Analysis: The R16bn ‘Gupta premium’ – how the Transnet locomotive acquisition went from R38.6-bn to R54.5-bn

Gupta fatigue has set in.

As a country we're holding back yawns over yet another revelation of how the Guptas defrauded us with the help of their pimpernel, Salim Essa.

But we must stay awake, stay engaged, because the damage is so deep, so extensive that it represents a profound crisis for our democracy.

The only way to deal with that damage is not to avert our eyes, but to master the detail and demand consequences up and down the chain of command.

As an object lesson – a case study in the enormous cost of state and corporate corrosion – it is hard to match Transnet's R54-billion purchase of 1064 locomotives – supposedly needed to meet a rail-freight revival dubbed the Market Demand Strategy (MDS).

Transnet was the ground zero of state capture and the focus of amaBhungane's first articles on that phenomenon.

Now a report by law firm Werksmans (assisted by forensic accountant Harvey Wainer) has unpacked the train-smash at Transnet in all its gory particulars, filling in gaps in our own knowledge and confirming the accuracy of our reporting.

Transnet commissioned the report following the #GuptaLeaks exposures, but has not implemented its recommendations.

It is impossible to overstate the crisis: the R54-billion cost is the same as the Arms Deal in nominal terms, and the Werksmans report demonstrates that Transnet failed to uphold and protect the national interest in nearly every respect.

What's worse is that some key architects of this failure – chief executive Siyabonga Gama and group executive for manufacturing Thami Jiyane – are still in place, even though the state capture brains-trust of Brian Molefe and Anoj Singh has departed.

Gama, Molefe and Singh did not respond. Jiyane denied any responsibility.

Read Jiyane's full reply here.

Transnet said its executives “follow stringent procurement procedures and processes and this was not an individual exercise but a collective team effort with a number of committees aimed at ensuring that the final result is to the benefit of the company”.

“The executives you quote have not been given the opportunity to be in possession of the report or an opportunity to factually respond to those allegations and to engage with it as it is still the exclusive property of the Board.”

See Transnet's full response here.

But the Werksmans report is devastating.

If anything justifies public enterprises minister Pravin Gordhan's decision to purge the previous Transnet board, it is their inaction in the face of this report, which they have had since December 2017.

Let's unpack the damage.

The big MDS gamble

The rationale for the size of the fleet renewal programme (1064 new locomotives) was optimistic at best, based on a prediction that Transnet would be able to achieve large increases in freight tonnage which would pay for the enormous outlay.

As early as October 2013, Gordhan, then minister of finance, wrote to Transnet to raise concerns about the viability of this strategy.

The letter, quoted in the Werksmans report, notes:

“I am concerned that the profitability of the project is highly dependent on Transnet's general freight business being able to grow the volumes transported at amounts above GDP [gross domestic product] growth and tariffs charged at above CPI [inflation].

“Failure to achieve these optimistic growth figures would have an adverse effect on the expected revenues and thus the profitability of the project.”

In fact, business did not grow as predicted and were it not for delays in the supply of the locomotives Transnet would have faced a crippling cash-flow crisis, forced to pay for locomotives it did not have capacity for.

Well placed observers (including senior Transnet employees and consultants) are divided over whether the MDS was merely wishful thinking or a scam to justify a massive procurement project.

What is clear is that the claim that the locomotives would provide a huge growth opportunity was the trump card used to justify decisions that were otherwise patently damaging to Transnet's interest, notably the decision to split the tender among four suppliers to accelerate the delivery of the new fleet.

Localisation

One of the first reports to raise the alarm over the 1064 project was a confidential briefing, apparently prepared for local rail industry players.

In March 2014, Transnet signed contracts with China South Rail (CSR) and Bombardier Transportation (BT) for electric locomotives, and China North Rail (CNR) and General Electric (GE) for diesel ones.

A month later the briefing rubbished claims of local capacity-building that, as with the Arms Deal, were used to sell the project. It warned:

“Most of the locomotive spend will go to foreign companies, BEE front companies and procurement controllers, and attempts by Transnet Engineering (TE) to duplicate already existing technology available in the local private sector.

“Losers will be existing local companies that ironically already enjoy a fairly significant technological base to manufacture a 'South African' locomotive at a lower cost...

“The broader implications of the deal will be: the outflow of much needed foreign currency to overseas companies; the emergence of a state sanctioned monopoly that will produce locomotives at uncompetitive rates; the further entrenchment of corrupt patronage networks; cost overruns for the project and the inevitable taxpayer subsidized bailouts for Transnet.”

The report was prescient.

Despite tender requirements which set local content thresholds at 55 percent for the diesel locomotives and 60 percent for the electric ones, the Werksmans report reveals that no-one really knows how much is being spent here.

It reveals that Transnet Internal Audit (TIA) flagged the issue as at 31 December 2016, saying, “No local content verification has been conducted to date.”

By August 2017, the internal audit assessment was “certain [manufacturers] are behind schedule whilst others have not achieved their local content requirements at all”.

