Disputes in the transport sector: key questions, methodological issues and current trends

Introduction to disputes in the transport sector

The transport sector covers many subsectors, including road transport, rail, aviation and maritime transport, which give rise to a broad range of disputes including investor–state disputes, disputes between construction companies and public sector entities and disputes between construction companies and private investors. In this article, we explore the types of disputes that arise in the transport sector and the key considerations for estimating damages in such disputes.

Several common features of the transport sector naturally lead to these types of disputes:

• high levels of government involvement: governments may choose to amend the terms of existing contracts for political popularity and to create a perception of creating a ‘better deal’ for taxpayers. Some governments may even terminate and re-tender contracts altogether. This can be a particular issue for contracts that are longer than one election cycle, with incoming governments looking to undo unpopular concession agreements made by previous administrations;^[1]
• long project life cycles: the project life cycle for transport infrastructure can span several decades and includes many stages in which disputes can arise, such as planning and approval, construction and operation. Long life cycles may also lead to greater risks of government interference, as set out above. The types of damages that may arise in these longer projects can broadly be split into:
  • delay-related damages (eg, due to unexpected increases in construction costs that require additional project funding or due to delays in obtaining necessary government approvals);
  • disruption-related damages (eg, due to external factors such as covid-19); and
  • termination-related damages or expropriation damages; and
• terms of concession agreements becoming subject to dispute: concession agreements may include pre-agreed terms regarding issues like the setting of tariffs or allocation of project risks, which may result in losses to the concessionaire in the event of unexpected changes to the economic environment. The covid-19 pandemic and the recent global rise in inflation rates provide some examples.

Key considerations in estimating damages in transport disputes

In this section, we discuss some key questions that arise when estimating damages in transport sector disputes and the relevant considerations for addressing these questions.

Over what time period has the claimant suffered losses from the alleged breach?

Consider a case in which an investor in road infrastructure has suffered losses for a period of time due to a construction delay (ie, a delay case that will not necessarily affect financial performance indefinitely). In such a case, one approach may be to estimate losses over the delay period only. This may be appropriate if, following the end of the delay, traffic levels are likely to immediately return to the levels observed prior to the delay. For example, in the case of a disruption to traffic on an existing highway, it may be appropriate to assume traffic levels will immediately return to the trajectory witnessed before the disruption began, as road users were already familiar with the road before the disruption and will immediately return to using it once they are able to do so.

In other cases, it may be more appropriate to assess losses by including a ‘catch-up’ period, in which losses decrease after the delay period has ended but do not completely disappear for some time; for example, as traffic levels catch up with the original trajectory observed prior to the delay, as illustrated in Figure 2.

In the extreme case, a project’s financial performance may become negatively affected indefinitely, despite only a temporary delay or disruption, resulting in losses over the entire lifetime of the project. This type of situation may arise, for example, if the reputation of a route is damaged as a result of the breach; passengers switch away as a result of the damage and they stay away because they are happy with the alternative route.

As a general rule, it is important to consider financial performance over the entire lifetime of the project, even if the breach period only spans a fraction of the project life, to account for the possibility of the mitigation of losses in the period after the breach. For example, a concession agreement for a toll road may set out a maximum toll charge each year. If in the period prior to the breach the concessionaire has set toll rates below the maximum charge, it may be able to mitigate some of its losses by raising toll rates in the period after the breach.

In other cases, the breach may result in the loss of an entire asset or a cash flow stream in perpetuity. An example of this case includes expropriation of airport infrastructure. This type of dispute differs from the previous examples in that the investor’s ownership of the asset, and therefore its ability to generate any cash flows from it, is permanently taken away.

In such cases, the basis for estimating damages is typically the overall value of the investor’s share in the asset or project itself, rather than financial performance over a specific period of time. As with the previous examples, it is nevertheless important to consider whether this value should be offset by any residual value the investor has retained, for example, where only a partial expropriation has taken place and the investor retains the value of any assets not taken.

Who has directly suffered losses as a result of the alleged breach?

While quantum is generally concerned with direct losses to the claimant as a result of the alleged breach, this may not always be the case. Consider the previously discussed stylised example of a disruption to a highway in which the main investor in the road infrastructure claiming for losses is a government entity. In such a case, the majority of losses may have been suffered directly by the population of the state rather than the government.^[2] While the question of whether governments generally have the right to claim for direct losses to their population is a matter of law rather than economics, quantum experts can help tribunals distinguish between direct costs to the population and costs borne by the government (eg, through lost tax revenue).

