Tunnel operator seems to profit from excessive reasonableness
'Look at the profitability and cash flow of this thing ...'
E-mail from reader
THAT CRYPTIC NOTE was in the subject line of the e-mail heading and underneath all was blank except for an attachment with the 2003 accounts of New Hong Kong Tunnel.
I had glanced at them before and noted that the company was doing well but at the time, I had already come to an opinion on this fracas about toll increases at the Eastern Harbour Tunnel.
Briefly stated, it was that the company was fully within its rights to raise the tolls. It had taken on the project on a 30-year build, operate and transfer scheme, whereby ownership of the tunnel would revert to the government in 2016 and, in the interval, it could remunerate itself from 'reasonable but not excessive' tolls.
The definition of 'reasonable but not excessive' twice went to independent arbitration and both times the arbitrators came to the same conclusion. It meant an internal rate of return (IRR) of 15 per cent to 17 per cent over that 30-year time span.
Far be it from me, I said, to question the decision of the arbitrators without being privy to their facts or going to the same pains to arrive at an appropriate figure. This is binding on the government. I shall take it as binding on my views, too.
Thus, if an IRR of 15 per cent to 17 per cent requires that tolls be raised, then they should be raised. We cannot have government reneging on its agreements with the private sector on infrastructure projects. We have rule of law here. A deal is a deal and we are in big trouble if deals can be broken on the whims of officialdom.
I still say so, but yesterday I looked more closely at the cash-flow statement attached to that e-mail and I have to admit my eyes opened wider.
You can see that statement in the table. Shareholders who contributed $750 million of their own money to the project have already been paid $1.93 billion in dividends, $327 million in 2003 alone.
The company has also paid off all its borrowing for the project and the balance sheet (not shown here) reveals a further $460 million available for dividend distribution. That figure will now rocket upwards with higher tolls.
Hang on, there's something wrong here, I said to myself. How can this company claim that it now needs a 66 per cent toll increase to make a reasonable return and how could the arbitrators agree with this? Surely an IRR of 15 per cent to 17 per cent does not produce such numbers?
But it does. I worked it out and the company is right. The net present value of free cash flow, even with the sorts of revenue to be expected from the recent toll increase, balances out to about zero over 30 years on an IRR of 15 per cent to 17 per cent.
And then it struck me. The arbitrators got it wrong. This IRR is much too high for a 'reasonable but not excessive' return. It is based on inflationary assumptions up to the mid-1990s, when consumer prices were rising by about 9 per cent a year.
Let us construct our own figure for an appropriate IRR. We shall start with a basic inflation assumption of 3 per cent. A higher figure is not on the cards with the inflationary control that the peg to the US dollar now exerts on us.
Then we shall assign a Hong Kong country risk rating of 3 per cent. Other authorities have it at above 7 per cent but I am not buying. For the mainland, yes, but not for Hong Kong.
Next we shall put in a 2 per cent equity risk figure. This is low but so is the risk on a tunnel company. This kind of equity has the sort of risk you would normally associate with a government bond. In fact, it is a government bond.
Finally, we shall put in a 3 per cent figure to compensate the company for the loss of its asset when the tunnel reverts to the government in 2016. It cannot be much higher when you think of a 30-year time span for this build, operate and transfer scheme.
Argue with my figures if you wish. They are admittedly rough and I could find quibbles with them, too. I do not think, however, that 'reasonable but not excessive' could really justify more than an IRR of 11 per cent at the moment.
And here is the punch line. An IRR of 11 per cent tells you the firm would not have had to raise tolls at all to achieve a reasonable return. But the arbitrators said 15 per cent to 17 per cent and we have to respect arbitration decisions or our whole economy is in trouble. I only hope, however, these arbitrators put their thinking caps on the next time they deal with a project like this.