Conclusions

If it had proceeded to completion, the entire EWL project would have cost in excess of $22.8 billion in nominal terms. Limitations in the business case meant there was little assurance that the prioritisation of significant state resources to this project was soundly based.

Key decisions during the project planning, development and procurement phases were driven by an overriding sense of urgency to sign the contract before the November 2014 state election. The significant risks arising from this situation were further compounded by legal challenges to the project and by the absence of comprehensive advice on the potential benefits of deferring the signing of the contract.

Signing the contract in these circumstances was imprudent and exposed the state to significant cost and risk. The risks associated with this decision were increased when the state agreed to amend the contract to provide additional compensation to EWC if the legal challenge to the project planning approval succeeded. The available evidence suggests that the state knew at the time that there was a significant risk that this would happen.

These circumstances demanded comprehensive advice to government on its options and the best course of action for the state. However, advice to government in the lead-up to signing the contract fell short because it did not sufficiently assess the benefits of delaying finalisation of the procurement and contract to mitigate the risks posed by the unresolved judicial review. Instead, achieving the government's desired time line for contract signing was given disproportionate emphasis despite the risks and implications for the state.

The amount payable by the state under the termination settlement negotiated by the new government with EWC was substantially lower than the cost of terminating under the project contract. However, the decision to terminate was made without full consideration of the merits of continuing with the project. Failure to properly assess the benefits of termination against revised costs and benefits of continuing the project means the government was deprived of comprehensive advice to assure it that termination was the best use of public funds.

Further, the validity of project costs reimbursed by the state could not be fully verified because the state accepted EWC's refusal to allow access to the financial records of its related party contractors. This created a risk that EWC's related parties had a windfall gain.

Terminating the EWL project involved the expenditure of hundreds of millions of dollars for little tangible benefit. Following final settlement of outstanding costs, the state will have incurred costs in excess of $1.1 billion. This includes costs for the acquisition of properties which the Department of Treasury & Finance estimates can be resold for around $320 million. Pre-construction activities including design and geotechnical work and elements of the complementary projects may provide some value in the future.

Over the life of this costly and complex project, advice to government did not always meet the expected standard of being frank and fearless. This highlights a risk to the integrity of public administration that needs to be addressed. Action and leadership is required from government to reinforce these standards and the related expectations for public servants.

Findings

Project business case

The EWL business case did not provide a sound basis for the government's decision to commit to the investment because it did not:

• clearly establish the need for the investment through robust analysis of the costs, benefits and risks of reasonable options
• provide a sound basis for prioritising the eastern section over other sections of the road
• include sufficient information and evidence to demonstrate the accuracy and plausibility of the assumed wider economic benefits of the project, or the validity of underlying traffic modelling
• adequately address significant issues raised about the traffic modelling by peer reviewers.

The project delivery approach proposed in the business case was sound notwithstanding that undue weight was given to the government's desire to begin work on the project prior to the 2014 state election in the assessment of available options.

Establishing the project contract

The Linking Melbourne Authority (LMA) managed the procurement process well in challenging circumstances, completing it within the tight time lines stipulated by government at the outset of the project. The analysis and advice on the assessment of bids, and selection of the preferred bidder, was generally robust and conducted in accordance with the government's procurement requirements.

The uncertainty created by the unique circumstances in the lead-up to the decision on signing the contract warranted comprehensive advice to government on its options and the best course of action for the state. However, the advice to government did not:

• comprehensively examine the merits of alternative options, including delaying finalisation of the procurement and contract
• directly support or oppose the proposed timing of the transaction and neither identified nor recommended a course of action in the best interests of the state.

Notwithstanding this, the significant implications for the state arising from the unresolved legal challenge to the project planning decision prompted the then Department of Transport, Planning and Local Infrastructure and LMA to provide advice to government in August 2014 emphasising the importance of resolving the judicial review before the contract was signed. This advice indicated that an expedited court timetable was achievable, would deliver early certainty and would provide the best mitigation to the substantial cost and risk exposures to the state that existed at that time. Despite this advice the government decided not to seek an expedited hearing and LMA was instructed to proceed to contract close for the project before the state election in November 2014.

Despite the significance and complexity of the project and the risks and implications for the state, the focus on achieving this time line was given disproportionate emphasis. As a result, subsequent advice to government focused on options to mitigate identified risks if the government determined to proceed to contract close rather than considering and emphasising the merits of delaying signing.

If contract signing had been deferred until after resolution of the judicial review, the state's exposure under the non-standard contract provisions, which were accepted to secure EWC's execution of the contract, could have been avoided.

The contract signed by the state with EWC was standard in most respects and generally consistent with the standard commercial principles established by the National PPP Policy and Guidelines and the Partnerships Victoria requirements, as well as with recent precedent transactions. However, in departures from standard practice for PPP transactions in Victoria, the state agreed to the inclusion of clause 58—Specific Key Approval Event in the contract, and signed a side letter confirming the state's commitment to honour the contract. These variations from standard contractual terms were requested by EWC.

Clause 58 increased the state's exposure in circumstances where the planning approval decision was found to be invalid, as compared to the standard provisions of the contract. The risk and exposure for the state created by clause 58 was linked to the outcome of the judicial review of the planning decision for the project.

Given that the state was aware of the significant risk that the planning approval decision would be quashed, the decision to proceed to contract signing was, in effect, a 'gamble' that the judicial review proceedings would not impact the project significantly.

The only scenario under which the side letter can be argued to have created additional exposures for the state is one in which the state did not have the power to sign the contract. Legal advice obtained by government both before and after the election indicated that this was very unlikely.

Terminating the project

The total cost of the final termination settlement will be around $642 million. This excludes state expenditure on the planning, development and procurement of the project, and is substantially less than an estimated amount—in excess of $900 million—that would have been payable under the contract's termination for convenience provisions.

However, to achieve this outcome the state accepted limited verification of the funds spent by EWC and the risk that an EWC-related party contractor had a windfall gain. 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 state's due diligence adviser reported in June 2015 that they were only provided with confirmation that payments had been made from EWC to its design and construction (D&C) and operations and maintenance contractors and that they did not have access to the contractors' supporting documentation. 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 in December 2014.

The due diligence adviser indicated that this created a risk that a related party 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 conversion into cash at a later date. Ultimately, this limited verification was accepted as part of the 'price paid' by the state to secure agreement by EWC to the terms of the settlement.

In an attempt to mitigate the risks identified by the due diligence adviser, the state sought warranties from EWC and its contractors that they had identified all hard assets and intellectual property acquired, and had complied with obligations under the contracts to mitigate project expenditure. However, the warranties provided were subject to limitations that meant they did not fully mitigate or address the risks identified by the state's due diligence adviser, and in particular did not directly address the risk that the D&C contractor was holding surplus cash.

The Auditor-General requested information from EWC and its contractors in July and August 2015 to address the gaps in the due diligence process undertaken by the state. These requests were refused. The Auditor-General does not have explicit power under the Audit Act 1994 to require provision of such information by private parties.

The final termination agreements involved a different settlement outcome to that initially announced by the government in April 2015. The revised approach to the settlement was based on sound advice to government and delivered a better outcome for the state. The advice 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 was undertaken of the option to complete the project. Although the new government's intention to terminate the EWL project was clearly articulated at the November 2014 election when it was in Opposition, it did not at that time have access to complete and up-to-date information on the project's benefits and cost.

The new government was not 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 merits of terminating the contract. This meant it was deprived of comprehensive advice to assure it that termination was the best use of public funds.

Lessons

The Public Administration Act 2004 (the Act) imposes an obligation on public officials to provide frank, impartial and timely advice to government. Meeting this obligation means there is sometimes a need to provide advice that a government may not necessarily want to receive.

While the advice to government examined in this audit was generally comprehensive, in some critical instances it fell short of the required standard of frankness. These instances involved advice that did not provide recommendations or that gave too much emphasis to the benefits of approaches that were in line with the government's preferred outcome and little emphasis to alternative options that could be argued were more aligned with the state's best interests.

Presenting options to government without a recommendation in circumstances where public officials know that the option favoured by government will expose the state to significant potential risks and costs is clearly not in the best interests of the state. It is not sufficient for officials in such circumstances to stop at disclosing the potential risks and consequences of the available options, they need to provide a recommended course of action.

The departments of Premier & Cabinet and Treasury & Finance disputed this and advise that the Code of Conduct for Victorian Public Sector Employees (the Code) requires the public service to implement government policy decisions once the government of the day has made a clear policy decision. This is a quite narrow reading of the Public Administration Act 2004 (the Act) and the Code because neither the Act nor the Code explicitly state or imply that the requirement to 'implement government policy' sits at the apex of public sector values.

This suggestion is also inconsistent with the objects set out in section 3 of the Act. The Act does not oblige public servants to implement government policy at any cost. Rather, it seeks a public service which responds to government policy priorities in a manner that is consistent with public sector values. Those values include:

• providing frank, impartial and timely advice to the government
• making decisions and providing advice on merit
• objectively considering all relevant facts and fair criteria
• seeking to achieve best use of resources
• using their views to improve outcomes on an ongoing basis.

The Act and Code empower and oblige public servants to act with integrity and, most importantly, with impartiality.

Some public officials involved in this audit indicated that providing frank and fearless advice when they believe a government does not want to receive it will negatively impact their influence or career opportunities. This belief is regrettable and if it becomes common in the public sector it poses a significant risk to the integrity of government decision-making and public administration, with consequential implications for the effective management of public resources and services.

Recommendations

That the Department of Treasury & Finance:

1. provides guidance to support whole-of-project cost tracking and reporting against budget for major projects that involve multiple stages managed by different agencies
2. improves its business case development guidance material, the adherence to this guidance by agencies, and its quality assurance over key inputs by:

• critically reviewing the analysis of options in business cases against the requirements of existing guidance material and providing feedback to agencies
• developing further guidance on methods for transparently determining and quantifying wider economic benefits
• strengthening its processes for reviewing and advising government on the adequacy of actions taken to address findings and recommendations arising from peer or other external reviews of key business case inputs such as economic and financial analyses, demand modelling, cost estimates and procurement options analyses

3. develops minimum standards and enhanced guidance for managing the risks associated with concurrent planning, scoping and procurement processes on major projects
4. mandates the appointment of separate parties to undertake the probity advice and probity compliance review functions on High Value High Risk projects
5. 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.