The report added:

“TIA has further informed Werksmans during interviews that Transnet management has prevented TIA from conducting a full audit on local content, this notwithstanding that such activity falls within TIA's scope and preparations were already in place.”

Transnet Engineering

Meanwhile, Transnet's insistence that the foreign manufacturers use TE as their main local subcontractor has come at a terrible price.

Wainer's forensic report notes that the manufacturers demanded Transnet pay a premium for them to use TE as a subcontractor, rather than other local suppliers. He reports:

“The premium... of R2.8 billion is at least 38% of the subcontract prices — which is simply remarkable. Per supplier, the TE premium as a percentage of the subcontract amount is 105% for BT, 54% for CSR and 26% for GE... This excludes any TE premium for CNR, as that was not separately identified — thus the 38 % is understated.”

That's right: Transnet is paying at least R2.8-billion more to keep most of the work in-house, rather than let other South African companies benefit. Bombardier is charging us more than double what they would charge for using other South African companies, to compensate for the pain of having to use Transnet's engineering services.

As Wainer points out:

“The sheer size of the premiums should have been the cause for much investigation and consternation... Notably, there was no link between the amount added to each supplier's [final offer] for TE premium in deriving their locomotive price, and the actual subcontracts concluded between each of the suppliers and TE. Thus, there was no assurance that the TE premium to be paid to the suppliers (as part of their price) would ever be recovered via TE profit on work subcontracted to TE by the suppliers.”

He quotes former Transnet chief financial officer Gary Pita as saying TE discounted prices to be as competitive as possible. Wainer notes:

“If that is so, either TE is grossly inefficient in terms of cost and/or the [manufacturers] exploited the situation... simply inflating the prices.”

He adds:

“Compelling the [manufacturers] to use TE as the subcontractor also carried with it significant delivery risk for the whole project, as it then created a situation for a ready excuse for non or late delivery by the [manufacturers], who could attribute non or late delivery to inadequate performance by TE.”

Indeed, as of 25 September 2017, the report claims that BT and CNR – which, at Transnet's request, had to relocate their operations from Gauteng to Transnet's Durban workshops – had not delivered a single locomotive. Zero.

The report adds that the R1,2-billion cost of relocating BT and CNR should probably be counted as part of the TE premium (see our relocation report here).

Implementation – tainted by graft and incompetence

If the strategy was ill-considered and self-interested, implementation was worse.

In June last year amaBhungane's first report on the #GuptaLeaks revealed how the Guptas and their associates signed kickback agreements totalling R5.3-billion with CSR – roughly R10-million on each locomotive delivered.

In Part 1 and Part 2 of our Great train robbery series, we showed how their pawns at Transnet manipulated the procurement process for two earlier deals, for 95 and 100 locomotives, paving the way for the big one, the 1064.

The Werksmans report underlines the accuracy of our reporting, notably confirming the conflict of interest attaching to Iqbal Sharma, then chair of the powerful Transnet Board Acquisition & Disposal Committee (BADC), and the improper way in which CSR was substituted for Mitsui in an uncontested “confined” tender for 100 heavy-duty locomotives for Transnet's coal line.

But Werksmans and Wainer are also scathing about the level of engagement and oversight offered by Transnet management and directors relating to a transaction that was huge and risky.

Wainer notes:

“It would be expected that the senior executives of Transnet, and the Board, would carefully and comprehensively critically examine and consider the entire business case [for the procurement]... This is particularly so considering the vast sums of money involved and the risks.”

But no.

Werksmans concludes:

“The board of directors failed to exercise objective judgment of the business enterprise and on its corporate affairs, independent from management. It would appear that the [board] was supine in its deliberations at best...

“There was a lack of appreciation of and application of mind (at the very least) by the executives and the board to the actual 1064 business plan and to the interest of Transnet.”

Werksmans stresses that the project cost originally put to the board escalated by almost R16-billion, yet was approved despite the increase being largely “inexplicable, unreasonable and excessive.”

The reports and our own research highlight four interrelated slights-of-hand that made for a deal that was corrupt, grossly inflated and inappropriate to Transnet's needs – to the extent the company was placed in real financial jeopardy and remains vulnerable.

The four trick cards were: inflating, shifting, splitting and accelerating.

And they were dealt mainly by four players: Brian Molefe, then the chief executive; Siyabonga Gama, then head of freight rail and now Molefe's successor; Anoj Singh, the former chief financial officer; and Thamsanqa Jiyane, the chief procurement officer at the time.

Inflating (the price)

The first key slight of hand was the misinformation contained in a report to the board on the “business case” for the 1064 procurement, dated 25 April 2013.

The business case had been prepared by internal Transnet experts and confirmed by McKinsey as external consultants.

It estimated the total cost of the project was R38.6 billion, including provisions for foreign exchange escalations and inflation.

But, mysteriously, the executive summary quotes the total cost to be R38.6 billion excluding “the potential effects from forex hedging, forex escalation and other price escalations”.

