An important partnership

Australia is a very sophisticated market for infrastructure with world-class investors and enormous capability, but its success depends on collaboration, writes Domini Stuart.

Twenty-five years ago, infrastructure was only a story when it failed. “Unless a bridge collapsed or a tunnel became impassable, infrastructure stayed very much in the background, which gave governments an opportunity to postpone spending on building and maintenance,” says Brad Vann, chairman of the IFM Australian Infrastructure Fund’s Investor Advisory Committee and director of innovation at Clayton Utz.

“Since then it has gradually made its way on to the front pages as more people realise that infrastructure is fundamental to the proper and effective functioning of society, as well as an important aspect of the economy.”

An audit by Infrastructure Australia estimated that, in 2011, economy-wide spending on infrastructure services accounted for 13.3 per cent of gross domestic product (GDP).

“A reduction in the major construction projects in the resources sector has left a distinct gap in our economy, so new infrastructure projects are particularly important now,” says Graham Bradley AM FAICD, chairman of Infrastructure New South Wales, HSBC Bank Australia and EnergyAustralia Holdings.

“It is also important for us to address our backlog of public infrastructure including transport, energy, water and communications if we are going to remain a competitive economy and take advantage of export opportunities afforded beyond the mining sector.”

The right infrastructure projects have the power to transform communities. “Enabling infrastructure which facilitates productivity creates employment and increases public wellbeing,” says Nora Scheinkestel FAICD, chairman of Macquarie Atlas Roads and a director of Macquarie Atlas Roads International Limited.

“For example, the knock-on effects of better transport include easy access to new housing, schools and other community facilities. New infrastructure can also benefit the environment by reducing congestion and pollution.”

Infrastructure Australia predicts that by 2031, the demand for public transport will have increased by about 30 per cent. “If we do nothing, congestion alone will cost us $53 billion a year,” says Philip Davies FAICD, chief executive officer (CEO) of Infrastructure Australia.

This doesn’t mean the government should rush into projects at any price, however. “They need to be very carefully selected and have a good governance process around them to ensure that scarce capital is applied to the highest and most productive returns,” says Bradley.

The proper process

As the nation’s independent infrastructure advisor, Infrastructure Australia acts behind the scenes gathering evidence, doing research and determining which projects are of most value. It also reviews all infrastructure proposals – excluding defence projects – which will cost the government $100 million or more.

“Recently we released a fully-revised priority list of 100 national infrastructure projects,” says Davies.

“We also have a reform agenda and, in February 2016, we released a 15-year infrastructure plan. This includes 78 recommendations for the longer-term reforms we need in order to maintain world-class infrastructure. As far as I’m aware, we’re the only country with this approach and it is attracting interest from around the world.”

As they are not tied to electoral cycles, Infrastructure Australia and its state-based equivalents are well placed to take a long-term view.

“If they’re well constituted and empowered, these organisations can be regarded as an objective, expert view on the merits of a project,” says Scheinkestel. “Having dedicated ministers and public authorities can also be very helpful in providing focused resources, facilitating ‘whole of government’ participation and assisting in creating alignment between the various stakeholders. This can be critical in terms of timing and execution.”

Three types of boards

It is common to have three types of boards involved in the construction of infrastructure. “There is usually some kind of government delivery authority with a board whose prime concern is political accountability,” says Vann.

“The directors also have an auditing responsibility and, of course, financial accountability because taxpayers’ money is ultimately being spent.”

These dedicated boards promise more effective governance for large projects. “Some of the projects we have in Sydney, for example, have price tags in excess of $10 billion, employ thousands of people and have complicated contractual arrangements,” says Bradley.

“They deserve to have the focused government attention that comes with a project-specific board. These boards typically include a mix of people from business and senior government so they bring to bear some of the experience and disciplines from the private sector.”

Most projects also have a special purpose vehicle, which is a subsidiary company with a liability structure and legal status that makes its obligations secure, even if the parent company goes bankrupt.

“The directors of these organisations need to match the obligations agreed with the government with all of the contracts and subcontracts that go downstream to the principal contractors,” says Vann.

