Part 18: The Council takes possession of the assets

18.1
In this Part, we discuss:

• the commercial acceptance process in the Project Deed;
• changes to the dates for commercial acceptance;
• whether the process for completing commercial acceptance in the Project Deed was met; and
• our comments.

18.2
In summary, we conclude that:

• Commercial acceptance was given even though significant elements of the wastewater scheme were not complete and the scheme had not been proven to work. There was no evidence that KDC was told this before it paid the purchase price.
• The changes to the dates for commercial acceptance did not save KDC money. Rather, they ended up costing KDC significantly more than it would have saved. Modifications appear to have been agreed without regard for the effect that they would have on the dates for commercial acceptance.

18.3
In July 2008, there were changes in the ownership of EarthTech. Tyco, EarthTech's parent, sold part of that company to AECOM Technology. Tyco retained the part of the former EarthTech company responsible for constructing and operating the wastewater scheme, which became Water Infrastructure Group (WIG). Throughout this report, we refer to this company as "EarthTech".

The commercial acceptance process in the Project Deed

18.4
As we discussed in Part 12, the Council agreed to a two-stage commercial acceptance process. This meant that the first part of the scheme was to be completed, and then paid for by KDC, while work continued on the remaining part of the scheme. The Project Deed provides that "Facility 1" was to be completed first. This was made up of the wastewater treatment plant and the reticulation network to service 540 properties. "Facility 2" was to be completed last. This was made up of the reticulation network to service the remaining 676 properties, the transfer pipeline, the dam, and the reuse/disposal system.

18.5
The Project Deed required each facility to go through a process to establish that it met technical completion and commercial acceptance.

18.6
Technical completion was essentially a check that the facility was constructed in accordance with the Project Deed (except for minor defects or omissions) and was capable of being operated for its purpose and in accordance with all consents. For technical completion to be met, all the restoration works at the sites had to be completed, and the Operation and Maintenance Manual for that facility had to be completed.

18.7
The Project Deed also provided that EarthTech had to carry out pre-commissioning and commissioning tests. Once EarthTech was satisfied that the facility met the requirements for technical completion, it was required to notify the Project Director. KDC was then required to instruct its "Technical Adviser" to carry out a technical audit of the facility. The Technical Adviser was required to be appointed by KDC. After the technical audit, the Technical Adviser was required to issue KDC and EarthTech one of three things:

• A certificate stating that, in its view, Technical Completion has been achieved in respect of the Facility and then issue a Certificate of Technical Completion; or
• A notice that in its view Technical Completion has not been achieved and such notice shall include the matters and things required to be done before the Facility shall achieve Technical Completion; or
• A notice that the Facility is so far from Technical Completion that it is not practicable to issue the notice specified above, and require the Promoter to continue with the execution of the Works.

18.8
The Project Deed provided for a similar process for commercial acceptance. Figure 13 sets out the timing and dates set by the Project Deed.

Figure 13
Timing and dates of Technical Acceptance and Commercial Acceptance

Source: Schedule A, Project Deed, section 11.

Changes in the dates for commercial acceptance

18.9
The various modifications and other problems meant that the date for Commercial Acceptance 1 could not be met. As we discussed in Part 12, our work suggests that the Council did not consider the potential cost consequences of signing the amended project documents in December 2007, when the scope of the works was not final.

18.10
The project documents set out the dates for Commercial Acceptance 1 and Commercial Acceptance 2, and the Council agreed to this two-stage process after receiving advice that it would save KDC money. It appears that the Project Director and EarthTech agreed in March 2009 to extend the date for Commercial Acceptance 1 by 21 weeks. They then agreed in July 2009 to change the date again so that Commercial Acceptance 1 would occur on the same date as Commercial Acceptance 2. This eliminated the cost savings that they had been trying to achieve.

18.11
The Project Director and EarthTech appear to have agreed these changes using the modifications process in the Project Deed. KDC's files do not hold any of the modifications papers on this issue. Nor could we obtain all the relevant papers on this issue from Beca. We were unable to determine what matters the Project Director considered in agreeing to the modifications.

18.12
A paper that EPS prepared in February 2009 referred to the need to change the dates for commercial acceptance. We discussed this in Part 17 in relation to the swap agreement KDC used to hedge its interest rate risk. We were unable to determine whether this paper was provided to the Council or whether the need to change the dates for commercial acceptance was discussed with the Council.

