Chapter 3 - Turnkey

Turnkey contracting is being used to an increasing degree for public works projects in the United States and abroad. FTA has supported attempts by transit systems to undertake major transit investment projects through a Turnkey procurement process whenever possible. However, the nature of the Federal grant program, combined with the needs of turnkey managers, made this project management approach difficult, at best. A confirmed use of the Full Funding Grant Agreement (FFGA) approach, may result in greater usability of the turnkey process.

Turnkey in Transit

The first application of turnkey ¹ procurement probably dates back to the first fixed price construction contract in ancient Greece or Rome. In transit, the practice originated overseas, in such far-flung places as the Philippines, Hong Kong, and Greece. The common factor in turnkey contracts of all kinds is a more or less independent contractor, who is responsible for delivering a product (usually a building or other construction project) at a certain time at a negotiated price. If the project is delayed, the price paid by the owner usually declines. If the project is early, or under budget, the contractor's profit increases. Acts of God and other unforeseen circumstances (how these will be handled financially) are negotiated as part of the turnkey contract.

There are many types of turnkey contract in use today, but the underlying rationale in each type is to allocate risk to that party in the transaction more able to manage the risk. The simplest contract is called "Build/ Transfer." As the name implies, the contractor builds a facility, then transfers it to the owner. The reason for an organization, such as a transit authority, to use this mechanism is that it may be unfamiliar with all of the technical requirements of the project, or it may not have sufficient staff to effectively manage the project. The contractor is usually in charge of scheduling, equipment, construction and assembly, hiring of sub-contractors, and securing of necessary permits and inspections. The transit authority undertakes to review and approve architecture and engineering plans, to make regular payments on time, and to assist the contractor in acquiring the necessary permits and inspections. The contract specifies the total dollar cost of the project, as well as the settlement of delays, change orders ², and early completion. Once the project is completed, the owner inspects and accepts it. This usually ends the relationship between owner and turnkey manager.

A "Build/Operate/Transfer" contract is somewhat more complex. The builder is contracted to operate the facility for a time after construction, then to transfer it to its owner. This mechanism has been used particularly with new light rail and rapid rail transit system construction. New rail transit systems tend to be unique, and they may take a decade or more to complete the first operable portion. The turnkey manager is most often the designer of the transit equipment (vehicles, control systems, etc.). By agreeing to operate the system for a time after its completion, the turnkey manager demonstrates that the system can operate within the parameters specified in the turnkey contract. Usually, the operation portion of the contract is relatively brief--not exceeding five years.

Beyond this level are contracts known as "Super Turnkey." They involve the initial design, construction, operation, and transfer, but they may also include maintenance, financing, or a lease. In a structure known as DBOM (Design/Build/Operate/ Maintain) the turnkey manager will in fact become a permanent contractor to the transit operator, undertaking to operate and maintain the new transit system, possibly for all of its useful life. In a super turnkey project, the manager may:

• Maintain the equipment for a specific time. This is often because the equipment or project is state-of-the-art, and requires significant time for the owner's maintenance and operations staff to learn how to properly maintain the equipment or system.
• Finance. The project owner may not be able to finance the project with its own resources. Most transit providers are in this position, as they must depend upon annual appropriations to buy rolling stock, facilities, and whole new systems. In such a case, the turnkey manager may be able to use its own credit rating to seek financing for the project. The transit operator may defray the cost of financing in part through progress payments (as it is able to obligate grant funds or other funds year by year), or through a bond issue of its city or State. The local bond issue acts as "take-out" financing.
• Lease. This variant on vendor financing provides a mechanism for the turnkey manager to lease the completed facility to its eventual owner. Generally, the turnkey manager is granted a nontransferable ownership interest in the project, once it is completed. The cost of construction may have been met with a combination of vendor debt and owner capital. The turnkey manager then leases the new system to the transit operator for a time, and at a cost, sufficient to cover the financing cost and provide a profit. This is a very flexible mechanism, which allows other factors to be addressed such as ongoing maintenance, fleet replacements, and system expansions. At the end of the lease term, the turnkey manager is "bought out" by the transit operator, which then takes full possession of the system. This may take 10, 20 or even 30 years from beginning to end.

Why a Turnkey?

