IMPACTS OF CONSTRUCTION EVENTS
ON THE PROJECT EQUITY VALUE OF THE
CHANNEL TUNNEL PROJECT
ABRAHAM PARK1 and CHEN YU CHANG2
1Graziadio
School of Business and Management, Pepperdine University, USA
2Bartlett School of Construction and Project Management, UCL, UK
Introduction
• With the growing strains on public resources, many
governments in recent years have turned to the
private sector for infrastructure project financing.
• The special purpose vehicles (SPVs) taking such
project usually has a 2 stage business model: a
construction stage followed by an operating stage.
• However, the project risk in stage 1 is very high, and
in most cases, the impacts of specific construction
events on project risk and capital cost are
unobservable due to lack of informational
transparency.
• Eurotunnel (the Channel Tunnel project) is unique in
that the share price data for the entire construction
period is publicly available.
• The goal of this paper is to contribute to the
measurement and assessment of project risk by
providing empirical data on the impact of various
events that occur during the construction phase of
the project finance company’s life.
• Using the event study methodology, our study shows
that: (1) during the construction stage, efforts to
better manage the interests and incentives of
contractors produce more significant positive impact
from investors than efforts for cost containment;
• (2) during the construction stage, meeting the
project deadline is a higher investor priority than
containing construction cost; and
• (3) once the construction phase is complete, the
investors’ priority then becomes the overall cost
and the impact of construction events on the
expected returns from investment.
• Finally, the level of risk and the potential conflicts
of interest that arise during the construction
phase of a mega infrastructure project are such
that turning to IPOs to provide equity capital may
not be appropriate.
Background on PPP
• A public-private partnership (PPP) is an arrangement
between public sector and private investors and
businesses whereby private sector provides a service
under a concession for a defined period on a nonrecourse or limited recourse basis.
• In the UK, the PPP procurement framework gave rise to
Private Finance Initiative (PFI), which is a type of project
finance where public infrastructure projects are
financed with private sector capital through the use of
privately funded Special Purpose Vehicles (SPVs).
Project Finance
• Conceptually, there are many benefits to project
finance: a standalone legal entity, access to
significant levels of non-recourse or limited
recourse debt based on expected cash flows,
customizable risk allocations, and asset-specific
governance systems.
• Under the umbrella of appropriate strategic
alliances with participating governments, project
finance with private sector participation allows for
the undertaking of many sorely-needed
infrastructure projects which otherwise would not
be feasible due to size, risk, efficiency and
complexity issues.
Project Finance
• In practice, however, the analytical effort necessary
to accomplish proper due diligence with respect to a
project’s economic viability is vastly underestimated,
especially in large infrastructure projects
(Flyvbjerget al., 2004).
• Since expectations of cash flows are at the heart of
project finance, extensive and accurate feasibility
analyses and risk assessment/measurement are
critical in determining the project’s economic
viability.
• Often, not only are the length and cost of delays
underestimated, the revenue expectations are
overly optimistic, and changes in project
specifications and designs are inadequately taken
into account.
Project Finance Risk
• Because project finance involves single project
companies, it could potentially provide
researchers with valuable insights into the
constantly evolving risk profile of projects as well
as the financial impacts of various events on the
project equity value.
• Although several previous studies have examined
the causes and impacts of project delay and postcontract award design changes (Fen et al, 1997;
Bordoli and Baldwin, 1998; Cox et al., 1999),
there is a gap in empirical research concerning
the impact of such construction events on overall
project risk and equity value.
Lack of Transparency
• The challenge for researchers has consistently
been the lack of informational transparency.
• This lack of transparency stems primarily from
concentrated ownership structure of project
finance companies.
• Typically, project companies have a few equity
shareholders as sponsors with a syndicate of
banks as debt investors (Esty, 2004).
• As such, whenever events that affect the
expected cash flows and risk of a project occur,
the impact of such events on the project value
remains undisclosed, except among the few
equity and debt investors.
The Channel Tunnel
• The Channel Tunnel project is a unique case in project
financing in that the concessionaire of a BOOT project,
Eurotunnel, was listed on London Stock Exchange
from the very beginning of the project.
• Unlike most other project finance companies,
Eurotunnel’s equity capital base included funds raised
through an initial public offering, and the historical
stock price data is available from the beginning and
through the entire construction phase of the project.
• During the period of 1990 to 1994, Eurotunnel
suffered several public disputes and construction
delays with its construction contractor, TransmancheLink (TML).
• The Channel Tunnel case provides a unique
opportunity in the field of project finance to
quantitatively measure the impact of disputes and
delays during the construction phase on the
market value of the entire project.