That the Department of Premier & Cabinet:

6. consults with the Victorian Public Sector Commission to support further guidance to clarify the requirements for frank, impartial and timely advice in the public sector by:

• establishing clear minimum standards for agencies on how to satisfactorily discharge this obligation when providing advice to government
• advising government on strategies and options for addressing any cultural issues underpinning the serious deficiencies in the advice provided to government highlighted by this report.

Submissions and comments received

Throughout the course of the audit we have professionally engaged with:

• the Department of Premier & Cabinet
• the Department of Treasury & Finance
• the Department of Economic Development, Jobs, Transport & Resources
• the Department of Environment, Land, Water & Planning
• the Department of Justice & Regulation and the Victorian Government Solicitor's Office
• the Linking Melbourne Authority
• VicRoads
• the Environment Protection Authority
• Planning Panels Victoria
• the Treasury Corporation of Victoria.

In accordance with section 16(3) of the Audit Act 1994 we provided a copy of this report to those agencies and requested their submissions or comments.

We have considered those views in reaching our audit conclusions and have represented them to the extent relevant and warranted. Their full section 16(3) submissions and comments are included in Appendix C.

1.1 Introduction

The East West Link (EWL) project was one of the largest transport infrastructure projects ever proposed in Australia. The full project included an 18 kilometre cross city road connecting the Eastern Freeway at Hoddle Street to CityLink, the Port of Melbourne precinct and the Western Ring Road at Sunshine West. Figure 1A shows the planned EWL.

Figure 1A

Planned East West Link

Source: Commonwealth Budget 2014–15.

In May 2013, the then government announced that funding had been allocated as part of the 2013–14 State Budget for the eastern section of EWL—to become known as Stage 1—at an estimated cost of between $6 and $8 billion.

Stage 1 consisted of the following main elements:

• a new tolled motorway linking Hoddle Street and CityLink—mainly via tunnel
• upgrades to both the Eastern Freeway and CityLink
• public transport enhancements north of the central business district.

The tolled motorway between Hoddle Street and CityLink was to be delivered by the end of 2019 in conjunction with the private sector under an availability public private partnership (PPP). This involved the private sector financing, designing, constructing and then operating and maintaining the road for 25 years in return for payments from the state based on the availability of the road. The state was to retain toll revenues and also the associated risk that demand might be lower than expected.

In May 2014, the state announced its commitment to deliver the western section of the EWL (Stage 2) at an estimated cost of between $8 and $10 billion with initial works commencing in 2015. Stage 2 involved connecting Stage 1 to the Western Ring Road and improving freight access to the Port of Melbourne precinct. Work on Stage 2 did not proceed substantively beyond the planning stage.

On 29 September 2014, the state appointed the East West Connect (EWC) consortium following a competitive tender, to finance, design, construct, operate and maintain the tolled motorway component of Stage 1. The project agreement (contract) included a new clause 58 in response to concerns about the potential impact of a legal challenge to the validity of the planning approval decision for the project which was pending at the time. In addition, the Treasurer issued a side letter to the consortium, reaffirming the state's commitment to honouring the contract and related payment obligations, in response to EWC's concerns about questions raised in relation to the state's power to enter the contract. Appendix A sets out the key features of the contract.

Consistent with public commitments made prior to the 2014 state election while it was in Opposition, in December 2014 the new government instructed the consortium to suspend works and commenced negotiations to terminate the contract.

On 15 June 2015, the state announced the final termination agreement and acquired the EWC business and associated project assets for $1. The state paid EWC $424 million to cover its claim for costs incurred on the project. This included $81 million spent by EWC to establish a $3.1 billion loan facility for the project. Under the termination agreements the state acquired the interest rate swap facilities established by EWC as part of the project financing to manage financing risks on the project. The cost of closing out this swap agreement position will depend on interest rate movements but was estimated at $218 million at 30 June 2015.

As part of the termination the state also negotiated a $3.1 billion uncommitted note issuance mandate, which gives the state discretionary access to future debt funding, with some members of the EWC banking group. This was a new agreement between the state—through Treasury Corporation of Victoria (TCV)—and the relevant banks and not the loan facility established by EWC for the project.

1.2 Key project events and decisions

Figure 1B outlines key events and decisions in the planning, development and management of the project up to its termination in June 2015.

Figure 1B

Key project events and decisions

Source: Victorian Auditor-General's Office.

1.3 Project governance and management

1.3.1 Decision-making on the East West Link project

Key decisions on the EWL project were made by government through the Cabinet process. The Cabinet made decisions following consideration of advice and/or recommendations from the Minister for Roads and relevant departments and agencies. The Premier and Treasurer also made project decisions.

The government decision-making process was supported by a project steering committee that included senior representatives from the former Department of Transport, Planning and Local Infrastructure—now the Department of Economic Development, Jobs, Transport & Resources (DEDJTR)—LMA, VicRoads, the Department of Treasury & Finance (DTF) and the Department of Premier & Cabinet (DPC).

The EWL project was declared under MTPFA in December 2012 for statutory planning assessment, approvals and project delivery. MTPFA was selected because it is a process specifically designed for projects like EWL. MTPFA combines planning and delivery powers under one Act, and consolidates approvals under 11 separate Acts into a single decision by the Minister for Planning. In addition to consolidating approvals, MTPFA also provides time line certainty.

1.3.2 Agencies involved in planning and development of the project

Department of Economic Development, Jobs, Transport & Resources

DEDJTR was responsible for whole-of-project scope and budget as well as designing the tolling policy for when the road was operational. DEDJTR provided oversight of LMA (which managed and had financial oversight of Stage 1 of the project), and established the EWL steering committee which undertook the core coordination role. DEDJTR was responsible for preparing the final EWL project business case.

Linking Melbourne Authority

LMA was a statutory authority, established in July 2010, as the successor to the Southern and Eastern Integrated Transport Authority. LMA was established to manage complex road projects and was accountable to the Minister for Roads.

The LMA was given responsibility by the government to deliver Stage 1 of the EWL project, including financial oversight, budget monitoring and financial reporting. It was also responsible for the initial development of the business case, statutory planning, developing the Expressions of Interest and Request for Proposal procurement documents, evaluating the bidder's proposals, selecting a preferred bidder and leading negotiations with this bidder to prepare contractual documentation for the project.

In January 2015, the government announced that LMA was to be abolished following the decision to suspend and ultimately discontinue the EWL project.

Department of Treasury & Finance

DTF was responsible for the commercial principles and financial structuring of the project—including structuring revenue and tolling risk transfer. DTF was represented on the project steering committee, which had direct involvement in the governance and management of the project.

DTF also had direct involvement with the contractual and financial arrangements between the state government, Commonwealth Government and EWC. It also provided financial forecasts and assessments, and negotiated with Transurban—the operator of CityLink—on the interface of the proposed EWL with the CityLink toll road.

VicRoads

VicRoads provided technical advice for Stage 1 of the project—road based corridor planning and assessment—and was responsible for the planning and delivery of complementary works on both the eastern and western sections such as the Eastern Freeway upgrade and Doncaster Area Rapid Transit bus upgrade.

Department of Premier & Cabinet

DPC was represented on the project steering committee and provided briefings and advice to government on the progress of the project from planning through to the signing of the contract.

1.3.3 Agencies with a limited role in the planning and development of the project

Department of Environment, Land, Water & Planning

The Department of Environment, Land, Water & Planning—formerly the Department of Transport, Planning and Local Infrastructure—provided advice and support to the Minister for Planning, to inform his approval decision for the project under MTPFA.

Planning Panels Victoria

The Minister for Planning appointed an Assessment Committee under MTPFA to consider the matters associated with the proposed EWL Comprehensive Impact Statement.

The committee conducted public hearings and considered submissions on the Comprehensive Impact Statement from LMA, the Minister for Planning, several councils—Melbourne, Yarra, Moonee Valley, Moreland and Darebin—the Environment Protection Authority (EPA) and a number of community groups. The committee reported to the minister on 30 May 2014 with 43 recommendations.

Environment Protection Authority

Under the Environment Protection Act 1970 the construction of twin multi-lane road tunnels (with ventilation systems) for Stage 1 of EWL required a works approval from the Minister for Planning. EPA's role was to advise the minister whether a works approval should be issued and what conditions, if any, it should be subject to.

Treasury Corporation of Victoria

TCV was engaged by LMA to provide market interest rate benchmarking services at the signing of the project contract.

Victorian Government Solicitor's Office—Department of Justice & Regulation

The Victorian Government Solicitor's Office (VGSO) and counsel engaged by VGSO provided legal advice to the government on the legal challenges to the validity of the Minister for Planning's EWL project planning approval decision under MTPFA, as well as advice on the power of the state to enter into the contracts with EWC and the side letter.

1.3.4 Agencies involved in the termination of the project

Department of Premier & Cabinet

DPC led implementation of the new government's policy decision that the project would be terminated. DPC was responsible for negotiating a settlement and termination agreement with EWC.

Department of Treasury & Finance

DTF was responsible for seeking to achieve the 'repurposing' of the EWC project loan facility as part of the termination negotiations with EWC and its financiers.

Treasury Corporation of Victoria

TCV provided assistance to DTF on the negotiation and termination of the project finance documents. TCV also assisted DTF in the implementation and management of an interest rate hedge strategy, to limit the interest rate exposure associated with the interest rate swap that transferred from EWC to the state under the termination agreements.

1.4 Audit objective and scope

Audit objective

The objective of the audit was to determine if the state effectively managed the EWL project and related costs by assessing the:

• total costs of the project, including ongoing financial implications and risks associated with terminating the project
• appropriateness of advice supporting key project decisions that influenced the project's outcomes and total costs
• lessons for future major projects.

Audit scope

The audit examined the:

• governance and management arrangements for the project
• key project events and decisions and the soundness of the advice underpinning key government decisions
• costs associated with project planning, procurement and termination, including risks and future obligations of the state arising from the termination
• outcomes of any lessons learned analysis performed by relevant departments and agencies on this project.

