Part 7: Changing to a different kind of project

7.1
In September 2002, the Council had selected a preferred provider, Simon Engineering, and was ready to begin negotiating the final contract. All of the work to this point had been based on a proposed BOOT scheme, under which:

• The private sector partner would build the infrastructure at its own cost.
• The partner would then own and operate the wastewater scheme for 25 years.
• KDC would pay toll payments to the partner once the scheme was operating.
• At the end of the 25 years, ownership would transfer to KDC with no further payment.

7.2
Between September 2002 and the end of 2007, when construction was able to begin, KDC encountered several significant difficulties and many changes were made to the project. This Section examines those five years and assesses how well KDC responded to the changing circumstances. Although the events we describe in this Section often occurred simultaneously, we deal with each issue separately to make it clearer.

7.3
In the Parts that follow, we discuss:

• the steps taken to fund the project;
• the change to contracting with EarthTech instead of Simon Engineering;
• the need to find a disposal site for the effluent;
• the decision to increase the scope of the project;
• other significant changes to the project;
• how the community was kept informed; and
• our overall comments.

7.4
In this Part, we discuss:

• the effect of the enactment of the Local Government Act 2002;
• the advice provided to the PSC on how the project could be reshaped and continue;
• the Council's decision to continue to negotiate with Simon Engineering on a revised basis;
• what the change to the delivery method meant for the proposed contract; and
• our comments.

7.5
In summary, we conclude that the enactment of the Local Government Act 2002 should have prompted a more fundamental reconsideration of how the project was being approached. That is, the Council should have asked whether a PPP was still the best option; if so, what models were now available and their relative merits; what options were available for funding the purchase; and so on. Instead, the Council very quickly decided it could carry on with the current parties, after negotiating some adjustments to the contracting terms. In our view, this decision was based on inadequate information and analysis.

What did the Local Government Act 2002 do?

7.6
During 2001 and 2002, the Government had been working on major reforms to the Local Government Act 1974. A Bill was introduced into the House on 18 December 2001, and one of the many points of public debate was the ownership and control of infrastructure for basic functions such as water services. The Bill was reported back from the select committee on 10 December 2002 with new provisions inserted on this issue. The Local Government Act passed by Parliament in December 2002 stated that councils could enter into contracts to provide wastewater services with private sector entities for only 15 years. Councils also had to own the wastewater infrastructure.

7.7
Effectively, this meant that KDC was no longer able to proceed with the BOOT scheme, which was premised on the private provider owning the asset for the 25-year life of the contract.

Immediate advice to the Project Steering Committee

7.8
In January 2003, Beca and EPS prepared a report for the PSC outlining the major effects of the Local Government Act 2002 on the project and recommending next steps. The advice was that the project could proceed, but it would need to use a different approach. The costs would also change.

7.9
Under the proposed new approach:

• Simon Engineering would build and finance the scheme through the "nominated period".
• Ownership of the scheme would transfer to KDC once it was built and "commercial acceptance" had been achieved (that is, once the scheme had been tested and proven capable of providing the required services to the required standard).
• KDC would have to pay for the scheme at that point.
• Toll payments for operating and maintaining the scheme would be made to Simon Engineering for the remainder of the contract period.

7.10
The report noted that the price for construction would probably increase because Simon Engineering would not be able to take advantage of taxation benefits from owning the assets. The project managers suggested that KDC could offset the increase in costs by using funding from the Government's Sanitary Works Subsidy Scheme (SWSS), which had been introduced in March 2002 to help small communities afford wastewater schemes. EPS later quantified the increased costs as possibly being $530 for each property each year.

7.11
The report also noted that the changes resulting from the Local Government Act 2002 would affect the risk profile that had been previously agreed. The project managers concluded that minor changes only would be needed. The report noted that the requirement to own the asset affected "the extent Council is involved in longer term sustainability of the disposal options".

7.12
Although the report discussed the risk profile, it is not clear that the full risk matrix and allocation of risk from 2001 were reviewed. In theory, the risk allocation under a BOOT type of PPP should differ from the type of contract proposed now. As previously discussed, the allocation of risk can have a major effect on the price.

7.13
Beca told us that a complete risk review was not carried out. However, both Beca and EPS considered that the risks associated with the change in contract type were addressed. Beca told us that the major change was that KDC would not be able to respond to prolonged poor performance by taking ownership of the asset as a remedy of last resort. Instead, it would have to rely on guarantees or sue to recover any losses. We discuss these questions about allocation of risk in more detail shortly.