“They have to keep track of any debt and equity that is being using to fund the project, how well the project is proceeding and whether there are any major variations or disputes emerging. They must also consider the long-term operation and maintenance of the asset that is being built.”

The third board is at the coalface. “This is the construction company itself, where directors are focused on whether the building is proceeding to budget and on time,” says Vann.

At every level, these boards must be confident of the project’s eventual commercial success. “All shareholders have the legitimate expectation that investments will be accretive,” says Scheinkestel. “A project may have a short-term negative impact on yield and distributions for shareholders but the board must be able to assure investors that short-term cost will be repaid by long-term value creation.”

This is the compact that exists between companies willing to make significant investment in their own future and that of the country and the people who invest in them. “Government and regulators are necessarily part of that compact in that those assurances can only be made in the context of a stable and predictable regulatory and legislative environment,” Scheinkestel continues.

Uncertainty and risk

Current uncertainty is creating a high level of regulatory risk. “We don’t have a firm energy policy or agreed settings for greenhouse gas emissions,” says Vann. “And, while the federal government has every right to form a view that an asset being privatised raises security risks which need to be examined as part of the Foreign Investment Review Board process, they should be upfront with that concern. No-one knew about its intention to block the sale of the New South Wales electricity network Ausgrid until very late in the process.”

Levels of political risk are also as high as they’ve ever been. In a speech to the Committee for Economic Development of Australia, NAB chairman Dr Ken Henry AC, who led the Federal Treasury under three prime ministers, pointed out that almost every major infrastructure project announced in every Australian jurisdiction over the past 10 years has been the subject of political wrangling.

“In the most recent federal election campaign, no project anywhere in the nation – not one – had the shared support of the Coalition, Labor and the Greens,” he said.

Politicians are also inclined to speak too soon. “They love announcements because we have a 24-hour media cycle and they’re under huge pressure to counter bad news with good news,” says Vann.

A report by the Grattan Institute found that Australian governments spent $28 billion more on transport infrastructure over the past 15 years than taxpayers had been led to expect. And, while only 32 per cent of all projects were announced early, these accounted for 74 per cent of the value of the overruns.

“There is little to stop politicians making dubious commitments on the basis of weak or undisclosed business cases, particularly during election campaigns,” says Grattan Institute transport program director, Marion Terrill.

“Cost overruns are rarely analysed from the first funding promise yet, once politicians announce a project, they and the public treat the announcement as a commitment and two thirds of these projects end up being built.

“All main political parties have committed to sound planning of infrastructure and to making decisions with broad social benefit yet, in practice, they continue to promise projects that Infrastructure Australia has not evaluated or has already found to be not worth building.

“At a time of declining private investment and historically low interest rates, when many politicians and commentators are calling for more transport infrastructure spending, cost overruns are a vital public policy issue.”

In recent years, a number of major infrastructure projects failed to deliver returns to investors because they fell short of their usage forecasts. The Cross City and Lane Cove tunnels in Sydney and the Clem Jones Tunnel in Brisbane left the parent company in receivership.

“Any large capital investment project requires a board to turn its attention to a number of issues that don’t come up every day on the board agenda, including testing the assumptions being made about the demand for the services,” says Bradley.

“It doesn’t just apply to roads. A significant over-estimation of the likelihood that drought would continue caused all of the governments on the east coast of Australia to invest billions in desalination plant projects that have yet to yield any financial return.”

The rigorous testing of assumptions used in forecasting is crucial in times of disruption and volatility. “Key metrics including lead and lag indicators must be agreed and the board should insist on regular, warts-and-all progress reports, as well as periodic audits or peer reviews,” says Scheinkestel.

“Project management is critical to ensure that there is no fragmentation and that key people are appropriately empowered and accountable. Culture is also critical – everyone should have a clear understanding of what trade-offs will be acceptable and what will not be compromised – customer satisfaction, for example. There should also be an open and transparent environment where issues are escalated and not suppressed.”

When projects get into serious trouble it’s often because by the time difficulties surface, it is already too late for the board and management to take appropriate action.

“While the risk of director liability isn’t any different in projects of this kind, I do think there’s a heightened reputation risk, and this is another reason why boards need to ensure that they have early-warning mechanisms in place,” says Bradley. “Major projects will obviously be very important to shareholders and other stakeholders and slippage or bad outcomes can be very destructive to boards’ reputations.”

