Introduction

The Euro Tunnel, also known as 'Channel-tunnel', is a series of three tunnels (two carrying, one service tunnel) linking the southern coast of England near Folkestone to the northern coast of France outside Calais. The tunnels are 50km long, with an undersea section of 39 km, making it the longest undersea tunnel system in the world.

The Euro-tunnel project was privately financed and continues to be privately operated. Group Eurotunnel S.A. manages and operates the Channel Tunnel between Britain and France. The Company operates the car shuttle services and earns revenue on other trains (freight by DB Schenker and passenger services by Eurostar) passing through the tunnel. It is listed both on the London Stock Exchange and Euronext Paris. The idea of a Channel Tunnel was first explored by French mining engineer, Albert Mathieu, who formulated early designs for Napoleon in 1802.

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The first attempt to make a cross channel link was in 1880 when the Beaumont and English tunnel boring machine began digging undersea tunnels on both sides of the Channel. But the British military became increasingly concerned about national security and the project was abandoned with no further attempts being made for almost a century. In 1974 work began again on the tunnel, but had to be abandoned shortly afterwards due to financial problems. Following announcements in 1981 by the French and British governments that a cross-channel link would be explored, private companies were asked to tender for contracts to construct and operate the tunnel link. In early 1986, Margaret Thatcher and Francois Mitterrand announced that contracts had been finalized and work finally began in mid 1986.

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Contract Complexities
The Channel Tunnel proposal was originally conceived as a combination of two functions: financing and construction, so it is natural that the two groups of promoters were banks and construction companies. The construction side was handled by a massive consortium of 10 contractors called TransManche Link or TML for short, together with five banks, making 15 founder shareholders who put up the initial equity of 47 million. The founder share-holders were evenly divided between English and French, like almost everything else in this project. It is important to look at the network of legal contracts that define the project because in the early days Eurotunnel as a company did not exist. All there was, was a series of contracts and a number of dedicated staff all of whom were on secondment from the interested parties. The Construction Contract outlined without any great definition, most of the engineering work not just in digging the tunnel but also in setting up the physical side of the operations. This was a design and build contract between Eurotunnel and TML. The Anglo-French Treaty and the Concession set the framework within which Eurotunnel operates. The Channel Tunnel Link shall be financed without recourse to government funds or to government guarantees of a financial or commercial nature. This was the only basis on which British Prime Minister Margaret Thatcher would accept the project. The Concession was originally for a period of 55 years but was later extended to 65 years. It expires in 2052 and Eurotunnel then has to hand back the system in good working order. The Treaty provided for the setting up of a binational Intergovernmental Commission (IGC) and Safety Authority who monitor Eurotunnels compliance with the Concession, and who have exercised considerable power over Eurotunnels operations. The Railways Usage Contract provides Eurotunnels only committed source of income. Under this Contract, Eurotunnel is required to make half of the tunnel capacity available to the British, French and Belgian railways for their Eurostar and freight trains. In return, the railways pay a fixed charge and tolls based on the volume of traffic passing through the tunnel together with a contribution to Eurotunnels operating costs. There is a minimum charge level, a mechanism to ensure a guaranteed level of cash flow to Eurotunnel Page | 3

over the first 12 years of operation. The Contract will provide 35%40% of Eurotunnels expected revenues. The Partnership and Corporate Structure Agreements govern the relationship between the various subsidiaries within the Eurotunnel Group, and provide for a Joint Board for the Group. The Maitre dOeuvre (MdO) is an independent Consulting Engineer who ad- vises the IGC, the banks and Eurotunnel on construction safety, etc. The Concession was awarded by the British and French governments to Eurotunnel in January 1986. One of the features that led to the award was the financing plan and the very early commitment in principle by 31 leading banks to underwrite the debt part of the funding.

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Financial & Economical Scenarios

The estimated 4.9 billion total cost of the tunnel turned out to be a serious miscalculation, as the cost increased to almost 12 billion by the time it opened in 1994, more than double the original estimates. However, there were then delays, disputes and spiralling costs until the project's completion in 1994. Shares of Eurotunnel were issued at 3.50 per share on 9 December 1987. By mid1989 the price had risen to 11.00. Delays and cost overruns led to the share price dropping; during demonstration runs in October 1994 the share price reached an alltime low value. Eurotunnel suspended payment on its debt in September 1995 to avoid bankruptcy. In December 1997 the British and French governments extended Eurotunnel's operating concession by 34 years to 2086.