• Some of the biggest sources of risk in BOOT
structue projects are delays in construction,
delays in projected revenue flow, technical failure,
poor management, and regulatory changes
(Beidleman et al., 1990).
• In particular, the main sources of financial risk in
major transportation infrastructure project are
cost overruns (especially in the construction
phase), increased financing costs due to delays,
and lower than expected revenues (Flyvbjerg et
al., 2004).
• At any time during the life of the project,
events that affect the risk profile of the
project, therefore, have a direct impact on the
overall value and the financial viability of the
project.
• From the lenders perspective, unexpected
events may jeopardize the completion of the
project and timely repayment of debt, which
is substantially larger in proportion than
equity investment in project finance
companies.
Management of Risks
• The main elements of project risk management include
the identification, the measurement/assessment, and
the process of prioritizing and responding to various
project risks (Thomas et al., 2006).
• Among these elements, risk measurement/assessment
is the most difficult task, which involves evaluation of
the probability of occurrence of risk events and their
impact on the project (Thomas et al., 2006).
• This paper is an attempt to clarify the dynamics of
project risk by providing empirical evidence on the
impact of construction events on the overall risk profile
of the project finance company, which can help to
better quantify financial risk factors for the purposes of
assessment and measurement.
Research Methodology
• According to finance theory, when a specific event
occurs during the construction phase of a project
which affects the risk level of equity investors, there
should be a significant impact on the project’s market
equity value as a result of the change in the cost of
equity.
• Since the Eurotunnel project is unique in that the
market price data for the entire construction period are
available, we can use the event study methodology to
test and observe the impact of occurrences of specific
construction events on the project equity value.
Event Study
• Our hypothesis is that when events occur which
impact the SPV’s risk level either positively or
negatively, the impacts should be observable
through significant abnormal returns as well as
through changes in the direction of the volatility
measure.
• An event study is a widely used methodology in
the fields of economics and finance for measuring
the impact in share prices as a result of an
announcement event.
• Brown and Warner (1985), Mackinlay (1997), and
Binder (1998) provide for comprehensive
descriptions of the procedures in the event study
methodology.
Step 1
• The first task of conducting an event study is to
identify the event(s) of interest.
• Due the public nature of the project, the news
surrounding the various disputes and resolutions
of Eurotunnel construction as described in the
previous section were covered extensively by the
media.
• We reviewed and identified from LexisNexis
database the following seven important
announcement events during the Eurotunnel
construction period of 1988 to 1994:
Dispute Events
ble 1: Disputeevent chronology
ent Dates
Title of Announcement
Source
Disputes
12 Jan. 1990
“Deal Cuts Risk of Channel Tunnel Overruns”
Financial Times
Event #1
10 Feb.1991
“Eurotunnel Costs Set to Soar After Ruling”
Independent
Event #2
30 Mar. 1992
“Dispute Panel Rules Eurotunnel Should Treble
Monthly Payment to Meet TML’s Expenses”
Evening Standard
5 Oct. 1992
“Opening Date Delay Adds to Worries”
Evening Standard
Event #4
29 Mar. 1993
“1bn Shortfall as Tunnel Hits New Delay”
The Guardian
Event #5
28 Jul. 1993
“Eurotunnel and TML Reached Agreement about
Interim Payment”
The Times
Event #6
6 Apr. 1994
“Settlement of £1.14bn Payment from Eurotunnel to Financial Times
TML”
Evening Standard
Event #3
Event #7
Event Study Steps
• Event Study Step 2: Event Window
• Event Study Step 3: Estimation Window
• Event Study Step 4: Measuring Normal Returns
1. Market Model
2. Capital Asset Pricing Model (CAPM)
3. Intertemporal CAPM (ICAPM)
4. Asset Pricing Theory (APT)
• Event Study Step 5: Measuring Abnormal Returns
• Event Study Step 6: Testing for Significance of
Cumulative Abnormal Returns
Results
• Seven events
• All four models showed consistency in producing
significant results for all seven events.
• Both the market model and the CAPM showed
almost identical results, while all four models
produced the same order of ranking for the
degree of impact among the seven events.
• The signs were also consistent for all four models
Event 1
• The event Deal Cuts Risk of Channel Tunnel Overrun
(Event #1) was a public dispute that came to an
agreement on January 12th of 1990.
• This event produced the highest positive cumulative
abnormal return.
• The agreement contained three main components: (1)
increase in total construction cost from £5 billion to £7.2
billion; (2) TML to bear 30% of all cost overruns, rather
than 6% as originally agreed; and (3) a stronger incentive
upon TML to complete the project on time through
bonuses and more severe penalties.
• Even though there was an increase in total construction
cost, better alignment of incentives by TML clearly
outweighed the negative factor generated by cost
overruns.