7.14
The report does not explicitly discuss how KDC would fund the purchase of the scheme on commercial acceptance. However, it seems that the proposal was to fund this through a loan from Simon Engineering/ABN Amro.

7.15
The report considered the effect that the change to KDC owning the assets after the construction period would have on the process used to evaluate the tenders. The project managers considered that the evaluation criteria and weightings used to select Simon Engineering were still relevant.

7.16
The paper recommended that negotiations with Simon Engineering proceed on the basis that the operating period would be for a maximum of 15 years, although the financing for the project could be over a longer period.

The Council's decision to continue negotiations on a revised basis

7.17
The PSC accepted the recommendations in the report from the project managers. The minutes record:

Following this discussion it was determined to progress negotiations with Simons/ABN on the basis of ABN providing competitive risk weighted financing option which would then be compared with a risk adjusted Council borrowing rate.

7.18
The Chief Executive presented a paper to the Council that set out the PSC's recommendations and attached the report from the project managers. This paper stated that:

... [the] Council is able to proceed with a Design, Build, Finance and Operate option with operations over a 15 year term and financing over a term of 15 years or longer, possibly 30 years. However, this does mean that Council's Treasury Policy will not be complied with.

7.19
The paper noted that:

A key driver behind the use of Build, Own, Operate and Transfer was to provide the Mangawhai community with an affordable wastewater scheme that would eventually be owned by Council and to meet the borrowing guidelines of Council's Treasury Policy. That Policy indicated that, under conventional approaches, Kaipara did not have the capacity to borrow sufficient funds to fund this project.

Council has however identified that it wishes to review this and has identified that debt segmentation may provide the answer to this problem. The key issue for Council being the ability of the consumers to pay rather than the constraints of what could be considered to be an artificially constructed Treasury Policy.

Council may have to consider this project as an exception, for sound reasons, to its Treasury Policy.

7.20
The Council's minutes do not record that the Council explicitly agreed to change from a BOOT type of PPP to a Design, Build, Finance, and Operate (DBFO) scheme. However, this is implied by it accepting the PSC's recommendations and by subsequent documents that refer to a DBFO process. The Council resolved at that meeting:

1. That negotiations proceed initially to:

• Secure best risk weighted financing arrangement possible from ABN Amro; and then

• Compare it with Council's interest rates (risk adjusted) to determine most appropriate approach; and then

• Complete negotiations with SEA based on outcome of the above.

2. That negotiations now proceed based on a 15 year maximum operating period and a range of financing options that may include a 25-30 year financing period, and a residual value if appropriate.

6. That Council notes the revised method of funding the EcoCare Project as recommended by the Project Steering Group breaches its current Treasury Policy and accepts this recognising that the most important factor is the ability of the community to pay for the scheme and its operations and this is to be part of further consideration of this project by Council. In addition Council is considering amending its Treasury Policy to enable communities who are able to meet the costs of such infrastructure to fund that infrastructure by way of loan.

7.21
KDC's former Chief Executive told us that the Council was "keen on the finance element because they believed the market would bring a better finance deal than normal local government sources". KDC's files did not contain any analysis of this issue.

7.22
There are no precise definitions of what a DBFO is. At its simplest, it involves the promoter designing, building, financing, and operating an infrastructural asset. Some definitions suggest that ownership of the asset and the financing risk remain with the promoter for the life of the contract. In such cases, the public entity effectively pays for the asset and the services that it provides through regular toll payments. However, given the restrictions in the Local Government Act 2002, that was not the case here. KDC had to purchase the asset as soon as it was built. The important point is that the risk profile in a DBFO of this kind is different from that of the BOOT arrangement that had been worked on until this point. This affects the costing, allocation, and management of the project risks.

7.23
Beca told us that there is a general understanding that a DBFO excludes the promoter owning the asset, and therefore the "finance" in the DBFO refers to construction phase finance, not finance over the nominal life of the asset.

7.24
Although the Council was told about the core parts of DBFO as set out above, KDC's files contained no evidence to suggest that the Council was given any explanation of the risks and benefits of a DBFO. However, both KDC's former Chief Executive and a former councillor told us that there was much discussion about the change to a DBFO both at the PSC and Council meetings.

7.25
The Council agreed to continue negotiations with Simon Engineering, on the basis that a contract would be for a 15-year maximum operating period with financing over a term of 25-30 years.

7.26
In March 2003, after the PSC and the Council had decided to change to a DBFO, a PSC meeting discussed how the project was to be financed. It also appears that the meeting discussed the issue of whether to use a DBFO or design/construct project delivery method.

