At a glance
The government announced final agreements to bring the East West Link (EWL) project to an end in June 2015. The termination settlement involved the state reimbursing East West Connect (EWC) for claimed expenditure on the project and acquiring the project assets and interest rate swaps established for the project. The state also negotiated an uncommitted bond financing mandate for up to $3.1 billion with some members of the EWC banking group.
The cost of the final termination settlement was substantially less than estimates of what would have been payable under the contract's 'termination for convenience' provisions. However, to achieve this outcome the state accepted limited verification over the funds expended by EWC and the risk that a related party had a windfall gain. Failure to properly assess the option of continuing the project means that there is limited assurance that the termination was the best use of public funds.
- The advice to government on the merits of terminating the project did not adequately examine the costs, risks or benefits of completing it.
- The final termination agreements involved a different settlement outcome to that initially announced by the government. These changes were based on sound advice to government and delivered a better outcome for the state.
- The total cost of the final termination settlement will be around $642 million.
- The state accepted limitations in the due diligence investigation caused by EWC's refusal to provide detailed expenditure information. VAGO could not address these weaknesses due to gaps in the Audit Act 1994.
That the Department of Treasury & Finance establishes clear guidance for the terms of future negotiations involving the state reimbursing expenditure by private entities, to require full disclosure and transparency of the underlying information and evidence.
Consistent with public commitments made in the lead up to the 2014 state election, in December 2014 the new government instructed East West Connect (EWC) to suspend works on Stage 1 of the East West Link (EWL) project and began negotiations to terminate the contract. At this time, around $425 million had been spent by the state on EWL, including property acquisition costs.
In June 2015, the government reached an agreement with EWC to terminate the project.
The Department of Premier & Cabinet (DPC) had primary responsibility for managing the termination process. The Department of Treasury & Finance (DTF) managed negotiations on the termination of EWC's loan facility for the project.
Advice to government on negotiation of the termination of EWL comprehensively examined the available approaches, settlement terms and related costs and risks. The strategy adopted was a practical solution to a highly complex situation. However, only limited analysis of the option to complete the project was undertaken, meaning the government was deprived of comprehensive advice to assure it that termination was the best use of public funds.
The total cost of the final termination settlement will be around $642 million depending on the final cost of the interest rate swap arrangements. The cost to the state, negotiated without reference to the termination provisions in the contract, was substantially less than estimates of what would have been payable under the 'termination for convenience' provisions of the contract.
However, to achieve this outcome the state accepted limited visibility over the funds expended by EWC and accepted the risk that a related party had a windfall gain. The government was not able to fully confirm the reasonableness of the expenditure it reimbursed or the assets it received because EWC refused to allow the state or its advisers access to information at a sufficiently detailed level.
5.3 Decision to terminate the project
The advice to government on the merits of terminating the project did not comprehensively examine the costs, risks or benefits of completing the project. This appears to have been due to election commitments to discontinue the project and because the project was considered to have a low benefit-cost ratio (BCR).
5.3.1 Incoming government advice
Advice and recommendations from DPC and DTF as part of the incoming government briefings contained a useful summary of the key issues associated with terminating the EWL contract and were appropriate, assuming that the decision to cancel the project was final and that the government would seek to terminate for convenience under the contract. Under the termination for convenience provisions of the contract, compensation was estimated to start at around $900 million and depended on the timing of the termination. The advice correctly noted that a decision to terminate sooner rather than later would minimise the amount paid by the state. However, it did not fully assess the benefits of completing the project.
While there was no direct discussion of the merits of continuing the project in this early advice, this was understandable given that advice to the incoming government is intended to focus on the implementation of announced policy positions.
5.3.2 Analysis of project completion option
Although the intention to terminate the EWL project was clearly articulated at the November 2014 election, the then Opposition did not at that time have access to comprehensive information on the costs, benefits and funding arrangements for the project.
On its election, the new government should have been provided with updated, comprehensive information on the impacts of completing the project versus the option of cancelling it, to provide a more complete assessment of the costs and benefits of terminating the contract.
The limited advice that was provided to the new government on the completion option was superficial. It simply compared the costs of a termination settlement to the 'much greater costs to the state if the project proceeded'. There was little mention of the costs previously incurred on the project.
