November 05th, 2010 | Economic Observer Why China Railway Construction Corporation Lost Money on the Mecca Light Railway
The Mecca Light Rail, constructed by the China Railway Construction Corporation Limited (CRC) for Saudi Arabia, will become operational on November 13. Zhao Guangfa, president of CRC said within the company that this project was more a political mandate than a commercial project. Failure was not an option.
The CRC has finished the task, but it has cost them 4.15 billion yuan in losses.
The Mecca Light Rail is an important but complex project. The project concerns relations between China and Saudi Arabia and many local regions; the price of the project does not match the contract. Labeled a “political” by the CRC, the project was destined to incur losses.
However, as the CRC is already a public company listed on both the A-share and H-share markets, it has to strike a balance between political considerations and commercial interests. Sometimes the two are in conflict, and the conflict is not easily settled. The key lies in how companies find the balance. What the CRC experienced in constructing the Mecca Light Rail will become a common challenge among all Chinese enterprises that are planning to go global.
A Special Project
In February 2009, with Chinese Premier Hu Jintao and Abdulla, King of Saudi Arabia, both present, the CRC signed a contract with the Ministry of Municipal and Rural Affairs (MMRA) of Saudi Arabia to construct the Mecca Light Rail. This is the first project to take place after the two countries signed an agreement to strengthen cooperation in infrastructure construction and its primary function will be to ease the traffic burden brought about by millions of Muslim pouring to Mecca every year.
According to one insider with the CRC, the company was recommended by the Ministry of Commerce to construct the railway. It negotiated directly with Saudi Arabia on pricing the project (price discussion) instead of inviting a public biding. At that time, the CRC thought the project would be profitable.
“Price discussion” allows the purchaser to negotiate the price of the project with one of the selected service-providers. It is not open to the public nor is it competitive. Although it may save time and is a flexible process, it easily opens the door to backdoor deals.
Mecca Light Rail is considered to be the world’s most difficult light railway project with the longest construction time and the largest passenger volume. But the price offered by the CRC is the lowest of any railway construction company in the world.
Zhao Guangfa said that it would take three years for ordinary Chinese companies to construct such a light railway. But the Mecca Light Rail only took 16 months, the shortest construction time in history.
However, it was not easy for the CRC to obtain the contract.
In January 2010, Abdulla said to Chen Deming, when selecting the contractor, many Saudi Arabians opposed assigning the project to a Chinese company. But the King finally chose the CRC because he trusted the company.
The Mecca Light Rail is 18.06 kilometers long and the predicted construction period was around 22 months. The price of the contract was 12.07 billion yuan, based on the exchange rates of September 30. But the cost of the project had already reached 16.06 billion yuan by September 30, incurring a loss of 3.99 billion yuan. Adding the 154 million financial fee, the total loss of the project is around 4.15 billion yuan.
This is the largest loss Chinese enterprises have ever suffered on an overseas project. The CRC had earned a net profit of 3.37 billion in the first half of this year, but suffered a 1.36 billion yuan loss in the third quarter because of the Mecca Light Rail, dragging its revenue down 193.52 percent from the same period last year.
The CRC says that work involved in the project was more than what was listed in the contract, and the MMRA raised the passenger volume requirements of the project while delaying the construction of underground pipes and the removal of existing houses. These measures greatly increased the CRC’s work load and construction costs.
According to standard industry practice, a contractor is authorized to cease construction before receiving new construction fees or before reaching an agreement on compensation for delays. Contractors may also demand an additional compensation for losses caused by the cessation of construction.
But the CRC did not cease construction because it knew the Mecca Light Rail is constructed for Muslims and will prove a huge benefit to the Muslim world.
A Passive Role
Although the CRC is the general contractor for the Mecca Light Rail, the company created conflicts in taking on more responsibilities than expected.
The contract says the CRC is responsible for the designing, material-purchasing, construction, equipment-installing and maintaining operations for three years. This is called a “EPC and O&M” contract.
According to an expert on international construction projects, the largest characteristic of an “EPC” contract is that it requires the contractor to complete a set project within a fixed term, and at a fixed price. The contractor will carry out project design, select materials and complete construction according to the MMRA’s requirements. Experienced contractors will always demand a high price for such a contract. They will also try to reach an agreement on insurance or set a hazard cost.