Event 1
• Some of the increase in construction cost must have
been anticipated, but the sign of a greater certainty of
construction completion produced an overwhelmingly
positive impact on the returns.
• This event shows the importance of having a
construction contract that focuses on the alignment of
interest rather than simply low cost.
• This result also shows that the concept of transferring
construction risk to contractors through a set of legal
contracts may not be so straightforward in
infrastructure projects with highly specific assets.
• In particular, deals that focus on the management and
alignment of interests in a dynamic way, especially
during the initial stages of construction, could result in
superior results.
Event 2
• The event Eurotunnel Costs Set to Soar After Ruling (Event
#2) was a ruling from the arbitration panel on February
10th of 1991 concerning two main issues.
• The first issue was a ruling in favour of the contractor,
TML, that Eurotunnel was responsible for cost increases
(as indicated in Eurotunnel’s annual report in May of
1991).
• The second issue was a ruling in favour of Eurotunnel,
indicating that TML was denied a time extension of 55
weeks.
• Surprisingly, this ruling produced the second highest
positive cumulative abnormal return. This result suggests
that construction delay was a bigger risk issue to equity
investors at this junction than potential cost increases.
Event 2
• Even though the increase in cost would have
resulted in a lower IRR for investors, it appears
that a greater certainty of project completion is a
more significant issue for equity investors,
especially at the beginning of the construction
phase.
• The implication is that the reduction of overall
project completion risk as a result of achieving a
more definite completion deadline is a more
important factor to equity investors than a
limited increase in the level of construction cost.
Event 3
• In the event Dispute Panel Rules Eurotunnel Should
Treble Monthly Payment to Meet TML’s Expenses,
30 March 1992 (Event #3), Eurotunnel was
ordered to treble its monthly interim funding
payments to TML from £25m to £75m.
• This event produced the lowest negative impact
and the third highest absolute impact among all
the events. In October of 1991, the progress
payments from Eurotunnel to TML did not reflect
the cost increases and TML faced negative cash
flows and threatened to suspend work due to
negative cash flows.
Event 3
• The matter was taken to the Disputes Panel
and in March of 1992, the panel ruled in
favour of TML, and ordered an additional £50
million (from original £25 million) to be paid
to TML each month. This event had a double
negative impact for Eurotunnel: first, the
negative cash flows by TML were a serious
threat to the overall project completion and
second, the additional payments represented
over £1.2 billion for Eurotunnel.
Event 4
• The event Opening Date Delay Adds to Worries (Event
#4) had two main negative implications for Eurotunnel.
After the previous ruling on the interim payments,
Eurotunnel took the matter to the Court of Appeals,
which the investors knew was going to be a lengthy
legal battle with a potential for a major delay or
suspension of work.
• On October 5th of 1992, the London Evening Standard
published an article indicating two main negative news
for Eurotunnel investors: first, a delay in the
construction completion date and second, a sharply
lower revenue forecasts for the first year as a result of
Eurotunnel missing the summer peak season.
• This news produced a negative cumulative abnormal
return.
Event 5
• The event ’1bn Shortfall’ as Tunnel Hits New
Delay, 29 March 1993 (Dispute #5) produced a
significant negative cumulative abnormal return
as a result of the final verdict by the International
Chamber of Commerce that the disputed issues
had to be resolved claim by claim.
• This ruling essentially represented a tedious and
costly process of itemising each claim to recover
payments which meant the project was faced with
worries over additional delays.
• Once again, a potential delay resulted in a strong
negative impact on the returns.
Event 6
• On the other hand, a protocol of agreement
that was reached in July 1993 (Dispute #6)
produced positive abnormal returns primarily
because of TML’s commitment on setting a
hand-over date of 1 December 1993.
• This agreement gave a definite hand-over
date which put a limit on the construction
delay.
Event 7
• Finally, the resolution of the drawn out dispute
regarding payments was reached in April 1994
(Dispute #7). TML had made a final claim
submission seeking £1.980 billion, but both sides
reached a final agreement of Eurotunnel having
to pay TML £1.14 billion in cash.
• This event produced the second lowest negative
cumulative abnormal return. Once the
construction was finally complete, the issue
turned to the final cost of construction, and the
ruling that Eurotunnel, rather than the contractor,
had to bear the cost produced a significantly
negative reaction from the equity investors.
Discussion
• It is a common practice in project financing that the
sources of finance change over the project’s life cycle to
match the evolving pattern of risks and incentives.
• During the constructional phase, the expenditures are
financed with sponsor equity and bank loans.
• Because construction is subject to significant
uncertainty and risk, there is plenty of room for moral
hazard, and it is appropriate that that the banks
perform a monitoring role at this stage.
