On 22 June Western Australia’s state government scrapped its new Children’s Hospital as a public-private partnership. A joint one-off royalty payment of A$350 million ($314 million) from mining giants BHP Billiton and Rio Tinto will instead fund construction, which starts 2012. The decision has cast a further cloud over Australia’s already patchy PPP pipeline.

The private sector is furious that another state government has scrapped a promised PPP. The Children’s Hospital decision follows the cancellation in 2009 of the $557 million South Australia prisons project, which was to be procured as a PPP, and the cancellation of New South Wales’ $3.5 billion CBD metro rail project in February this year. The fact that the cancellations are not confined to a single state is no comfort.

“Even the very thin pipeline we have is subject to some disruption,” said Graham Brooke, a partner in KPMG’s corporate finance division. “If we’re not careful the pipeline will be so thin that people will not be willing to invest in building up the bid teams necessary to put forward good submissions.”

Australia’s patchy PPP pipeline, along with steep bidding costs, are major stumbling blocks to the development and attraction of more competitors into the market, particularly offshore players that could challenge the dominance currently enjoyed by a handful of local companies.

The issue has come to a head with the release of a KPMG report, “Review of Barriers to Competition and Efficiency in the Procurement of PPPs”. The report was commissioned by Infrastructure Australia, a statutory body set up by the Rudd government in 2008 to co-ordinate infrastructure development around Australia.

Infrastructure Australia asked KPMG to provide strategies to address criticism that Australia’s PPP bid costs are too high, that contracts take too long to be awarded, and that a patchy pipeline is a major barrier to entry for new competitors. While the report praised the nation’s PPP market, noting it is “world leading” in many respects, it called for action to address the toxic combination of high bidding costs and uncertain PPP pipelines, including a commitment from governments to the PPP model.

The report is now being assessed by the Council of Australian Governments’ (COAG) Infrastructure Working Group, a high-level group of state, territory and Commonwealth officials chaired by federal infrastructure minister Anthony Albanese. A response is due soon.

With Australia’s population growing faster than any other developed economy, the federal government believes that the country is facing an infrastructure shortfall. Infrastructure Partnerships Australia, a body that includes public officials and private CEOs, estimates there is an infrastructure project backlog of A$700 billion. It thinks that PPPs need to help address those infrastructure needs and deliver large and complex projects efficiently.
Is the effort worthwhile?

But lenders and sponsors are sceptical that Australia’s state governments have enough commitment to PPPs to address the problems outlined in the report and cut bidding costs and improve pipeline transparency necessary to attract more foreign players.

The Infrastructure Australia-commissioned report follows long-held criticism of how infrastructure in Australia is procured, including high bid costs, particularly from the private sector – criticism recognized as valid by the Government. “Bid costs have long been identified, particularly by contractors, as an issue that requires some focus,” said Brendan Lyon, executive director of Infrastructure Partnerships Australia. “There’s agreement and understanding that large bid costs are largely a result of design innovation and reflect the scale and complexity of projects. The thrust of the report is we can make valuable adjustments in terms of the way projects are bid which will result in lowering bid costs.”

But Lyon says the report also indicates that government would find the private sector more accepting of high bid costs if it was sure of long-term PPP opportunities. A more transparent PPP pipeline would give the private sector more confidence to launch expensive bids on projects because, even if they lost that bid, they could be confident of spreading the costs and risks by winning other projects later.

On the face of it, Australia’s PPP market is world-leading. The KPMG report recognises this and highlights an OECD report in 2007 that ranked Australia as the world’s most mature PPP market, ahead of the UK and Canada. But it warns there is room for improvement and other countries are catching up, which could suck competitors and resources out of Australia “Canada has gained in reputation and number of transactions in recent years,” it says.

Australia, the report indicates, should be looking at Canada rather than the UK as the market to beat. The KPMG report says the time to procure contracts in Australia is 17 months on average, compared with 16 months for Canada and 34 months in the UK. It found that bid costs typically run to A$2.5 million for projects worth A$250 to A$300 million; A$5 to A$6 million for a A$1 billion hospital; and A$30 million-plus for a A$2 billion-plus economic infrastructure project.