Wainer shows the correct position should have been evident from a cursory analysis of the business case itself and he questions how this misinformation could get past half-competent officials.

“If the Transnet executives believed that the R38.6 billion excluded the cost of forex hedging and escalations then it is rather unclear how the executives could have properly applied their mind...

“A consideration and recommendation... would have been foolhardy, as then there would have been no assessment at all as to the total cost to Transnet, and the cash needed...”

He adds:

“It appears from [subsequent] interviews that Messrs Molefe, Gama and Jiyane made no enquiries as to the estimated cost of forex hedging and escalations... [they] seemed remarkably unfamiliar with the business case.”

Wainer says the same failures applied to the board.

This is significant because forex and inflationary escalations were later key factors blamed for the eventual increase in the price from R38.6-billion to R54.5-billion, when in fact, Wainer shows, they were double counted.

“The assertions in the May 2014 Memorandum to the Board that the R38.6 billion excluded the cost of inflation escalations and forex hedging (which assertion was repeated, and repeatedly emphasised) was used as the main explanation for the increase.”

Shifting (the goal posts)

In December 2013, Transnet resolved to ask shortlisted bidders for best and final offer (BAFO) prices.

But this was selective. Molefe and the other senior executives directed that, while all four bidders in the diesel tender be asked for a BAFO price, only two bidders in the electric tender be asked.

This curious distinction appears to have worked in certain suppliers’ favour.

In the diesel tender CNR was fourth out of four suppliers, but during the BAFO offered a much more competitive price, with the end result that CNR was selected as the second supplier.

In the electric tender, the decision to only ask the two top-scoring suppliers (Bombardier and CSR) for a BAFO price effectively cut Mitsui out of contention despite Mitsui’s locomotive being cheaper than CSR’s.

It is notable that there is now evidence that both CSR and CNR engaged with companies controlled by Salim Essa and the Gupta family in order to gain an advantage in aspects of the tender process.

In addition to this, Molefe also confirmed a recommendation from the evaluation team that maintenance costs be excluded from the adjudication of the total cost of ownership (TCO) score.

TCO looks not only at the purchase cost, but also energy and maintenance costs over the lifetime of the locomotive.

Werksmans considers this a change in evaluation criteria which is prohibited by tender rules.

This decision gave a significant advantage to CSR’s bid, given that it – with a TCO of R110-million per locomotive – vastly exceeded what Transnet considered acceptable.

CSR’s locomotives have much more expensive scheduled maintenance costs (R55-million versus a benchmark of R25-million), and will likely be much more expensive for Transnet in the long run.

Splitting (the spoils)

Originally the business case proposed that Transnet select one bidder for 599 electric locomotives and one bidder for 465 diesel locomotives, making up the 1064.

But in January 2014, Molefe directed a new memorandum to the board proposing to split the deal into four, with two bidders sharing electric and two bidders sharing diesel.

Combined with the shifting of the goalposts already described, that opened up space for CSR and CNR, who might otherwise have been excluded.

The motivation was ridiculous.

As Wainer notes:

“Three of the six reasons provided as supposedly supporting the use of two suppliers instead of one are directly contrary to an argument for splitting of the business.”

Splitting would supposedly promote “standardisation” of the fleet; splitting allowed for “critical mass” on price and also “critical mass” for localisation.

Wainer comments:

“Self-evidently, exactly the opposite would be achieved.”

But the main argument rested on the spurious claim that the forecast freight volumes of the MDS were at risk and using four suppliers would mean Transnet would take possession of the locomotives sooner and be able to haul all that extra freight.

Transnet executives told the board that the cost of splitting added an additional R2.7-billion to the price, but Wainer estimates that the decision actually added R5.1-billion. Each of the four bidders, who had priced their offer on the full number of electric or diesel locomotives, increased their unit price when they were told the volumes would be halved.

Accelerating

For this final trick, Transnet brought in the professionals, Regiments Capital, a group of consultants who, in Wainer's words, “hold themselves out to be, and were appointed as, financial experts”.

Regiments Capital played a central role in delivering the supposed justification to accelerate the delivery of the locomotives, to take place over just three years instead of six.

This, they argued, would save costs based on inflation, interest and foreign exchange payments.

It is worth quoting Wainer at some length to understand the implications of proposing to deliver 1064 locomotives over three years instead of six years as originally planned.

“This time shortening was a fundamentally important change which had a material effect on matters. From the documents provided by Transnet, it appears that this important matter was not explicitly addressed in any paper to the board, or to the Board Acquisitions and Disposal Committee.

“The rapid acceleration of the required delivery period... naturally introduced profound obvious risks for Transnet such as:

• the logistical ability to actually receive and commission 1064 locomotives over three-years. (From interviews conducted it seems that this was unrealistic);

• the financial ability to fund the acquisition over three years instead of over six years — involving many billions of Rand extra that would be required in each year;

• the effect on supplier prices;


• the very high growth rates in freight volumes over three years that would be necessary... exacerbating the risk in relation to the already optimistic future volume and tariff increases assumed in the business case...

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