North East Link – Key insights

PFI Yearbook 2022
19 min read

Allens infrastructure and project finance specialists from the North East Link sponsor team provide insights into key innovations and learnings arising from a landmark transaction. By David Donnelly, partner, Michael Ryan, partner, Lisa Zhou, managing associate, and Timothy Leschke, senior associate, Allens.

The North East Link (NEL) is Victoria's largest ever road project, involving a number of work packages to deliver the "missing link" in Melbourne's freeway network, which will connect the M80 Ring Road to an upgraded Eastern Freeway.

The A$11.1bn primary package is the largest ever PPP in Australia, encompassing two 6.5km three-lane tunnels and significant at-grade works. It will utilise a first-of-its-kind incentivised target cost (ITC) regime in an availability PPP. The primary package achieved financial close in late October 2021 almost wholly electronically and will be designed, constructed, financed and maintained by the international Spark consortium comprising Webuild, GS Engineering and Construction, CPB Contractors, China Construction Oceania, Ventia, Capella Capital, Pacific Partnerships, John Laing Investments and DIF, with project finance from Australian and international lenders, both commercial and institutional.

Various secondary packages will be procured separately, likely using a collaborative contracting delivery model. Once completed, NEL will be tolled, and a government-owned State Tolling Corporation has been established to operate and manage the tolling assets and associated tolling revenue.

Project insights

* Adopting an incentivised target cost model in a PPP – While an incentivised target cost (ITC) model is common in alliance or collaborative contract frameworks, NEL signifies the first time an ITC model has been adopted in a PPP, or indeed in a PPP project financing. It is an apparent response to the well-documented reduction in contractor risk appetite, particularly on complex linear infrastructure mega projects. It is also a tacit acknowledgement that, where projects are "too big to fail", the government holds the residual political and service delivery risk in any event. But rather than losing the well-documented benefits of a PPP, NEL represents a hybrid model, which seeks to provide increased certainty on delivery time and performance outputs in exchange for less certainty but more transparency on construction cost.

At a macro level, the ITC model involves the state and the contractor sharing in the risk of cost overruns, or the benefit of savings, throughout the delivery of the project. This is often referred to as a painshare/gainshare regime.

A target outturn cost (TOC) to design and construct the project is calculated on expected allowable costs, which include certain allowances for profit and overhead and exclude a variety of specific costs (such as financing costs). The TOC is fixed, subject to limited adjustments. The "allowable costs" incurred are closely monitored and transparently reported throughout the delivery phase to determine the actual outturn cost (AOC).

If the AOC exceeds the TOC, government shares in the additional costs, the painshare. If the AOC is less than the TOC, government shares in the savings, the gainshare. The painshare and gainshare may be subject to various adjustments, capped, and/or trigger certain default and termination rights, depending on the circumstances and the quantum of the delta between the AOC and TOC. In each case this seeks to incentivise a lower cost to deliver on time and to the requisite performance standards. None of this is particularly ground breaking – indeed, it's been done before, many times, in collaborative contracts.

What is novel is doing it in a PPP, with private finance. An ITC model represents a fundamental mindset shift in relation to cost management during the delivery phase on PPPs. Typically, cost risk is allocated fully to the private sector – through a lump-sum D&C price financed by debt, with fixed availability payments or other revenue streams to repay debt – subject to limited express risks being retained by the state, through change compensation event relief. These risks are wholly allocated to one party, with a risk-share being represented as a retransfer of risk at a point in time from one party to another once certain quantitative or qualitative materiality thresholds are met.

The ITC model refocuses cost management from isolating individual risks and allocating them to one party, to managing and sharing risks on a whole of project basis. This is particularly beneficial on complex mega projects where there are a number of unquantifiable or uncontrollable risks, many of which may never materialise or may materialise in an unexpected way and result in disproportionate cost impacts.

The ITC also recognises that, while most delivery risks are typically allocated to the D&C contractor on a PPP, risk transfer is subject to practical limitations, which have been borne out recently on high-profile projects in distress, including that:

* Any risk transfer is subject to the D&C contractor's creditworthiness and the willingness of the D&C contractor to complete for the agreed price;

* It is difficult for lenders to enforce and recover against a half-completed distressed asset with no revenue stream; and

* It is similarly difficult to terminate a defaulting D&C contractor and replace it with a new D&C contractor to complete a distressed project on a cost or risk effective basis.

All of this means risk is never fully transferred to the D&C contractor on high-profile city-shaping projects. The ITC model recognises there is inherent risk share and codifies this upfront.