Financial restructuring of Eurotunnel occurred in mid-1998, reducing debt and financial charges. Despite the restructuring, The Economist reported in 1998 that to break even Eurotunnel would have to increase fares, traffic and market share for sustainability. A cost benefit analysis of the Channel Tunnel indicated that there were few impacts on the wider economy and few developments associated with Page | 5

the project, and that the British economy would have been better off if the tunnel had not been constructed. In 1999 Eurostar posted its first ever net profits, having previously made a loss of 925m in 1995. In July 2003, a Eurostar train broke the record for the fastest train in the UK, reaching 208 mph during safety testing of Section One of the new Channel Tunnel Rail Link. This section was completed ahead of schedule in December 2003. However, plans to extend the routes followed by trains using the Channel Tunnel have been slow to get off the ground.

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Problem Statements and Findings

Problem-1: Do Eurotunnels shareholders deserve to be compensated for their losses? Solution-1: Eurotunnels shareholder deserves to be compensated for their losses. But not all shareholders proved to be worse off. Any shareholder who bought at the time of the original Offer for sale or early 1988 and then sold in the first half of 1989 would have realized substantial capital gains. But the vast majority of shareholders have undoubtedly incurred substantial losses on their investment. The financial statements provide a historical record, but it seems clear that the share price reacted to events announced in the media, rather than to the financial statement. If the November 1987 Offer for sale document had reported the estimated project cost for each of the year construction, shareholders might have been in a better position to compare estimated and actual construction costs and appreciate earlier significant problems faced. Problem-2: Discuss the proposition that agents have an incentive to be optimistic when proposing large capital projects. Solution-2: Management was arguably successful in achieving completion of the project and therefore maintaining their employment. The history of large capital projects suggests that almost invariably, agents tend to underestimate capital cost and overestimate revenues. Including more detailed estimates of the phasing of capital expenditure at the outset would have given the principal an opportunity to monitor actual expenditures compared to predict expenditure and this would have improved accountability.

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Management incentives were determined at the beginning of the project and turned out to be inappropriate, given the high construction costs. Problem-3: Which stakeholders were most adversely affected by Eurotunnels financial difficulties? Solution-3: Among all the stakeholders, the shareholders potentially have the most to loss. Shareholders were noticeably unsuccessful in terms of preventing the substantial declines in net present value of their investments. High construction costs did not provide sufficient incentives to protect the interests of the shareholders. Until the project opened a major uncertainty involved initial traffic volumes plus growth rates. After operation had started the area of uncertainty reduced to growth rates. Eurotunnel is unable to service debt. There has also been uncertainty over the amount of debt the banks will want to convert to equity. If the banks convert a relatively large amount, interest charges will be lower but profit available for dividend will be distributed over a large number of shares. Problem-4: Briefly outline the causes of Eurotunnels financial problems. Could, or should, these problems have been foreseen? Solution-4: In 2004 Richard Shirrefs, chief executive of Eurotunnel, told BBC News that the cross-channel rail industry was working on a "failed business model". He told Radio Page | 8

4's Today programme that "you can't have a 25bn infrastructure which is not generating enough traffic - this is a big structural problem". Construction of the tunnel started in 1988, the project took approximately 20% longer than planned (at 6 years vs. 5 years) and came in 80% over budget (at 4.6 billion pounds vs. a 2.6 billion pound forecast). The issues that caused delay and financial problems later on resulted from various factors: Changed specifications for the tunnel, there were needs for air conditioning systems to improve safety that were not included the initial design. The communication between the British and French teams who were essentially tunneling from the two different sides and meeting in the middle could have been improved. These sorts of communication issues are relatively common in delayed projects when tensions rise. When the tunnel was built it was assumed that traffic levels would have grown rapidly enough to generate a healthy income for Eurotunnel. 2003's 6.3 million rail passengers, though, fell far short of original predictions of 16 million a year. The 1.7 million tonnes of freight carried in 2003 can be set against an initial forecast of an annual 7 million. Another interesting aspect of the Channel Tunnels forecasts were that a lot of revenue was projected to come from driving the existing ferry operators out of business. Of course, these ferry operators were the main way to cross the English Channel before the Channel Tunnel existed. However, this analysis ignored the possibility that the ferries would react to the Channel Tunnel with improved pricing and service, leading to them retaining market share. In addition the creation of budget airlines providing cheap air travel between UK and France was not foreseen. It is a good reminder that in making strategic forecasts of benefits or results you should bear in mind how competitors will react to the project you are envisioning. Page | 9