The attraction of an EPC project to the contractors lies in that they are responsible for designing and equipment purchasing, and thus may optimize the design and purchasing to gain more profit.
However, rather than playing a dominant role, the CRC has been under the control of others.
On July 22, 2010, Zhao Guangfa said in a regular meeting that the CRC did not dominate the design process for the Mecca Light Rail. The infrastructure was based on an American standard while its railway system was based on a European standard. All sub-contractors were chosen by the MMRA.
All this caused problems for the CRC.
Backed by the strict contract, the MMRA repeatedly changed the construction standards, delayed the approval process for equipment and construction materials and hired sub-constructors for key parts of the project including design and civil engineering (the contract requires an approval from the MMRA for each sub-contract worth over nine million yuan), leaving the CRC with less control in the project but complete responsibility.
Saudi Arabia has changed the engineering of the bridge span, the framework, train station size, equipment indexes and function requirements of the railway, causing the CRC to dig 5.2 million cubic meters of earth, 3.2 million more than planned.
During the construction, even wall color had to be approved by the vice minister of municipal-rural affairs, greatly postponing the approval process.
Some insiders have said that this has indicated that the CRC is either not familiar with or not experienced in the operation model and sub-contract management of local projects. In fact, by the end of 2009, the CRC had already realized that the schedule of the Mecca Light Rail would be tighter than any project it has ever undertaken, and there would be no end to the financial risks.
But the company did not publicly voice the risks of the project.
The CRC admits that had given inadequate consideration to the difficulties of the project, and had been too dependent on sub-contractors. The company has had poor spot management and did not have a general control mechanism for the safety, quality, construction period and cost of the project.
The CRC has reported the changes and claims for compensation to Saudi Arabia, and Saudi Arabia has promised to establish a specialized commission to negotiate possible compensation.
By the publication of this article, neither the Ministry of Municipal-Rural Affairs nor the Saudi Arabian embassy in China have responded to the EO’s request for an interview.
But according to a source from the CRC, the Chinese government will support the CRC’s request for compensation. But the result has not been settled.
The CRC has said that the Mecca Light Rail is a commercial project and the company will voice the interest of its shareholders.
But the Mecca light railway has been an important concern of leaders from both Saudi Arabia and China. The Ministry of Railways, the Ministry of Commerce and the State-owned Asset Supervision and Administration Commission (SASAC) have all given tremendous support to the project. The high executives of CRC have stated many times within the company that the Mecca Light Railway is a “political project” and it has to be constructed with high standards of quality.
The president of CRC has demanded that CRC employees to do their best to complete the project, despite difficulties. This spirit is in the tradition of China’s state-owned enterprises. But since the enterprises have become modern companies with a joint-stock system, the question of how to operate a project according to business principles while avoiding risks is an area of concern.
Though “political projects” might result in losses, it does not mean they will never be profitable. On the contrary, they may be more profitable than normal projects since they are backed by governments. The key is for the company to strike a balance between commercial interests and political considerations.
Lu Duojia, board chairman of the First Huida Risk Management Company who once helped the SASAC to draft the Guidelines of State-owned Enterprises’ Complete Risk Management, said that it has been learned that there were many contractors who applied for the Mecca project. The reason the CRC finally received the contract might be that it had provided the best price.
“You can refuse to do it if you think it will lose money. We cannot say political projects between Saudi Arabia and China are guaranteed to incur losses. It is the CRC who should bear more responsibility.”
Some insiders have said that although the MMRA’s capriciousness and delays are responsible for the CRC’s losses, the core reason still lies in the CRC’s inadequate evaluation of potential risks. It lacks experience in constructing overseas projects based on American and European standards and has done a poor job in reducing risks in drafting contracts.
But the root of the failure lies in the crude organization and working habits the CRC formed when constructing railways at home. But when the company goes global, facing a complicated international environment, these problems will create many complications.
Lu Duojia said that for the CRC, following the SOEs’ strategy of “going global” was one of their largest risks. There had been too many cases of failures and the SOEs should learn from their mistakes.
By Liu Weixun, Jianglei, Kang Yi, Wang Fang