The audit included the following departments and agencies:

• the Department of Premier & Cabinet
• the Department of Treasury & Finance
• the Department of Economic Development, Jobs, Transport & Resources
• the Department of Environment, Land, Water & Planning
• the Department of Justice & Regulation and the Victorian Government Solicitor's Office
• the Linking Melbourne Authority
• VicRoads
• the Environment Protection Authority
• Planning Panels Victoria
• the Treasury Corporation of Victoria.

1.5 Audit method and cost

The audit was conducted in accordance with section 15 of the Audit Act 1994 and the Australian Auditing and Assurance Standards. Pursuant to section 20(3) of the Audit Act 1994, unless otherwise indicated any persons named in this report are not the subject of adverse comment or opinion.

The total cost of the audit was $630 000.

1.6 Structure of the report

The report is structured as follows:

• Part 2 examines the project cost
• Part 3 examines the project planning and business case
• Part 4 examines the procurement and contracting of the project
• Part 5 examines the termination of the project
• Part 6 sets out lessons for future major projects.

2.1 Introduction

In May 2013, the state announced its intention to proceed with Stage 1 of the East West Link (EWL) project at an estimated capital cost of $6 to $8 billion. Following a competitive tender process the state appointed a consortium—East West Connect (EWC)—to finance, design, construct, operate and maintain Stage 1.

In May 2014, the state announced its commitment to deliver Stage 2 at an estimated capital cost of $8 to $10 billion with initial works commencing in 2015.

In June 2014, the Commonwealth Government committed funding of $3 billion for the EWL project—$1.5 billion each for Stages 1 and 2. It paid the state $1.5 billion in June 2014 comprising $500 million for Stage 1 works and $1 billion for Stage 2 works.

Following the 2014 state election, the new government instructed EWC to suspend works on Stage 1 and commenced negotiating a termination settlement, which was finalised on 15 June 2015.

This Part of the report examines the financial implications of the project, considering both the termination and the outcome had the project progressed to completion. It also considers the management and reporting of costs by the key entities involved.

2.2 Conclusion

The estimated total project cost of Stages 1 and 2 of EWL, had it proceeded to completion, was in excess of $22.8 billion in nominal terms over the life of the project. This funding was to be met primarily through imposing tolls on users of the road, with $3 billion provided by the Commonwealth Government, and the Victorian Government meeting the remaining costs, including taking on the risk that toll revenue might be lower than expected.

The EWL project was terminated in June 2015 with more than $1.1 billion paid, or expected to be paid, by the state. This cost will be partially offset by future proceeds from the sale of properties acquired for the project. The Department of Treasury & Finance (DTF) estimates that these properties can be resold for around $320 million.

This significant expenditure will yield little tangible benefit. Pre-construction activities including design and geotechnical work and elements of the complementary projects may provide some value in the future.

2.3 Actual and expected project costs

The EWL project was terminated in June 2015 at an expected total cost to the state in excess of $1.1 billion. This includes expenditure on the planning, development, procurement and termination of the project.

2.3.1 Costs incurred on the eastern section

Figure 2A shows the total costs for the state associated with Stage 1 including actual costs incurred up to 30 June 2015, and costs expected to be incurred after 30 June 2015 relating to the final settlement of outstanding costs on the project.

Figure 2A Stage 1 total costs

(a) The total costs for planning, developing and establishing the project includes costs for business case development, property acquisition, and other state costs including procurement and contract establishment.

(b) The total costs for terminating the project includes termination payments to EWC, the expected future cost of settling the interest rate swap and the costs of advice on termination.

Source: Victorian Auditor-General's Office.

Figure 2A includes around $350 million in costs relating to property acquisitions. These properties have been offered back to their original owners and a sales strategy is currently being developed for the remaining properties. DTF estimates that these properties can be resold for around $320 million.

The costs of the project will also be offset by rental revenue on acquired properties and any proceeds from the sale of assets acquired from EWC as part of the termination settlement.

Interest rate swaps

The termination settlement involved the state assuming the interest rate swap established by EWC for its loan facility. The state will realise a loss when it finalises this swap.

An interest rate swap is a financial instrument in which two parties agree to 'exchange' interest rate cash flows or the amount of interest they pay, which effectively results in the parties paying—or receiving—a different interest rate to the rates in their agreements with their financiers. Interest rate swaps assist entities to manage their cash-flow requirements and interest rate risk exposure.

As part of the financing arrangements, EWC entered into an interest rate swap with five of the major financiers providing the loan facility—two major Australian banks and three international banks.

The swap arrangement allowed EWC to effectively pay a fixed instead of a variable interest rate during the construction period. This is a standard component of public private partnership (PPP) financing arrangements as it provides the state with some certainty of the future payments that will be required once the PPP enters the operational period.

The value of the interest rate swap at 30 June 2015 was $217.9 million. The state will be required to pay the value of the interest rate swap when the arrangement is closed. The amount will depend on interest rates at that time.

2.3.2 Costs incurred on the western section

Stage 2 was still in early planning and development and therefore the procurement method had not been determined by the time the project was terminated. Total costs incurred on the western section to 30 June 2015 were $15.2 million, comprising:

• costs incurred by the Department of Economic Development, Jobs, Transport & Resources (DEDJTR) in completing the detailed planning work and the interim business case
• costs relating to a package of early works completed by VicRoads, which were passed on to DEDJTR.

2.4 Project costs if it proceeded

The estimated total project cost of EWL had it proceeded to completion was in excess of $22.8 billion in nominal terms over the life of the project. This estimate is detailed in Figure 2B and is based on approved business cases and budgets and the financial modelling for the PPP.

Figure 2B

Total estimated cost in nominal terms($ billion)

(a) The Present Value equivalent for this amount is $4.3 billion discounted to 30 June 2013.

(b) The total estimated cost for Stage 2 did not include costs for operation and maintenance during its operating phase.

Source: Victorian Auditor-General's Office.

The project was to be funded by the Commonwealth Government, state government and by road users through tolling arrangements.

2.4.1 Eastern section

Project cost and funding

Figure 2C shows the total budget for Stage 1 of the EWL project, based on the outcomes of the tender process that appointed EWC.

Figure 2C

Total budgeted eastern section costs ($ billion)

(a) As at financial close, October 2014.

Source: Cabinet submission, financial model for the PPP and Victorian Auditor-General's Office.

Figure 2D shows how the funding for Stage 1 was structured.

Figure 2D

East West Link funding structure for Stage 1

Source: Victorian Auditor-General's Office.

Toll revenue

The majority of the costs of Stage 1 of EWL were to be met by tolls on users of the road. Under the PPP terms, the government would collect and retain toll revenue. Actual toll revenue collected would not affect the payments to the road operator. This was different to the models previously used for Victorian tolled road infrastructure—i.e. CityLink and EastLink—where the private road operators charge and collect tolls directly, and therefore bear the risk that revenue will be lower than expected. In the event that EWL traffic volumes were lower than expected, the state would have been required to fund any shortfall, but the state would have benefited from higher than forecast traffic volumes.

Commonwealth Government funding

On 28 June 2014, the government entered into a memorandum of understanding (MoU) with the Commonwealth Government under the National Partnership Agreement on Land Transport Infrastructure Projects. Under the MoU, the Commonwealth committed $1.5 billion funding for Stage 1, of which $500 million was received by the state in 2013–14. The early receipt of funds allowed for interest to be earned on the contribution, which could then be applied as a further offset against the state costs.

State government funding

As part of the business case, it was identified that for very large projects—those with a capital cost in excess of $2 billion—a funding contribution from the state may be required to address issues associated with the size of the debt funding required and available funding from debt markets. As a result, in October 2013, the government approved contributions to be made to the selected PPP partner for Stage 1:

• $2 billion to be made available during construction—$1.5 billion of which was to be funded from the Commonwealth Government funding contribution plus $0.5billion from the state
• $1 billion to be made available two years after construction was complete, fully funded by the state.

2.4.2 Western section

The 2014–15 State Budget included an initial capital budget for Stage 2 of the project of $10 billion. This included $4 million of funding in 2013–14 and $100 million in 2014–15 to finalise the business case and commence planning work.

The MoU with the Commonwealth Government also included $1.5 billion in funding for Stage 2, $1 billion of which was received in 2013–14.

The initial package of works for Stage 2—the upgrade of Paramount Road and Ashley and Dempster Streets—was to commence construction by the end of 2015 to meet the Commonwealth Government's funding conditions.

2.5 Monitoring of project costs

The arrangements in place for agencies to track EWL costs were mostly comprehensive and robust. However, there was no regular monitoring and reporting of costs against budget at the whole-of-project level.

2.5.1 Eastern section

As part of the project governance arrangements, the then Department of Transport, Planning and Local Infrastructure (DTPLI) established the EWL steering committee whose responsibilities included endorsing all recommendations to the Minister for Roads and to Cabinet, including those in regards to whole-of-project scope and budget management.

The steering committee's meeting agendas and minutes indicate that regular reports were provided by the key operational entities for the project—the Linking Melbourne Authority (LMA), DTPLI, DTF and VicRoads. LMA tracked its own expenditure against the approved project budget together with costs for which other departments and agencies sought reimbursement. LMA reported this information to the EWL steering committee.

The regular reports from departments and agencies were generally noted in the steering committee meetings. However, there was little documentation of discussions that may have occurred and questions that may have been asked. The steering committee only considered Stage 1 and not Stage 2.

2.5.2 Western section

For Stage 2, DEDJTR established a project code in its finance system against which project costs were charged. There was no evidence of regular monitoring and reporting of costs against budget for Stage 2 or at the whole-of-project level.

2.5.3 Departments and agencies

Figure 2E summarises the responsibilities of departments and agencies and to what extent project costs were tracked.

Figure 2E

Agency responsibilities and cost tracking

Source: Victorian Auditor-General's Office.

Some departments did not capture the staff costs attributable to the EWL project. For example DTF, Department of Premier & Cabinet, and DEDJTR staff do not complete timesheets, and therefore internal staff costs were not captured and included as part of the project cost. These departments only passed on costs associated with external consultants to LMA.

