Rewards and risks of the BOOT route

05 January 1996

NEW approaches to large scale projects in the Middle East are providing new opportunities for contractors. But the considerations can be very different from a traditional procurement process and contractors may be required to take long-term equity positions in order to secure project work. There will be greater risk participation by contractors who will need project finance expertise in developing the key project agreements.

Consortium bids In larger scale privately financed projects.

such as build-own-operate-transfer (BOOT) and build-own-operate (BOO) schemes, it is likely that consortia will be formed. A consortium grouping may include local and international investors, one or more operators, one or more contractors or major equipment suppliers and financial institutions which will provide debt finance.

The consortitim will bid and negotiate.

usually with a government or a government controlled authority, for the award of a concession or implementation agreement. A typical project could be an independent power plant, water treatment plant, toll road development or similar capital project. Contractors do not traditionally seek long term investment in projects but it is clear that some major contractors will be prepared to take equity positions in order to secure a role for themselves in these high profile projects.

The role of the contractor in the early stages of the consortium Contractors joining such consortia face a very much greater front-end involvement and cost than would be the case for a traditional project. Such a grouping would normally require an agreement to deal with exclusivity, confidentiality and cost bearing or sharing. If a bid is successful the consortium arrangements will probably be replaced by a project company with the positions of the participants regulated through a more detailed shareholders' or founders' agreement.

Contractors within a bidding consortium will need to define and agree their construction role with other consortium members and price that role. They will participate in shaping the structure of the consortium that will ultimately, if the bid succeeds, become the contractor's client and participate in the presentation of an overall project bid.

The difficulties and costs will be substantial, as will the potential conflicts to be resolved between the interests of the consortium as a whole and its individual members.

It may be that contractors participating at the very front end of these schemes will commit to a construction management or management/contracting role. This could be linked to an overall construction performance guarantee but leaving it open to the consortium to engage works contractors - who may or may not be related to the original contractor -on an arms length basis at a later date.

Alternatively, a major contractor might propose a total design and construct solution linked to a guaranteed maximum price.

However, the need to convince fellow consortium members and lenders of competitive pricing may militate against this approach.

Development of the construction agreements Construction will be a major cost within the financial model for the overall project. Price parameters are likely be set with a broad reference to terms - probably FIDIC based which would be refined if the consortium wins the bid and moves forward to negotiation of key project agreements. It will be difficult for the consortium to agree the final form of the key project agreements, and the concession/ implementation agreement in particular, without knowing that it has contractors committed to build the project at its projected cost.

These construction agreements are likely to be substantially different from those used with contractors for traditionally procured works because the project company is likely to have substantial risks and conditions imposed upon it through the key project agreements. The project company will normally want to place these risks, as far as possible, back to back with its contractors.

Even if the contractor has a relatively large equity stake in the project company, the project lenders are likely only to be satisfied if the major risks are passed out of the project company.

Contract risks In addition to the obvious risk of penalties for delay in completion of construction, contractors are likely to be faced with a range of contract conditions that have their origin in the commercial deal established in the concession or implementation agreement.

There are likely to be particular powers for testing and inspection of the construction or the plant and equipment to be supplied.

There are likely to be performance related penalties designed to ensure compliance with an output specification. The contractor is also likely to be constrained in the use of provisions which deal with delays to the works or additional costs. And it is likely that the project company will seek to regulate the contractor to the same extent as the project company itself is regulated. Provisions relating to force majeure or change of law are likely to have qualifying criteria that match the key project agreements. It may be that the contractor will only be able to claim for such items to the extent that the project company itself is actually successful in pursuing a claim further up the chain. This would be akin to a pay when paid obligation. In short, contractors, whether part of the original bidding consortium or engaged later by the project company, are likely to face unusual contract conditions that extend their risk and liability.

Types of construction approach As indicated above a contractor who is part ot the original bidding consortium may seek an overall construction management or management contracting role for itself. In these circumstances lump sum works packages are likely to be tendered separately but difficulties may arise if the consortium cannot demonstrate a certain cost budget. Also a profusion of works contracts can lead to a muddling of liabilities and increase the likelihood of claims that the project company will not be able to afford. An alternative is for a major contractor to take on a lump sum turnkey role. In any event, lenders to the project are going to be looking for a high degree of cost certainty. They will also look for the project construction risks to be concentrated in one or more contractors sufficiently strong to absorb those risks.

Client risk profile Everyone involved with construction in the Middle East has heard complaints about some public sector clients delaying payments to contractors. Whatever the truth of these complaints, governments and public authorities tend not to become insolvent and generally honour their debts.

The risk profile for a large, privately financed project on a BOOT/BOO basis is rather different. In these schemes it is the newly formed project company that will be the contractor's client. A single purpose project company will almost inevitably have an equity capital which is substantially less than the project construction cost and will inevitably have taken on a large burden of debt financing. The project company will not have any ability to generate its own income until the construction works are complete and the project is operating.

Hence the project company must be regarded as very fragile client. If unexpected financial pressure is applied to it, either through unexpected substantial contractors' claims or other unbudgeted costs, it may crack.

The project company will be bound under its concession or implementation agreement and under the financing agreements to perform the project in the required manner. A breach of those agreements will almost certainly permit the lenders to step in to control the project and replace the project company and may entitle the public authority to terminate the concession.

In the event the lenders step in, the contractor may have some practical advantages in seeking new employment by the project lenders to complete the project but it is most unlikely that the lenders will observe defaulted payment obligations of the project company.

Accordingly, on the one hand contractors may look forward to dealing with a private sector client with whom they may have influence as a participating shareholder. On the other hand their exposure to client insolvency risks will be substantially increased over and above the traditional public procurement route.

A partial solution in some instances to the risk of client insolvency can be obtained through export credit cover but this is unlikely to answer the entire problem and will not provide comfort to local contractors.

Opportunities for BOOT/BOO Power projects are the most promising BOOT/BOO developments. The technology is tried and tested. Power is a necessary requirement for developing countries and it is a saleable commodity. Given the scarcity of available public funding for large scale capital intensive projects it is logical that further opportunities will arise in this sector.

There are arguments about the political sensitivity of existing price subsidies but price subsidies can still form part of the picture if governments want to fund these.

Water schemes are more politically sensitive but what could be more politically sensitive than a water shortage? Again, subsidies can be retained if required. Wastewater projects are already starting to come through.

In other parts of the world, transport schemes of various kinds, notably toll roads, have been conducted on a BOOT basis and certain countries are already considering such projects.

A danger in the Middle East is that governments will invite involvement in such schemes but then prevaricate and fail to make awards. Potential participants could quickly become unwilling to invest the very considerable front-end cost and effort that is inevitable in pursuing further schemes of this kind.

Proactive contractors are already seeking participation in prospective BOOT schemes.

For the reasons indicated above there are a whole range of considerations that add extra layers of complexity and cost. Contractors will need to consider such issues when pricing these schemes.

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