Where to next for risk allocation on Australian mega projects and PPPs?
Published on LinkedIn on 21 September 2020
I was delighted to be invited by SoCLA to share my thoughts regarding risk allocation on Public Private Partnerships (PPPs) and Australian mega-projects more broadly this evening. Below is an edited version of what I had to say.
Is mega project risk allocation broken?
Earlier this month the Society of Construction Law Australia hosted a webinar that lamented the usual approach to risk allocation on major projects, where fixed price contracts are awarded to the contractor that offers the best value for money – typically the one that offers the lowest price and/or pushes back against the project owner’s preferred risk allocation the least.
Contractors in the Australian market quickly learn that if they want to win major government infrastructure projects that they need to underprice the risks – because if they don’t, someone else will.
The contractor who underprices the risks the most wins.
Project owners – principally governments – are mostly to blame for this, because that’s the level of the construction supply chain where it starts.
Governments and private sector project owners have learned that the easiest way to get the lowest price and maximum risk transfer for a fixed scope of workis to competitively tender it.
And if the project owner isn’t sure it’s got the best price possible, or the best possible risk allocation – perhaps because it has adjusted the scope of the work towards the end of the competitive tendering process – then the easiest way to make sure is to extend the competitive process, and run a BAFO. Ask the tenderers to bid their best and final offer – but do that in a competitive environment where the tenderer that’s presently in front knows that someone might undercut them – and pip them at the post – to win the work.
Competition is a wonderful thing. It forces market participants to innovate and become more efficient, in order to survive. We all benefit from healthy competition. It drives costs and profits margins down to their absolute minimum. And it encourages tenderers to be optimistic about the risks they might face in delivering the scope of work.
Pricing risks fully won’t win you the work, if one of your competitors is prepared to take a more optimistic view about the chances of a particular risk occurring, or its likely consequences.
So contractors end up underpricing the risks in order to win the work.
The contractor who takes the most optimistic view on the potential risks, including risks that it is ill equipped to manage or absorb, is usually the one that wins.
The position of the project owner on the date of contract award looks terrific. The project owner has a great price, and a contract that transfers a stack of risk to the head contractor. High fives all around for the project owner’s procurement team. Job well done!
Of course, it isn’t just governments and other project owners that engage in this practice of using competitive tension to drive the lowest price and maximum risk transfer. Head contractors run exactly the same process over their subcontractors and suppliers, and so on, right down the supply chain.
Just say no (?)
It was suggested during the webinar earlier this month that contractors should ‘just say no’ to requests to price risks that they are ill equipped to manage or absorb.
This strategy – of just saying no – would work if every contractor did this.
But they won’t. The reality is that there will almost always be at least one tenderer who is prepared to take a more optimistic view of the risks and thereby underprice them, in an attempt to win the work.
There is no single correct way to quantify and value risks. We can all run Monte Carlo simulations and the like to come up with some numbers, but it still comes down to judgement calls on probability and consequences. Historical data is not necessarily an accurate predictor of the future.
If you think one of your competitors might price certain risks more cheaply than you, you’ll probably lose the work unless you are prepared to match or better them.
It is certainly true that winning work by underpricing it is not a good long term business strategy. It will eventually send you broke. But if you continually lose tenders to others who are prepared to take a more optimistic view when pricing risks, you’ll also end up out of business because you won’t have any work.
So ‘just saying no’ isn’t going to provide contractors with a solution to their current dilemma.
Why would a project owner not accept an offer by a contractor to take a risk for no price increase?
At the end of the last webinar, one of the listeners asked the above question. It’s a great question as it’s one that project owners face every day.
As already mentioned, having used the competitive tension that a tendering process creates, the position of the project owner on the date of contract award generally looks terrific. The project owner has a great price, and a contract that transfers a stack of risk to the head contractor. High five!
If the winning tenderer’s optimistic view of the risks that it has accepted holds true, this is a great outcome, as everyone should get the financial and other outcomes they are after.
But what are the odds of this actually occurring?
