The SkyCity bailout: it is common for private sector mega-projects to fail

SkyCity is sniffing around the New Zealand government for a $130 million bailout. The initial project estimate was $402 million for a convention centre and enlarged casino.

SkyCity was very clear when the convention centre deal was announced that it would be at no cost to either taxpayers or Auckland ratepayers. That is a clear assumption of the entrepreneurial risks – both the upside of high profits and the downside of cost overruns and losses.

The literature on mega-projects suggests that large engineering projects frequently fail to achieve their intended financial and operating objectives. Nine out of ten mega-projects have cost-over runs:

  1. Miller and Lessard (2000) studied 60 large engineering projects with an average size of $1 billion. Almost 40% of the projects performed very badly and were abandoned totally or restructured after a financial crisis.
  2. Merrow et al. (1988) found that four of the 47 megaprojects they studied came in on budget – the average cost overrun was 88%. Of the 36 projects that had sufficient data, 26 failed to achieve their profit objectives.
  1. Flyvbjerg et al. (2003) analyzed 258 large transport projects (toll roads, bridges, railroads, etc.). Cost overruns of 50% to 100% and revenue shortfalls of 20% to 70% were common.

Table 1 below gives more details on cost overruns in rail, bridge and road engineering projects overseas. Cost overruns averaging 27.6% were found with rail having much larger cost overruns than road or bridge construction.

Table 1: Inaccuracy of transport mega-project estimates

Project type Number of projects Average cost escalation
Rail 58 44.7%
Bridge 33 33.8%
Road 167 20.4%
All projects 258 27.6%

Source: Flyvbjerg et al (2003).

Cost over-runs are not the preserve of the public sector. Merrow (2011) found that over half of large-scale engineering and construction projects – off-shore oil platforms, chemical plants, metals processing, dams, and similar projects – had poor results: Billions of dollars in total overruns, long delays in design and construction, and poor operability and revenue shortfalls once completed.

Alchian (1950) illustrated the unreliability of cost estimation with the range of bids made in tendering processes. When contractors bid for the same project, they routinely disagree over its likely cost by margins of 20 percent. The contractors are predicting their own costs, about which they are knowledgeable, and they have an incentive to be truthful to win the initial tender. Initial cost estimates by engineers have margins of error of 25 percent (Alchian 1950).

Central to capitalism is the notion of profit and loss. Entrepreneurial endeavours that anticipated the matort well make a profit. The rest fall by the wayside.

SkyCity is a private investment that should stand or fall on the same criteria as any other business venture in New Zealand.

What should be asked by the taxpayer in all these business subsidies is what the value for money for their tax dollars is?

What is the problem that has been solved other than common garden business failure? Can this problem be solved by market process on its own at its own pace subject to hard budget constraints, competition in the market place, the threat of innovation at home and abroad, and continuous updating of the knowledge available to the entrepreneurial decision-makers by changes in prices and profits and losses. As Friedman said:

The strongest argument for free enterprise is that it prevents anybody from having too much power.

Whether that person is a government official, a trade union official, or a business executive, it forces them to put up or shut up.

They either have to deliver the goods, produce something that people are willing to pay for, are willing to buy, or else they have to go into a different business.

Losses and bankruptcies are fundamental to the success of the market economy. Losses are a clear signal that need to restructure, cut costs or go out of business. The paraphrase Mao, ‘Bankrupt one, educate a thousand’.

Corporate welfare, such as a bailout to SkyCity and at such an early stage in the investment postpones these difficult choices. As George Stigler explained:

One great invention of a private enterprise system is bankruptcy, an institution for putting an eventual stop to costly failure.

No such institution has yet been conceived of in the political process, and an unsuccessful policy has no inherent termination.

Indeed, political rewards are more closely proportioned to failure than to success, for failure demonstrates the need for larger appropriations and more power.

The fact that the government regulates part of SkyCity’s business because it is a casino is no case for a bailout. The purpose of casino regulation is to constrain the size of that industry, not help it grow.

3 Comments (+add yours?)

  1. nottrampis
    Dec 24, 2014 @ 12:29:50

    socialising their losses and capitalising their profits! Very interesting Jim

    Liked by 1 person

    Reply

  2. Ben Ross - Talking Auckland
    Dec 24, 2014 @ 12:38:53

    Reblogged this on Talking Auckland and commented:
    Well this is timely given the Sky City blow out dogging the Government. My message is still the same, flip the bird to Sky City and walk away Steven Joyce (and Auckland Council as well in regards to operation subsidies).

    Never before has Left, Centre, Right, Liberal, Conservative and Libertarian been so united against Sky City in this instance. Well done Sky City for that dubious and rare feat.

    Now I see the average cost of blow outs backed up by some good evidence is mentioned. So I link this old but goodie: http://voakl.net/2012/05/18/the-crl-and-the-rail-fallacy/

    Those Fallacy posts for the CRL served as a warning so we can avoid such blow outs like the disaster of the motorway tunnel construction in Seattle.

    I note the average rail cost blow out was 44.7% with ranges between 0-100%. This would put it close to my 1.5x or 50% blow out potential.

    However, before someone complains about rail I point out that the Sydney Toll Roads have gone bust twice, the Brisbane Airport Toll Road once, and a few in America going bust….

    Liked by 1 person

    Reply

  3. Jim Rose
    Feb 11, 2015 @ 10:22:52

    Reblogged this on Utopia – you are standing in it! and commented:

    This casino bailout is back in the news again. I am reposting this blog post from Christmas eve.

    Like

    Reply

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