The “One Belt, One Road” (OBOR) initiative – or the “new Silk Road” as it is often referred to – is China’s grand vision for the creation of co-ordinated trade routes on both land and sea. Spanning 65 countries, when completed it would give industry freight access to over 60% of the world’s population and create significant new opportunities for trade integration.
The “Road” part of the project is to connect shipping routes via major ports from China to Africa and Europe. The “Belt”, more ambitiously, involves the creation of a transnational railway connecting Asia, Russia and Europe, with journeys potentially taking as little as eight days from end to end.
The importance to China of OBOR was reiterated during President Xi Jinping’s recent trade visit to England, in which he made cl-ear the significance of the initiative as a principal component of China’s foreign policy.
OBOR will require not just the creation and operation of primary transport infrastructure but also extensive supporting infrastructure including power generation and transmission, roads, airports and freight distribution to name but a few. Total investment is already forecast to be in excess of US$1 trillion, a significant portion of which will be provided by the newly formed Asia Infrastructure Investment Bank comprising 57 of the member countries who have an interest in the project. Arguably, by far the most challenging aspect of OBOR is the delivery of the rail infrastructure. Those involved in major rail projects know that this remains one of the most challenging sectors in major project procurement.
Whilst many of the issues facing the OBOR “Belt” initiative are common to those of any other major rail procurement and too extensive to cover in this article, the following are a few project specific issues particularly worthy of note in the context of OBOR:
Rail projects require the management of several complex interfaces involving not just civil works but also, typically, sophisticated engineering and systems (e.g. signalling, SCADA, GPS), supporting infrastructure (e.g. power generation and transmission), rolling stock delivery and commissioning, operations and ongoing maintenance. All parts need to come together to provide an effective project.
Often the risk in these interfaces is managed by aggregating requirements within a single point of responsibility, wrapping all interfaces under the auspices of one provider, using a well-established model such as a Build-Operate-Transfer (BOT) structure.
However, OBOR is not a single project. It will involve multiple projects of different types, each essential for OBOR to operate as an integrated network but with each one being delivered using one of a number of different procurement and contract models. Even so, whilst distinct in terms of their procurement, very few OBOR schemes will be treatable as a genuine stand-alone project. As a result, the critical interfaces for OBOR are not those within a project but the “project-to-project” interfaces. It will not be possible to manage these interfaces by bringing them under a single umbrella; OBOR is just too large.
Instead OBOR will require a new approach, with careful planning and modelling, in which understanding dependencies and associated risks will be essential. Considered risk allocation, informed by a thorough understanding of OBOR, will be essential in developing investable projects, as will a co-ordinated interface between strategic project direction and individual project delivery. That interface could be managed in many ways but needs to be set out in the early stages based on collaborative models.
As a result of the “project-to-project” interface risk, demand and usage of any one project forming part of OBOR will also be dependent upon inter-related projects. Projects in any given country may well depend on the progress of the connecting infrastructure in adjoining countries outside their control.
A consequence of this relationship is that the revenue generation potential for a project is also inextricably linked to other infrastructure. For example, a section of the rail network which sits between other established and fully operational sectors is likely to benefit from higher demand or usage than those which are, initially at least, poorly connected and with only local usage. Similarly levels of power being purchased from generation assets intended to power OBOR infrastructure will be directly linked to network usage in a given area.
What this means in practice is that traditional “revenue” based models (where operators are remunerated by taking a share in revenue generated) might not be possible. Revenue payment models are often preferred by owners, as demand risk is passed substantially to the operator. Equally it incentivises operators to seek to increase profits, to the extent that it is within their control, by increasing income and controlling costs. However, where the usage driving revenue is dependent on other projects potentially in other countries, it is wholly outside an operator’s control and not a risk the market is likely to accept.
Instead, these project-to-project dependencies may force parties towards “availability” type models where payment is linked to the asset being available and ready for use, regardless of actual demand or revenue as operators (and funders) are likely to want the security that they will be paid, provided they have fulfilled what was asked of them and the assets are available for use regardless of whether there is a current demand to be met.
Whilst projects will be procured on a standalone basis, they need to be structured to ensure that they offer flexibility and are scalable, to cater both for future increases in demand as the network expands globally, and for new operating models. For example:
Future-proofing could take the form of passive provision of infrastructure, in which case consideration needs to be given to the funding of those assets which may not have any immediate revenue generating benefit. Funders often prefer to see this excluded from projects as it adds cost and risk without any immediate commensurate benefit in terms of revenue.
Operating agreements will need to include suitable ramp up and steady state running provisions together with options for capacity increases, whether in services or rolling stock, to accommodate increases in demand.
So too will maintenance requirements increase. Experience suggests that relying on change control mechanisms to cater for these changes over time can be problematic. Robust change control provision will always be needed but so too will sensibly procured options as part of a pre-planned upscaling of the network.
More interesting still is the possibility of future “horizontal integration” providing common operations and systems as the network expands and becomes fully operational. A project the size of OBOR presents significant scope for operational efficiency being achieved in this way. For early projects in particular, there should be careful and considered structuring to ensure that a “privatised” approach to single project procurements does not become the kind of obstacle to subsequent horizontally integrated operation and management which could stifle many of the economic benefits OBOR promises to deliver.
The impact of currency fluctuations is often overlooked but can have significant consequences. Revenues for such projects are typically generated in local currency but the underlying finance or operating costs are often linked to an alternative currency. If exchange rates diverge between the two currencies it can have a dramatic impact on the finances of a project and the ability to service costs.
Sometimes the use of contingencies and reserving mechanisms can be sufficient to mitigate the risk. On other occasions currency hedging mechanisms may be employed but these are often complex and can themselves become fertile ground for dispute. It is something which requires careful management.
Value capture is a different type of challenge. Unlike others, this is not about overcoming obstacles but, rather, making sure that opportunities are not missed. Governments are becoming increasingly aware of the indirect benefits that the creation of major infrastructure hubs can have. Not only will OBOR open up economic opportunities through increasing access to trading markets; improvements in infrastructure should also provide a catalyst for the creation of new manufacturing, operating and economic hubs. This can create new revenue streams and value in land, giving a windfall to local landowners and developers fortunate enough to have been located in surrounding areas.
Understandably government or public-private partnerships are seeking ways to share in those wider “windfall” benefits that their investment has created but effective mechanisms require a balanced approach, ensuring that there is fair attribution without stifling the appetite for external investment needed to make these emerging hubs work.
This is by no means an exhaustive list of the issues to consider or challenges to be addressed when procuring transnational rail projects. Successful delivery requires a combination of a thorough understanding of the challenges affecting the industry generally, and a depth of experience in transnational rail infrastructure. Combining these sets of expertise allows us to harness the many and considerable opportunities that the OBOR initiative presents in both traditional and project financed transactions.
Equally, the success of OBOR will rely on interested parties organising themselves not just at a local level but to think and organise themselves in a truly global way – big projects require big thinking. There is significant scope for international collaboration of interested groups to provide a framework within which the ambition of OBOR can be realised.
Understanding the legal challenges may be a small part of that overall ambition, but it is an important one, and needs to be closely integrated with wider OBOR strategy and implementation for successful delivery.
For further information please contact David Weare, Partner, Fladgate LLP (email@example.com)