• The fact that the initial equity sponsors in project
financing are often interested parties (operators or
contractors) adds to the responsibility of the banks to
provide tight control over the project company and the
building contractor’s behaviour.
Debt/Equity
• One of the ways a project is monitored by the
banks is to require a certain level of
debt/equity ratio with a certain percentage of
the SPV to be financed by the sponsors who
are often the contractors and operators. This
requirement ensures alignment of interest
between the lenders and the sponsors.
• In the case of Eurotunnel, the debt to equity
ratio for Eurotunnel remained stable at
approximately 80% to 20%.
IPO
• In September of 1986, Equity 1 of £ 47 million
was raised by the founder shareholders/sponsors.
• Equity 2 of £206 million was raised in October of
1986 through private placements.
• Equity 3 was a public issue which raised £770
million in November of 1987 at £3.50 per share.
• Equity 4 was raised through public issue for £568
million in November of 1990 at £2.85 per share.
• The primary reason for the IPOs in both 1987 and
1990 was due to the lenders’ requirement for
maintaining debt to equity ratio(total equity was
approximately £1.6 billion while total debt was
approximately £6.8 billion).
• This resulted in the majority of the sponsor
equity for the construction phase of
Eurotunnel coming from passive, small time
investors from the IPO.
• This dilution also resulted in the original
sponsors to shift their loyalty and incentives
towards the contractor side rather than the
SPV (Eurotunnel) side.
• This shift left the equity investors from the IPO
to be in an unfairly vulnerable position, and
the cost of equity was in actuality much higher
than originally presented.
• The estimated IRRs included in the prospectus and
the 1990 Rights Issue were in the range of 17- 18%
considering long term investment horizon.
• However, this type of hurdle rate should only have
been appropriate for investors in the operational
phase of the project rather than in the construction
phase, which contains significant uncertainty and
higher risk compared to the operational phase.
• Considering that there were no dividends promised
during the construction period and limitations to
revenue growth, the government’s position to
support the IPO of Eurotunnel to individual investors
during the construction period seems unwarranted.
Conclusion
• Results provide some clarity as to the dynamics of
project risk during the construction phase of a
PPP/PFI project:
• (1) during the construction stage, efforts to better
manage the interests and incentives of contractors
produce more significant positive impact from
investors than efforts for cost containment;
• (2) during the construction stage, meeting the
project deadline is a higher investor priority than
containing construction cost; and
• (3)once the project is finished, the investors’ focus
then turns to the overall cost and the expected
returns from investment (adjustments to IRR and
investment horizon).
• Collectively, these findings indicate that
construction delay poses greater risk to project
equity investors at the beginning of the
construction phase than cost overruns.
• A possible explanation is that due to the high
leverage structure of project finance
companies (high level of debt compared to
equity), the potential accumulation of finance
charges due to delay poses greater financial
risk than limited cost overruns.
Implications
• At least two practical implications can be extracted:
• One, having a construction contract that focuses on the
alignment of interest is critical for project risk
management and economic viability of the project; and
• Two, the concept of transferring construction risk to
contractors through a set of legal contracts may not be
so straightforward in infrastructure projects with highly
specific assets.
• Conceptually, the Eurotunnel case has revealed that
raising equity capital through IPO during the
construction phase can significantly affect the agency
structure and the interest alignment among the
participants in the project.
• Unlike in other project finance cases, in
Eurotunnel the equity ownership percentage of
the original sponsors became diluted by
passive investors from the IPO.
• As the contractors were also the original
sponsors for Eurotunnel, this dilution left the
equity investors from the IPO in a vulnerable
position.
• Accordingly, we believe this ownership dilution
makes the cost of equity for IPO investors in
project finance to be significantly higher than
equity investors in non-IPO project finance
cases.
• For this reason, the level of risk and the potential
conflicts of interest that arise during the
construction phase of a mega infrastructure
project are such that turning to IPOs to provide
equity capital may not be appropriate.
• Moreover, although Esty (2004) argues that the
most important economic motive for using
project finance is the reduction of agency
conflicts inside project companies, the
Eurotunnel case demonstrates that turning to IPO
for equity capital for project finance can increase
agency conflicts for project companies.
Limitations
• The Eurotunnel case is unique in that its share price
data allows us to empirically measure the impacts of
construction events on overall project risk and equity
value.
• However, the atypical nature of Eurotunnel ownership
structure (dispersed rather than concentrated equity
ownership structure of typical project finance
companies) also means the implications of this research
paper could be limited to project finance cases seeking
to raise equity capital through IPO.
• On one hand, the availability of Eurotunnel’s share
prices allows us to study the impact of construction
events; on the other hand, the unusual change in the
ownership structure as a result of the IPO is revealed to
add to the overall project risk.