Recommendation

1. That the Department of Treasury & Finance provides guidance to support whole-of-project cost tracking and reporting against budget for major projects that involve multiple stages managed by different agencies.

3.1 Introduction

The East West Link (EWL) project was one of the most significant investments ever proposed for the state in terms of impact, complexity and cost. In October 2011 the government approved funding for the development of a business case for the project. The business case was developed between late 2011 and mid-2013.

In April 2013, the government approved the eastern section of EWL to proceed as Stage 1 of the project based on a March 2013 business case. The business case was subsequently updated with the final version noted by government in September 2013.

The former Department of Transport and former Department of Transport, Planning and Local Infrastructure—now the Department of Economic Development, Jobs, Transport & Resources (DEDJTR)—were responsible for developing the business case, and were supported by the Linking Melbourne Authority.

3.2 Conclusion

The EWL business case did not provide a sound basis for the government's decision to commit to the investment. Gaps and weaknesses in the business case—including a failure to adequately address the issues raised by external reviews of key underlying information—meant that it did not clearly establish the need for the investment through a robust analysis of the costs, benefits and risks of reasonable options.

Further, the business case did not provide a sound basis for prioritising the eastern section over other sections of the proposed road.

These issues mean there was little assurance that the prioritisation of significant state resources for this project was soundly based.

The proposed project delivery approach was sound, however, the assessment of options appears to have given undue weight to the government's desire to begin work on the project prior to the 2014 state election.

3.3 Project planning and development timing

While no public commitments were made on the timing of the project in 2011 when the government agreed to fund the business case, it is clear that the government was focused from the outset on accelerating the planning and development of the project.

Figure 3A outlines key events in the project planning phase.

Figure 3A

Key events in the project planning phase

Source: Victorian Auditor-General's Office.

In April 2012, the government was advised of the risk of legal challenges to the progress of the project. Other advice to government on the project similarly highlighted risks to robust decision-making due to the emphasis on meeting the government's challenging time frame.

The government considered this advice but did not agree to allow additional time for project planning and development. In June 2012 the government approved a target forward program for the project that required construction to commence in October 2014, before the caretaker period for the November 2014 state election. This required concurrent activity on project development and statutory planning processes including approvals, procurement and contracting.

In addition, the government's target time line for the project was given undue weight by the then Department of Transport in arriving at their recommendation in the business case on the procurement and project delivery approach, and associated risk allocation.

3.4 The business case

The Department of Treasury & Finance (DTF) defines a business case as a 'document that forms the basis of advice for executive decision-making for an asset investment. It is a documented proposal that considers alternative solutions and identifies assumptions, benefits, costs and risks'. It is generally accepted that a robust business case is critical to the success of an investment.

The business case initially completed for the project in March 2013 formed the basis for government decisions. This business case was subsequently revised and finalised in June 2013.

The March 2013 business case indicated that the eastern section of the project had weak direct economic benefits arising from the core eastern section project scope and the investment merit relied on wider economic benefits (WEB).

A benefit cost ratio (BCR) of less than 1 indicates the benefits of the investment are less than the costs. Excluding complementary projects and WEBs, the direct BCR was 0.45. Including both WEBs and a range of complementary projects achieved a BCR above 1. This position was not significantly changed when the business case was revised in June 2013.

Figure 3B shows the BCRs disclosed in the March 2013 and June 2013 business cases.

Figure 3B

East West Link project (eastern section) benefit cost ratios

(a) Comprised the eastern section and a package of integrated land use and public transport initiatives, but not complementary projects such as the Eastern Freeway upgrade.The BCR analysis excluded costs and benefits from urban renewal and public transport initiatives.

(b) Comprised the eastern section and a package of integrated land use and public transport initiatives plus complementary projects including the Eastern Freeway upgrade, public transport improvements and CityLink widening. The BCR analysis excluded costs and benefits from urban renewal and active transport initiatives.

Source: Victorian Auditor-General's Office.

DTF guidelines on economic evaluation for business cases acknowledge that traditional BCR analysis has limitations and is not recommended as the sole quantitative assessment tool for decision-making purposes because it is biased towards small projects and those with early returns.

The March 2013 and later updated business cases:

• set out the strategic rationale for pursuing EWL over other transport investments
• proposed the eastern section as the preferred option for Stage 1 of the project over the other sections—despite the western section likely having a higher BCR
• presented a base case comprising a tolled motorway between Hoddle Street and CityLink, as well as additional options for complementary public transport works with the potential to deliver added benefits over the base case.

However, these business cases did not provide a sound basis for the government's decision to commit to the investment due to weaknesses in the:

• rigour of the economic assessment—specifically the accuracy of the estimates of WEBs and the reliability of the traffic modelling
• basis for prioritising the eastern section over other sections.

As a result the business case did not clearly establish the need for the project by robustly assessing the costs, benefits and risks of reasonable options.

3.4.1 Economic assessment

DTF's Investment Lifecycle guidance emphasises that robust economic evaluation of investment proposals is a vital component of the business case, to support informed investment decision-making by government.

The economic analysis underpinning the EWL business case was developed by a consultant in 2012 and updated during 2013. This analysis was subject to a range of qualifications and caveats due to its preliminary nature given the tight time frames for completing the business case.

Figure 3C summarises the results of the economic assessment in the March 2013 business case as well as the revised assessment in the June 2013 business case.

Figure 3C

Economic assessments in business cases ($ million in present value terms)

Note: The June 2013 business case was based on the final approved project scope which included a number of complementary projects.

Source: Victorian Auditor-General's Office.

Figure 3C shows significant increases between the March and June 2013 business cases in the value of estimated benefits in a number of important categories, such as travel time and reliability savings and WEBs. It is important to note that these increases were primarily due to the refinement and resolution of the project scope following the government's consideration of the March 2013 business case. Despite this, the June 2013 business case did not fully explain the basis for these increases in claimed benefits.

Wider economic benefits

The EWL business case relied heavily on the inclusion of estimated WEBs to support the assertion that the project was of net benefit. Without these WEBs, which were unusually high as a proportion of total benefits, the project cost was clearly higher than the expected benefits.

WEBs relate to economic benefits that are not typically captured in traditional cost-benefit analysis. Commonly considered WEBs include:

• 'agglomeration' impact (an increase in productivity due to improved proximity to suppliers and labour markets)
• the impact of transport on increasing competition
• competition related user benefits.

The DTF guidelines indicate that WEBs are most relevant to transport and other large infrastructure projects. However, guidance materials from DTF and Infrastructure Australia indicate caution should be exercised when estimating and considering WEBs as part of the economic assessment of projects.

DTF's guidelines note that the extent to which WEBs exist over and above benefits counted in the standard economic evaluation is not yet clear, and will depend on the nature of the project under consideration.

The June 2013 business case does not provide sufficient information to explain the basis for the significant change in WEBs from the March 2013 business case.

This was important, because an external peer review of the March 2013 business case raised significant issues with the plausibility of the level of WEBs claimed for the project in terms of their ratio to total benefits. Specifically it stated:

• 'initial observations are that the ratio between core travel benefits and WEBs is very atypical with the latter being much higher as a proportion of overall benefits than would normally be expected
• a thorough review of the literature has confirmed our knowledge and experience that WEBs...typically represent around 10–40 per cent of the traditional benefits
• the higher values are for CrossRail in London where WEBs have been estimated 40–50 per cent...mainly [due] to the ability of CrossRail to allow tens of thousands of additional workers to access high value jobs in more productive areas that would otherwise simply not have been possible. This is an extreme situation that is certainly not replicated in Melbourne with the East West Link'.

The peer review concluded that the relationship between the standard user benefits and the WEBs was so highly unusual that they warranted a detailed discussion and explanation if they were not to be discounted as implausible.

The final business case did not satisfactorily address this issue. It only provides a high‑level discussion of the approach used to calculate the WEBs and does not specifically address the issues identified by the peer review. As a result, the information included in the business case offered insufficient assurance about the robustness and reliability of the estimated WEBs for EWL.

Limitations of traffic modelling

Around 70 per cent of the estimated $3.2 billion in direct benefits from the project related to estimated travel time savings derived from traffic modelling undertaken in 2012 and updated in 2013 for the final June 2013 business case.

The then Department of Transport commissioned two peer reviews to examine the traffic modelling. A detailed peer review of the traffic modelling approach, inputs and outputs was undertaken in December 2012 and a broader peer review of the economic analysis underpinning the business case in March 2013 also commented on the traffic modelling.

The December 2012 peer review identified a number of issues impacting on the reliability of the traffic forecasts, including assessments of wider congestion impacts. The peer reviewer concluded that it was more likely that the demand would be lower, rather than higher, than the traffic forecasts relied on in the business case. However, the reviewer indicated that the traffic model used was reasonable for that stage of the business case development process. The peer review made 21 recommendations for improving the model, however, these recommendations were not addressed in the final business case.

The later peer review also identified limitations in the traffic modelling and related business case analysis that were not adequately resolved or addressed in the final business case.

The external peer review in March 2013 noted that the business case did not provide detailed information on estimated traffic flows and that this omission was unusual in a transport project business case. The review stated that the information in a traffic model report appended to the business case was not comprehensive and in some cases was difficult to understand.

The peer review recommended that specific traffic numbers and illustrative diagrams be included in the business case. The review suggested that it would be useful if this section included a description of the effect of the project on public transport patronage and that it should include a detailed discussion of freight traffic. This was not done in the final business case.

Induced demand

There was limited consideration in the business case of induced demand—additional traffic created by improved roads and routes.

Our 2011 audit, Management of Major Road Projects, highlighted the significant risks associated with failing to adequately assess induced demand. That audit found that the failure to take induced traffic into account meant that major road projects tended to overestimate benefits and give false confidence to decision-makers about the capacity of the project and the surrounding roads to cope with future traffic flows.

There are six dimensions of induced traffic that need to be considered when assessing major road projects:

• changing route—drivers make the same journeys but use the improved route
• changing destination—drivers decide to travel to more distant destinations because the improvement makes the journey time acceptable
• changing mode—public transport passengers switch to car because the improvement makes road travel more attractive than rail
• changing time of travel—drivers decide to travel in the commuting peak period because the improvement reduces journey times to an acceptable level
• making additional journeys—people are willing to make additional car journeys because of the improvement
• relocated trip—people and businesses relocate to take advantage of the improvement and so make new journeys to the area.