Government claimants may also argue additional traffic would have resulted in positive network externalities and net social benefits, which would further affect the project’s impact on the population and indirectly on the government, such as via tax revenue. While net social impacts – both positive and negative – can have a sizeable impact on project value, the question of how tribunals will deal with estimates of these values remains, as far as we are aware, relatively untested and a potentially important issue for future cases.

Is it possible to separate the impact of the alleged breach on traffic levels and conditions?

The role of the quantum expert is to assess the financial position the claimant would have been in absent the breach. In transport projects, a key determinant of the claimant’s financial position is likely to be total traffic and traffic conditions. Any calculation of damages therefore must assess the expected traffic levels and conditions absent the breach. It is also crucial to carefully consider and control for factors that may have affected traffic levels and conditions over the breach period but that are unrelated to the breach itself to ensure damages do not reflect other factors unrelated to the breach.

Is there sufficient relevant data available to assess the impact of the breach on traffic levels and claimant’s financial performance?

Assessing a transport project’s financial performance and value generally requires high-quality data for two parameters:

• traffic levels and any variables affecting traffic; and
• project financial performance.

Several databases for traffic data exist, such as IATA for aviation and government databases for road traffic.^[3] However, to assess a transport project’s future performance, forecast data are typically required. If no relevant traffic forecast data are available from available databases, it may be necessary for the practitioner to create their own forecasts. The creation of one’s own forecasts presents a need for further data; for example, data on explanatory variables that can be used to predict the future value of traffic, like gross domestic product (GDP). Additional data from comparable projects may also be needed. For example, in a delay to an expansion of a capacity-constrained airport terminal, estimates of traffic in the but-for scenario would need to incorporate data on rates of traffic growth at similar but unconstrained airports.

While existing projects may have some historical financial performance data available, projects in the pre-operational stage will not and the project’s financials will therefore need to be estimated. One option is to rely on management or investor forecasts, which may be available from the project’s business plans. However, such forecasts need to be carefully scrutinised by the quantum expert to assess whether they can be reliably used for estimating damages.^[4]

Methodology for estimating damages for transport projects

Similar to disputes in other sectors, the general approach for estimating damages in the transport sector is to take the difference between the value to the claimant in:

• the counterfactual scenario (ie, a hypothetical scenario in which the breach did not occur); and
• the actual scenario in which the breach did occur.^[5]

The two most common approaches to valuing a project in the transport sector in the counterfactual and actual scenarios include: ^[6]

• the income approach (eg, the discounted cash flow (DCF) approach); and
• the comparables approach (eg, the use of market multiples or transaction multiples).

The income approach provides an estimate of value based on the present value of all future cash flows the project is expected to generate, as illustrated in Figure 3.

The comparables approach provides an estimate of value based on observable values of comparable companies (eg, market valuations of listed comparators or purchase prices of comparable assets sold as part of a transaction) as illustrated in Table 1.

It can often be difficult to find suitable comparators for transport projects due to the unique characteristics of each project, such as size, traffic composition and ancillary revenue, making the comparables approach difficult to apply in practice.^[7] As a result, it may be necessary to rely on the income approach when estimating damages for transport projects. However, if data on comparable assets are available, they serve as an important cross-check to the income approach, ensuring the value estimated using the income approach is grounded in reality.

The application of the income approach typically requires estimating project revenues and costs in both the counterfactual scenario and actual scenario to estimate the project’s cash flows, as illustrated in Figure 4. The difference between the counterfactual and actual cash flows then forms the basis for estimating losses for a given year, which, when discounted back to the valuation date, provides an estimate of total damages.^[8]

For transport projects, it is common to estimate revenues based on traffic estimates, especially if revenue is directly related to traffic levels such as for a toll road or an airport. In transport disputes, it is common for losses to arise due to differences between traffic levels in the counterfactual and actual scenarios. One way to capture these differences in traffic is through econometric modelling, as we discuss in detail in ‘Estimating traffic levels in the but-for scenario’, although other approaches are also widely used, including the use of transport planning statistical software.

To derive a set of revenue estimates from traffic estimates, traffic figures can be combined with industry benchmarks such as revenue per passenger. Sector-specific measures may be available, such as revenue per available seat kilometre for aviation projects or revenue per available tonne kilometre for cargo traffic. For toll road infrastructure, it is common to use the toll rate as the estimate of revenue per passenger. Practitioners should carefully consider which revenue lines are included in industry benchmarks; ancillary revenue lines may not always have a strong direct relationship with traffic levels and duty-free revenues may be more directly based on the retail floor space.