The advice presented the project costs in nominal dollar terms and stated that the project would involve a significant economic cost to the state, because the:
- tolling revenues may be insufficient to cover the quarterly service payments due to EWC over the term of the operations phase
- business case suggested a direct economic benefit of only 45 cents for each dollar invested in the project
- project funding obligations may limit the state's capacity to fund other election commitments and major infrastructure projects.
The expected project benefits were not discussed beyond the reference to the direct BCR from the initial business case. This BCR of 0.45 excluded wider economic benefits and the positive BCR of complementary projects, and was based on information from 2012–13.
Updated analysis should have been provided to government on the benefits of the core project scope and the complementary projects. These updated project benefits could then have been compared to the expected costs of the project, which were known with greater certainty.
Other relevant factors that were not fully explored in advice to government included the:
- forecast $8.0 billion (nominal dollar value) of toll revenue from the completed project
- $1.5 billion Commonwealth funding contribution to Stage 1 of EWL that was at risk of being lost if the project was cancelled
- significant funds already expended by the state on the project.
The state had spent significant amounts on planning, developing, procuring and contracting EWL. Although these were 'sunk costs' they may have impacted the extent of 'future costs' required if the option of completing EWL was compared directly to other priority projects. This is because other projects would have required expenditure on pre-construction and procurement activities that had already been completed for EWL.
The absence of detailed analysis of the completion option means the government had limited assurance that the termination of the project represented the best use of public funds.
5.3.3 Government consideration of termination options
Subsequent advice focused on the available approaches to termination. This advice contained little analysis of the merits of completing the project, but it was otherwise generally comprehensive and accounted for expected future costs and risks from termination, including sovereign risk issues.
The consideration of termination options was supported by detailed analysis and advice from the departments and commercial and legal advisers. The advice adequately articulated, assessed and costed the alternative approaches of:
- terminating under the 'termination for convenience' provisions of the contract
- terminating the contract using legislation
- achieving an effective termination through an agreed settlement with EWC and its financiers—the approach ultimately adopted.
The settlement strategy adopted by the state involved an 'aggressive' approach of effectively repudiating the contract and treating it as unenforceable, in conjunction with the exploration of options to legislate to extinguish any liability to EWC.
The state sought to mitigate its exposure through a negotiation strategy that included:
- a direction to EWC to suspend work on the project and mitigate costs
- a refusal to terminate using the defined 'for convenience' provisions of the contract, given the expected payment required
- consideration of the option to extinguish liability to EWC using legislation
- 'without prejudice' negotiations to achieve an agreed settlement with EWC and its financiers, including consideration of options to 'repurpose' the loan facility.
EWC largely refused to negotiate on this basis between December 2014 and February 2015 and instead demanded that the state terminate for convenience under the contract. This position meant that the state found it necessary to consider a range of unilateral options, such as:
- legislation to extinguish liability under the contract
- a public inquiry into the project
- limits on the right of EWC members to participate in future projects
- offering opportunities for other state work.
5.4 Achieving project termination
On 15 April 2015 the government signed a non-binding heads of agreement (HoA) with EWC to facilitate termination of the project. The HoA set out key commercial terms, a process and a timetable for termination of the contract.
The commercial terms included in the HoA involved:
- the state acquiring the companies in the EWC consortium for $1
- EWC being reimbursed for net funds of $339 million already drawn down from the project loan facility to cover already incurred project-related costs, subject to a cost certification process
- the state reimbursing EWC for the $81 million in fees paid when establishing the loan facility with the intention of taking over this $3.1 billion facility, to contribute to funding for the Melbourne Metro Rail Project, to obtain value for those fees.
A cost sharing arrangement was agreed with EWC on 2 June 2015 which required the state to meet 75 per cent of EWC's financing costs for the period 15 May to 15 June 2015 and to reimburse EWC for any legal costs, above a threshold of $50 000, incurred by the financiers' external legal advisers in reviewing, negotiating and finalising replacement refinancing documents.
Final agreements terminating the project were completed on 15 June 2015. The agreements involved:
- the state acquiring, for $1, the hard assets and intellectual property (IP) owned by EWC and the design and construction (D&C) contractor, and the rights to the business name, domain name and logo of EWC
- relevant contracts being terminated and releases from future legal liability being granted
- the state paying EWC $424 million as reimbursement for project costs, including the $81 million in fees paid to establish the credit facility and $4 million under the cost sharing regime
- the state taking over the interest rate swap established by EWC on the project loan facility in September 2014, which was valued at $217.9 million, at 30 June 2015—the state will be required to pay the value of the interest rate swap when the arrangement is closed
- the state separately establishing an 'uncommitted note issuance mandate' of up to $3.1 billion with a number of the banks involved in the project credit facility—this was a different facility to that established by EWC for the project.