The model used in the EWL business case only addressed the first three of these. The consultant acknowledged that its model did not capture the other elements and acknowledged that further research was required to accurately assess the potential impacts of these elements. There is no evidence that any further action occurred.

The terms of reference for the December 2012 peer review of the traffic modelling included examination of how the traffic model complied with VAGO's prior recommendations relating to induced demand. However, the report did not specifically address this issue other than in a footnote indicating this was considered by the reviewer.

DEDJTR advised that it has recently established a governance framework to oversee transport modelling and economic appraisal of projects and developed guidelines to support a standard approach to traffic modelling.

3.4.2 Prioritisation of stages

A strategic issue when considering potential investment in the EWL project was whether it should be constructed as a single project or in stages, and the order of any staged construction. This was acknowledged in advice to government in April 2012 which indicated that while the business case would examine the case for the entire EWL, it would also take into account the likely need for delivery in stages, given the scale of the project.

A review of subsequent advice to government indicated that a preference to construct the eastern section emerged during 2012, well before completion of the business case in 2013. The advice did not clearly demonstrate the basis for this preferred staging of the project. Relevant departments have advised that the decision to pursue the eastern section first was a policy decision of government.

The business case asserted that while the western section offered significant benefits in its own right, the eastern section would generate 'greater and more widely dispersed benefits' and was the preferred option for Stage 1 of the project. However, the business case did not support this assertion with sufficiently detailed evidence and analysis.

A March 2013 peer review of the business case economic appraisal supported this view. It noted that the absence of an economic analysis of the full road link, and of each of the related stages, was both unusual and an issue that reduced the transparency of the analysis and the decision-making.

The business case analysis included reference to previous cost-benefit assessments undertaken for the former WestLink project—discontinued following the 2010 election—which broadly covered the scope of the western section of the proposed EWL. An appendix in the EWL business case acknowledged that two separate cost-benefit analyses (CBAs) of the WestLink project commissioned by the state in 2009 and 2011 yielded positive and higher BCRs than the proposed eastern section of EWL, both with and without the inclusion of WEBs:

• The 2009 CBA showed a BCR of 1.95 for the full EWL (2.35 with WEBs), and a BCR of 1.33 for WestLink (1.65 with WEBs)
• The 2011 CBA showed a BCR of 1.5 for the western section (1.65 with WEBs).

The BCR disclosed for the eastern section in the 2013 EWL business case varied from 0.4 to 0.8 without the inclusion of WEBs and up to 1.4 with WEBs included.

The BCR should not be considered in isolation when examining the relative merits of competing projects. However, the business case did not present a detailed comparative analysis of the results or any explanation of the differences. It is reasonable to expect that such an analysis should have occurred, given the significant scale of the proposed investment.

The economic analysis presented in the business case was restricted to options associated with the preferred eastern section of the full road only. The absence of such analysis for the other sections reduces assurance that significant state resources were being effectively prioritised to the area of greatest need or benefit.

The decision to prioritise construction of the eastern section was also inconsistent with information in the 2008 East West Link Needs Assessment (EWLNA) study which identified the eastern section as the second highest priority for development. The EWLNA study ranked the sections in order of priority as (1) inner section—i.e. Port to West Melbourne section, (2) eastern section and (3) western section. While the business case acknowledged the 2008 EWLNA study as context for the proposed project, it did not reconcile the difference in priorities.

3.5 Procurement and delivery model

In March 2013, the government was advised that the business case had explored all procurement models, with the view to maximising value for money for the state, and recommended an availability public private partnership (PPP) with the state retaining the toll revenue, and also the risk that demand might be lower than expected.

Analysis and advice on the project delivery model was robust and considered the relevant options including a traditional design and construct procurement approach. The choice of project delivery model was influenced by a reluctance in the market to take on full demand risk (the risk that actual demand for the road will not meet the forecast) and by the desire to sign the contract by November 2014.

The market sounding exercise undertaken for the project identified very little appetite for the traditional toll road model where full demand risk is transferred to the private sector, but some appetite for sharing with, or fully transferring demand risk to the state. This, together with timing considerations, was a key factor in recommending the availability PPP model under which the state fully retained demand risk.

The business case examined two main options, an availability PPP where the state retained full demand risk and a PPP approach where some demand risk was shared with the private sector. One of the reasons for dismissing the second option was the difficulty in implementing it within the government's target time lines.

3.6 Financial implications at planning stage

Development of the business case occurred during 2011–12 and 2012–13. In October 2011, the government approved $7.5 million to be provided to the then Department of Transport to commence work on a business case for EWL. A further $19.5 million was approved in December 2012 by the Treasurer for finalisation of the business case and to commence planning and development activities.

In May 2013, the government announced its intention to proceed with the eastern section at an estimated capital cost of $6 to $8 billion.

At the time of approving the final business case, the estimated project cost of the eastern section was $7.96 billion (in nominal terms) comprising:

• $5.5 billion capital for the EWL road design and construction
• $920 million for private financing costs
• $385 million for state costs for property acquisition, project management and procurement
• $400 million for other related complementary projects
• $755 million for risk and contingency.

There was no budget allocation in April 2013 for the operation and maintenance of the eastern section, given that this initial budget was developed on the basis of state based, rather than PPP, delivery and for the capital component only. The submission on the project budget noted that the operation and maintenance, toll collection and other life cycle costs were not taken into account as they were expected to be offset by the future toll revenue. Operation and maintenance costs of $399 million in present value terms over the life of the agreement were noted in later advice to government (after contract signing), but there was no formal budget approval. This is in line with DTF's normal budgeting practices for PPPs and other capital projects.

In May 2014, the state announced its commitment to deliver the western section at an estimated capital cost of $8 to $10 billion with initial works commencing in 2015.

The project was to be funded by the Commonwealth Government, state government and by road users through tolling arrangements.

Recommendation

2. That the Department of Treasury & Finance improves its business case development guidance material, the adherence to this guidance by agencies, and its quality assurance over key inputs by:

• critically reviewing the analysis of options in business cases against the requirements of existing guidance material and providing feedback to agencies
• developing further guidance on methods for transparently determining and quantifying wider economic benefits
• strengthening its processes for reviewing and advising government on the adequacy of actions taken to address findings and recommendations arising from peer or other external reviews of key business case inputs such as economic and financial analyses, demand modelling, cost estimates and procurement options analyses.

4.1 Introduction

The procurement phase of the East West Link (EWL) project Stage 1, the eastern section, involved engaging a contractor to finance, design, construct, and then operate and maintain the road and tunnel infrastructure through a public private partnership (PPP).

The contract for Stage 1 was signed by the Minister for Roads on behalf of the state with East West Connect (EWC) on 29 September 2014. The Treasurer provided a side letter confirming the state's commitment to honour the contract on the same day to address EWC's concerns with the suggestion that the state did not have the requisite power to execute the contract.

Under the contract the state had obligations to:

• acquire land for the project
• obtain and maintain applicable approvals
• provide state financial contributions and make quarterly service payments during the operations and maintenance phase linked to the availability of the road
• obtain agreement for the interface with CityLink
• deliver the toll collection system and required state works.

In the lead up to the government entering into the contract with EWC:

• there was a legal challenge to the planning approval decision for the project
• the then Opposition indicated that the project should not proceed by providing the government with a copy of legal advice questioning its power to enter into the contract and indicated that, if elected in the November 2014 election, it would not defend the legal challenge to the planning decision
• EWC was refusing to sign the contract unless the state agreed to amendments in its favour.

This Part of the report examines whether the EWL procurement phase was undertaken in accordance with the government's Partnerships Victoria requirements and was supported by robust and comprehensive advice. It also examines how well the risks that emerged as the process evolved were mitigated.

The departments and agencies providing advice were the Department of Premier & Cabinet (DPC), Department of Treasury & Finance (DTF), Department of Transport, Planning and Local Infrastructure (DTPLI) which is now the Department of Economic Development, Jobs, Transport & Resources, and the Linking Melbourne Authority (LMA).

4.2 Conclusion

LMA managed the procurement process well in challenging circumstances, completing it in line with the tight time lines stipulated by the government at the outset of the project, and in compliance with relevant procurement requirements.

Signing the EWL contract when there was significant uncertainty about the status of critical planning approvals was imprudent and exposed the state to greater cost and risk. It is evident that the state knew the risk was significant. The risks associated with this decision were increased when the state agreed to amend the contract in favour of EWC to provide it with additional compensation in circumstances that the state knew were likely to eventuate.

Advice to government did not fully explore or give sufficient emphasis to the potential benefits of delaying finalisation of the procurement and contract to mitigate the risks posed by the unresolved judicial review of the project planning approval decision. This was despite:

• LMA observing that it would be unprecedented for a PPP to proceed to contract signing with the judicial review and other relevant matters undetermined
• the state being aware that the risk the judicial review plaintiffs would be successful was significant, and that the proceedings could be expedited
• the potential for the judicial review to lead to extensive delays and scope changes and to EWC making a claim against the state under the contract.

4.3 Procurement of Stage 1—eastern section

The procurement process was undertaken in accordance with the government's Partnerships Victoria requirements.

The EWL business case proposed that a competitive tender process be adopted to engage a preferred bidder, but recommended the project team consider ways to streamline and improve the process to achieve better value for money by, for example:

• limiting the number of short-listed bidders to two due to the significant bid cost estimated at $30 to $50 million per bidder
• making the tender process as efficient as possible and providing for early selection of a preferred bidder where possible
• only taking the preferred bidder to full documentation as this would further contain bidder costs
• making a contribution to external bid costs.

All of these steps reflected the PPP reforms introduced by the government in May 2013 and were incorporated in the procurement process established by LMA.

4.3.1 Procurement documentation

The procurement process involved two stages—an Expression of Interest (EOI) followed by a Request for Proposal (RFP) for short-listed parties. The EOI and RFP procurement documentation was developed by LMA in close consultation with DTF and the former DTPLI. Figure 4A sets out the key steps and time lines.

Figure 4A

Key EOI and RFP events

Source: Victorian Auditor-General's Office.