The next step of implementing the income approach is to estimate project costs and consequently cash flows. Operating costs for the project may need to be estimated based on benchmarks (for example, IATA produces operating cost benchmarks for airports and airlines in the aviation sector) or databases from providers such as the World Bank. In addition to operating costs, cash flows may be affected by additional factors typical for transport projects that need to be incorporated in the damages calculation. These include:

• construction costs: increasing construction costs, for example due to high inflation for key raw materials, can cause transport infrastructure projects to become uneconomical. The way in which projects can evolve depending on future economic conditions is also a factor to consider and potentially incorporate into the valuation, such as through the use of a modified version of the DCF approach to include real options;^[9]
• load factors: practitioners should evaluate any expected changes to the load factors of vehicles, vessels and aircrafts. For example, an airline may need more aircrafts to accommodate rising passenger levels. If higher traffic forecasts are likely to require substantial capital expenditure (capex) on additional capacity to avoid current capacity becoming overly constrained, this additional capex that reduces cash flows will need to be factored into the valuation; and
• taxes and concession fees payable by transport companies: in concession agreements, contractors are likely to pay concession fees that may vary with revenue, depending on the risk allocation set out in the concession agreement. Government involvement may result in favourable tax rates for the project or an effective tax rate that is lower than statutory tax rates.

Estimating traffic levels in the but-for scenario

As discussed in the previous sections, a critical aspect of damages assessments in the transport sector involves estimating traffic levels in the but-for scenario – the levels of traffic that would have materialised had the breach not taken place. The difference between actual traffic and but-for traffic levels then serves as the starting point for estimating damages arising from the breach.

We set out the main steps involved in estimating traffic levels in the but-for scenario:

• As a first step, descriptive analysis is used to analyse historical traffic patterns. This step allows the practitioner to identify the primary drivers of historical traffic levels and consider whether and how these factors would be affected by the breach. This analysis helps identify potential variables that should be included in the model to estimate traffic in the but-for scenario and separate the effects of the breach from other factors.
• In the second step, an econometric model based on the insights from the descriptive analysis is developed, quantifying the relationship between historical traffic levels and key factors that drive traffic. This relationship is captured by the model’s coefficient, which measures the impact of changing one factor while keeping all other factors unchanged on traffic levels.
• In the third step, ‘but-for’ values or scenarios for the key factors that drive traffic are developed, capturing the key channels through which the breach affected traffic.
• In the final step, the ‘but-for’ values or scenarios for the key factors from the third step are combined with the model coefficients estimated in the second step to estimate traffic in the but-for scenario. The final step should also include sensitivity checks for the model coefficients and scenarios for the but-for key factors to test the robustness of the but-for traffic estimates.

There are several challenges that need to be overcome to robustly estimate traffic levels in the but-for scenario. These include gathering suitable data, processing the data and, most importantly, performing the analysis correctly. Practitioners should be able to obtain data before and after the breach in order to develop a deep understanding of the factors changing due to the breach and their impact on traffic. Once the relevant data are obtained, practitioners should ensure the data accurately represent the real world and can help distinguish the impact of external events from factors affected by the breach. This is important because many factors can influence travel demand, but the damages estimate should only reflect the impact of the breach and not other unrelated factors.

For example, consider a dispute involving a three-year delay in the construction of airport infrastructure, including terminal and runway expansions. This delay leads to capacity issues at the airport, hindering traffic growth. In this example, damages would be estimated based on the counterfactual traffic level that would have been achieved had the terminal and runway expansions been completed on time. To estimate the counterfactual traffic level, practitioners can develop a regression equation based on descriptive analysis of factors affecting traffic growth, including capacity and demand-related factors. The model can be estimated using data before the airport became capacity-constrained, so the impact of each factor on traffic is unaffected by the capacity constraint.

