually filed for bankruptcy and was dismantled.

17.2.2 Development of the Dabhol Power Project

Enron visited the project site to gather information regarding the project in June 1992. Enron was awarded the contract by the state government without any competitive bidding. Additionally, the state government did not perform a financial appraisal of the project or enlist independent technical assistance of any kind. The state government and Enron signed a memorandum of understanding regarding the project and each organization’s prospective roles.

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Construction Finance, Accounting, and Risk

17.2.2.1 Project Structure

The Dabhol Power Project was to be constructed in 2 Phases. The first phase would be constructed by December 1997 and the second phase would be constructed by December 2001.

17.2.2.2 Objections

Both Enron and the central government attempted to secure loans from the World Bank; however financial analysis from the World Bank concluded that the Dabhol Power Project did not meet a least-cost test, lacked an overall justification, and the memorandum of understanding favored Enron. Thus, World Bank rejected the central government’s loan application because the project was not economically viable. After review of the memorandum of understanding, India’s Central Electricity Authority also concluded that the document favored Enron due to stipulations.

17.2.2.3 Deal Closed

Despite the objections, the deal was closed in December 1993.

17.2.3 Power Purchase Agreement

The state electricity board was required to purchase power from Dabhol for 20 years regardless of the fact that cheaper fuel sources may exist. The price of energy was mainly dependent upon the exchange rates, oil prices, and the capacity of the plant. This agreement assured the Dabhol Power Company an internal rate of return between 26% and 32%.

17.2.3.1 Phase I Financing

Financing for Phase I of the project was secured in March 1995 and consisted of four main debt financing parts. Central government offered guarantees to attract private sector involvement in project.

17.2.3.2 The Agreement Revised

Before construction on the Dabhol project could begin, an election occurred and the leadership of India changed. The election platforms focused on the belief that dealings with foreigners were a disadvantage to India. A committee formed to review the project and its documents. The committee concluded that competition in bidding for the project was reasonable and the project costs were inflated, just to name a few. As a result, the state government cancelled the project in August 1995. Enron and the government agreed to revise the Dabhol agreement under new terms. Under the new terms, Dabhol Project Company’s annual return on the project was expected to be approximately 20%. The cancellation of the project by the government hindered the government’s efforts to attract foreign investors to India.

17.2.3.3 Phase II Financing

Financing for Phase II was secured in May 1999 with over 40 lenders committing to aspects of the project.

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Construction Finance, Accounting, and Risk

17.2.3.4 Godbole Committee

The new administration created a committee to review Phase II of the Dabhol Power Project. The committee’s findings were opposed by the project’s sponsors and negotiations between the government and Enron failed to reach an agreement.

17.2.3.5 Cash Crises

When Phase I of the project began operations, the government was not able to financially stay afloat, since the government was paying five times more than the price of electricity in comparison to other states. Facing this financial difficulty, the government sold half of its stake to the Dabhol Power Company, which increased Enron’s shareholding in the project. The government and Dabhol Power Company could not come to an agreement regarding financial issues of the project. In May 2001, Dabhol Power Company stopped Phase I operations and sought arbitration. This also halted construction for Phase II.

17.2.3.6 Claims and Settlements

Dabhol Power Company issued a termination notice at the same time that Enron’s fraudulent strategies were exposed. The project was later terminated and the three entities of Dabhol Power Company as well as the government sought to recover their losses.

17.2.4 Epilogue

The government aimed to minimize its financial losses and clear the foreign debts that arose from the project. The settlement enabled Dabhol to be revived and operations restarted in April 2006.

17.2.5 Analysis

Political changes were not anticipated in the Dabhol Power Project. Additionally, each entity, the state government and Enron, were focused on the benefits to that particular entity; the collaboration piece fell to the wayside.

17.3 (reference from Chapter 9) Public Private Partnership: London Underground

The Hong Kong MTR Corporation Limited (MTRC) explored purchasing Metronet Rail in 2007. This problematic rail recently went under a 30 year PPP, which was the largest and most complex private finance arrangement in the public sector of the UK. The government entered into the PPP in order to overcome under-funding of the transportation system and restore the system to its original state. The users of Metronet were dissatisfied with the lack of infrastructure improvements under the PPP contract even in its early stages. MTRC debated their options with the 2012 London Olympics fast approaching. If the Metrorail did not improve as expected a national public relations disaster would ensue for the company; however, if major improvements were made in a timely manner the company would receive unprecedented high-profile media attention.

17.3.1 Two Countries, Two Systems

17.3.1.1 The London Underground

The London Underground Limited (LUL) was cosmopolitan world city and was established in 1985.

critical in the development of London as a The quality of transportation allows a city to

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Construction Finance, Accounting, and Risk

maximize its economic efficiency and quality of life for its citizens. London’s Underground system became antiquated and unreliable by the 1990s. For example, without a second set of bypass tracks for emergency or repair work, trains had to stop running before workers could perform maintenance. Trains were frequently cancelled or broke down. LUL operated the transportation of the Underground, but was deficient in construction and maintenance specialists, resulting in poor service performance and high operating costs. Additionally, costs steadily increased throughout the 1990s, which sparked the need for the PPP. PPP operations began in 2003, yet the LUL only generated 71% of its revenue from tolls; the treasury provided the remained balance necessary to maintain and operate the infrastructure.