The EOI document provided information to potential respondents about the project including design and construction issues and risks, and the proposed PPP payment mechanism. The EOI also set out the evaluation criteria to be used for selecting a short-list of respondents to participate in the RFP phase.

The RFP document covered instructions for responding, project requirements for design, construction, maintenance, operation and hand back, and draft contractual documentation.

The development and release of the procurement documentation was conducted in accordance with the government's Partnership Victoria requirements.

4.3.2 Assessment of submissions

Assessment of EOI submissions was led by LMA. For RFP submissions, assessment was overseen by an executive panel comprising staff from LMA and representatives from DTF and the former DTPLI. This panel was supported by three subordinate panels that assessed three specific aspects of the EWL project—commercial, technical and urban design. These four panels collectively assessed the submissions against 22 criteria including value for money. Figure 4B shows the key assessment steps and time lines.

Figure 4B

Key assessment steps and time lines

Source: Victorian Auditor-General's Office.

The advice and documentation supporting the assessments prepared by LMA and DTF was robust, comprehensive, transparent, and met Partnerships Victoria requirements. Assessments were completed in line with the government's time lines.

4.3.3 Appointment of preferred bidder

It was evident that the decision to appoint a preferred bidder was influenced by the then government's desire to sign the contract by 30 September 2014.

Following endorsement of the executive panel's recommendation by the EWL steering committee, a briefing was submitted by the then Minister for Roads to government on 4 September 2014 seeking approval of a proposed strategy to sign the contract on or before 30 September 2014. The briefing emphasised that this involved approving and publicly announcing the preferred bidder by no later than 9 September 2014.

This briefing stated that the evaluation process had concluded which of the two submissions was superior and why, adding that rectifying the deficiencies in the unsuccessful bidders' proposal would take an estimated two further months.

The briefing further stated that a key rationale for selecting a single preferred bidder was that it increased the likelihood of signing the contract by no later than 30 September 2014. This was because:

• full documentation was only required to be progressed and finalised for one bidder, noting that this task can take approximately three weeks from the appointment of a preferred bidder
• finalisation of interface arrangements with Transurban, the operator of CityLink, and the two public transport service providers would be more efficient with only one bidder
• appointing a preferred bidder provides greater impetus for that bidder to finalise the contracts—there is also an incentive for the preferred bidder to finalise arrangements before the caretaker government period.

The government accepted the recommendation and announced the preferred bidder on 9 September 2014.

4.3.4 Probity arrangements

Probity practitioners are engaged for significant procurements to provide independent oversight of compliance with procurement process requirements, and provide assurance on the integrity of the tender process.

LMA engaged a probity practitioner to provide advisory services for the EWL procurement process. The adviser's initial task was to develop a probity plan to provide straightforward guidance to the project team on the practical application of probity throughout the procurement process. This plan was completed in May 2013.

The probity adviser was also required to examine and provide an opinion on compliance with the probity plan. The probity reports subsequently presented to LMA during the procurement process attested that the EOI and RFP phases had been conducted in accordance with the probity plan, evaluation manual and other probity requirements.

Engaging a single party as both the probity advisor and the probity compliance reviewer weakened the independence of the probity practitioner. The scale of the EWL project warranted the appointment of separate parties to undertake these two functions.

4.4 Unresolved issues affecting the project

The procurement phase and contract negotiation were undertaken in parallel with:

• the statutory planning approval process, which was the subject of an unresolved legal challenge
• negotiations with Transurban, the operator of CityLink, regarding the widening of CityLink and its integration with EWL.

Delay in finalising the statutory planning process

The EWL project was to be declared under the Major Transport Projects Facilitation Act 2009 (MTPFA) in July 2012 with statutory planning to start as soon as possible after that date and be completed by March 2014. However, declaration of the project under the MTPFA did not occur until 20 December 2012.

In March 2013 and again in April 2013, DTF advised the government that it was imperative that the statutory planning process commence as a matter of urgency, because without intervention the process was likely to be finalised around the same time as the procurement process which constituted a significant risk. DTF advised that in normal circumstances there is a gap between the receipt of final statutory planning approvals and the finalisation of the tender process so bidders have certainty when submitting designs as part of their bids.

RFP responses were submitted to LMA as required on 28 April 2014 but the Minister for Planning's approval decision, which was not made until 30 June 2014, imposed conditions and new requirements that affected the project's design and costs.

On 9 July 2014, DTF advised the then Treasurer that the most significant risk resulting from the minister's decision was the uncertainty that some of the conditions and requirements may create for bidders, and therefore the ability of the state to efficiently achieve contractual signing within the scheduled time frames.

On 17 July 2014, LMA applied for a variation to the minister's decision, requesting that he amend or clarify certain conditions he introduced. LMA's application, which requested a response by 1 August 2014, highlighted areas where meeting a condition in the decision would:

• not be physically possible
• be inconsistent with existing standards and requirements
• be highly impracticable (based on bidder feedback).

DTF advice emphasised that if the uncertainties created by the approval decision were not resolved well before contract finalisation there was a risk the preferred bidder may not be prepared to sign the contract. Further, if the preferred bidder was willing to enter into a contract it was likely that the state would be required to bear the cost and time consequences of any alterations required to satisfy the minister's approval decision.

LMA requested the two short-listed bidders to submit revised bids by 8 August 2014 that addressed the changes to the project caused by the minister's approval decision, assuming the variations requested by LMA to the approval decision would be accepted. In making this request LMA recognised there was a risk to the procurement process timing if the changes requested were not accepted by the minister.

Despite this uncertainty the preferred bidder was announced by the government on 9 September 2014 while the variations sought to the approval decision remained unresolved until 19 September 2014 when the minister varied his decision predominantly in line with LMA's requests.

Unresolved legal challenges to planning approval decision

Compounding this uncertainty were unresolved legal challenges to the Minister for Planning's approval decision of 30 June 2014.

On 21 July 2014, two local government councils lodged a claim in the Supreme Court seeking a judicial review of the approval decision asserting that the minister had failed to examine the EWL business case in considering the economic costs and benefits of the project. A second claim was lodged in the Supreme Court on 20 November 2014 by a third council seeking a judicial review based on a claim that a requirement to consult it had not been met when the Minister for Planning determined the variations to the approval decision.

An earlier legal claim against the project had been lodged in April 2014. This claim by a local resident sought a Supreme Court injunction to prevent contract execution on the basis that the project benefits had been misrepresented.

Unresolved arrangements to access CityLink for construction works

As EWL was intended to connect to CityLink it was necessary for an agreement to be reached with Transurban, the CityLink operator, to enable access for construction work.

When the RFP was issued to the short-listed bidders on 31 October 2013, negotiations with the CityLink operator were under way. Updated RFP documentation was subsequently reissued to bidders on 7 March 2014 following assessment of interim submissions requested as part of the tender process. However, as negotiations with the operator of CityLink were still in progress, the updated documentation did not include finalised access arrangements.

Access arrangements were still not finalised when RFP submissions were due, and when the preferred bidder was appointed on 9 September 2014.

In addition to the uncertainty this situation created for bidders, it had the potential to require the state to compromise its position with the CityLink operator in order to finalise the agreement and, conversely, strengthen that operator's negotiating position. It is unclear if this occurred.

4.5 Decision to enter the contract

In addition to the above unresolved issues, in September 2014 the then Opposition stated that it would not proceed with the project if elected in November 2014.

4.5.1 Advice leading up to contract signing

It is not standard for a PPP to proceed to contractual signing when there is significant uncertainty about the status of critical planning approvals. However, this is what occurred on EWL. Such circumstances warranted comprehensive advice to government on its options and the best course of action for the state.

Advice from agencies noted the potential implications of signing the contract despite the litigation and planning risks. This advice included preliminary quantification of:

• potential delay costs estimated at between $40 million and $110 million permonth, and advice that any scope changes arising from a new planning approval decision may lead to further costs
• compensation payable under termination scenarios which, while difficult to estimate and dependent on the timing of any termination, was advised to be in excess of $900 million by February 2015 and higher if terminated later.

However, relevant advice to government, associated briefings from DTF and DPC and, to some extent, LMA presentations to the project steering committee, did not fully explore the merits of options to defer selection of a preferred bidder, delay signing the contract, delay finalisation of the project financial arrangements and/or implement some form of 'standstill', 'go slow' or 'short-term' agreement. This was seemingly driven by a view within the departments and agencies that the government would be unreceptive to advice arguing against its objective of signing the contract before November 2014.

LMA advice in August 2014 indicated that, given the significant implications, it was critical that all efforts be made to resolve the judicial review before signing the contract. LMA also advised DTF, the steering committee and DTPLI that it was unprecedented for a PPP contract of this scale to be executed while a judicial review of this nature remained undetermined.

The LMA advice was particularly important given that the government was aware that:

• the risk that the plaintiffs seeking the judicial review of the planning approval decision would be successful was significant
• it was possible to have the proceedings brought to a hearing quickly if the state wished.

In August 2014, DTPLI recommended that the government take action to have the judicial review of the planning approval decision determined as quickly as possible. This recommendation was supported by an awareness that there was a significant risk that the challenge to the planning approval decision would be successful. Therefore its timing was critical because the longer the judicial decision took, the higher the potential contracting risks and the greater the potential financial exposure of the state under the contract, should a contract be signed before the judgement. DTPLI advice indicated that an expedited court timetable was achievable, would deliver early certainty, and would provide the best mitigation to the substantial cost and risk exposures to the state that existed at that time.

Despite this advice the government decided not to seek an expedited hearing. LMA advised that following this decision DTPLI provided it with verbal:

• advice that the state intended to seek a hearing date in December 2014 for the judicial review proceeding
• instructions that the government wished to proceed to contract signing for the project in accordance with its previously determined time line and LMA should seek to finalise the contract documentation with the preferred bidder.

The focus on achieving this time line was given disproportionate emphasis given the significance and complexity of the project and the risks and implications for the state. Consistent with the overriding desire to achieve the established time frames, subsequent advice to government focused on options to mitigate identified risks if the government determined to proceed to signing the contract rather than emphasising the potential benefits of delaying signing and fully exploring the merits of alternative options.

