Australia: Government sole source procurement: Are contractors destined to miss out?

Whether it is a major augmentation initiated by government or initiated by the private sector through a market-led proposal, sole source procurement has emerged as a major area of activity in the infrastructure sector. Several Australian State governments have recently closed major augmentation contracts for projects as diverse as light rail, hospitals, convention centres and toll roads.

When public-private partnerships are involved, existing asset owners, facility operators and maintainers and suppliers of specialised equipment are in the box seat. If the new infrastructure fulfils a public need, delivers value for money and government wants to proceed, then these parties need to be part of the augmentation project due to their incumbency.

Not so contractors. Even if the first stage of a project has been delivered well, the construction component of the augmentation is typically parcelled up and put out to tender. The contractor – a key member of the consortium which played such an important role in delivering the original project – is back where it started slugging it out with its competitors. So, why are incumbent contractors on the outer?

Of all procurement models, sole source procurement is one which can make governments feel quite uncomfortable. This is because they have a responsibility to deliver demonstrable value for money outcomes across their infrastructure procurement and so for a new stand-alone project, a competitive tender process is the default go to method. It provides assurance that they have fulfilled their duty to deliver maximum value for their citizens and tax payers. Sole source procurement without a competitive process does not give this simple way to demonstrate value.

Dealing with incumbents

In adding an extension to a light rail system, a new wing to a hospital, further exhibition space to a convention centre or lane upgrades to a toll road, a full competitive tender process is not a viable option. There will be existing project owners whose co-operation is essential to successfully integrating the new infrastructure into the existing project. Typically, once an augmentation is completed, the entire project will need to be operated and maintained as an integrated facility by the same operation and maintenance contractor. For rolling stock projects, it often makes sense to purchase the same vehicle models as currently in use and extend the same signalling system. The same goes where other specialised equipment is involved. And even existing financiers often need to be accommodated, especially if the debt is in the form of long term bonds or involves associated interest rate hedges, which makes the cost of refinancing that debt prohibitive.

Government is left to negotiate on a bilateral basis with the existing private sector project company on the basis that each of these parties has a veto on the augmentation proceeding. Government must look at pricing and risk against market benchmarks and the overall budget for the project. While the outcome needs to satisfy all parties and deliver value for money – or otherwise the project will not proceed – government is forced to rely on analysis and judgement to justify the investment decision rather than the outcome of a competitive tender process.

Different rules for contractors

But when it comes to the construction package, the longing for the security of a competitive process is overwhelming and government insists that this part of the project by tendered by the project owners. Apart from the perception of security this provides, it should be asked whether this is the best approach. In the original project, the contractor was responsible for delivery of the major component of the overall project and managed the majority of the project risk. Much of the innovation comes from the contractor. Are there benefits from dealing with all of the consortium members, including the contractor, as incumbents?

THE BENEFITS OF THE ORIGINAL CONTRACTOR

Working with existing contractors can deliver substantial benefits in a number of areas.

Physical interfaces

First and foremost having built the original project, the original contractor will be more familiar with the existing infrastructure and site. One of the key issues for augmentations is integrating the new works with the existing facility. An entirely new builder, sourced from a competitive tender process, needs detailed existing asset information, will seek to qualify the interface risk which they accept based on that information and will seek to have others take legal responsibility for that information.

Existing relationships

An incumbent contractor also bring the benefits of existing relationships. Increasingly, project owners are related investment arms of the original contractor, all within large corporate groups. Forcing the investment arm of a major civil contractor group to engage a competitor can present challenges of culture and fit.

Working with existing O&M

Another key interface is that between the contractor and the operator and maintainer taking over the asset once it is completed. The original contractor will have worked closely with the O&M contractor during both the tender and delivery phases to optimise whole of life outcomes. One of main shortcomings of sole source procurement is that it is difficult to achieve any meaningful life cycle optimisation. A key reason for this is that the contractor is simply not on board early enough for any meaningful engagement between them and the O&M contractor. If the incumbent contractor can be included in the overall consortium in developing the augmentation from the outset, then there is a real opportunity for meaningful lifecycle optimisation.

Innovation through design

But the most important interface is between design and construction. With the initial procurement process, the contractor will have worked closely with a designer to optimise design, constructability, cost and program. And importantly for government and financiers, the head contractor will carry the risk of the design being fit for purpose. With a sole source procurement, the timelines are such that the designer needs to be engaged at the start of the process. If there is a competition run for the contractor, there is no opportunity for the close interaction between contractor and designer. And even if legally, the designer has agreed that its engagement can be novated to the contractor, once they are eventually determined, commercially the contractor is often reluctant to accept the same level of design risk. The contractor has not chosen or worked closely with the designer before it has to sign up to the construction contract.

HOW CAN THIS WORK?

For governments to entertain using incumbent contractors, they will need assurance from the outset of the procurement process that the incumbent contractor will deliver value. The great fear is that as the procurement process progresses and nears its conclusion - at the point where it is politically difficult for government to pull out or switch to a competitive process - the contractor will put its hand up for additional costs or push back on the government's preferred risk allocation.

Put in place a detailed process agreement

The key is to agree a detailed process agreement with the government up front. The agreement would cover the detailed steps through to contract close. It would have detailed deliverables at agreed milestones to give government assurance that the procurement is unfolding as it expects and the opportunity to take action early if it is not.

Determining price

It will be critical that the process agreement includes a detailed process for determining price. A contractor will need to be prepared to set caps on margins and preliminaries and agree a clear formula setting out what costs those percentages are applied to. There would need to be full transparency for obtaining quotes for trade costs, justification for the using of preferred suppliers and open book information to validate the costs of self-performed works.

Agreed risk allocation

Risk allocation is also critical. The risk allocation government seeks in the PPP sector is well understood and contractors will be familiar with it. The initial project will typically provide a clear basis for the approach to be taken for the augmentation. If there are some areas where contractors need to carry out due diligence before a risk can be accepted (such as site contamination), these should be specifically identified and a detailed process agreed for that due diligence to be undertaken with a view to the risk being efficiently priced and accepted. A key benefit to using the incumbent contractor will be a streamlined approach to wrapping interface risks. This needs to be a prominent part of the contractor's offer up front.

Committed security package

Finally, there needs to be acknowledgement that the financing structure for the augmentation will require a satisfactory contractor security package to support it. In a bid situation, contractors will always wish to optimise the position and there are typically robust discussions with financiers as parties arrive at their 'best for bid' positions. But if an incumbent contractor wishes to be included with the other consortium members up front, then the government and owners will need reassurance that the contractor will be prepared to provide an acceptable security package based on prevailing market norms, when all is said and done.

CONCLUSION

If during the initial tender phase for a project, contractors can see they will be treated on an equal footing with the other consortium members for future augmentations, they can look forward to a long term relationship with the sponsoring government on the project. This can only add to their willingness to bid competitively up front. Incumbent contractors will also have the incentive to bring good ideas for augmentations to government. Now that several major augmentation projects have reached contract close and with governments seeking to build more flexibility into projects upfront to facilitate future augmentations, it would seem the time to update the National Guidelines for Infrastructure Project Delivery and their State equivalents to provide support for this more inclusive approach.

But this only works if contractors understand that this is no opportunity for profiteering. It is only by continuing to deliver better value for money than from the alternative competitive process that government will feel comfortable engaging with incumbents.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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