Public interest also increases the risk of community backlash, or even litigation. “Litigation is likely to be very expensive, can hold up the completion or even the commencement of projects for many years and often destroys the economics of a project,” says Bradley. “The board must work with management to engage the support of the community.”

The right skills

Among the many skills required to oversee a major infrastructure project is a grasp of rapidly-advancing technology. “So-called digital disruption is as relevant in the project space as much as any other – and the challenge of cultural transformation generally follows on its heels,” says Vann. “If technology causes you to re-invent your business, you have to start thinking about whether you have the right people in place. That includes a board member or advisor who understands the significance of these issues and how they are likely to play out.”

The directors must also be able to assess the capability of the management team. “Management can sometimes be over-optimistic about its ability to manage a project that is a much bigger undertaking than anything they’ve experienced in the past,” says Bradley.

He recommends creating a specific project team so that the entire venture is run by dedicated people. “Most companies also understand that an effective project management office can bring the disciplines of oversight,” he says.

“This will help top management to ensure that, at every stage, the project has been properly planned, that the best contractors have been engaged and that the contracts include sensible incentives and penalties. It is also important to have good dispute resolution mechanisms in place so that disputes don’t become more contentious than they need to be, are resolved quickly without litigation and don’t ultimately hold up the delivery.”

Directors have a role

Australia is a very sophisticated market for infrastructure with world-class investors and enormous depth and capability in terms of our ability to manage infrastructure. But, as Davies points out, success ultimately depends on collaboration.

“It is important that all three levels of government are engaged and that business and local communities are on board,” he says.

“Whenever we have had reform in the past the business community has played a key role. I would now like to see corporate Australia supporting some of the reform recommendations in our 15-year plan and encouraging government to meet the challenges that will drive those reforms forward. We can’t expect governments to deliver them in isolation and I think there’s a big role for boards and their directors to play in ensuring our future success.”

The AICD’s Blueprint for Growth sets out a plan for long-term growth that includes recommendations for national infrastructure and calls for a 15-year infrastructure plan. Read the Blueprint at companydirectors.com.au/blueprin

Staying out of trouble

Graham Bradley AM FAICD shares 10 tips for avoiding problems that can arise in overseeing a major infrastructure project.

1. Take sensible precautions

Projects can get into trouble for a variety of reasons. Some cannot be anticipated but often many can. Boards need to manage these risks sensibly – for example, by making sure that contractors have requisite skills and track records and are not being chosen simply because they put in the cheapest bid.

2. Lock in long-term funding

Long-term debt arrangements remove the risk of sudden increases in interest costs and the possibility that debt markets will not be available in the future. It is worth the extra cost.

3. Don’t rush the early stages

Most projects that get into trouble do so in the very early stages because not enough time has been spent on defining the needs, doing the detailed planning work and analysing risk. This leaves the board ill-equipped to make informed decisions.

4. Test demand

Boards have been known to make incorrect assumptions about the future demand for a particular piece of infrastructure to the detriment of the investors. All underlying assumptions must be rigorously tested before the board commits to any undertaking.

5. Talk to the community

A good, open relationship with the community will minimise the risk of backlash and subsequent litigation, which has the potential to cause delays or even to derail the project.

6. Seek out independent advice

A third party expert can provide the board with independent, periodic reviews of progress and whether the project is heading for a successful outcome.

7. Report the project separately

Boards will have a clearer view of how a large infrastructure project is proceeding if it is treated like a separate company or subsidiary for reporting purposes.

8. Establish a separate project management office

A dedicated project team will ensure that a large infrastructure project is being managed by people who can give it their full attention. An effective project management office adds the discipline of oversight and ensures that procedures which have previously proved successful are adopted as standard practice.

9. Make good use of incentives and penalties

Appropriate incentives and penalties can drive performance and delivery. Contracts should also include sound dispute resolution mechanisms to ensure that any disagreements are resolved quickly and without litigation.

10. Encourage early disclosure

If workers are afraid to report bad news, conditions are likely to worsen. The board should encourage a culture where workers feel able to speak out.