Specific gaps in the advice to government included the failure to:

• comprehensively examine the merits of alternative options—while noting that options to delay contract signing and/or finalisation of the project financial arrangements existed, the advice contained only limited discussion and analysis of these options and gave undue weight to the need to reach agreement with EWC on possible options
• directly support or oppose the proposed timing of the transaction—i.e. advice did not directly recommend any course of action in the best interests of the state.

The reasonable prospect that the planning approval decision would be overturned by the judicial review warranted more comprehensive advice to government examining options other than signing the contract in terms of potential costs, benefits and risks. These options should have included extending the tender process to defer the selection of a preferred bidder and contract signing while, at the same time, seeking to expedite the application for judicial review. If the approval decision was overturned, such options could have offered a better outcome for the state than a scenario of a claim under the contract. The state had discretion to extend the procurement process if it wished to do so.

The 24-day period from announcement of the preferred bidder on 9 September 2014 to contract signing on 29 September 2014 and finalisation of the project financial arrangements on 3 October 2014 was relatively short. Benchmarks published by Infrastructure Australia and otherwise established by recent PPP transactions in Victoria suggest that around six weeks would have been considered efficient.

While there were no missed steps in the typical finalisation process for a PPP transaction, the government's overriding desire to achieve its time line, compromised the state's ability to:

• adequately explore options to extend the tender process—i.e. defer selection of a preferred bidder, delay signing the contract, delay financial close and/or implement some form of 'standstill', 'go slow' or 'short-term' agreement; and/or
• negotiate optimal contractual terms with EWC in relation to the litigation and planning risks.

Options to minimise construction expenditure, and avoid or reduce the significant up-front costs until the planning risks could be resolved were flagged in advice to government, but were not pursued.

If contract signing had been deferred until after resolution of the judicial review, the state's exposure under the non-standard contract provisions accepted to secure EWC's execution of the contract, could have been avoided.

4.6 Executing the project contract

The state signed a contract appointing EWC to finance, design, construct, operate and maintain Stage 1 of EWL in September 2014. The Treasurer also issued a side letter to EWC affirming the state's commitment to honouring the contract and related compensation payment obligations.

4.6.1 'Non-standard' contract provisions

The contract was standard in most respects while also including a number of project-specific provisions relating to land acquisition, key approvals, the interface with CityLink, the toll collection system and state works.

The termination and compensation provisions in the contract were also generally consistent with the standard commercial principles established by the National PPP Policy and Guidelines, the Partnerships Victoria requirements and with recent precedent transactions. However, in departures from standard practice for PPP transactions in Victoria, the state agreed to the inclusion of clause 58—Specific Key Approval Event in the contract and signed a side letter to the contract.

These variations from standard contractual terms were introduced at the request of the preferred bidder. EWC's requests were prompted by the legal challenge to the Minister for Planning's approval decision for the project and the Opposition's announcement that it had legal advice questioning the state's power to enter into the contract and that it would not defend the application for judicial review of the planning decision if elected in November 2014.

Clause 58

Under the contract, the state bore the risk of any litigation or changes relating to key project approvals such as statutory planning approvals. This is part of the standard risk allocation in PPP contracts.

EWC requested that a new clause (clause 58) be inserted in the contract and the state agreed. Clause 58 increased the state's exposure in circumstances where the planning approval decision was found to be invalid, as compared to the 'standard' provisions of the contract.

Specifically, clause 58 exposed the state to the following primary consequences if the approval decision was held to be invalid within two years of finalisation of the project financial arrangements:

• higher delay cost caps than those applicable to other delays—up to $2.5 million in Prolongation Costs per day
• an obligation to terminate 'for convenience' where any decision that the planning approval decision was invalid had a material impact on EWC for a continuous period of 12 months—under this scenario, the standard compensation payout formula was modified to include a fixed payout to equity of around $30million, as opposed to fair market value, plus the termination costs payable by EWC to its management services provider during the contract.

In addition, if the judicial review of the planning decision resulted in changes to the approval decision this could trigger a claim from EWC for costs under another clause of the contract.

The side letter

The Treasurer executed the side letter in favour of EWC on the same day the contract was signed. The obligations in the side letter would have been triggered if a court declared within three years of finalisation of the project financial arrangements that the state did not have the executive power to execute the project contract, and that the contract was void or unenforceable.

In this scenario, the side letter committed the state to pay EWC compensation calculated in accordance with the contract as if the contract had been terminated by the state three months after the date on which the contract was declared or decided to be void or otherwise unenforceable.

The payment obligation created by the side letter was subject to a number of conditions, including that the state was entitled to a three-month period to remedy the fact that the contract was void or unenforceable.

The only scenario under which the side letter can be argued to have created additional exposures for the state is one in which the state did not have the authority to sign the contract. Legal advice obtained by government both before and after the election indicated that this was very unlikely.

4.6.2 Advice on contract provisions

The state's external legal and commercial advisers signed off on the general alignment of the contract with the National PPP Policy and Guidelines but qualified this with specific reference to clause 58.

Advice to government clearly explained the basis for, and implications of, the new clause 58 and the side letter. However, the advice did not clearly explain the rationale for aspects of the higher compensation payable under clause 58 and did not adequately highlight the qualifications included in the 'sign-off' letters from the state's legal and commercial advisers for the project.

DTF advice to government in September 2014 stated that the side letter was a proportionate and appropriate way of calming investor and funder nerves over the executive power issues. This was consistent with the legal advice that the state did have the power to enter into the contract and therefore the side letter would never be triggered.

The risk and exposure for the state created by clause 58

The risk and exposure for the state created by clause 58 was linked to the outcome of the judicial review of the planning decision for the project.

The grounds for the application for review of the planning approval decision included that the Comprehensive Impact Statement assessment committee and Minister for Planning failed to have regard to mandatory relevant considerations. These principally related to the economic effects of the planning scheme amendments and in particular that the assessment committee unreasonably refused to require production of the state's business case and other documents relevant to economic costs and benefits of EWL.

The available evidence suggests that the state knew on 19 August 2014 that the risk and exposure relating to the potential for the judicial review to quash the approval decision, later the subject of clause 58, was significant. This position was presented to government in advice from DTPLI on 20 August 2014.

A file note prepared for the EWL project steering committee at the end of September 2014 indicated that the state's prospects of success in the judicial review may have been more positive. The basis for this view was not documented but the view was conveyed to government on 23 September 2014.

Basis of the potential $30 million payout to equity

Clause 58 modified the 'termination for convenience' compensation formula to include a fixed payout of return of capital plus $30 million, and the termination costs payable by EWC to its management services provider.

Advice to government on the basis for the $30 million was not clear or consistent. Despite this, LMA advice to government on 23 September 2014 suggested that under the standard termination provisions of the contract the payment for return of equity would be 'immaterial' but under the proposed clause 58, it would be $30 million. Based on this advice, the fixed payout to equity component of clause 58 did create 'additional' exposure for the state as compared to the standard provisions.

The likelihood of this payment being triggered was linked to the likelihood that the planning approval decision would be quashed, and the length of time that might have been required to 'remake' the decision, assuming the then government sought to do so.

Rationale for higher delay cost caps

Clause 58 exposed the state to higher delay cost caps than those applicable under the 'standard' provisions of the contract, noting that EWC was only entitled to actual, additional, net costs properly and reasonably incurred and directly attributable to the relevant delay event.

The cap on prolongation costs if clause 58 was triggered was set at $2.5 million per day plus CityLink Traffic Impact Fees plus Financing Delay Costs.

This $2.5 million figure compared to the standard range of caps applicable to prolongation costs, as in Schedule 4 of the contract, as follows:

• $555 000 per day for months one to three after financial close
• $1.75 million per day for months four to 18
• $2.05 million per day for months 18 to 40
• $1.75 million per day beyond that point.

The likely time frame for when clause 58 could have been triggered was early 2015, so the most relevant comparator is the $1.75 million per day for months four to 18 after financial close. There was no clear commercial rationale for an increase of around 43 per cent in the relevant daily cap under clause 58. This is because there was little logical basis for one specific type of delay event warranting a higher cap than other types of delay events.

Advice to government did not explain why one specific type of delay event warranted a higher cap than other types of delay events. From the state's point of view, the request for higher delay cost caps should have highlighted the need for further consideration of options to mitigate the exposure of the state, pending resolution of the judicial review.

With more time it may have been possible to negotiate a more favourable position for the state in relation to clause 58 and related provisions. For example:

• the commercial rationale behind the increase in the delay cost cap was not clearly explained, nor was the basis for calculation of the potential $30 million payout to equity in a termination scenario
• advice to government noted the possibility of negotiating some form of 'standstill' or 'go slow' arrangement to help mitigate the costs incurred by EWC until the judicial review was determined—it appears that LMA discussed this option with DTF but it was not raised with the preferred bidder due to a reluctance to introduce further risks to meeting the time line for finalising the contract.

Alternatively, the potential exposure under clause 58 could have been avoided by deferring contract signing until the judicial review was resolved. This would have required an extension to the time lines previously disclosed to bidders.

In taking the decision to proceed to contract signing the state was, in effect, 'gambling' that the judicial review proceedings would not impact the project significantly.

Recommendations

That the Department of Treasury & Finance:

3. develops minimum standards and enhanced guidance for managing the risks associated with concurrent planning, scoping and procurement processes on major projects
4. mandates the appointment of separate parties to undertake the probity advice and probity compliance review functions on High Value High Risk projects.

5.1 Introduction

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.

5.2 Conclusion

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.

Figure 5A

State costs relating to the termination

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.

Recommendation

5. 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.

6.1 Introduction

The Public Administration Act 2004 (the Act) seeks to ensure the maintenance of an apolitical public sector that responds to government priorities in a manner that is consistent with public sector values. Figure 6A shows key public sector values specified in the Act. Values of particular relevance to our assessment of the quality of advice provided to government on the East West Link (EWL) project are shown in bold text.

Figure 6A

Public sector values specified in the Act

Source: Victorian Auditor-General's Office based on section 7(1) the Act.

