Escalating Road Costs in Zambia What Are the Reasons?

Regional Conference on Innovations in Road Financing and Management

Arusha 26-27 August 2010

Session 5: Options for Mitigating Construction and Maintenance Cost of Roads

Escalating road costs in Zambia– what are the reasons?

By Abdul Awadh and Gary Taylor,

I.T. Transport, UK[1].

1.Introduction

Road costs in Zambia have risen significantly in recent years. A Study carried out in Zambia in 2009 examined this issue as part of an assignment to develop a system for estimating unit rates for road construction.

The cost of road construction works can be considered as a combination of two types of items. Firstly, those that can be estimated through some form of calculation, for example, the direct labour, material and equipment inputs. Secondly, items that cannot be calculated directly such as risk factors that depend on the contractors’ assessment of the situation at a particular time

Part of the aim of the road cost unit rate study in Zambia was to determine the causes of the increases in road construction costs. This Study revealed some common ground but also significant differences in the opinions of the causes between government and the private sector stakeholders.

2.Views of Government Officials

There had been significant increases in basic material costs such as diesel fuel,bitumen, cement, etc.,in Zambia in the previous three years. However, the feeling amongst government officials interviewed was that this alone was not sufficient to explain the high increases in unit rates for road construction. One piece of evidence put forward for this was that there had been no corresponding decrease in unit rates following a subsequent fall in diesel prices. The other reasons for high unit rates suggested by government officials were:

• Lack of competition between contractors, and
• Collusion between contractors.

Two reasons were put forward for reduced competition for recent contracts. Firstly, there was a belief that many larger regional contractors were occupied with the upsurge in work in South Africa due to the construction of venues for the football World Cup. Therefore,they were less interested in bidding for work in Zambia. In addition, in March 2008, the Government of Zambia had blacklisted 42 contractors as part of an investigation into possible corruption and failing to deliver on government contracts. These factors considerably reduced the pool of available contractors bidding for government work.

Secondly, some officials also firmly believed that there was collusion between the contractors. This was because the number of larger contractors in Zambia is relatively small and they know each other well. There had been an increase in government contracts put out to tender in 2008 and this presented an opportunity for “sharing” the work.

3.Views of Contractors and Consultants

Contractors and consultants confirmed that the recent increases in prices for fuel and other basic materials had resulted in significant increases in unit rates. However, they also mentioned a number of other factors affecting their prices including:

• The volatility of the exchange rate;
• The wider effects of the blacklisting of contractors in 2008;
• The effect of the removing of advance payments from contracts (later reinstated);
• The shortage of cement supplies in 2008;
• The transport difficulties, especially at borders, for materials brought from South Africa;
• Delayed payments and the other impacts of the stop and start of government funding for road projects.

These factors are discussed in more detail below. However, one of the broad conclusions of this Study was that the combined effect of these factors appears to have led to a situation where the road construction sector becameperceived as a higher risk sector than before. Consequently, existing contractors had become more cautious in their bidding for new contracts and new contractors weremore reluctant to enter the sector. This is one of the reasons for higher unit rates.

On the issue of competition, the views of the contractors and consultants interviewed were that competition in the sector washigh. Their opinion was that there were plenty of contractors for the average workload in the sector. However, some contractors conceded there had been periods when the larger contractors have been “stretched” i.e. there was more potential work than they could manage.

Based on limited evidence, it appears that the fluctuation of the workload in the sector occasionallycaused a temporary imbalance between demand and supply. This probably only affected competition for the larger projects, for which there were fewer registered contractors.Because there was a large number of small and medium scale contractors, lack of competition for smaller contracts appearednot to be a problem.

The conclusion was that lack of competition had probably been a factor increasing rates on larger contracts.

No evidence was found of major collusion between contractors. The opinion of some close to, but not directly involved in, contracting was that there might be some low-level collusion between contractors. This would typically take the form of one contractor asking another if they were going to bid for a particular contract. However, no evidence of direct collusion on the pricing of contracts was found. On the contrary, the impression given by the contractors wasthat they tended to be very secretive about revealing information to other contractors. Because of the high level of competition between medium and small contractors, collusion at this level was unlikely.The conclusion was that collusion between contractors may affect the occasional larger contract but wasprobably not having a major affect on unit rates for most contracts.