It should be noted that a great deal of the financial problems with the Channel Tunnel were caused by overly optimistic revenue projections, on top of the construction cost overruns, and those projections failed to anticipate that the set of options for getting from Paris to London might change, both in reaction to the tunnel and because of innovation in other areas such as the development of the budget airline business model. The tunnel wasnt completely unprecedented. The Seikan Tunnel in Japan had similar length and depth. Nonetheless, part of the reason for cost overrun was the absence of many precedents and associated experience to base sound estimates off. It was very difficult to predict accurately and complete the project in due time based on initial estimates. In fact, subsequently, the Channel Tunnel has been listed as one of the engineering wonders of the world, which emphasizes its uniqueness. Problem-5: Eurotunnel has been both a success and a disaster. Discuss. Solution-5: Euro Tunnel is the finest engineering achievement of the 20th century as well as one of the most expensive white elephants in the history. Construction of the Eurotunnel was the realization of a centuries-old dream to connect England and France. It is probably the most significant international transport project since the Panama Canal, and the largest project ever paid for entirely by private finance. Engineers have dreamed of building a Channel Tunnel for at least 250 years which runs beneath the busiest shipping lane in the world. Between the dream and the reality lay a dramatic and unimaginably complex engineering project. In 1996 the American Society of Civil Engineers identified the tunnel as one of the Seven Wonders of the Modern World. In 1999, Channel Tunnel was awarded first Page | 10

prize amongst the top 10 construction projects of the 20th century by an international construction panel in the United States. The Channel Tunnel promotes the trading connection between UK and France and improves living conditions by cheaper and faster transport for both sides. The construction as well the tunnel operation improves employment in the respective regions. For such a great advantage of it, the project can be considered as a success. But if we focus on the financial performances, we cannot express the same opinion. The tunnel cost two times more to build than the most pessimistic original estimate. Together with additional finance charges caused by the delays in completion, which meant that no income was received despite all the money having been spent, the tunnel that should have cost 6 billion ended up to an estimated final cost of around 12bn. That meant that the revenue needed to break even was two times more than projected. Eurotunnels financial results have of course proved extremely disappointing, way below the documented expectations of 1987-94. Once the trials of late opening and the November 1996 fire had been overcome, Eurotunnel achieved a turnover of around 600 million a year over the period 1998-2008, and an operating margin of around 55 per cent. But turnover was way below the prospectus forecasts and after depreciation and financial charges; losses were severe, averaging 137 million a year, 1998-2004, before exceptional items. The volume of traffic is a fraction of what projected. Passenger and freight trains through the tunnel are running at about a fifth of the projected numbers. The vehicle shuttles are running at about a third of the projected numbers. The tunnel expected to gain substantial income from the sale of duty-free goods at the terminals. Duty free sales of alcohol and tobacco had always been a tremendous money spinner for the ferry companies, making up a substantial part of their profits. But the advent of the European Single Market spelt the end of duty free sales on Page | 11

journeys between two EU countries, so the duty free shops at each end of the tunnel never provided the revenue that had been hoped for. It was clearly a misfortune for Eurotunnel to embark on a long construction process during a time of relatively high inflation, and then commence operating when the rate of inflation fell and prices became more stable. In such a situation, the weight of the debt burden remained stubbornly in place, creating difficulties for the owners of capital as it became clear that revenues were likely to be insufficient to service the debt. With passenger and freight trains running at a fifth of the projected rate, passenger and freight shuttles running at a third of the projected rate, duty free sales running at zero, stuck with debts it could not afford to service and the capital cost of construction running at two times that projected, the tunnel is an unmitigated financial disaster.

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