Australia is about to enter a phase of record infrastructure construction, with large-scale transport and energy projects being developed over the next five years. Meanwhile, economic commentators are recommending additional fiscal stimulus through infrastructure capital expenditure, in response to sluggish economic conditions. The call for "shovel ready" projects that can be rolled out relatively quickly and easily, on top of the major projects, requires a realistic assessment of the capacity to deliver this new build.

S&P Global Ratings believes that the construction chain is likely to become stretched toward breaking point. We see the usual key risks being present (time and cost overruns) stemming from design and scope changes, complex projects, thin margins, aggressive timetables, tight labor supply, and inflating input costs.

However, the bigger risk is that any failure from one contractor or even significant problems on one transaction could ripple through to multiple projects, creating bigger problems. Any knock-on effects could negatively affect the engineering and construction (E&C) sector, government infrastructure programs and related equity and credit markets.

A Pipeline Dream

There is no doubt that the Australian major construction market is "hot" at the moment. State governments are compiling significant forward pipelines of major projects. Large-scale transport projects will be under development for the next five years in New South Wales (NSW), Victoria, and Queensland. On the energy front, there is "Snowy Hydro 2.0" and other likely required electricity generation and transmission projects.

E&C companies are at full tilt. Subcontractors are fully booked and occasionally backed up between jobs. Design houses are becoming busier. Building material input prices are rising. Labor costs are only headed one way.

We know the pipeline is huge but what does it really look like? It is actually hard to be precise given that no one source records all private and public sector procurement information by project in a single document. State government and other industry linked databases track elements of the construction task but there is no definitive overall picture.

The chart below depicts the forecast value of major Australian transport projects and shows a peak annual expenditure of over A$22 billion in 2022. This is more than double the previous peak of more than A$10 billion in 2013. Viewed in the light of transport construction over the past 13 years, there is no question that we are moving into new territory.

To give some context to the task, CIMIC Group Ltd., in its July 2019 investor presentation, says it has A$60 billion (US$42 billion) of tenders relevant to its total business (not solely Australia) still to be bid and/or awarded in 2019, with around A$400 billion of projects coming to the market in 2020 and beyond, including about A$130 billion of private-public partnership (PPP) opportunities. These are enormous numbers. Plus this is on top of an existing CIMIC order book of A$37 billion of work in hand.

But A Management Headache?

At a macro level the outlook looks wonderful for the industry and helpful for the economy. But is it viable and sustainable? We believe record activity will lead to challenges for governments, sponsors, and investors. Without proper planning and structuring of projects to attract the strongest bidders on appropriate terms, problems could ensue including shortages of skilled labor and expertise, over-committed contractors or overly aggressive project schedules.

Market participants say they are mindful of the situation and behaving accordingly. Indeed, there are a number of well-intentioned initiatives aimed at trying to alleviate problems before they occur.

The NSW Government Construction Leadership Group's 10-Point Action Commitment to the Construction Sector Plan identifies areas where it believes it can assist the construction industry to work better with the government as a client. The first two points are aimed directly at addressing past challenges:

• procure and manage projects in a more collaborative way
• adopt partnership- based approach to risk allocation

Another initiative, the Construction Industry Leadership Forum, has been launched by representatives from industry and the NSW and Victorian public sectors. The purpose of the Forum is to improve the effectiveness and value (to governments and industry) of the procurement and delivery of governments' infrastructure programs.

Both these initiatives are welcome although they are in their early days and little information is available at this stage on what is being done in practice and what results are expected to be achieved.

Governments are continuing to revise procurement processes so that price isn't necessarily the most significant determinant. But for many projects, price and risk transfer are always going to be paramount.

Construction companies say they have maintained disciplined price bidding such that margins aren't too thin, but it is difficult to gain insight into bidding from the outside.

A number of major foreign construction companies (Acciona S.A., Ferrovial S.A., Bouygues S.A., Salini Impregilo SpA, Laing O'Rourke, Samsung C&T) have entered the Australian market in recent years, attracted by the volume and size of projects on offer. This development has certainly been a boost for Australian governments and infrastructure investors, bringing competition and experience to the market.

However, arguably the Victorian government's local content rules (including 90% minimum on construction projects) will also exacerbate the tight construction market, especially in Victoria.

Additionally, the opportunities for tier-2 engineering and construction firms will increase in the next few years, both as support for tier-1 companies on major projects and in leading smaller projects. This feature of the market may bring its own challenges from a credit perspective given the lesser financial capacity and lower ratings or implied ratings on a number of these firms.

Cracks Have Been Appearing

Stresses are already apparent, and this is before we even move into the height of the projected new build period. Here is just a quick snapshot of some negative events over the past 18 months:

Lend Lease and NorthConnex.  Problems on the NorthConnex toll-road project in Sydney and other projects led to Lend Lease Corp. Ltd. announcing a writedown of its engineering and services business. As at Dec. 31, 2018, Lend Lease incurred an A$500 million pretax loss due to cumulative issues in a number of engineering projects. Further, the company has confirmed that it considers the Engineering and Services business as non-core and no longer a required part of the strategy. The current Lend Lease share price is trading at a significant discount to the share price of A$21 in August 2018. Compounding and related to the recent engineering related problems, the company is also defending a class action being brought by securityholders.