In the old days of smaller and less complex major projects, perhaps the odds weren’t so bad. But these days, major projects are now called mega projects, for good reason. The value of the construction works is immense – often in the billions.
And the projects are not just bigger. They are more complex, often involving the integration of technology, or systems from multiple different suppliers, as well as complex third party interfaces.
Consequently, the chances of something going wrong are very high.
And the cost consequences when things do go wrong on mega projects can be immense.
History tells us that mega projects usually mean mega losses for the construction companies involved. A 2017 study of 50 Australian projects undertaken since the year 2000 with a contract value of $500 million or more found that across the 28 completed projects in the sample, the average net profit was negative 16%, meaning that the contractor not only lost the average tendered profit margin of 9%, but then a further 7% on top of that (ie almost the same amount again). In dollar terms, this represented an average loss of $215 million for every mega project since 2000.
The projected losses for the 22 remaining projects in the sample were even worse. On average, those projects were projected to lose their average tendered profit margin plus almost double that amount again
For companies that win roles on several of these mega projects, these losses are life threatening
But is this something that project owners need to worry about?
If the owner can enforce the contract and get the project built for a price well under the actual build cost – as occurred on most of the projects in the study sample – then that’s a great outcome for the project owner.
Well done. More high fives! Why do things differently?
Why should project owners do it differently?
The way Australian mega projects have been priced over the last 20 years is unsustainable. The tier 1 contractors that undertake these projects can’t survive if they are not profitable, over the longer term. Without change, insolvencies and greater consolidation within the Australian civil contracting industry is inevitable.
But again, is this a problem for governments and project owners?
For many project owners it won’t be, so long as they can avoid being in a contract with a contractor that becomes insolvent part way through the job.
But for some project owners, particularly those like government, that are constantly contracting with the tier 1 contractors across multiple contracts, it will be a problem.
Those owners will inevitably end up in contractual arrangements with contractors that ‘play the insolvency card’. One day the contractor will simply say to the owner: “unless you agree to settle my claim for extra money, I’m afraid I’m going to have to declare myself insolvent”.
When an owner is faced with this prospect, whether the contractor has a contractual basis for its claim can cease to matter. If the additional costs and losses that the owner will incur in completing the project with a replacement contractor will exceed the amount the current contractor says it needs to stay afloat, the owner will want to settle the claim.
At this point, the risk transfer that the owner achieved under its contract with the contractor becomes illusory – worthless.
But even for governments that are constantly contracting with the tier 1 market across multiple projects, the longer term inevitability of this situation won’t necessarily be enough to motivate a different approach to risk allocation.
Because each construction project is a shorter term prospect, most government project teams will continue to roll the dice and take their chances if the decision is left to them.
What if the project owner is satisfied that its contractor has the balance sheet strength to absorb the losses it might suffer due to underpriced risks? Are there other reasons why project owners should approach risk allocation differently?
I believe there are, for the reason set out below
Firstly, fixed price contracts are inherently adversarial because they place the commercial interests of the owner and the contractor in fundamental opposition.
Having agreed to deliver the works for a fixed price, the contractor’s financial interests are best served by minimising its costs and delivering the bare minimum to achieve compliance, as doing this will maximise the contractor’s profit. The owner, on the other hand, wants to maximise the quality outcomes that it gets for its fixed price. In this commercial framework, disputes about scope and quality requirements are almost inevitable.
And if the owner has engaged multiple contractors to deliver different parts of the project, it will want each contractor to cooperate with the others so as to achieve the best project outcomes. But cooperating will be contrary to the financial interests of each contractor if it delays or increases the cost of delivering that contractor’s scope. So they will refuse to do it, unless the owner compensates them for the additional cost or delay. Yet another source of tension in the relationship.
When problems arise, as they inevitably will given the complexity of modern mega projects, the same dynamic will apply. Having agreed a fixed price for a fixed scope, it will be in the commercial interests of each contractor to argue that the problem is the fault of the owner or one of owner’s other contractors.