Despite the use of an ITC model during the delivery phase, most key features and benefits of PPPs were left unchanged or arguably enhanced on NEL. This included a fixed delivery timeframe and usual assurances the asset will meet all performance requirements and be fit for purpose on completion and throughout the operations phase. The fixed availability payment to repay debt and cover project costs following completion remained, as did the usual D&C progress payment and drawdown profile to fund construction. Further, before the state takes any painshare (whether on an interim or final basis), equity and debt must make all contributions required at the relevant time in accordance with the agreed drawdown profile.

NEL and the future

From an asset delivery perspective, there are a few additional key learnings and developments to flag:

* Bespoke risk frameworks – Despite the use of the ITC model, a number of bespoke frameworks for well-publicised material and known risks were nonetheless required on NEL. This demonstrates that not all risks are appropriate to be shared through an ITC model where one party and/or a bespoke framework is still clearly best placed to manage the risk. However, the ITC model nonetheless allowed many risks to be consolidated into an aggregate risk pool and minimised the need for bespoke risk frameworks.

* Monetisation of economic infrastructure – Government's establishment and use of State Tolling Corporation points towards government seeking to monetise the asset in the future, through isolating the tolling revenues and the availability payment profile on a standalone basis. It remains to be seen whether government will consolidate various toll roads as a publicly held economic asset, or facilitate privatisation of its assets in future, similar to Westconnex. However, government establishing a statutory authority to monetise economic infrastructure assets is a trend that may develop.

* Split-packaging provides value – Government deliberately split the overall project into smaller packages, including an early works package to mitigate unknown risks associated with relocation of utilities and ground conditions, and various secondary packages to encourage a tier two contracting market. This recognises that government may be better placed to manage certain interface and project risks itself or may creatively package projects to support broader market developments, rather than seek a wholesale transfer of all responsibilities to a single party.

* Future application of ITC model – While the ITC model has potential for expanded use by both the private and public sector sponsors, it seems unlikely to replace traditional lump-sum models for simpler projects where risks are better known and quantifiable – it is administratively intensive and is best directed at managing unknown or unquantifiable risks. For complex or novel projects, the model could be used by equity sponsors with significant balance sheets to obtain project finance where they are able to credit-wrap the painshare on the same basis as government. Certain other debt and equity products may also develop to fund all or part of the painshare, in exchange for a potential increased return on investment through the gainshare upside. These would obviously be riskier investments and potentially drive up the cost of capital, but it may facilitate a different form of private investment on projects that may have not otherwise been bankable.

* Insurance and alternative risk transfer – Given the hard insurance market, the need for alternative risk transfer solutions is becoming more apparent, with the Victorian Managed Insurance Authority being the primary insurer for NEL as it is for Melbourne Metro. In addition, a number of private alternative risk transfer solutions were adopted to seek to obtain the requisite insurance coverage for a project of this magnitude. We are likely to continue to see increased use of captive and managed insurance to manage project risks as the level of premiums payable to commercial insurers becomes increasingly disproportionate to the levels of cover provided.


* Innovations and market developments – From a debt perspective, NEL demonstrated that, not only can an ITC model be successfully banked, it has potential to improve the bankability of large-scale greenfield PPP projects. By facilitating risk-sharing between the government and the private sector, the use of the ITC model for NEL may have attracted a wider and more significant pool of debt investors compared with greenfield PPPs underpinned by other risk allocation models. The more nuanced approach to, and reduction of, a number of project risks, particularly during the construction phase, strengthened a long-term debt solution, with a mix of commercial bank debt and long-term debt from institutional and fund investors forming part of the final package.

The stretching of debt tenors to create a long-term debt solution on NEL was also bolstered by a broader market trend of government procurement authorities emphasising the need for a long-term debt solution as part of bids, as well as market conditions that improved across 2021 as we saw renewed appetite from offshore institutional investors in stable, long-term infrastructure projects with strong government counterparties.

NEL is a good example of a market trend over the past decade of the stretching of debt tenors and diversification of debt sources beyond the traditional mini-perm structure of commercial bank debt. There are a number of examples of debt diversification and longer debt tenors achieved on PPP-procured projects. This tends to be more typical on projects that have reached or are close to reaching the operational phase, with the construction commercial bank debt being refinanced during operations with a more diversified and longer term debt package, including USPP debt.

NEL provides a refinement to this trend, with significant debt tenors being viable on day one for a greenfield PPP procured project.

* Predictions for future PPP financings – Following the successful close of the NEL project financing, we have seen a number of government and sponsor commentators supporting more collaborative risk-sharing models on future PPP procured projects. Although some commentators may query whether the popularity of mega PPP projects may be tempered as a result of previous high-profile projects where contractors have come under pressure, if innovations like the ITC model on NEL become a trend on future projects, this may counteract that view by paving a new pathway to support large, complex PPP projects requiring substantial capital.