4.Volatility of the Exchange Rate

All contractors found the volatility of the exchange rate one of the most difficult risk factors to handlewhen setting unit rates. Because the world price of copper has such a big influence on the Zambian economy and the price has been volatile, the value of the Zambian Kwachahad been subject to sudden upswings and downswings. Figure 1 shows that the value of the Kwacha to the US dollar had moved between 3,000 and 6,000 between 2006 and 2009.

Under standard road contract conditions in Zambia, all payments were made in Zambian Kwacha with no automatic price fluctuation clause[2]. Therefore, the exchange rate risk on the purchase of imported materials or equipment was borne by the contractor. The exchange rate affected a large range of input costs including fuel, bitumen, equipment purchase and spare parts, steel reinforcement, etc.

Figure 1: Value of Zambian Kwacha to US Dollar

Larger contractors used various tactics to reduce the risk of the exchange rate adversely affecting their bids. This included forward buying of materials, engaging specialists to forecast likely exchange rate movements over the life of the contract and front-loading their contract rates. These tactics reduced but did not eliminate the exchange rate risk. Moreover, theywere mainly confined to larger contractors with more sophisticated pricing strategies.

The conclusion was that the risk of exchange rate fluctuations has a significant effect on unit rates. Generally, because the contractor was carrying the risk, unit rates were higher than if the Client had carried the risk.

5.Impact of Blacklisting of Contractors

In March 2008, the Zambian Government blacklisted 42 contractors as part of an investigation into corruption on government contracts[3]. After further research, 21 were subsequently cleared. The obvious impact of lower competition due to fewer contractors eligible to be awarded government contracts was mentioned by both government officials and contractors. However, contractors also mentioned other consequences of the blacklisting that had a potential impact on unit rates.

The loans to all blacklisted contractors were immediately revoked. At least two contractors went bankrupt. The blacklisting caused significant disruption in the industry and shook confidence. Banks and insurance companies perceived increased risk in the construction sector with consequent impacts on the cost and ease of obtaining loans and performance bonds.

The opinions of all stakeholders were that the blacklisting of contractors reduced competition and consequently increased construction costs. In addition, the opinion of contractors was that the perceived increased in risk in the sector had increased financing costs and tended to discourage new entrants including contractors based outside Zambia.

6.Impact of Removing Advance Payments

Advance payments were removed from Government construction contracts in 2008. This had a significant impact on contractors’ prices, as the cost of borrowing in Zambia is high. At the time of the Study in 2009, the bank rate was about 23% but the loan rate obtainable by contractors was about 10% above this. Moreover, some contractors were unable to obtain the necessary financing and consequently competition for bids was reduced. The Government had subsequently reintroduced advance payments on contracts. However, according to contractors, there has been a residual impact, as there was increased uncertainty in the private sector over what changes to contract conditions may be announced without warning in the future.

7.Cement Shortages

Cement is produced locally in Zambia but demand exceeded production until a new plant commenced operating in 2008. To cope with the previous cement shortages, contractors on larger projects had to start ordering and collecting cement as soon as a contract was signed. Some trucks had to wait 5-6 days at the cement factory. Back orders went up to 12,000 tonnes at one point. By procuring throughout the contract period, one contractor described how he had just managed to keep ahead of the requirements on one of his major road construction sites. The last cement deliveries arrived just in time for the last concrete works to be completed. The queuing of trucks at the cement factory and the stockpiling of cement were extra costs borne by the contractors. The conclusion was that this cost had been passed on in higher unit rates.

8.Delays at borders for imported materials

Zambia is heavily dependent on the importation of materials for the construction industry. For roadworks, this particular concerns diesel and bitumen. The effect on unit rates was not only confined to exchange rate movements, as discussed above, but also to the logistical problems of importation.

Bitumen used to be produced at the refinery in the Copperbelt but now most it is imported from South Africa. Contractors reported that the delays at the international borders had increased in recent years and some trucks had to wait more than a day to pass. One contractor estimated that there had been a doubling of transport rates into Zambia due to border delays. Typical transport costs for a truck from South Africa to Zambia were around SA Rand (ZAR) 75,000. Costs for return loads to South Africa were only around ZAR 25,000, reflecting the lower demand for back loads. We were told that the increased costs for transporting bitumen into Zambia had significantly increased prices.

The conclusion was that increased materials costs due to the factors described above had an impact on unit rates for road construction. This had a particularly significant impact on larger projects involving relatively high volumes of materials relative to the local market because contractors had to buy ahead and stockpile materials.