Bid costs in Australia are on average 25% to 45% higher than in Canada for similar sized projects, but significantly lower than in the UK. This reflects, in part, that PPPs in Australia are usually larger than in comparable countries. But “there are some inefficiencies in the process,” Brooke said. “For example, there have been occasions where on PPP projects there has been a requirement for too much detail, particularly in the design process.”

But the KPMG report found the biggest challenge in the Australian market is the relatively small number of PPP projects compared with Canada and the UK. These two markets, by putting some, if not all, of the public policy debate behind them, can ensure a steady stream of business, while potential sponsors of Australian deals debate whether the market has any potential. “That can deter new entrants from establishing the capability to go head to head with the existing highly competitive field of bidders,” Brooke said.

Trying to test the pipeline

There are a number of PPP projects out to bid in the Australian market: the Royal Adelaide Hospital, for which two consortiums have been short-listed; the A$1 billion Parkville comprehensive cancer centre in Melboure; the Gold Coast rapid transit project in Queensland; and the Mundaring Weir water supply improvement project in Western Australia.
But the outlook beyond these deals is uncertain. “In terms of pipeline we do have that uncertainty as to what’s coming up in 2011,” said Geoff Daley, head of infrastructure advisory at Royal Bank of Scotland. “We have a feeling about what’s going to happen but nothing that’s decided or announced.”

Daley says in Western Australia, after the cancellation of the Children’s Hospital, there are a prison and hospital car park mooted as PPPs; in Victoria, Parkville is the only known PPP, though Daley says others are being looked at. “NSW has no pipeline of any sort,” Daley notes, while Queensland only has the Gold Coast rapid transit project and no prospective pipeline after that.

The question is: why is the pipeline so patchy? Brooke says while there are national guidelines for PPP projects, there don’t seem to be any positive incentives for State Governments to take projects forward as PPPs. “Departments are defaulting to traditional processes, which is traditional procurement,” he said. “They’re reverting to what’s easier in terms of procurement.”

Brooke believes that projects over a certain size and nature should progress as PPPs in the absence of any evidence they should take another route. “It has been well proven for hospital projects in excess of A$200 million, for example, that there are huge value-for-money savings made by going down the PPP route,” he said. “We believe that if a department doesn’t want to go down the PPP route the onus should be on the department to prove the PPP won’t work. At the moment it’s almost the opposite.”

John Bowyer, CEO of Capella Capital, a Lend Lease-backed financial sponsor and developer, says “most [state governments] come and say they have a PPP policy, but they tend to lack an absolute commitment to that policy,” he said. “They need to ensure they have got a pipeline with transparency. It’s pretty much what Victoria does – looking at the time transactions will be brought to the market and trying to sequence those transactions. Other states are very much ad hoc and often fail to deliver according to timetables.”

Infrastructure Partnership Australia’s Lyon said NSW in particular, and despite being the nation’s largest economy, has a very variable approach to PPPs, with no consistency in terms of project priority. “There’s a lack of transparency for the private sector,” he said. “One of the things that industry and many governments would like to see is a move towards a more nationally consistent way of planning over the long term.”

The cancellation of the Children’s Hospital in Western Australia has particularly angered the market, especially as the state had been lauded as pro-PPP by many players. “There has been a lot of rhetoric about a commitment to PPPs (in Western Australia) as the preferred delivery model, but progress appears very slow,” said one industry player who did not wish to be named. “It makes it difficult for the private sector to make serious commitments of people and capital to Western Australia.