This procurement method has several different benefits, depending upon the owner's situation. For most U.S. transit operators, the benefit comes from executing one contract with one entity at a pre-determined price. The transit operator avoids negotiations with subsidiary contractors, and it avoids the risk of labor and raw materials price changes. Of course, the fee paid to the turnkey manager includes a fair return for assuming these risks. However, the fixed price contract avoids another risk--that of price inflation. Since price increases may result only from agreed-upon changes to the contract, the transit operator has considerable assurance that when it presents a turnkey contract to its board for ratification, the price specified in the contract will be close to the actual price. Thus, as stated in the introduction, the turnkey contract allocates the risks of the project between the turnkey manager and the transit system, in general accordance with the ability of each to manage its portion of the risk. The transit system manages the institutional and public risks, while the turnkey manager handles project and timing risks, for example.

Most rail transit projects today involve non-U.S. systems and equipment. Some of the major providers in recent years have included Siemens/Duewag of Germany, Breda of Italy, and GEC-Alsthom of France. Thus, project costs may be affected by foreign exchange fluctuations. Few transit operations in the U.S. are adept at managing foreign exchange risk. Using a turnkey manager with the right qualifications may help to mitigate this risk.

Finally, the turnkey manager may help in putting together a financing package for the project. In Hong Kong, a car and light rail tunnel under the harbor cost well over $1 billion. The financing partners were from Japan, Hong Kong, and China. The Hong Kong Government negotiated project timing and cost with the turnkey manager, who in turn negotiated the financing package with its several partners. This was a particularly complex issue, as it involved toll revenues and transit fares that would be set by the Hong Kong Government, as well as residual development opportunities near the tunnel entrance. The financial partners were to be paid from revenues in excess of operating costs, as well as from land made developable by the tunnel. The involvement of the Chinese Government in direct negotiations with Hong Kong would have been problematic, at best.

A Financial Example

The following table ³ summarizes how project acceleration, as through a turnkey process, can reduce the total cost of a project significantly. In this example, a $600 million rail startup takes three years rather than six, due to construction financing provided by the turnkey manager. Inflation is projected at 5% annually, and project management cost is 30% of construction. In a specific case, the transit system would assess whether it could avoid $65 million in overall project costs by providing its own financing. The difference between the vendor financing and in-house financing should not be able to equal 11 percent of the cost of the project.

The U.S. Environmental Protection Agency has long promoted public/private turnkey arrangements for such projects as solid waste management, waste water treatment plants, and drinking water supplies. Case studies of these projects identify the benefits as follows:

• Lower capital and operating costs
• More rapid project completion
• Better or more comprehensive product performance guarantees (i.e., fewer opportunities for multiple contractors to "pass the buck"
• Access to sophisticated technology and methods
• Flexible financing
• Risk sharing
• Fixed Price contracting
• The parallel between EPA and public transit projects is that of the public utility. Water works are often regulated by a local public utility board, which sets rates, geographic boundaries and operating practices. Public transit service is usually governed by a locally elected or appointed board, which sets rates, defines geographic boundaries, and sets operating policies. The biggest difference between EPA and public transit projects is that water works are integrally linked to the land, and to development, which provides a predictable, long-term revenue source through development fees and property taxes. Public transit is usually maintained in operation through grants and local tax initiatives which are rarely long-term. Very few communities link the provision of transit service with the establishment or improvement of local communities. It is this kind of link that will make possible the broader use of turnkey procurement in public transit in the U.S.

A Practical Application

In November, 1990, a study was proposed by the Hennepin County Regional Railroad Transit Authority (Minneapolis, MN) to help determine the relative benefits of turnkey and more traditional procurement methods in the initiation of a new light rail transit project. The study was conducted by Capital Partnerships, Inc., in association with DeLoitte & Touche, L.S. Gallegos & Associates, and Hart, Bruner & O'Brien. The study was to compare various procurement methods on the basis of schedule, cost control, and quality assurance. In addition, the study was intended to develop a project management framework that optimized the trade-off between project control and risk. Case studies were prepared for three traditional and three turnkey projects that were deemed to be most comparable to the Hennepin County situation:

• Traditional
  • San Diego Trolley (South Line)
  • Portland Banfield Transitway
  • Los Angeles Metro Blue Line
• Turnkey
  • Hong Kong (Tuen Mun)
  • London Docklands
  • Manchester Metrolink
  • The case studies showed that the turnkey projects were implemented more quickly than traditional projects -- 40-43 months versus 67-73 months after completion of the preliminary engineering. The greatest schedule risk factors were site access (particularly for right of way), utility relocation, and tunneling.

Difficulties were found in estimating and controlling "soft" costs such as engineering, construction management services, and agency support in traditional procurement. This finding was confirmed in a subsequent FTA-sponsored study of comparative capital costs of constructing light rail transit systems in Portland, Sacramento, San Jose, Pittsburgh, and Los Angeles. ⁴ The turnkey projects were better able to control soft costs and other project expenses, as a result of incentives implicit in a guaranteed, maximum-price contract. On the other hand, turnkey projects were found to require improved quality assurance efforts for transit station finishes and the reliability of self-service fare collection systems.