The audit included examination of advice provided to government by the:

• Department of Premier & Cabinet (DPC)
• Department of Treasury & Finance (DTF)
• former Department of Transport, Planning and Local Infrastructure now the Department of Economic Development, Jobs, Transport & Resources (DEDJTR)
• Department of Environment, Land, Water & Planning (DELWP)
• Linking Melbourne Authority (LMA).

The planning, development, procurement, contracting and termination of EWL spanned two governments with directly opposing policy positions on the merits of pursuing the EWL project. In addition, key decisions on the project were taken shortly before and after a state election. These circumstances created significant challenges for the public officials tasked with providing comprehensive advice in the best interests of the Victorian community.

6.2 Conclusion

Meeting the obligation to provide frank and fearless advice means there is sometimes a need to provide advice that a government may not necessarily want to receive. While the advice to government examined in this audit was generally comprehensive and clear, it did not always meet the required standard of being frank.

This highlights a risk to the integrity of public administration that needs to be addressed. Action and leadership is required from government to reinforce these standards and the related expectations for public servants.

6.3 Frank and fearless advice

The instances where the advice provided was not sufficiently frank involved advice that did not provide recommendations or that gave too much emphasis to the merits of approaches that were in line with the government's preferred outcome and little emphasis to alternative options that were more aligned with the best interests of the state.

The clearest example of this was advice provided to government in September 2014 in the lead-up to its decision to sign the contract with East West Connect (EWC) for Stage 1 of the project. While the submission to government about the decision on whether or not to sign the contract was from the Minister for Transport, DPC and DTF did not provide a recommendation to government on the best option for the state.

Outlining options to government without a recommendation in circumstances where public officials know that the option clearly favoured by government will expose the state to significant potential risk and costs is not in the best interests of the state. It is not sufficient for officials in such circumstances to stop at disclosing the potential consequences of the available options, they need to provide a recommended course of action. This advice is examined in detail in Part 4 of this report.

Similarly, the audit identified that advice to the new government following the November 2014 state election failed to properly assess the option of terminating the project against the revised costs and benefits of continuing the project. While this was consistent with the new government's announced policy position it meant there is limited assurance that the termination represented the best use of public funds. This is considered in Part 5 of this report.

DPC and DTF disputed this and advised that the Code of Conduct for Victorian public sector employees (the Code) requires the public service to implement government policy decisions once the government of the day has made a clear policy decision. This is a quite narrow reading of the Act and the Code because neither explicitly state or imply that the requirement to 'implement government policy' sits at the apex of public sector values.

This suggestion is also inconsistent with the objects set out in section 3 of the Act. The Act does not oblige public servants to implement government policy at any costs. Rather, it seeks a public service which responds to government policy priorities in a manner that is consistent with public sector values. Those values include:

• providing frank, impartial and timely advice to the government
• making decisions and providing advice on merit
• objectively considering all relevant facts and fair criteria
• seeking to achieve best use of resources
• using their views to improve outcomes on an ongoing basis.

The Act and Code empower and oblige public servants to act with integrity and, most importantly, with impartiality. This high standard of conduct cannot be achieved by the public service if this narrow reading of the Act and the Code holds sway.

This interpretation has contributed to the serious deficiencies in the advice provided to government on the EWL project.

Some public officials consulted in the course of this audit indicated that providing frank and fearless advice when they believe a government does not necessarily want to receive it is naive and creates a risk that they will lose influence or career opportunities. If this attitude becomes pervasive in the public sector there is a significant risk to the integrity of government decision-making and public administration, with consequential implications for the effective management of public resources and services.

Further guidance and support is needed to clarify and emphasise the existing requirements for frank and fearless advice in the public sector.

6.4 Transparency of advice and decision-making

The EWL project should now be used to identify lessons to prevent similar wastage of significant public and private resources on future projects in the state.

6.4.1 Broader lessons

At a high level, some of the drivers behind the significant wasted expenditure on the EWL project included:

• lack of transparency around the business case for the overall project and around the decision to prioritise the eastern section
• signing the project contract in circumstances where the merits of the project and the validity of the planning approvals were contested
• the nature of long-term public private partnerships (PPP), which typically involve high bid costs and high up-front payments to financiers, advisers and subcontractors.

In terms of the broader lessons from the project, areas for consideration by government include:

• encouraging greater transparency around business cases
• strengthening the role of non-partisan institutional bodies in investigating and prioritising investments
• ensuring that transaction time lines allow for the effective contribution of planning authorities and public consultation processes.

On the transparency of business cases, an inquiry into the circumstances surrounding the side letter to EWC commissioned by DPC in early 2015 recommended legislation requiring the release of business cases for major infrastructure projects to enable public scrutiny and increase transparency. The new government publicly released the March 2013 EWL business case and the final business case at the end of 2014.

On strengthening the role of non-partisan institutional bodies in investigating and prioritising investments, the Victorian Parliament passed legislation creating Infrastructure Victoria in early September 2015. When announcing this, the government indicated that Infrastructure Victoria will:

• take short-term politics out of infrastructure planning
• be tasked with ensuring Victoria's immediate and long-term infrastructure needs are identified and prioritised based on objective, transparent analysis and evidence
• consult widely, consider the needs of the whole state and prioritise the projects that deliver the best results
• support government decisions by assessing business cases for major projects.

6.4.2 Advice to government—potential lessons learned

'Compartmentalisation' of advice

LMA and its advisers did not have any direct involvement in the judicial review proceedings associated with the legal challenge to the Minister for Planning's approval decision. Advice to government in relation to the judicial review was presented to a different committee of Cabinet than that to which LMA typically presented. At a critical time in the project, this meant that:

• in one 'compartment', government was being advised on the likelihood that the plaintiffs would be successful in the judicial review proceedings, and on the importance of expediting the hearing
• in another 'compartment', LMA were being asked to consider the legal and commercial implications of proceeding to contractual and financial close while the judicial review remained undetermined, and to advise on the inclusion of a new clause in the project contract relating to the judicial review (clause 58).

This 'compartmentalisation' of knowledge and/or roles created silos and may well have constrained the ability of key agencies and advisers to obtain the 'full picture' relevant to their role, and may have compromised their ability to provide comprehensive advice that adequately assessed the risks and benefits of alternative options.

To illustrate, advice to government clearly stated that an assessment of the state's exposure under clause 58 depended on the outcome of the judicial review. At the same time, the sign-off letters provided by the state's commercial and legal advisers prior to awarding the contract stated that 'We understand that LMA is not involved in the judicial review and, as our scope of work does not include providing advice in relation to the judicial review, we make no comment in this respect'.

Sign-off letters in relation to PPPs

In accordance with standard practice for PPPs, LMA obtained 'sign-off' letters from its legal and commercial advisers in relation to the alignment of the project contract with the National PPP Policy and Guidelines.

In relation to the sign-off letters customarily provided in connection with PPP projects prior to contractual close, it would be beneficial if:

• relevant advisers were given formal access to any separate advice to government that is relevant to the opinions expressed
• any 'non-standard' qualifications or exclusions from adviser sign-off letters were specifically noted in relevant advice to government
• sign-off letters were more specific as to:
  • the aspects of the National Commercial Principles and jurisdiction-specific guidance that have been used to inform development of the PPP contract—for example which aspects of the principles for 'social' and 'economic' infrastructure projects have been applied
  • the areas of the PPP contract that represent project-specific departures or are otherwise not consistent with relevant aspects of the National Commercial Principles and/or jurisdiction-specific guidance
  • relevant client instructions.

Although these issues are unlikely to have affected the final outcomes of the EWL project, the value of the sign-off letters will be increased if these suggestions are implemented.

Entering contracts with other critical issues unresolved

At the time the project tender submissions were due, 28 April 2014, the access arrangements for the connection of the eastern section to CityLink were still being negotiated, creating uncertainty for bidders. This remained unchanged when the preferred bidder was appointed on 9 September 2014. In addition to the uncertainty this situation created for bidders, this potentially compromised the states negotiating position.

Also, delays in completing, and challenges to, the statutory planning process meant there was a lack of certainty regarding the final design and scope of EWL when the preferred bidder was announced.

DTF should develop enhanced guidance for identifying and managing risks associated with concurrent planning, scoping and procurement processes.

Nominal dollars, net present value and discount rates

The differences between cost and benefit forecasts in nominal dollar terms—the amount it cost when it was announced—versus net present value—what that amount of money is worth today—often leads to confusion in public debate, and has the potential to undermine the clarity of advice to government.

For example, advice to the current government in relation to the proposed cancellation of the project and the settlement with EWC:

• noted the state's commitment in nominal dollar terms over the 25 to 30-year contract term, which totalled $10.7 billion
• commented that this commitment 'created significant economic and opportunity costs' with reference to the initial EWL business case which suggested a direct economic benefit of 45 cents in the dollar.

This advice was presented without specifying the nominal dollar value of forecast toll revenue, or highlighting the state's commitment in present value terms. The way this advice was presented tended to overstate the net costs of completing the project.

Advice to government, and any associated public statements, should wherever practicable present costs and benefits in both nominal and present value terms, with the discount rate and other key assumptions explicitly stated.

Recommendation

6. That the Department of Premier & Cabinet consults with the Victorian Public Sector Commission to support further guidance to clarify the requirements for frank, impartial and timely advice in the public sector by:

• establishing clear minimum standards for agencies on how to satisfactorily discharge this obligation when providing advice to government
• advising government on strategies and options for addressing any cultural issues underpinning the serious deficiencies in the advice provided to government highlighted by this report.

RESPONSE provided by the Secretary, Department of Premier & Cabinet

Further audit comment in response to the submission from the Secretary, Department of Premier & Cabinet

The department has raised several significant issues and concerns in their responses that warrant my further comment.

RESPONSE provided by the Secretary, Department of Treasury & Finance

Further audit comment in response to the submission from the Secretary, Department of Treasury & Finance

The department has raised several significant issues and concerns in their responses that warrant my further comment.

RESPONSE provided by the Secretary, Department of Environment, Land, Water & Planning

RESPONSE provided by the Secretary, Department of Justice & Regulation

RESPONSE provided by the Acting Chief Executive Officer, Linking Melbourne Authority

RESPONSE provided by the Chief Panel Member, Planning Panels Victoria

RESPONSE provided by the Chief Executive Officer, Environment Protection Authority Victoria