The total cost of the final termination settlement will be around $642 million depending on the final cost of the interest rate swap arrangements. The final agreements involved a different settlement approach to that announced by the government on 15 April 2015 because the state did not acquire the EWC companies and did not take over the loan facility established for the project.
Adequate advice was obtained and provided to government in relation to the settlement approach and the final terms agreed with EWC and its financiers, including the:
- terms announced on 15 April 2015 following the signing of the HoA with EWC
- final terms of the termination and related agreements announced on 15 June 2015.
Following the signing of the HoA there was appropriate advice to government on the merits of adjusting the settlement approach in response to developments in the negotiations, and to information and risks emerging from the due diligence processes undertaken by the state under the terms of the HoA.
5.4.1 Repurposing of EWL loan facility
Advice on options for repurposing the EWC loan facility enabled a better value-for-money outcome for the state than the approach initially announced by government.
The government initially announced that it intended to take over that facility to contribute to funding for the Melbourne Metro Rail Project and that by doing this it would receive value for the facility establishment fees of $81 million that were reimbursed to EWC by the state.
The government ultimately determined not to take over the $3.1 billion credit facility established by EWC. This was based on robust analysis and advice from DTF on the complexities and value-for-money issues associated with this approach. Instead the state negotiated an 'uncommitted note issuance mandate' with selected members of the EWC banking group.
The advice to government recommending this approach noted that it involved lower fees as there was no commitment to underwrite the notes. However, this outcome meant that the state did not receive value from the $81 million paid to EWC as reimbursement for the costs of establishing its credit facility. On balance, these changes are likely to have delivered a better outcome for the state.
5.4.2 Cost of termination process
As at 30 June 2015, the government had incurred other costs of over $3 million relating to the termination. These are detailed in Figure 5A.
State costs relating to the termination
External costs ($'000)
Department of Premier & Cabinet
Department of Treasury & Finance
Treasury Corporation of Victoria
Source: Victorian Auditor-General's Office based on entity provided information.
These costs primarily related to legal and other professional fees incurred as part of the settlement negotiations with EWC and Treasury Corporation of Victoria costs for hedging the state's interest rate exposure arising out of the termination.
Costs are expected into the future to finalise arrangements not completed at 30 June 2015, including negotiations with the independent reviewer, the sale of physical assets acquired and the termination of the interest rate swap arrangement.
5.4.3 Value of acquired properties
As at 30 June 2015, $276.9 million had been spent on property acquisition, with a further $73.8 million to be paid for outstanding settlements. Acquired properties have been offered back to their original owners and a sales strategy is being developed for the remaining properties.
Property sales are not expected to commence until 2016–17 and may take several years in order to avoid an oversupply of property in the market. DTF estimates that the properties can be resold for around $320 million.
5.5 Cost certification process
The termination agreements included the state paying EWC $424 million as reimbursement for costs incurred on the project and $1 to acquire hard assets valued at less than $1 million and project IP owned by the EWC partnership, the D&C contractor and operations and maintenance (O&M) contractor.
Gaining access to detailed expenditure information was crucial given the:
- state's proposed settlement involved reimbursing EWC for reasonably incurred project-related expenditure
- inherent incentive in the settlement approach for EWC to overstate its costs and understate the assets to be transferred to the state.
However, the government was not able to confirm the reasonableness of the expenditure it reimbursed or the assets it received because EWC refused to allow the state or its advisers access to information at a sufficiently detailed level.
The Auditor-General's lack of 'follow the dollar' powers meant that we were similarly unable to access this information despite our direct requests to EWC and its contractors.
5.5.1 Due diligence process
In the lead up to the signing of the HoA, EWC was unwilling to provide any documentation to prove its claimed project expenditure. In early negotiations the state sought 'open book' access to EWC's financial records.
The due diligence process was to be a key feature of the HoA, to resolve the 'information asymmetry' between the state and EWC and ensure that the final settlement:
- only involved reimbursing EWC for legitimately incurred project-related expenditure
- ensured that EWC transferred all hard assets obtained with the project expenditure
- did not leave the state with inappropriate risks or liabilities.