Hennepin County's LRT Implementation Alternatives Study concluded that traditional and turnkey projects have several requirements for success in common:

• Well defined project concepts - What, why, when, and at what cost
• A strong project champion and local public support - Both public and private sector local support is required, especially by those most directly affected by the project during construction and operation. Strong and effective leadership is required to develop and maintain project consensus.
• Timely implementation of the first operable segment - This provides a successful startup that helps maintain public support and provides the basis for ongoing financial commitments.
• A small project management team - The cost-effective use of consultants permits simple and direct lines of communication, timely and responsive decisionmaking, and minimal interference with contractors.
• Appropriate risk sharing - Clearly identify and allocate risks through the owner/sponsor's procurement/contracting policies and procedures.
• Early right-of-way clearance - The project sponsor, either directly or through separate contracts, should be responsible for right-of-way acquisition, clearance, and utility relocations prior to the beginning of construction.

Issues in Turnkey Procurement

One of the primary benefits of innovative procurement techniques is the ability to allocate risks between public and private entities. The public sector bears most risks in traditional procurements relating to project implementation and future revenues. The nature of fixed guideway transit projects in the U.S. (they are grant-supported) does not normally permit revenue risks to be shared with a private partner when an entire system acquisition is undertaken. However, there are income-generating elements of transit projects, such as parking garages, which can attract private equity and a willingness to share revenue risks. Despite this limitation, many different types of uncertainties can be allocated, and traditional procurement processes can be adjusted to permit greater optimization of price, risk, and control.

The following sections outline risks normally associated with turnkey procurements, and special considerations related to fixed guideway transit systems.

General Procurement Risks

The private sector operates in a for-profit environment and will seek higher returns as the certainty of future revenues declines. A corollary to this concept is the time value of money -- the longer the period between the outlay of funds and future revenue streams, the lower the "present value" of the anticipated benefits. Fixed guideway projects are high-risk undertakings for either public or private entities, though the types of risk for each may differ. The bases for this risk include:

• There is significant uncertainty that a project will proceed to construction due to nearly uncontrollable factors involving project finance, economic conditions, political dynamics, environmental considerations, and institutional consensus on project leadership.
• Fixed guideway systems have very long development periods. Delays of months, or even years, can occur at any point in the implementation process. Delaying factors have included failure of a referendum, or an adverse vote in a legislative body; inability to avoid condemnation proceedings to acquire the right-of-way; and disagreement among public financing partners over the transportation alternative proposed by the project sponsor.
• Bidding for major projects can be a highly politicized process, with unpredictable outcomes after large front-end expenditures for proposal development.
• Underlying technology risks are high, due to uncoordinated deployment varying advanced technologies; specifications that effectively mandate "one-of-a-kind" systems; the interface of many project components, some of which may incorporate incompatible technologies; requirements for high reliability and safety in exposed weather conditions; the frequent interest of localities in incorporating innovative technologies (such as magnetic levitation) to create a positive community image and attract riders; and the need for design compromises to achieve political consensus, address environmental or alignment constraints, and meet budget limitations.
• Construction risks for fixed guideway transit projects are extensive because of the scale of such projects, the variety of alignment conditions (a single system may include tunnels, bridges, and at-grade operations, and may encounter a wide variety of environmental and sub-soil conditions); the need to perform precise construction in adverse conditions (in the middle of streets, or in residential neighborhoods); and the reliance on numerous subcontractors, each of whom must perform well and on time for the overall project to remain on-schedule and on-budget.
• The likelihood of project sponsor modifications of plans in response to field conditions, political decisions, budget changes, and external mandates is high. Modifications may, unless addressed in negotiations, result in claims that will take years of costly litigation to resolve.
• Warranty, acceptance and performance requirements may be difficult to meet due to problems with initial specifications, the impacts of changes during construction, or unforeseen problems in integrating several technologies. The frequent inability of project partners to pinpoint the causes of problems, and allocate responsibility, extends the risks of future liability until well after the project is completed.
• Although most contracts provide for inflation adjustment, surges in interest rates, fringe benefits, cost-of-living payments, and foreign currencies can vary more quickly than index calculations, or may be outside the scope of the turnkey contract.
• There are also general industry risks that may affect individual projects. If there are many similar projects under way at the same time, bid prices for certain classes of labor or materials may rise significantly. If many of the firms involved are heavily employed, this may raise performance bonding requirements and costs.