Mathematically, the model in its simplest form might be expressed as follows:

where:^[10]

• ‘log(PAX)’ represents the changes in passenger numbers over time (t);
• α₀ is a constant;
• the α₁, α₂ and α₃ coefficients measure the change in passenger growth as a result of a 1 per cent change in the explanatory variables:
  • ‘log(GDP)’ represents the growth rate of the GDP, used as a measure of economic activity;^[11]
  • ‘log(Ticket fares)’ represents the average value of ticket fares; and
  • ‘Event’ identifies the period during which passenger numbers were affected by an external event (such as covid-19, volcanic ash, conflict and natural disaster); and
• ‘Season’ identifies seasonal fluctuations in passenger numbers and is a set of seasonal dummy variables.^[12]

Once the model coefficients are estimated, the practitioner needs to determine but-for values for the model’s explanatory variables, in this case ‘GDP’ and ‘Ticket fares’, to estimate but-for traffic levels. For GDP, practitioners may simply rely on the observed values. This may be a conservative assumption, as higher passenger numbers flowing through the airport in the absence of the delay may have contributed to higher economic growth through increased connectivity and higher productivity across other industries as well as direct air transport- and tourism-related industries. For the price variable, it may be necessary to develop relevant counterfactual values that account for the impact of increased capacity on prices. For example, had additional capacity been available, the entry of low-cost carriers could lead to price reductions.

After estimating the model, it is important to check how well the model fits real-world data and how accurately it measures changes in traffic as a result of changes in each factor. This can be done by examining how the model responds to changes in its specifications, data sources or the techniques used for estimation. These checks ensure the traffic model can be trusted in various situations and scenarios, providing a robust estimate of traffic levels in the but-for scenario.

Current topics in transport disputes

There are number of recent trends in the transport sector that may give rise to potential disputes in the future, for example:

• the treatment of high inflation in concession contracts;
• climate change and other environmental considerations; and
• disputes emerging as a result of losses due to force majeure events, such as conflict in the Red Sea or the covid-19 pandemic.

The high inflation environment prevalent since 2022 may result in disputes over the raising of rates and tariffs. In particular, concession agreements may include a pre-specified formula for rate increases, which may not be suited to periods of high inflation. For example, consider a concession contract that includes rate increases linked to the consumer price index (CPI), a general measure of inflation used to track prices of consumer goods and services purchased by households.^[13] This general inflation index may not accurately capture the inflation faced by the concessionaire for its own capital or operating costs. While the two inflation measures may be broadly similar during normal market conditions, a high inflation environment may lead to the two materially diverging from each other, with the concessionaire’s cost inflation rapidly outgrowing the CPI, resulting in losses to the concessionaire during the high inflation environment.

Regarding climate change, there is potential for disputes to arise as a result of tighter environmental regulations set by governments, which some existing concessionaires and infrastructure operators may not meet. Some disputes have already begun as a result of investors in existing transport infrastructure failing to obtain environmental clearance from the government.^[14]

The covid-19 pandemic led to substantial disruptions to the global economy, particularly in areas such as air traffic and shipping, as a result of measures such as lockdowns and border restrictions imposed by governments. Actions taken by governments during the pandemic have given rise to disputes in the transport sector due to extraordinary government measures, disagreement on who should bear covid-19 risk, investor dissatisfaction with government support, and nationalisation or expropriation. Since the start of the pandemic, there have been examples of disputes or threats of disputes in Chile, Peru and Cabo Verde as a result of covid-19.^[15] Another emerging disruption to global trade, namely conflict in the Red Sea, may give rise to arbitrations taken out against the government of Yemen by shipping companies that have suffered direct losses or incurred additional costs finding and using alternative trade routes.^[16]

The role of economic experts in cases related to the above topics is likely to be two-fold: an assessment of the merits of the case from an economic perspective and an assessment of damages. In relation to the merits of a case, quantum experts can generally provide useful insights on matters that are typically considered mainly to be legal considerations. Such insights may include which party should bear relevant risks, whether contracts should be renegotiated as a result of the relevant risk factor (eg, inflation or covid-19) and whether any government support turned out to be adequate after the fact.

Conclusion

Disputes in the transport sector are common, arising naturally due to government involvement and interference in transport projects as well as contractual disputes. While there is debate over how best to estimate damages in transport sector disputes, the income approach is generally most reliable if it can be implemented using robust estimates of financial performance, which in turn typically rely on robust estimates of traffic levels.

Traffic estimates are typically developed with the use of econometric modelling, which allows practitioners to base forecasts on the relationship between historical traffic levels and key factors that drive traffic. Care must be taken to tailor the econometric model to the availability (and quality) of data and it is key that such models are structured properly to derive meaningful results.

There are a number of emerging areas for potential future transport disputes, including disputes around inflation indexation in existing contracts, changes in environmental regulations as a result of climate change, and the aftermath of covid-19 and other global events. For many of these disputes, quantum experts can provide inputs not only for assessing the value of damages but also for the merits of the case.

Endnotes