There is no incentive for a party that can avoid legal responsibility for the problem to help develop a solution. Rather, its commercial interests will be best served by simply blaming others for the problem. This usually leads to sub-optimal outcomes for the project owner, even if the owner can ultimately pin full legal responsibility for the problem to one or more of its contractors and force them to overcome the problem at their own cost, as the solution that suits the relevant contractor may create new problems for the other contractors.
Finally, fixed price contracts provide no incentive for contractors to minimise the cost impacts of any owner initiated variations. Rather, they provide an opportunity for contractors to charge ‘monopoly’ prices for the additional work, as it is usually impractical for the owner to competitively tender the extra work.
Indeed, this is the mechanism through which contractors who buy work by underpricing it hope to recover their profit margin.
The absence of an incentive on the contractor to minimise the cost of owner initiated changes is not a problem for the owner if the owner doesn’t initiate any variations. But for complex mega projects that involve the integration of different systems and third party interfaces, it is almost inevitable that the owner will want to initiate some variations to the works. Accordingly, an incentive for the non-owner participants to minimise the cost of variations becomes important.
Where does this leave us?
If a project owner is confident that:
the contractors with whom it is dealing have the financial strength to absorb the risks that they underprice; and
they can avoid any ambiguity in their scope and quality requirements, so that they can’t be successfully challenged; and
they can otherwise manage the contracts in a way that avoids the need to reach any further agreement with their contractors,
then the current approach to risk allocation will work fine, and there is no need the change.
Accordingly, there will always be a place for tendered fixed price construction contracts., and I’m not suggesting otherwise.
But, for complex mega-projects, and for governments and project owners that are constantly contracting with the tier 1 contractor market, there is good reason to believe that these three preconditions won’t be met – in which event the owner’s interests would be better served by entering into alternative commercial frameworks that better align the commercial interests of contractors with those of the owner.
Doing it differently
There are lots of things that project owners should do differently, but I’ll mention just five of them.
1. Commercial framework
As I’ve already suggested, for complex mega-projects, and for project owners that are constantly contracting with the tier 1 market, there is good reason to believe the owner’s interests would be better served by abandoning tendered fixed prices in favour of alternative commercial frameworks that better align the commercial interests of the parties.
In these scenarios, commercial frameworks that provide for cost reimbursement coupled with a gainshare/painshare regime that ties the profit margin of the non-owner participants to whole of project outcomes will generally deliver better value for money outcomes to owners than a fixed price.
2. Stronger entitlements to extra money and time
In those situations where a fixed price is more attractive to an owner, or a fixed price is needed to enable the project to raise project finance (such as a PPP), the interests of owners can be better served by giving the contractor clear entitlements to extra money and extra time for risks that the contractor is unlikely to fully price in a competitive tendering environment.
Such risks would include:
unforeseen ground conditions, including contamination
unplanned work arising from utility relocations or third party interfaces
unforeseen changes in law, whether in response to a pandemic or otherwise; and
unforeseen increases in the cost of key materials such as concrete and steel
3. Softer time obligations
The approach to time obligations can be softened in many contracts.
Sometimes there is a need for the owner to have a clear entitlement to pre-agreed damages in the event of late completion, for example where the owner is raising limited recourse project finance. But many times, all the owner really needs is for the contractor to be financially motivated to achieve timely completion.
There are many ways to incentivise a contractor to achieve completion sooner rather than later, without the need to impose a strict time obligation and support it with an extension of time regime. The angst and tension that administering an extension of time regime creates can often be avoided without undermining the financial incentive for timely completion, for example by having a material completion payment, or not releasing security until completion is achieved.
A related issue, in the context of PPP transactions, is that late completion not only results in delayed commencement of the revenue stream for the owner SPV, but it also results in a reduction to the revenue earning period. This occurs because the PPP expiry date is generally tied to the target completion date. The consequent reduction to the revenue earning period eats into the returns to the SPV’s equity investors, which diminishes their capacity to take on and manage other risks. The interests of governments would be better served by extending the expiry date for late completion, and giving the SPV a guaranteed revenue earning period.