7.27
As set out above, under a BOOT contract, KDC had no involvement in how the construction or operation of the scheme was to be funded. It simply paid a monthly toll for services provided. However, under the DBFO approach, it needed to work out how it would finance the purchase of the scheme. Although Simon Engineering would finance the initial construction, these financing costs would become part of the purchase price to be paid at the end of construction.

7.28
A presentation prepared for the PSC discussed the different loan options that Simon Engineering had put forward. The presentation noted that the interest rates Simon Engineering proposed took account of the fact that it bore the interest rate movement risk, the construction finance risk, and the costs of arranging the loan. It stated that these costs would be $200,000 a year.

7.29
The presentation had a slide headed "Issues" that set out:

• Can KDC borrow approx. $14.5 M at significantly lower than 7.8%?

• Is KDC prepared to carry interest rate risk?

• Is KDC positioned to carry Construction cost risk and largely supervise design & construction?

• KDC will need to answer all these questions and provide surety in additional project management to manage a D & C or DBO style contract.

• Simon Engineering have assessed the above risks to them (and ABN Amro) as being some $200,000 per annum based on 5 year contract.

7.30
The minutes of this PSC meeting record that the PSC decided to pursue a five-year fixed interest rate loan, with interest only to be paid. The paper also stated that:

Simon Engineering has confirmed they will accept all construction finance risk. KDC will not be exposed to cost over runs on the project, nor for costs in delays during design and construction, material price increases, site issues or industrial relations risk once Consents have been achieved. They will also take change in interest rate risk. Construction finance charges will be capitalised and included into the Project capital costs.

What the change to the delivery method meant for the proposed contract

7.31
Under the BOOT approach and the proposed contract terms set out in the RFP, Simon Engineering had strong financial incentives to build a cost-effective plant that would operate efficiently and be well maintained over the 25-year period. These incentives included that:

• Simon Engineering was to own and operate the scheme over 25 years, so it was in Simon Engineering's interest to construct a plant that would operate efficiently over that period of time without needing too many repairs.
• The scheme had to be built so that its various components would meet their specified design lives. An independent specialist was required to prepare asset condition reports during the operation of the scheme. These would report on the condition of the components of the scheme and how this compared to the design lives. Simon Engineering would be required to carry out remedial work if the components were not meeting the design life.
• Simon Engineering was required to maintain and repair the scheme to ensure that the scheme met the operating performance standards in the contract.
• If the scheme did not meet the performance standards for operation in the Project Deed, KDC could reduce or not pay the toll. The monthly toll payment included the costs of both operating and constructing the scheme, so this sanction provided a strong financial incentive to maintain performance.
• If the scheme did not meet the performance standards for operation in the Project Deed, KDC could take over the asset from Simon Engineering in limited circumstances.
• Simon Engineering was required to provide warranties and indemnities in the proposed contract with KDC.
• Simon Engineering was required to have its parent company, Henry Walker Eltin (HWE), provide a guarantee to KDC that Simon Engineering would carry out its obligations under the contract.

7.32
With these protections, which are reasonably standard under the BOOT model, KDC was reasonably well protected if anything went wrong. It was not KDC's asset, and KDC had several ways in which it could both recover any losses it suffered and impose sanctions on Simon Engineering. These overall protections in the BOOT model meant that KDC did not need to have strong oversight of construction of the scheme. The contract put strong financial incentives on Simon Engineering to get construction right.

7.33
This is one of the major differences between the BOOT model of contracting and the more traditional "design and build" type of contract. The two sit at different ends of the spectrum of contracting models. If the purchaser simply buys and pays for the asset at the end of construction, the purchaser needs more assurance that the asset has been properly constructed. Common contractual requirements to manage this risk include:

• an engineer to the contract appointed by the purchaser: this role can include providing directions to the contractor and certifying payments, inspecting and testing the works being carried out, and requiring work to be fixed or redone if it is not satisfactory;
• a contractor's bond: the purchaser holds a sum of money provided by the contractor to ensure performance of the contractor's obligations under the contract;
• a proof of performance period: payment to the contractor is not due until the asset has operated satisfactorily for a specified period of time;
• defects liability period: a period of time after construction, during which the contractor must repair any defects found in the asset that are due to poor workmanship or materials;
• retentions: the purchaser keeps back some of the contract payment for a period of time until after the end of the defects liability period;
• liquidated damages for late completion: the contractor has to pay the purchaser money for the loss it suffers if the works are completed late; and
• indemnities: a commitment to reimburse the purchaser for losses suffered because of poor work or failures by the contractor.