Turnkey vendors will tend to increase fixed-price proposals to compensate for the greater uncertainties inherent in transit projects outlined above. The risk premiums should be offset, in many cases, by savings arising from accelerated completion, ability to negotiate (and leverage) subcontracts and material acquisitions, greater control over the implementation process, and stronger project management capabilities. The net benefit to the public sponsor should be a fixed-price, date-certain delivery that, at a minimum, costs no more than the projected cost of a conventional procurement.

At the same time, in order to realize these benefits, the public sponsor must be prepared to accept the terms of the new relationship. For example, changes in design or specifications which had been fixed within the agreed scope, can be expected to result in cost adjustments in a turnkey project that are as great, if not greater, than would be found in a conventional procurement. If the change requested results in an overall project delay, or the inability to meet an agreed performance criterion without additional modifications, there may be a "snowball" effect on the entire project and its costs.

General Financing Risks

The factors identified above do not address project-related financing risks. The most serious concern to a private sector partner is the inability of the public sponsor to meet its financial obligations. Project financing risks are noted below and affect procurements even when the public sector sponsor absorbs the risks of farebox revenues:

• Decline in the anticipated yield of a dedicated revenue source due to economic conditions or over-optimistic growth forecasts
• Failure to appropriate funds conditionally pledged
• Pre-emption or discontinuation of dedicated funding for other purposes by a higher level of government, by legal challenge, or by popular referendum
• Expiration of the legal authority to levy a dedicated tax
• Inadequacy of funding to build and operate the project due to rising costs, poor financial planning, or inadequate contingency reserves

Examples of these risks are not hard to find in the transportation industry in conventional as well as innovative procurements:

• A drop in Portland, Oregon's employment tax receipts in the early 1980's created difficulties in maintaining core transit services and limited funding for planned extensions to the light rail line.
• Overbuilding, lack of demand, and falling property values resulted in a 25 percent decline in property tax receipts in the Route 28 special assessment district in Fairfax County, Virginia. This impaired the ability of State and local project sponsors to meet long-term debt requirements. Shifting market conditions have also slowed transportation projects along the Hudson River waterfront and at Allied Junction in New Jersey.
• The Resolution Trust Corporation was forced to void many letters of credit that supported infrastructure projects as a result of the Savings and Loan crisis in the 1980s.
• Los Angeles' attempts to impose special assessment districts around its rapid rail stations have been thwarted in the courts by property owners. Proposition 'C' sales tax levies are under strong legal challenge throughout California.

These risks are present in any fixed guideway project and can be addressed through well-recognized techniques, such as Full Funding Grant Agreements, Letters of Credit, Board Resolutions from the sponsoring agencies regarding the flow of funds, pledges to maintain certain levels of cash or tax receipts in reserve, and limitations on the use of certain revenues. In addition, more sophisticated risk assessment methods can be applied to forecasts of dedicated tax revenues and project costs.

Innovative Financing Risks

The risk profile of turnkey procurements is magnified when the public sector attempts to shift risks which are not construction/acquisition-related to the private vendor, or when it broadens the project scope to encompass factors that are not directly related to construction, such as financing. It has become a well-established practice to include solicitations of private sector financing and/or joint development in public/private partnership procurements.

An overriding risk in such procurements is that a proposer will win a procurement on the basis of an attractive financing offer which then fails to materialize. Such an outcome inevitably undermines the credibility of the project. Failure to deliver on promised financial support jeopardizes the integrity of the procurement process itself by eliminating bidders whose cost proposals may have been higher, but more feasible. At worst, if the project sponsor is unable to replace the failing bidder or to secure the necessary financing, the entire project may be abandoned. To avoid this outcome requires careful analysis and a sound bid evaluation process.

One of the more dramatic examples of a project vendor becoming unable to deliver on promised financing is the Downtown Las Vegas MagLev Project. The system supplier promised to build and operate a circular system at no cost to the State and local governments. The project was intended by its sponsors to demonstrate an innovative technology, and to generate profits from operating revenues, advertising, and other sources. Construction began, with several vertical support columns in place, before it became clear that the financial exposure of the undertaking was beyond original expectations, that the technology itself was not really ready for a showcase demonstration, and that local support for future expansions at public expense was lacking. The result was termination of the project.⁵

While the transit systems resemble public utitlities in many respects, unlike public utilities they operate under no presumption of profitability. Where the local water works or gas distributor may recoup its capital costs by raising fees, the transit system struggles to raise fares on any regular basis. And, where no one expects the local utility to operate at a loss, the local transit system is expected to remain in operation with an average farebox recovery of 40 percent of its operating costs. Thus, any request for proposals that depends entirely upon vendor financing is unlikely to succeed. The more useful alternative will be a clear division of financing risk between the public partner and the private partner, with each contributing what it can to alleviate the risk.