18.13
It is not clear to us that the Project Director had the authority to modify the dates for commercial acceptance in this way, without any formal reference back to KDC.

Was the Project Deed process for commercial acceptance followed?

18.14
As we set out earlier in this Part, the Project Deed sets out a process for determining whether commercial acceptance had been met.

18.15
Although Beca provided technical advisory services, we could find no evidence in KDC's files that KDC formally appointed a person to carry out the role of Technical Adviser as required under the Project Deed. KDC's former Chief Executive told us that Beca was appointed to carry out this role. The Technical Adviser was required to carry out a technical audit of parts of the scheme to determine whether they met "technical completion". The Project Deed enabled technical completion to be met if minor omissions or defects existed, provided that they did not prevent the scheme being used. The Technical Adviser was also required to carry out a technical audit of parts of the scheme to determine whether commercial acceptance had been met and to issue a certificate if this was the case.

18.16
It is not clear to us that the process for technical completion and commercial acceptance set out in the Project Deed was followed. We set out below what was done.

18.17
Beca's contract for project management set out that Beca would provide technical auditing services. The contract stated that:

The nature of delivery mechanism for this project requires [EarthTech] to establish its own quality management systems and inspection/monitoring procedures to ensure the project is completed in accordance with agreed Project Plan including any agreed modifications to this plan.

The technical auditing service is targeted at providing Council with confidence that [EarthTech] is following its own quality management system and is generally constructing the project to comply with contracted quality standards.

18.18
The contract set out that Beca would provide, at a minimum, quarterly technical audit visits to the project to assess whether EarthTech was implementing agreed quality management systems. The contract also provided that "Sampling inspections will also be made of critical ‘as constructed' elements of the project."

18.19
EarthTech told us that, in addition to the Beca technical audits, ABN Amro visited the site each month and carried out its own technical audit of the works before making any payment to EarthTech.

18.20
Beca staff carried out several technical audits starting in December 2008, although work started on the scheme at the beginning of 2008. The early technical audits provided that the purpose:

… was to establish that [EarthTech] is following its own quality management system and is generally constructing the project to comply with contracted quality standards. Focus was on the [wastewater treatment plant] rather than reticulation. Focus was put on items with design life significantly longer than 15 years being the period after which the works will be handed back to KDC.

18.21
Later technical audits looked at the reticulation system.

18.22
EarthTech advised EPS in June 2009 that it expected to achieve Commercial Acceptance 1 by 4 July 2009.

18.23
In early July 2009, a Beca Technical Director carried out a high-level review of the design reports prepared by, or on behalf of, EarthTech. Beca's Technical Director reviewed the reports on the wastewater treatment plant and the transfer pipeline. He concluded that both reports "demonstrate a robust approach to defining design inputs and assumptions as a basis for the detailed design of these assets". However, he noted that he had not reviewed the process design for the wastewater treatment plant in detail.

18.24
Beca staff carried out the fifth technical audit on 16 July 2009. This was finalised on 24 August 2009 (after commercial acceptance had been given on 28 July). The technical audit report states that the purpose of the technical audit was "to establish whether or not the works are technically complete". The report noted that a large number of works were outstanding at that date, including:

• completion and commissioning of the effluent disinfection systems (UV and chlorination);
• completion of CCTV testing of the reticulation system;
• completion of the testing of the storage dam liner; and
• completion of the Operation and Maintenance Manual and the as-built documentation.

18.25
The report recommended following up several issues to ensure that outstanding works were completed, including ensuring that the required dam inspections were carried out.

18.26
In Promoter's Notice Number 4, dated 17 July 2009, EarthTech requested that the Project Deed be amended so that references to the Technical Adviser were replaced with references to the Project Director. It proposed that commercial acceptance be given even though the works had not been completed. EarthTech proposed that it provide a $2 million bank guarantee that could be called on if the agreed outstanding work or works were not completed by 30 June 2010. The Project Director accepted the modification request on 17 July 2009.

18.27
We could find no evidence in KDC's files that EarthTech arranged for a bank guarantee or that evidence of such a guarantee was provided to EPS before it issued the commercial acceptance certificate. Again, it is not clear whether the Project Director could make such a significant change to the Project Deed without referring it back to KDC.

18.28
There were risks in giving commercial acceptance for the scheme when there was work outstanding and the scheme as a whole had not been proven to operate. KDC took ownership of the scheme after commercial acceptance, so it needed to understand those risks and take steps to mitigate them. We were unable to determine from KDC's papers why EPS decided to give commercial acceptance when the scheme was clearly not completed.