The unnamed industry player said former state treasurer Troy Buswell, who resigned in April, was committed to PPPs and PPP policy. “But with him no longer treasurer that commitment seems to have diminished,” he said. “It seems they are falling back to traditional procurement.” But a spokesperson for Colin Barnett, WA premier and treasurer, said the cancellation of the Children’s Hospital as a PPP was a one-off. “We had different circumstances that allowed us to put some more government money into it,” she said, but added that as a general policy “we’re still happy to look at PPPs.”
But the industry player adds that the stated reason for the Children’s Hospital PPP cancellation was puzzling. “The increased royalty deal with Rio Tinto and BHP, which will bring in an extra A$350 million of royalties, will go into the new children’s hospital but there was no mention where the other A$650 million is coming from,” he said. “It is illogical to link mining royalties to a children’s hospital and completely misses the key point of effective risk allocation.”

Equity, old and new

The biggest spur to the development of PPP in Australia was the pressure from superannuation funds for suitable assets to invest in. This pressure is undiminished, even as foreign bidders seek exposure to Australian infrastructure assets, giving the domestic funds a chance to recycle their commitments. But Bowyer says the patchy pipeline was discouraging not just bidders but also investors. “For example, industry super funds want to get involved in PPPs, but when they see a pipeline without transparency, they ask: ‘why would we want to start to invest in PPPs?’” he said.

RBS’s Daley said overseas investors are also being discouraged by lack of pipeline transparency. “It’s an issue particularly when you’re trying to introduce overseas investors and the like who haven’t been in the market before,” he said. “An investor will spend a lot more time on the first deal than the second deal. If they can’t see where the second, third and fourth is coming from it just provides additional doubt.” The Canadian Pension Plan Investment Board, for instance, is anxious for greater exposure the Australian market, but is switching its attention from one mature toll operators, Transurban – to another – Intoll.

Brooke said that improved pipeline transparency would attract overseas players, providing competition in a market dominated by a few major local players such as Leighton. He expects large overseas contractors, particularly European, would enter the market if the PPP pipeline was more certain. “Also potential financers as well, providers of debt and equity,” he said.

How to fix the process

So what needs to be done? When it comes to bid costs the KPMG report recommends changes to the bidding process, including rationalisation of information requests, particularly relating to design; the recruitment and training of high-quality government project team members; and, having one bid stage unless absolutely necessary.
RBS’s Daley says that state governments are already trying to address excessive bid costs: “The KPMG report highlighted a lot of things the industry has talked about,” he said. “We see that governments are trying to respond – trying to be sensible about what they’re asking for, and asking for what they need for evaluation purposes rather than anything more.” But he understands that Governments need to be rigorous when making decisions, while smooth PPP procurements involve “discipline around making decisions quickly, which is hard for government because every decision gets scrutinised to within an inch of its life,”

Improving pipeline transparency, however, could be much tougher than streamlining the bidding process. “It is a big task,” Brooke said. He believes part of the solution is better infrastructure planning. “The infrastructure planning horizon is a bit short at the moment,” he said. “If each state has a 10-year plan, and there was central co-ordination by the likes of Infrastructure Australia, in theory it should be quite straightforward to provide a pipeline of PPP projects – to at least give an indication to the market that over the next 10 years there are those 20 to 30 projects likely to come out as PPPs.”

Bidders and their equity and debt backers could then start to plan around that pipeline. “At the moment it’s almost impossible to plan for a horizon that’s so uncertain” Brooke said, adding that Canada, which has provincial-level procurement, has a more effective planning process, while the UK has a deeper market and therefore more certain pipeline.

Other recommendations the KPMG report makes to improve transparency include:
• The earliest possible announcement of potential future PPP projects
• A more consistent and rigorous application of National PPP Guidelines on criteria for determining if a PPP is suitable for a project
• Greater focus on national co-ordination of the release of projects to the market.

The report has spurred some response in government. Queensland’s minister for infrastructure and planning, Stirling Hinchliffe, said his government is committed to taking action in response to the report’s recommendations. That includes indicating to the market (subject to required approvals) as early as possible the projects that are likely to use the PPP model and to publicise this information on the Infrastructure Australia website; to explore with the private sector opportunities to materially reduce information-related bid costs without compromising the state’s ability to reach a value for money decision; and to co-operate to standardise aspects of the interactive tender process and other best practice initiatives.