There are two basic sources of risk in a Turnkey transit project--completion, and revenue shortfall. Stated another way, they are capital, and operating cost. The transit system is best positioned to absorb the capital cost of the project, while the turnkey manager is probably in the best position to discount (not absorb) the operating risk. However, the transit operator should be prepared to share some of the operating risk with its turnkey partner.

Capital - The most realistic applications of vendor financing in turnkey projects occur in the area of construction financing. Where the transit system has been able to rely upon grant funding to acquire facilities and rolling stock in the past, this has not added any depth to its credit rating. The turnkey partner, on the other hand, is likely to have developed a history of successful performance under bond, and a correspondingly favorable credit rating. Thus, an agreement can be negotiated between the project sponsor and the turnkey manager that will cover construction period financing. The risk of project delay from reduced or delayed appropriations will be minimized by the vendor financing. But the transit system will benefit from the turnkey manager's credit rating, which will reduce the cost of borrowing for the construction period.

One recent example of this is the New Jersey Transit (NJT) light rail project in Bergen County, along the Hudson River. This project has received a Full Funding Grant Agreement from FTA, which will provide sufficient funding for the project over a period of about six years. NJT advertised for a turnkey manager able to provide construction period financing, secured in part with the FFGA. The turnkey manager will help NJT "smooth out" a $260 million shortfall during the construction period. The borrowing costs will be reimbursed with subsequent years' grant funds from the FFGA. The only additional security provided by NJT is a standby authority to draw on the New Jersey Transportation Trust Fund. This authority is only invoked if the FFGA fails to be sufficiently funded in a particular year.

Another way in which the vendor financing could be managed is through "take out" financing. The project sponsor (or its State or municipal authority) could issue long-term bonds to repay the turnkey manager at the end of construction. This could substitute long-term, tax-exempt debt for short-term, private debt.

Operating - The operating characteristics and revenue projections developed at the project planning and design stage rarely resemble projections made near the close of construction. If it remains involved in the project after construction, the turnkey manager's profit motive will provide a "real world" test of revenue projections made by the project sponsor. The turnkey manager will discount these projections to ensure an adequate cushion on operating performance--particularly if payments are based on performance measures such as passenger counts.

In all of the major overseas transit turnkey projects, the project sponsor has retained full control of fare policy. This is mostly for reasons of public policy. Without control over fares, the turnkey manager has usually insisted on a minimum guaranteed revenue level, in case passenger counts do not meet expectations. The project sponsor, on the other hand, has sought to introduce an incentive system, to "keep the contractor honest." Both sides meet in the middle by various means, including what has been called "shadow pricing." Under this mechanism, the project sponsor agrees to pay the turnkey manager a fixed cost per trip, within a certain range. Thus, if trips fall below an agreed level, the payments decline, but if trips rise above an agreed level, the turnkey manager receives a higher increment.

Conclusions

Turnkey procurement appears to be an excellent mechanism for major transit projects, particularly light rail or rapid rail startups. Although it offers many advantages for large, complex projects, it brings with it some risks and complexities that smaller transit systems may not be comfortable with. Also, where the technique is employed, the transit system will have to be proactive in addressing as many issues as possible in contract negotiations. The most successful turnkey projects have been those where most contingencies were resolved in negotiation prior to contract signing. The turnkey projects that failed generally did so as a result of poor planning, exacerbated by a "surprise" that either exploded costs or reduced revenues.

Footnotes

1. The term "turnkey" refers to the delivery of a building in finished condition, so that the owner may take possession by turning the key (as in a lock or control panel).

2. A change order is most often a request by the owner to modify some aspect of the project after the contract has been signed. Such changes usually increase the cost of the project by a set amount. Some times the change order arises from unforeseen circumstances, such as a change in local zoning or building codes or geologic anomalies.

3. "Turnkey Financing for Public Transportation Projects," by KPMG Peat Marwick LLP, for the FTA Office of Planning, October 1996, p. 14.

4. "Light Rail Transit Capital Cost Study" Booz, Allen, Hamilton, Inc., et. al, Washington, D.C. April, 1991. UMTA-MD-08-7001.

5.Most of this chapter derives from "Turnkey Procurement - Opportunities and Issues" - FTA report FTA-MA-08-7001-92-1, June 1992