The due diligence process was also intended to enable the state to confirm that EWC had adequately mitigated its expenditure following the project suspension notice of 12 December 2014.
EWC resisted a robust due diligence process and refused to have it extended to its D&C and O&M contractors. This was significant because these entities were related parties of EWC members, and had been paid significant sums for which EWC was seeking reimbursement from the state. EWC had paid around $164 million to the D&C contractor and $2.5 million to the O&M contractor.
The HoA required only limited cost certification and verification and was reliant on an existing process established under the project contract. The HoA outlined a 'certification and verification process and methodology' which stated the process would be successfully completed by EWC providing evidence that payments to the D&C contractor were certified by the firm appointed by the project financiers to certify project-related expenditure claimed by EWC.
This process provided limited visibility on what the payments were actually used for, and provided little capacity for the state to gain insight into the arrangements at the contractor level and below.
The state's due diligence adviser reported that it was only provided with confirmation that payments had been made from EWC to the D&C and O&M contractors and that it did not have access to supporting documentation from the contractors. The adviser indicated that this meant it could not verify:
- what these contractors used the money for
- whether or not further undisclosed assets existed, and noted that the list of 'hard assets' was very short and the value immaterial
- whether any expenditure had been refunded
- whether EWC and the contractors took reasonable steps to mitigate expenditure following the issuing of the state's project suspension notice.
The due diligence adviser indicated that this created a risk that a party related to EWC, particularly the D&C contractor, was holding either surplus cash, hard assets that were yet to be identified, or prepaid assets capable of being converted into cash at a later date. The adviser indicated that should any of these scenarios eventuate, the state would not receive the benefit of these assets and EWC members would receive a windfall gain. The adviser noted that the level of assets purchased by the D&C contractor was extremely low given the payments it had received from EWC.
This process was substantially different to the 'open book' process sought by the state during early negotiations with EWC. Ultimately, this limited verification was accepted as part of the 'price paid' by the state to secure EWC's agreement to the terms of the settlement.
5.5.2 Adequacy of warranties obtained by the state
In an attempt to mitigate the risks identified by the due diligence adviser, the state sought, as part of the final termination agreements, warranties from EWC and its related parties—including the D&C and O&M contractors—that they had identified all hard assets and IP acquired with the project debt.
These warranties were particularly important for the state given the limited expenditure verification process and associated risks identified by the due diligence process.
The warranties provided by EWC and the contractors included that:
- the lists of tangible assets were complete and accurate
- the project IP was accurately represented
- they had complied with obligations under the contracts with respect to mitigation.
However, these warranties did not directly address all the risks, given that they were:
- limited to hard assets and IP and specifically excluded cash or other liquid assets
- quite specific in relation to the extent to which costs were avoided or mitigated, because the D&C and O&M contractors provided no warranty in relation to the mitigation of costs prior to 15 April 2015.
The warranties were also subject to, or qualified by, disclosures made in a letter included as one of the termination agreement documents. For example, the disclosure against the warranty that the list of assets was complete and accurate clarified that the list only covered items 'to be incorporated into the works' and for which the D&C contractor had claimed payment and been paid. This raised the possibility that other assets had been acquired, with expenditure ultimately reimbursed by the state, and were not disclosed or transferred to the state on the basis that they were not to be incorporated into the project works.
Given these limitations, the risk that EWC's contractors had a windfall gain from the project through holding 'surplus' cash or assets procured from project funds was not fully mitigated or addressed by the warranties included in the final agreements.
5.5.3 VAGO request for information
In July and August 2015, VAGO wrote to EWC and its contractors seeking access to the information the state had been seeking from the contractors. Specifically, we sought information and evidence on payments made and received by the D&C and O&M contractors to and from third parties to inform a view on:
- the completeness of assets made available to the state under the termination agreements
- whether payments were made for goods and/or services that were not ultimately received or rendered
- the reasonableness of cost mitigation actions subsequent to the state's project suspension notice of 12 December 2014.
This information was needed to inform our assessment of the adequacy of the state's due diligence process. EWC and its contractors refused our requests. The Auditor-General does not currently have explicit 'follow-the-dollar' powers under the Audit Act 1994 to require the provision of such information by private parties.
- That the Department of Treasury & Finance establishes clear guidance for the terms of future negotiations involving the state reimbursing expenditure by private entities, to require full disclosure and transparency of the underlying information and evidence.