NorthConnex was initiated under the NSW government's Unsolicited Proposals process. Procurement of a design and construct contract was led by Transurban and its partners in the WestLink M7 with the successful proponent being a joint venture between Lend Lease and Bouygues, a major global construction company. Originally scheduled as an approximate four-year build project, NorthConnex is running behind the original program and is expected to open sometime in 2020 according to Transurban, although none of the parties are commenting publicly on a likely opening date. At the time of contract award, the project was reported to demonstrate "the benefits of private sector-led procurement, which resulted in a fast-tracked timeframe in the bidding process as well as reduced cost for tenderers and innovative solutions."

Sydney Light Rail / Acciona.  Total costs for this PPP in the center of Sydney have increased from an original estimate of A$1.6 billion to around A$2.7 billion. Part of this increase relates to a recent settlement of a dispute between the NSW government and Acciona, where the NSW Government has agreed to pay Acciona up to an additional A$576 million. Further, construction is running a year behind the original expected program with the light rail due to open in 2019.

WBHO.  South African firm Wilson Bayley Holmes-Ovcon Ltd. (WHBO) is the lead contractor responsible for delivery of the Western Roads upgrade PPP in Victoria. WBHO made a loss provision of A$50 million on the project and a writeback of A$6.9 million previously recognized in the 2018 financial year. The reason for the loss was reported to be due to the interpretation of the project's technical specifications. WBHO also said it would temporarily withdraw from a design and construct role on new project bids with the same risk profile in the eastern region of Australia.

RCR Tomlinson.  Australian engineering contractor RCR Tomlinson went into liquidation in November 2018 just one month after raising A$100 million from shareholders.

Can you replace a construction company on a major project? – The Carillion example

In our view, it isn't easy to replace a lead construction company on a major project. In theory it is possible if sufficient time is built into the project program, enough liquidity is available to support the project, and the contract terms are generally "at market." However these conditions may not be present, and even if they are, there is no guarantee a contractor can be replaced, especially on a complex task.

When rating projects under S&P Global Ratings' Project Finance Transaction Methodology, we assess the factors that support the assumption that a contractor can be replaced if it fails. We consider what provisions a project has in place to manage a contractor replacement. This is viewed from the perspective of overall construction complexity as a starting point and credit enhancement that would be needed to cover additional project related burdens such as search and re-contracting costs, time-based costs for the replacement period, subcontractor fees, and potential additional margin on the contract.

The recent case of the U.K.'s Carillion provides some good insight into the challenges of replacing a contractor. Before filing for compulsory liquidation in January 2018, Carillion was the second-largest construction and facilities management (FM) company in the U.K. At the time it went into liquidation, Carillion had two large hospital PFI projects in construction (Royal Liverpool University Hospital and Midland Metropolitan Hospital), which both defaulted and the projects' senior lenders lost significant money. Another project in Scotland (the Aberdeen bypass road PPP) was successfully completed as Carillion acted as part of a construction joint venture (JV) and the remaining JV partners took over Carillion's portion of the works.

The Carillion case illustrates that replacement of a construction contractor is generally more challenging than replacing a FM contractor on a project that is already operational. Carillion had numerous operations / facilities management contracts in place, but these were transferred to alternative providers comparatively smoothly and in some cases even at lower cost.

The Carillion failure has provided some lessons in relation to contractor replacement:

• Replacement of a builder often takes longer than expected and costs more than expected.
• If the contract was underpriced / if there are significant cost overruns, liquid security is unlikely to be sufficient to fund replacement.
• What are currently market standard security packages may be insufficient to fund replacement without requiring a restructuring of the senior debt

Be Ready For Surprises

History has shown that major problems are usually a surprise. Who saw Lend Lease's (or Carillion's) problems coming? In both cases the timing and extent of the difficulties encountered were a real surprise to the market. The defaults in the two Carillion hospital projects show that even appropriate risk allocation and structuring may not be enough to protect debt and equity investors when more fundamental problems exist or emerge.

The infrastructure sector in its entirety will no doubt continue to develop and finance the project pipeline. Significant appetite remains from both equity and debt investors for properly prepared projects that offer appropriate returns on investment.

Risk will continue to be allocated to "the party best equipped to manage it."

However, delays, cost blowouts or major problems in any individual project have the potential to create flow-on effects to other projects. If any key player suffers financial difficulty, this could have ramifications for multiple projects and set the overall program back markedly in terms of delivery. For projects with multiple contractors acting jointly and severally as part of a joint venture, the failure of one contractor can affect the financial health of the surviving contractors if the project is delayed, over budget, and very large relative to their balance sheet. Even worse, there is the risk of a project failure without adequate government or equity support.

The patience and diligence required to properly prepare projects will need to be carefully managed, alongside the inevitable desire from governments to demonstrate action and deliver results as soon as possible.

From a credit perspective, the key will be to keep an eye on counterparty activities and exposures beyond any one particular project or company. Investors need to remain vigilant to risks in the E&C sector.