2.7 The challenge of extensions

It is contemplated that there will be linear extensions to each of the projects considered in this paper.

Customers are likely to want the extension to be operationally integrated with the part of the network covered by the PPP contract. It's unlikely customers will want to have to switch vehicles at the point where the extension joins on to the network covered by the PPP contract.

To achieve this outcome, either the incumbent Operator needs to operate both the original line and extended line as a fully integrated service, or a new Operator needs to be engaged to operate both lines as an integrated service - it's not possible to have a different Operator on each part of the network.

This leaves government with two basic options.

Option 1: Strike a deal with the incumbent Operator (and its SPV). It's not possible for government to deal directly with the incumbent Operator (and cut out the SPV), as the Operator will need to reach agreement with the SPV on consequential changes to the operational performance regime in the O&M contract. The SPV won't agree to these changes with the Operator unless corresponding changes are made to the operational performance regime in the PPP contract between the SPV and government.

Option 2: Terminate the existing Operator, and engage a new Operator to operate both the existing railway and the extension. To do this, government will need to either:

a terminate the PPP contract early - which is very expensive; or

b get the SPV to terminate its O&M contract with the existing Operator and enter into a new O&M contract with a new Operator - which is less expensive, but very difficult to achieve.

Option 2a is very expensive because PPP contracts generally require government to pay a termination payment for early termination sufficient to enable the SPV to:

• repay its debt (including hedge break costs and the like);

• fully compensate its Operator for early termination of the O&M contract (including profits foregone); and

• give its equity investors a return on their equity investment.13

Option 2b is less expensive, as it is only the incumbent Operator that needs to be compensated for early termination (rather than the SPV). However, this is very difficult to achieve as it involves great risk for the SPV and its Equity Investors and Debt Financiers, who will bear the risk of poor performance by the new Operator. These parties will want to be protected against this risk if they are forced by government to switch Operators, which would completely undermine the PPP contract's allocation of operational performance risk to the SPV, and the value for money this provided to government.

Faced with these options, the government will choose to pursue Option 1, i.e. negotiate amendments to the PPP contract to enable the incumbent Operator to operate both the original line and extended line as a fully integrated service, unless the commercial terms demanded by the SPV or the Operator are so extreme that it is cheaper to switch to Option 2.

This is an unenviable negotiating position for the government. Unfortunately, it is the inevitable consequence of entering into a PPP contract.

The solutions to this challenge fall into two basic categories:

• The first is to try to build additional flexibility into the PPP arrangement. This is what has occurred, to varying degrees, on each of the projects considered by this paper. However, for reasons explored later, there is only so much that can be done in this regard, given the inherent features of the PPP model.

• The second solution is to consider an alternative delivery model for the initial project.

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13 The level of return the equity investors receive varies between projects. For some projects (Sydney Metro, Gold Coast light rail, and Sydney light rail (pre-completion)), they receive the return they expected to receive on their equity investment when the PPP contract was signed. On others (Canberra light rail, Sydney light rail (post completion)), they receive the fair market value of the equity as assessed by an independent expert.