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December 27, 2005

Sea-to-Sky Expensive and Overbuilt

Partnerships BC, the arm of the government that looks after public-private-partnerships (P3s), released a Report on the Sea to Sky Highway in which it admits that its P3 option is more expensive than the public sector comparator (PSC) but it justifies it by reference to over-built options for the highway. The bidding process was turned upside down; instead of asking for the best price, the Ministry of Transportation (Mo T) specified the price and asked what could be built for that amount. In the words of the report (page 10):

"Proposal evaluation usually involves some element of low price competition in which the specifications or outcomes are set and proponents provide a price. For the Sea-to-Sky DBFO project, this process was reversed - the maximum price that MoT was prepared to pay for the private sector portion of the baseline highway improvements and for operations, maintenance and rehabilitation of the entire corridor was prescribed in the Request for Proposals (RFP) document (in the form of an annual affordability ceiling, or AAC)."

It estimated the net present cost of the project in 2005 dollars as $789.8 million compared to $744.0 million if the Ministry of Transportation had used private companies to design and build the highway, after which it took responsibility for financing, operating and maintaining it. A table on page 17 of the report shows that as of December 2003 the government thought that the P3 option would be less expensive than the public sector comparator, but by December 2005 the analysis had changed with the public sector cost comparator decreasing by $11.7 million and the P3 cost increasing by $101 million. Partnerships BC argued that the additional cost of the P3 is justified because the public will get what they estimate as $131 million in net present value benefits as a result of extra features delivered by the contractor because of the backwards bidding process. (For example, 20 km of additional passing lanes and 16 km of additional median barrier.) The extra features will be very nice for users of the highway, but they are beyond the Ministry of Transportation's specifications and hence amount to over-building; unless the concept of opportunity cost is meaningless, that means some other transportation project will be short-changed or not done because of the backwards process used to the benefit of the Sea-to-Sky.

Over-building the highway and revising the cost estimates by $112.7 million would be bad enough, but footnotes in the Report indicate that the P3 was even more expensive than admitted in the main text of the Report. Some figures used in the report are present value; that means that an interest rate is used to "discount" future costs to current day dollars. For example, if the interest rate is 2.0%, then $1.00 today is the same as $1.02 one year from now, equivalently $0.98 today is the same as $1.00 a year from now. The interest rate used to determine present values in the Partnerships' Report is 7.5%. The following footnote commented on how that matters (NPC is net present cost, DBFO is design, build, finance, operate, S2S is the contractor):

"Sensitivity analysis of the 7.5 per cent discount rate showed that the NPC of the DBFO contract would have been about $32.4 million more than the PSC if a 8.5 per cent discount rate had been applied, and about $62.2 million more than the PSC if a 6.5 per cent discount rate had been applied. The 7.5 per cent discount rate is the weighted average cost of capital (WACC) estimated by S2S, and reflects the actual risk profile of the project from the perspective of the investor."

In other words, the lower the interest rate used for the analysis, the greater the disadvantage of using the P3. The rate chosen was not what the public can borrow at, but what the private sector consortium could borrow at. According to Public Accounts, the weighted average of the interest rate on all outstanding provincial debt was 5.8% in 2004, current borrowing rates are lower. If 5.8% is used to discount the Sea-to-Sky Project, the present value cost disadvantage of the P3 balloons to more than $120 million (you have to calculate that with a spreadsheet since it's not in the report). Bias in favour of the P3 is revealed further in a footnote that essentially says that because the public sector comparator has cost advantages with respect to taxes it is penalized by adding a cost to level the playing field. That's the kind of thinking that restructured BC Ferries even though it means paying GST and other federal taxes, previously exempt and now paid by ferry users. In this case, the comparison introduced what it called a "competitive neutrality adjustment" which it described as follows (page 18, note 5, PSC is public sector comparator, NPC is net present cost):

"The competitive neutrality adjustment is made to ensure that the PSC does not reflect any competitive advantage that would simply be the result of public sector ownership. This allows a like-with-like value for money assessment. Without a competitive neutrality adjustment, the PSC may be artificially low and not reflect the full costs to government. The competitive neutrality adjustment decreased by $21.2 million (from $62.5 to $41.3 million NPC) to reflect the final tax payable under S2S's corporate structure. The final amount ($41.3 million NPC) adjusts for the tax-exempt status of public sector corporations ($4.2 million) and the self-insurance policy of the Province ($37.1 million)."

Partnerships BC admits to a cost disadvantage for the P3 of $45.8 million but tries to justify it with the over-building; however, re-doing their calculation, allowing for the interest rate (conservatively 5.8%) and tax advantages enjoyed by the public sector, puts the P3 more than $161 million behind the public sector comparator, not counting the $42.9 million "risk adjustment" assigned to the public sector comparator. Even if $131 is factored in as a net benefit for the over-building, the project ends up being $30 million worse than the public sector comparator. Data presented in a table on page 14 of the Report makes it possible to do the re-calculation.

The Vancouver Sun reported on part of the Partnerships' Report on its front page on December 23rd, prompting a Christmas Eve treat courtesy of Minister of Transportation, Kevin Falcon, in the form of a letter to the editor. He wrote: "Rest assured the project will not cost taxpayers $312 million more than forecast over the next 25 years. That figure was extracted from the non-risk adjusted Public Sector Comparator payments table on page 14 of the report." Falcon wanted to make sure that no one confused 25 years of operating and maintenance costs with the original promise that capital costs would not exceed $600 million. Falcon should worry much less about the initial capital costs and much more about the total costs over the term of the 25 year contract and the financial failure that is revealed by a close reading of the report. Remember that Falcon is the same minister who was responsible for a 990 year contract in the sale of BC Rail.

It is particularly disturbing that Partnerships BC at least partially co-opted BC's Auditor General with its Report. The Auditor was asked to verify the assumptions used in the Report. In his covering note he emphasized that he did not audit the report, he merely reviewed it. He concluded that: "Based on my review, nothing has come to my attention that causes me to believe that the Report prepared by Partnerships British Columbia does not fairly describe the assumptions, context, decisions, procurement processes and results to date of the Sea-to-Sky Highway Improvement Project." He's right that the Report is sufficiently transparent that a careful read shows the government made significant errors in costing the project in 2003, revised its figures in 2005 and justified its preference for a P3 by creating artificial costs assigned to the public sector comparator in the form of unrealistic interest rates and tax treatment. Perhaps the Auditor should do a real audit and comment on how the Sea-to-Sky project has affected funding for other transportation priorities, and whether he approves of backwards bidding that rewards spending millions for construction that goes beyond specified requirements.


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