The collapse of Carillion – why did it happen?

17 January 2018

In our latest blog, Martin Blaiklock discuses the collapse of Carillion in relation to infrastructure projects and the reasons for the collapse.

The collapse of Carillion raises some interesting issues in relation to infrastructure projects: how they are built; how they are operated; and how you they are financed. The dust has yet to settle – and the reasons for the collapse are far from clear – but a discussion is apposite.

Many infrastructure projects are major capital ventures costing hundreds of millions of pounds and take several years to build. They represent long-term assets. The construction industry is, on the other hand, ‘lumpy’, based on relatively short-term perspectives as resources are applied, then moved, from project to project. Construction companies are, typically, characterised by limited corporate assets and are reliant on management to effectively organise labour, materials, subcontractors and the supply chain. In short, many such companies are more contractors than constructors, which means that managers are under increasing pressure to get their construction cost estimates right.

Operating the assets once built and, in the context of infrastructure, delivering a public service is generally a low-risk, low-cost, low-profit activity. This is the case regardless of whether such projects are funded from government resources or with private capital.

It seems that in the case of Carillion, three UK projects – one highway and two hospitals – have caused construction cost overruns which have led to ‘losses’ or provisions of around £850 million. Given that the collective capital cost of these projects amounts to around £1.5 billion, the miscalculation (ie, a difference of £650 – £700 million) is unusual – or careless – and has brought about the company’s downfall.

All three deals were private finance initiatives (PFI)/public-private partnerships (PPP), where the government pays nothing until the service, which the assets provide, is delivered by a private concessionaire or licensee. As a result, the government should not be out of pocket if it picked up Carillion’s costs now, as it would have had to pay Carillion, albeit later, for the services provided if all had gone to plan. It just might upset HM Treasury’s cashflow a bit! 

It should also be noted that, in fact, the government could result in being the owners of Carillion’s half-built assets and inherit them at a significant discount or even ‘free’. Initially, the lenders might claim ownership or security of such assets; however, the last thing they would want is to be the owners of hospitals or highways.

One must also expect that the original PFI projects were fully funded by debt and equity when the deals were signed. Has the collapse arisen, therefore, because the financiers refused to pay for the extra costs?

Why were there cost overruns and who is responsible for them?

If cost overruns are due to bad management on behalf of the constructor, then responsibility in this case rests with Carillion and its shareholders. However, if cost overruns are caused by the actions of the government buyer (for example, by changing the underlying specifications of the project) then the contracts will normally include provisions to allow changes under circumstances when the financiers – whether state or private – give their approval, and adequate compensation is paid to cover any extra costs arising from the changes. It should be noted, however, that this area is not without its pitfalls.

Private sector investment in infrastructure can be a viable and effective option for government, when the government knows precisely what they want to be built, and when private financiers can control their risks.

For such projects, most analysts will agree that risks during construction are usually the major area of uncertainty, highlighting the need for prudent and comprehensive risk analysis of such circumstances by both the constructors and financiers, as described in Globe Law and Business’s Infrastructure Finance: An Inside View.

In the case of Carillion, however, it does seem as though the company has been hit by a ‘perfect storm’ of cost overruns with three major projects going ‘wrong’ at the same time. That said, it is arguable that Carillion’s management should have recognised the risks earlier when it bid or contracted such deals.

Another elephant in the room has been the burgeoning pensions deficit, which went from £393 million in 2015 to £805 million in 2016, purely on the basis of a change in assumptions used to calculate the amount of future liabilities (ie, the discount rate).  The pension trustees certainly have some questions to answer: this £400 million increase in pension deficit made an additional hole in Carillion’s balance sheet at a time when the company could have done without it!  

It takes two to tango, however.  The government’s role in this debacle deserves examination, too, not least if it was responsible for changing project specifications during construction. 

Why was Carillion awarded such large contracts when its financial structure was weak?

The government’s record of: (a) investing in infrastructure; (b) a preference for mega (ie,  ‘vanity’) projects, when more modest investments would suffice; and (c) the choice as to when to use private capital versus public resources, has been rather dismal.

In contrast, other EU governments, in spite of the application of EU procurement regulations, seem to be able to support their national contractors and protect their companies much more consistently than we do in the UK. (It is possible that this is due to language. The most commonly used international contractual language is English, but for many national infrastructure-type projects the contracting government may use, naturally, their national language, which could result in a more frequent use of local contractors.) 

Around 25–30 years ago, the UK boasted eight to ten major construction companies, five to six major engineering companies and eight to ten major consulting engineering companies, all of which had worldwide reputations for expertise, innovation and professional quality. These companies were essential components of a strategic UK infrastructure. Today, most of these companies (with a couple of exceptions) are either no more or have become owned by overseas groups who control their profits, intellectual property and know-how.
 
Not only has this harmed UK companies in our home market, but it also hits UK companies in our traditional export markets. The Whitehall mantra of ‘competition at all costs’ can have its consequences!

The Carillion debacle cannot be divorced from these facts. No other Western industrialised nation has allowed its strategic resources to be so decimated. One therefore questions why UK Governments – of both stripes – have allowed this to come about?

In this context, it is significant that of the 27 current secretaries and under-secretaries of state representing the ministries responsible for the UK’s built infrastructure (ie, transport, environment, health, education and energy/business), only two have achieved a quantitative/scientific degree at university. No civil engineers. No mechanical or electrical engineers. There is, however, one chemist and lots of PPE, history, English and geography scholars. Are the UK’s infrastructure decision-makers at fault?

Q.E.D.

Infrastructure Finance: An Inside View by Martin Blaiklock is published by Globe Law and Business Ltd.