Using the regulated asset base (RAB) model has the potential for cost-overrun that can be somewhat addressed through the 'alliance' model, that is, a model based on one unified agreement under which all parties share the benefits and risks, write Vincent Zabielski and Elina Teplinsky, respectively, special counsel and partner at Pillsbury Winthrop Shaw Pittman LLP.Vincent Zabielski and Elina Teplinksy (Image: Pillsbury Winthrop Shaw Pittman LLP)
"In July 2019, the Department for Business, Energy & Industrial Strategy (BEIS) issued its request for public consultation on the RAB model for financing development of new nuclear plants in the United Kingdom. In the Consultation, BEIS noted that the RAB model "has the potential to reduce the cost of raising private finance for new nuclear projects, thereby reducing consumer bills and maximising value for money for consumers and taxpayers". In a nutshell, the RAB is a construct whereby a government entity acting as an 'economic regulator' grants a licence to a company to charge a regulated price to users of the infrastructure. Under the RAB model, the costs of the project are passed directly to the end-users of the infrastructure.
The RAB model is different from the Contract for Difference (CfD) model used for Hinkley Point C because, unlike CfD which guarantees a minimum off-take price but doesn’t address the issue of cash flow during construction, RAB allows project developers and investors to recoup their costs during the construction period and pass some of the cost risk to electricity consumers. Because repayment of project costs is virtually guaranteed under the RAB model, the model can lower the interest rate on the project's debt and increase its return on equity.
Given that the cost of financing is a significant percentage of total costs for complex nuclear projects, the RAB can potentially reduce project costs in a meaningful way, resolving one of the key barriers to nuclear project development and financing. The RAB model has been used successfully in the UK for funding monopoly infrastructure, the most recent example of which is the GBP4.2 billion (USD5.3 billion) Thames Tideway Tunnel (aka the 'Super Sewer') upgrade to London's existing 19th century sewerage system. If we are honest, sewers and power plants are not particularly glamorous investment opportunities. At first look, the RAB model seems ideal for financing projects that no one wants but everyone needs.
A perfect fit for nuclear then, right? Maybe.
Other than reducing the cost of capital, the RAB model does nothing in itself to address the potential for cost overruns and schedule delays that have affected some nuclear power projects in Europe and the United States in recent decades. In fact, most new nuclear power plants in the United States were built in regulated markets which allow project owners to pass construction costs to the consumers, very similarly to the RAB model. In the absence of a robust mechanism to contain costs and manage project delivery risks, the low cost of capital combined with the consumer picking up the bill at the end has the potential to be a recipe for a cost-overrun disaster. Clearly there is something missing. How can the RAB be implemented in a way that won’t rip off the end-user?
Saints and heroes aside, it is a fundamental truth of human nature that contractors will behave in a way that makes them money. What if the RAB model were designed in a way which paid the developer to deliver the project on-time and on-budget, and pay them even more not to be late or over budget? What if instead of being adversarial, the RAB model required all interested parties to form an alliance based on a common set of goals, and provide an environment in which everyone wins or loses together? This form of contracting is known as the 'alliance model'. It was first used in Australia and New Zealand in the mid-1990s and has since been used successfully in Hong Kong, Europe, and the UK. One of the first applications of the concept was by Ampolex, an Australian oil company that used an alliance contract for the construction of a tank to store crude oil and gas in 1996. That project was widely considered a success and won the Australian construction achievement award in 1998. Subsequently, in 2010-2011, New Zealand successfully used an alliance model for recovery of areas devasted by a major earthquake.
In the United Kingdom, the Heathrow Terminal 5 contract used an alliance model and has largely been celebrated as a success. More recently, Network Rail has chosen the alliance model for major infrastructure works and the Department of Health has used the alliance model for a major IT and services outsourcing project for the NHS. Could the model also work for new nuclear?
For all of history, contracting had been, at its heart, an adversarial process. The goal of the alliance model is to transform contracting into a collaborative team effort. Under traditional contracts, each party tries to minimise its own risk by shifting risks to the other party. In a competitive environment, the risks are usually shifted to the contractor. The contractor, having to shoulder the majority of the risks, in turn has to allow for contingencies in its plans, adding additional costs to the project. All this allocating for contingencies costs money, and the winner and the loser are more often than not determined by forces beyond the control of either party. In the cases where things go wrong on a project, the contract serves as a tool to determine who is to blame for a particular outcome.
The alliance model reimagines the entire process of contracting starting with the fundamental assumption that contracts need to be adversarial. Under an alliance contract the owner works collaboratively with the contractor to deliver the project. Instead of risks being owned by one party or the other, under the alliance model the risks and benefits are shared by the owner and the contractor so that each is incentivised to identify and mitigate risks as soon as possible. Neither party is incentivised to sit on their hands and let the other party come up with solutions when problems arise. The 'gain' as well as the 'pain' are both shared under an alliance contracting model. Instead of being enemies, the owner and the contractor are fighting on the same side, and on-time and on-budget delivery rewards both parties. In the event that the project is delayed, both parties share in the impact of the delay.
The defining element of an alliance contract is that the parties share the same common objective of on-time and on-budget project delivery. This approach differs radically from traditional adversarial contracting models that priorities each party’s own interests over the other party’s interests. Of course, all of this would be rendered meaningless talk if the pricing structure of the project were not set up in a way that rewards both sides for cooperation and teamwork.
To be effective, alliance contracts typically provide sophisticated incentive mechanisms where rewards and burdens are directly tied to meeting the primary objective of on-time and on-budget performance. The contractor's operations are completely 'open book' and subject to observation and audit by the owner. All parties assume responsibilities, take ownership of risks and share any 'gain or pain' collectively. When the owner and contractor are acting as a team, any new developments that could impact the project objectives are reported and evaluated as soon as possible, so that the team can evaluate and mitigate the impact of any adverse development.
Of course, the alliance model is not perfect, and with the benefits also come some drawbacks. Because the alliance model depends fundamentally on honesty and openness between the parties, it will work most effectively where both sides enthusiastically adopt a team approach. This requires considerably more planning and focus on creating an open and trusting team than is present in a traditional contracting setting. Alliance contracts are more complicated to draft and negotiate than conventional contracts because the compensation mechanism must be very carefully considered and designed correctly from the outset. Alliance contracts also have a significantly greater administrative burden due to their open-book nature.
On the whole, the benefits of alliance contracting greatly outweigh the risks. Combining the RAB and the alliance models for the UK’s ambitious nuclear power program could be a match made in heaven that solves most of the problems inherent in delivery of large nuclear projects. Best of all, there is really nothing new to either concept. The RAB model is a proven method of financing large infrastructure projects, and the alliance model is an effective way of implementing such projects. Let’s get started."
Vincent Zabielski and Elina Teplinsky