7.34
The DBFO approach that the Council decided to use sat a little further along the spectrum towards a traditional design/construct contract. Simply using the contractual mechanisms from either approach would not be appropriate. The Council needed to consider the precise risks the DBFO approach created so that the contract could include appropriately tailored mechanisms for managing the risks.

7.35
One of the project's core risks was construction risk – that is, the risk that the scheme was not constructed properly or failed to operate as intended. As we set out above, under the proposed contract terms based on the BOOT approach, KDC did not bear this risk and was reasonably well protected if problems arose.

7.36
Those protections reduced somewhat under the DBFO approach. KDC had to pay for and own the asset after construction, and the operating period was shorter, so the long-term financial incentives for Simon Engineering to build and maintain the plant well were weaker. The ability to withhold toll payments now only affected the contractor's operating costs, not their construction costs. However, this still meant that about $1 million was at risk each year.

7.37
KDC's other main protections against poor construction and maintenance were now the warranties, indemnities, and guarantee from the parent company. These protections involve making a claim and taking enforcement action, rather than the direct imposition of a sanction.

Our comments

7.38
The enactment of the Local Government Act 2002 came at an unfortunate time for KDC. It was largely unexpected, although we note that the possibility had been raised during community consultation and that there had been some media coverage of the debate in the select committee. We consider that the Council did not recognise how significant the change was.

7.39
One of the Council's main reasons for taking a PPP approach had been to avoid having to borrow to fund the capital costs of construction up front. That was achieved with a BOOT arrangement that left ownership with the private partner for the length of the contract. The law change meant that was no longer possible. KDC would have to own the infrastructure as soon as it was built, and it would have to find a way to pay for it at that point.

7.40
The Council very quickly decided it could carry on with the current parties after negotiating some adjustments to the contracting terms. In our view, this decision did not recognise how much of the landscape had now changed. The Council needed to reconsider whether the proposed contractual terms were adequate to manage the increased risks it would now bear. In particular, the Council needed to consider whether those mechanisms adequately managed the risk of the scheme not being constructed properly or not working as intended. The documentation we have seen does not suggest that this careful a process was followed.

7.41
The other major change was to the capital cost of the project. Under the BOOT type of PPP that was initially negotiated, ABN Amro provided financing to Simon Engineering to construct and operate the scheme over its life. KDC had no direct exposure to the financing arrangements needed for the scheme. Now that KDC had to own the scheme once it was built, it had to finance that purchase itself. The obligation was now on KDC to acquire that financing, rather than on Simon Engineering. That is, the risk of financing had shifted from Simon Engineering to KDC. The Council had a range of possible options for financing the purchase, but there is no evidence that it considered any other options before it decided to obtain a loan from ABN Amro – the financing party already at the negotiating table.

7.42
The January 2003 resolutions refer to KDC comparing ABN Amro's financing against KDC's interest rates to determine the best approach. The Chief Executive's report to the Council for March 2003 stated that:

An indicative range of interest rates has been provided and these are comparable to market rates. They also include the construction risk factor which will ensure that Council is supplied with an effectively operating, efficient treatment plant and reticulation system.

7.43
KDC's files show that, in March 2003, the Finance Manager obtained likely interest rates from the Bank of New Zealand (BNZ). BNZ advised that the indicative interest rate would be 6.22% for a loan of $13 million for a five-year fixed term. A report from the PSC to the Council in May 2003 advised that the indicative financing rate from ABN Amro was 7.62%, although the amount of the loan was unspecified. However, the report estimated that the capital costs would be $15 million. It is difficult now, some nine years later, to determine whether the ABN Amro financing proposal was competitive and offered value for money at that time. However, on its face, KDC ignored an estimate from the BNZ that could have resulted in a saving on interest costs of 1.4% a year. Based on an estimated capital cost at that time of $15 million, this equated to about $210,000 a year. Importantly, KDC failed to obtain information to enable it to make an informed decision on whether the offered financing was appropriate.

7.44
In short, we conclude that the Council was too keen to keep the process moving and so looked for ways to adjust and carry on as quickly as possible. In our view, the change to the legislation should have prompted a more thorough reconsideration of how the project was being approached and funded.

7.45
KDC's former Chief Executive told us that the Council considered that a PPP was still the best option because it still met the criteria the Council had set for the project. However, we could not locate any KDC records to show that any substantial analysis had been carried out or formally submitted to, and discussed by, the Council. We consider that the complexity of the changes warranted more careful consideration than the records suggest took place.

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