17.3.1.2 The Hong Kong MTRC

The MTRC built its reputation in the transportation industry by operating the Hong Kong mass transit railway (MTR). MTRC promises on time trains and satisfied customers with a performance target of 99.5% and each year the company surpassed these performance targets. Additionally, the MTR is one of the few profitable as well as one of the most utilized and efficient metro systems in the world. With this success, the MTRC wanted to secure the opportunity to design, construct, and operate a transportation system outside of China.

17.3.2 Public Private Partnership

17.3.2.1 PPPs in the UK

Private sector participation in public infrastructure followed two models in the UK: PPPs and PFIs. These partnerships began in the early 1990s to secure extra value for money from investments and alleviate the under-investment in public services. These partnerships enabled programs and projects to be funded as well as delivered efficiency savings.

17.3.2.2 Political Sentiment For and Against the LUL PPP

Two different views regarding funding for the Underground diverged according to political parties, Conservative and Labour. Different views revolved around whether to use a PPP. In July 2002, the PPP was allowed to proceed without hindrance of legal proceedings.

17.3.2.3 Structure of the LUL PPP Project

The objectives of the LUL PPP were to raise investment over time, promote value for money, and foster efficiency.

17.3.2.4 A Public Sector Operating Company

The LUL was retained as a public-facing operating company that remained in the public sector and retained its public sector focus.

17.3.2.5 Three Private Sector Infrastructure Companies

The PPP set up three private sector companies to maintain and repair the track, signal, and stations.

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17.3.2.6 Union of Expertise, Division of Duties

The private sector companies maintained control of the assets and their maintenance, renewal, and upgrades; however they did not actually own the infrastructure. 6000 individuals would be transferred to these private sector companies with job protection assurances. Additionally, LUL remained responsible for train operations, staffing, customer services, fare collection, and safety. 8000 staff would continue working for the public sector. Investors were invited to bid for the private sector companies and their associated rights. The partnership focused on the private sector delivering defined outputs, which were linked to key performance measures. This link to infrastructure performance ensured that good performance was rewarded and poor performance was penalized. Additionally, focus was placed on economic efficiency, safety, and asset management.

17.3.2.7 Financial Incentives

Financial incentives were established through contractual arrangement to encourage the private sector to deliver projects on time and within budget as well as ensure that assets were properly managed.

17.3.2.8 Transfer of Risk

The public sector exchanged its own capital to transfer risk to the private sector. The private sector assumed responsibility and risks for delivering specific outputs.

17.3.2.9 Management Expertise

The PPP contract established a detailed plan to manage interactions between the public and private sectors. The public sector brought in management expertise from the private sector.

17.3.2.10 Long Term Planning

The PPP contract established a 30 year contract to provide the private sector with time to make investment decisions as well as procure and manage assets on a whole life basis. Additionally, this time provided the public sector with the opportunity to recover its investments.

17.3.2.11 The Bidding Process

The bidding process began in 1998 and sought bidders with the technical and financial capability to manage the Underground. The bidding process included a market consultation exercise, pre-qualification to bid for a contract, and invitations to tender. In 2001, the preferred bidders were announced. The selected preferred bidders were appointed in 2002 and their operations began in 2003.

17.3.2.12 Tube Lines

Tube Lines was an asset management company responsible for the maintenance and repair of numerous kilometers of track, stations, trains, bridges, structures, lifts, and escalators.

17.3.2.13 Metronet

Metronet was responsible for six lines as well as the modernization of 150 stations by 2012. This project required a £17B investment over the 30 year contract. Metronet was also responsible for the

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Construction Finance, Accounting, and Risk

maintenance and repair of numerous kilometers of track, stations, trains, bridges, kilometers of underground tunnels, crossings, travelators, lifts, and escalators.

17.3.2.14 Contract Commitment and Dispute Resolution

The contracts were based on four performance metrics: lost customer hours, journey time, ambience, and service points. These contracts were to last 30 years with a review occurring every 7.5 years and offered a guaranteed 18% return. Tube Lines and Metronet committed a significant amount of money to improve their respective lines over the first 7.5 years of the contracts. An independent Arbiter, who was appointed by the Secretary of State for Transport ensured that any financial disputes were resolved fairly and quickly.

17.3.2.15 PPP/PFI Performance Developments

The issue of whether the LUL should have been funded by the private sector rather than the public sector remained controversial.

17.3.2.16 LUL Performance Under PPP

The LUL service under the PPP did not meet customers’ expectations, especially with massive overcrowding at peak times, service disruptions, delays, and high profile failures. Each periodic report through 2006 indicated that poor delivery of maintenance and repair had occurred. Specifically, Metronet had not performed in an efficient and economic manner. Since the private sector companies were working under incentives to perform, they faced penalties for their poor performance; however the penalties that Metronet faced were minimal in comparison to the revenues the company received. Additionally, the PPP contract required an enormous amount of labor to monitor and oversee with more than 2000 aspects being evaluated each month.

17.3.2.17 Weighing Up the Risks

Metronet explored its options to partially privatize and bring MTRC into the Underground contract due to the importance of the 2012 London Olympics and the critical role that transportation systems will play at this event. MTRC required an outline of critical issues from Metronet prior to any decisions regarding investing in the Underground.

17.3.3 Endnote

Metronet continues to suffer financial uncertainty as well as operation and cash flow problems. The London Underground contracts had not tested all financial aspects of the venture. This case study illustrates the risk of applying a PPP model to ventures as complex and demanding as the London Underground. This study also highlights the importance of contractual completeness as well as the differences in managerial approaches as well as performance of the two private sector companies.

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