The importance of effective cost estimation in infrastructure projects
Posted 17/07/2019 by Alonzo Guzman
Why does reliable cost estimation play such a pivotal role in infrastructure project planning? Because cost overruns can quickly spiral out of control, wiping out equity for Sponsors, forcing write-downs for lenders, and destroying the credibility of everyone involved. Here's a brief guide as to how stop them dead.
Berlin’s third airport was planned to open in 2011. Instead, 2019 is seeing the German government pay €17 million per month to maintain an empty terminal building. The airport is now €5 billion over budget and is not expected to open until October 2020.
This and many other cases illustrate the importance of credible cost estimates whether you are a lender looking for approval from a credit committee, a project sponsor aiming at getting the most advantageous terms for your project, or the public sector agency ultimately accountable for the integrity of the PPP process.
The bidding process for large construction schemes can be highly competitive; as a result, bids are often under or overestimated by large margins. Factors ranging from unrealistic optimism to insufficient access to information can cloud the bidder’s judgment.
In the longer term this could be costly, as all stakeholders involved with Berlin airport can confirm.
As a lender, you would want to make sure that project costs are adequate – well sized to build, operate and maintain the project and that the project company is ringfenced, as much as possible, from design, execution, operational and maintenance risks. If you are a sponsor you would want to achieve the most competitive cost structure to allow you to win the bid.
At Infrata, we use experience and engineering judgment to help lenders take comfort by following a top-down and bottom-up approach. Early top-down assessments are usually made based on available engineering and the information from our extensive database of comparable projects. A first pass top-down cost review starts with identifying the main components of the project and estimating a cost ratio vs component benchmarks of comparable projects.
As the engineering is progressed to deeper levels of detail, unit prices are then validated to enhance the level of certainty of the cost review. The bottom-up approach requires a deeper degree of detail as it breaks down the costs to each individual component, starting from the lowest level of detail in the work breakdown structure and moving upwards. The rolling up of costs results in work packages, which itemises individual activities and tasks requiring costs allocated individual components following direct inputs from our team of specialists.
Further comfort is provided by interrogating the sponsors’ plans to manage potential risks of unplanned challenges from external and internal factors. Our approach is centred on the interrogation of the sponsor’s methodology and their identification, quantification, and mitigation of risks that could throw its cost structure off balance – the importance of contingency planning!
While clarity is critical in this process, we understand that it takes place in a competitive environment. Protecting cost information prior to a bid submission is paramount. That is why Infrata’s outputs are expressed in ratios rather than in monetary values. We normalise the project in question as 1 and express cost items in ranges in relation to the unitary value as per the example in the image at the top of the page.
Getting costs wrong could lose the bid if estimates are overly conservative. If they are overly competitive, and the bid may be successful but sponsors will be exposed to the ‘winner’s curse’ – a project which loses money.
Under this situation and if the project follows non-recourse lending, the construction contractor could be at higher risk of defaulting on its commitment. In this case, the concessionaire might need to spend even more time and money finding a replacement.
When cost estimates prove unrealistic, the impact can be far-reaching. Occasionally, companies go bankrupt. When this happens, public authorities might have to step in and take control of an asset that many people depend on. This can lead to more tax money required to rescue the project, loss of confidence in project procurement, loss of returns to investors, issues with early termination of project loans, and far-reaching ramifications for future projects.
At Infrata, we combine years of data analysis with decades of industry-specific experience. The result is a robust cost review that works both for project sponsors and lenders to provide the confidence required to make decisions.
If you would like to find out more? Get in touch!