Cost Overruns in Infrastructure Projects

The risk involved in an infrastructure project does not remain the same throughout the life of a project. Instead, the risk varies depending upon the stage in which the project is. The construction phase is supposed to be the riskiest phase of an infrastructure project. This is also the phase where investors demand the highest yield. This is because delays in the construction phase cause cost overruns. These cost overruns pose a significant risk to the success of the entire project.

In this article, we will have a closer look at the causes of cost overruns and how they impact the project as a whole.

What is a Cost Overrun?

A cost overrun is commonly defined as a variance of the final project cost from an estimate. The problem is that there are several estimates made within the lifespan of a project. Hence, which cost estimate needs to be considered is an important decision. In most cases, the final budget, which is prepared just before the construction phase of a project begins, is considered to be the planned scenario. The numbers mentioned in this scenario are then compared to the actuals in order to determine the variance.

Cost overruns are pretty common in the infrastructure sector. However, each cost overrun has a huge financial impact. Hence, it is important to mitigate these overruns in order to increase the overall profitability of a project.

How Cost Overruns Affect An Infrastructure Project?

Infrastructure projects generally run on a strict budget. In case of cost overruns, the project budget is exhausted much before the date of actual completion of the project. Hence, the project sponsors find themselves in a situation where they do not have sufficient funds to complete the project.

As a result, sponsors are exposed to several risks. They have to pool in funds urgently by liquidating their other investments. This has to be done since the sponsors have already invested a large sum of money into the project. Hence, they are forced to invest some more in order to salvage their previous investments. The bigger issue is that raising money for projects in which cost overruns have already occurred is extremely difficult. Most lenders do not want to fund the project since they believe that it is being managed poorly. Also, the few lenders who are willing actually to take the risk charge exorbitant interest rates.

From the equity shareholders’ point of view, a cost overrun can have disastrous effects. This is because a cost overrun increases the investment required. However, the return remains pretty much the same. As a result, the return on investment is reduced drastically. This reduction in return is regardless of the interest rate at which the new financing has been procured. An increase in costs without any increase in revenue severely impact the financial viability of the project. In many cases, the viability is completely destroyed, and financiers find it easier to abandon the project and move on instead of making attempts to revive the project.

Cost overruns are not good news for the lenders either! Like other stakeholders in the project, they, too, are negatively affected by these overruns. This is because lenders generally keep some margin when they give loans. This margin can be expressed in the form of a coverage ratio. For instance, if the lenders give a loan of $80 on collateral worth $100, the coverage ratio can be said to be 80%. In the case of cost overruns, the underlying collateral remains the same, however, the value of loans outstanding increases. This negatively impacts the coverage ratio. A higher coverage ratio means an increased risk for the lenders.

How Cost Overruns Can Be Mitigated?

  • One of the most commonly used ways of mitigating cost overruns is by using turnkey projects. Instead of contracting the construction phase on a cost-plus basis, it should be contracted out for a lump sum amount. Hence, the cost of delays has to be borne by the firm executing the project. The problem with this approach is that infrastructure projects are seldom awarded on a turnkey basis. Most delays are caused by factors such as strikes and political reasons, which are beyond the control of a contractor. Therefore, even in the case of a turnkey project, the government would end up paying more than the agreed-upon amount.

  • Another way of mitigating cost overruns is by awarding contracts only to companies that have a track record of completing the projects on schedules. In many countries like Canada and Singapore, timely completion of previous projects is a pre-requisite for applying for new projects.

  • Technological capabilities, such as big data, can also be used to mitigate the risk of cost overruns. There are tools being created which study cost data related to megaprojects in the past few years. These tools will analyze the data to find outline items in the budget where cost overruns usually happen. They will also help identify the root cause. Also, big data technology is capable of predictive analysis. This means that it will identify the trends leading to cost overruns and inform the relevant stakeholders about the same so that it can be prevented.

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Infrastructure Finance