18.29
On 28 July 2009, EPS sent EarthTech a Certificate of Technical Completion signed by Beca. The Certificate of Technical Completion noted that:

As per Modification Acceptance Number 4, requirements for completion have been modified and include a provision covering Outstanding Work. Outstanding Work means the work set out in Appendix 1 of this Technical Completion Certificate.

18.30
On the same day, EPS issued the Certificate of Commercial Acceptance. In doing so, EPS noted that the settlement date was 31 July 2009 but that the agreed date for EarthTech to begin operational service was 21 July 2009. This was based on the technical completion date of 20 July. EPS advised that payment for operations would begin from that date.

18.31
On 31 July 2009, MDHL invoiced KDC for the sale of the treatment plant and reticulation assets as due and payable under the Tripartite Deed. The amount specified in the invoice was wrong. KDC did not identify the mistake and paid the incorrect amount. When the mistake was discovered, the invoice was reissued and the overpayment was refunded. The correct purchase price in the second invoice was $51,476,960.76, including GST. KDC's former Chief Executive told us that the correct process was for the Project Director to approve the invoice before payment and that, in this case, KDC staff did not follow the correct process. We could find no record of this in KDC's files so were unable to verify that this was the case.

18.32
There was nothing in KDC's files to indicate that the Council was told that it was taking ownership of the wastewater scheme when there was work outstanding and the scheme had not been proven to work. There is also no evidence that it was advised that EarthTech would provide a $2 million bank guarantee to deal with this issue.

18.33
After commercial acceptance, Beca carried out another two technical audits in August 2009 to determine if the works were technically complete or operating as intended. The last technical audit identified that several works were still outstanding.

18.34
There was nothing in KDC's files about what the project managers or KDC did to ensure that the remaining works were completed or how works carried out as modifications after commercial acceptance were monitored or signed off.

Our comments

18.35
As we set out earlier in the report, there were a range of mechanisms in the contract that, if used, could help KDC manage its greater exposure to construction risk, including tools that were available during and after construction. The tools needed to be used in combination. If only the tools that were available after construction were used, KDC would be left in a weaker position to recover any losses. It also needed to fully use the tools that were available during construction to make sure that what was built was fit for purpose before it took ownership.

18.36
As discussed in Part 15, the main tools KDC had available during construction were reviewing design documents and monitoring construction, as well as the technical audits and commercial acceptance process discussed in this Part. The purpose of carrying out the technical audits before commercial acceptance was to ensure that the scheme was fit for purpose when ownership finally transferred to KDC. The contract clearly set out that commercial acceptance was to be given only if the scheme had been constructed in accordance with the Project Deed and was capable of being operated.

18.37
We have explained that the technical audits were carried out and identified issues that needed to be fixed. However, the parties proceeded to commercial acceptance without fixing these issues. By doing so, KDC effectively waived one of its main protections and weakened its position. It does not appear that the Council was ever told that it was purchasing a scheme that had not met the requirements of commercial acceptance set out in the contract.

18.38
It appears that, because of delays caused by the modifications, the construction works could not be completed by the date set for commercial acceptance. However, rather than delaying commercial acceptance to enable the works to be completed, the Project Director issued the commercial acceptance certificate. EarthTech proposed to secure the performance of the outstanding works with a bank guarantee. However, we have no evidence that such a guarantee was arranged.

18.39
In our view, it is questionable whether the Project Director could modify the Project Deed in such a fundamental way without referring it back to KDC as the principal party to the contract. The scope of the Project Director's delegated authority from the Council is not clear.

18.40
In any event, we do not consider that the risks in making such changes were properly identified, reported, and managed. There was no evidence in KDC's files that these issues were discussed with the Council. In our view, given the significance of the effect of the changes – that KDC was buying a wastewater scheme that was incomplete and had not been proven to work – these matters should have been discussed with the Council before the decisions were made.

18.41
We were unable to determine from KDC's files whether the work that was outstanding at commercial acceptance was completed and whether Beca or EPS carried out any further work to determine whether the works were complete and the scheme operated as intended.

18.42
In our view, KDC should have had closer oversight of the commercial acceptance process. Its lack of involvement is highlighted by no-one in KDC identifying that MDHL issued an incorrect invoice for the purchase price. We did not find any document in KDC's files breaking down the purchase price into different components. KDC staff had no way of checking whether the invoiced purchase price was correct or not.