9.Workload Fluctuations

Many contractors mentioned the fluctuation in the workload of government contracts as one of the major factors affecting their pricing. We were told that the tendering process often moved in fits and starts. The process could take a long time during which contractors were not able to turn away other work. Problems arose once a contract was awarded if the contractor’s equipment had subsequently been allocated elsewhere.

Even during the execution of a contract, it was not uncommon for a contractor to be asked by the client to slow down the work because funding was not immediately available. This caused inefficient working and sometimes had a knock-on effect to other work. Idle equipment on site attracted a standing charge if the client stopped the work. However, this did not fully compensate the contractor for the lost output from equipment that was notfully employed. One contractor reported that they are fortunate if they achieve a 50% utilisation rate for their equipment in Zambia[4]. In South Africa, utilisation rates of 80-90% would be typical. Reduced average equipment utilisation rates lowered productivities and thereby increasedunit rates.

The conclusion was that the fluctuating workload had a significant impact on unit rates. Because the Zambian construction sector is small relative to e.g. South Africa, higher variations in workload for contractors is to be expected. Consequently, higher average unit rates in Zambia compared to South Africa was expected. However, the message received from contractors was that the fluctuations of the past few years had been higher than normal. The frequent instructions to contractors to slow down or stop works due to lack of Government funds exacerbated this situation and led to inefficiency in the sector. The increased uncertainty that these factors broughthad inevitably increased prices.

10.Conclusions on Factors Affecting Unit Rates

The conclusion of the interviewswas that there was an array of factors affecting unit rates for construction works in Zambia. The determinants of unit rates could be divided into those that are susceptible to calculation,such as material input costs, and those that are not. The latter are largely factors the estimation of which depends on the contractor’s experience and attitude to risk. In general, the higher the level of uncertainty the higher will be the cost. Therefore, any measure that reduces uncertainty should potentially reduce costs and vice versa.

In the interviews held, various stakeholders gave their opinion on the proportion of the price of a road construction project that might be attributable to the non-calculable factors. Estimates varied widely from 20 per cent to several hundred per cent. There was some lack of clarity here in whether the estimated on-costs included overheads, profit, etc. Contractors were understandably coy about revealing the level of profit that they set when estimating contract prices. Some said that it was “double figures”. Others stated that when they were keen to win a contract, the level of required profit was below 10%. In moredeveloped economies, a profit of 5% would be considered reasonable. One contractor indicated that a profit level of 10% was the norm for South Africa but for Zambia it had to be higher.

The conclusions were that the level of profit, overheads and uncertainty used in setting prices in Zambia were significantly higher than in some other countries e.g. South Africa where the risks were considered lower. Fluctuation in the exchange rate was one of the biggest variables that the contractor had to accommodate. Because contractors estimated the exchange rate conservatively, this could result in a windfall profit for contractors if the Zambian Kwacha strengthened against other currencies.

Changes in contract conditions had added to a general perception of the sector being high risk. The combined effect of the factors described above had increased uncertainty in the implementation of construction projects in Zambia and this had inevitably resulted in increased unit costs.

11.Mitigation Measures?

In many sub-Saharan countries, the market for road works is relatively small. There is usually only sufficient work to maintain a few large roadworks contractors. For the larger contracts in particular, it is important to keep a steady stream of work/contracts. Sudden highs of workload cause high prices due to lack of competition. Paradoxically, prolonged dips in workload also cause higher prices as contractors exit the sector and seek work elsewhere thereby reducing competition.

The private sector is used to taking risks if the risk is something that can be controlled or at least estimated. Sudden changes in contract conditions are an example of a risk that a contractor finds hard to predict. Therefore, avoiding unpredictability can mitigate rising costs because contractors give the best prices in a predictable environment

Finally, there needs to be a mature attitude to risk sharing on contracts. Those risks that can be managed by contractors, e.g. material price increases by forward buying, could reasonably be put on the contractor. However, risks that are completely beyond the control of the contractor should be treated with care. If the contractor is required to carry these, the price will be high. In the case of Zambia, the exchange rate fluctuation was an example of an external risk. The contractor had to put a high price on carrying this risk and that was reflected in high unit costs. Because Government could have spread this risk across a large number of construction contracts, the net cost of the risk would have been far lower if it had not been carried out by the contractors.