Where government counterparties are prepared to collaborate with sponsors to develop and rebalance risk-sharing mechanisms, especially on key construction phase matters such as cost overruns and environmental issues, this can be expected to strengthen the ability of sponsors to raise more significant volumes of finance from a more diversified and wider pool of investors, especially those investors with a long-term investment horizon. As mentioned earlier, this aligns with the market trend of government procuring authorities actively encouraging long-term financing packages and may be further driven by the broader market trend of fund investors increasingly participating in the infrastructure sector, both from an equity and debt perspective.

Given these compelling forces that are driving increased participation from long-term financiers, we can expect to see the influence of long-term debt investment play out in PPP project financing over the coming decade and beyond. From a sponsor and government perspective, putting in place significant long-term debt from day one on a project will generate strong benefits in terms of minimising refinancing risk and while the current low interest rate environment continues, securing favourable pricing that is potentially maintained across the entire notional debt period.

While the scene is set for a continued increase in participation from long-term financiers, commercial bank debt will continue to have an important role to play, especially on greenfield PPP project financings. Therefore, greater diversity in lender groups is likely in terms of type of lender, tenor and specific lending terms and structures that may be required by particular lenders or lender groups. The resulting need to manage different lenders' interests, and requirements that are not always completely aligned across the lender group, will bring an additional moving piece to the balancing task for sponsors and government procurement authorities.

Key areas where we are likely to see refinements to PPP project financing market precedent as a result of greater diversity in lender groups are as follows.

i) Flexibility to address project issues. Sponsors are likely to build in greater upfront flexibility in debt documentation, including to streamline lender consent processes applying to project variations and augmentations. This may be reflected in lower lender voting thresholds on matters that are traditionally unanimous or super majority lender consent matters, reduction in the scope of veto rights for specific lender groups, more robust replacement of lender regimes and nuanced "snooze you lose" provisions that distinguish between "urgent" and "non-urgent" matters.

If such regimes are appropriately developed, they may arm sponsors, financiers and government counterparties to more nimbly navigate unanticipated project issues or disputes that may arise, particularly during construction.

Lenders may also be supportive and more comfortable to have less stringent levels of oversight with respect to project matters from both a credit risk assessment and an intercreditor perspective. This should be the case especially if the ITC model on NEL is a signal that government procuring authorities will be open to adopting similar risk-sharing structures on future PPP procured projects that reduce the overall project risk profile, including during the construction phase.

ii) Refinancing and changing allocations. Where there is a mix of bank debt and institutional debt, we can expect to see a greater focus on balancing the interests of different lender groups as between lenders and the interests of the sponsors, all against the backdrop of key objectives of government procurement authorities. We are likely to see more negotiation and refinement of market positions in relation to permitted refinancing parameters and structuring of different lender drawdown profile requirements to ensure there is adequate protection for both shorter and longer tenor financiers, while maintaining sufficient flexibility for sponsors to refinance where markets inevitably change over the long-term life of projects and ensuring efficient allocation of capital.

iii) Focus on debt assignability: Another issue that can be expected to increasingly receive attention and be refined as a result of increased institutional presence on PPP deals are debt assignment provisions that many institutional investors typically require greater flexibility around compared with traditional bank lenders, and the ranking of any make-whole and any early-call amounts.

Closing remarks

NEL truly is a landmark transaction, with a scarcely believable number of first-to-market milestones – both the government and private sector should be commended for their collaborative approach in negotiating and closing the primary package against the shifting sands of a global pandemic.

Contrary to various commentators' views and suggested market-trends, the ITC model on NEL demonstrates that PPPs remain a viable (and arguably the preferred) option for output-focused city-shaping mega projects. It also demonstrates that novel projects with various unknown or unquantifiable risks and less certain construction costs can be project financed if a creditworthy private sector or government sponsor agrees to fund its share of cost overruns. The ITC model provides a framework to effectively manage and mitigate any cost overruns, with the potential upside of sharing in cost savings.

Further, the use of the ITC model is likely to create diversity in the debt investor pool and increase availability of long-term and institutional debt for greenfield projects. With this will come different lender interests and requirements within the lender group, which will place increased focused on the tensions between managing the competing flexibilities and controls of equity sponsors, government and debt. This will create further opportunities to refine and innovate existing market positions and approaches.

To see the digital version of this report, please click here

To purchase printed copies or a PDF of this report, please email