4. Shorter and simpler contracts
Project owners should start using shorter and simpler contracts.
The initial RFT version of the legal terms and conditions for a Victorian PPP contract that is currently under procurement is around 800 pages long. That’s about 400 pages for the operative provisions of the contract, and another 400 pages for the schedules to the contract including the payment regime, the provisions dealing with change compensation events and termination payments, insurance requirements, intellectual property provisions and many other things that would ordinarily be addressed in the contract itself.
The 400 pages of schedules doesn’t include the technical specifications that also form part of the contract. The technical specifications are another 650 pages, and that’s before they have been populated with the winning tenderer’s bid submissions.
So we are looking at 1500 pages plus for this PPP contract!
It wasn’t always this way. It might surprise you to learn that the PPP contract for the Eastern Distributor project, signed in 1997, was just 100 pages in length, including the schedules.
Australian PPP contracts aren’t just overly long. They have, over time, become so complex, that they can only be navigated by those who have lived and breathe them for many years.
For example, the Commercial Principles in our National PPP Guidelines talk about Relief Events that entitle the project company to extra time, and compensation events that entitle the project company to extra time and extra money. Simple.
But how is this now reflected in the Victorian template PPP contract? Well, it’s far from simple.
Firstly, there is no reference to Relief Events. These have become either Extension Events and Intervening Events, which means the project company’s entitlement to extra time in the D&C phase differs from its entitlement to extra time in the O&M phase. Its entitlement to abatement relief for an Intervening Event also turns on whether or not the Intervening Event is an Insured Risk. And if the Intervening Event is a Force Majeure Event then there is no abatement relief, but the minimum service payment must cover O&M costs, debt service and any lifecycle payment.
Compensation Events have become even more complicated. These now divided into three broad categories. There are Compensable Extension Events and Compensable Intervening Events, so again entitlements differ between the D&C and O&M phases. Finally, there are Change Compensation Events which entitle the project company to compensation, but not to an extension of time. But are 20 different Change Compensation Events in the social infrastructure template – each with its own unique formula for the calculation of compensation, which again differs between the D&C and O&M phases.
Is it any wonder that new market entrants find our contracts overly long and overly complex.
It’s time to discard our existing template PPP contracts, and replace them with a new national template PPP contract that avoids unnecessary complexity. Less than 100 pages for the legal terms and conditions would be an admirable goal.
5. Greater drafting consistency between different contract models
Finally, the drafting in the different types of contract that are used by Australian governments should be identical whenever it can be.
There is no reason why most provisions in our PPP contracts dealing with the design and construction process cannot be identical to the design and construction provisions provisions in a D&C Contract, or a DBOM contract. Similarly, there’s no reason why the same or near identical provisions for the design and construction process can’t be used in an Incentivised Target Cost Contract, or a Delivery Partner Contract or a Managing Contractor Contract.
The NEC Suite shows us that it is possible to draft a full suite of construction contracts, including professional services contracts, contracts for the provision of maintenance and other services, a DBOM contract and an alliance contract, with core provisions that are laid out in the same order and that use identical drafting where that is possible.
We could do even better than NEC, and create a suite that note only includes the full range of alternative payment regimes found in NEC, but also includes alternatives for other key issues such as time, quality and liability. Doing so would enable government project teams to use the same base document for all of the delivery models that Australian governments presently use, including:
Construct only
D&C
Incentivised Target Cost
Delivery Partner
Developer Partner;
Managing Contractor;
Construction Management;
EPCM;
Alliance;
DBOM; and
PPP.
As with the NEC suite, the base document could also include options for Early Contractor Involvement.
Such a suite would revolutionise the way Australian governments procure construction and infrastructure services.
Participants could more easily apply the contract knowledge and skills they learn on one project to the next one. Productivity and efficiency gains would be enormous. Government’s legal costs cost be slashed, as project teams would be able to assemble and tailor their contracts to their desired delivery model without the assistance of highly skilled lawyers.
It astonishes me that despite the commitments given by governments in 10 point plans and the like that our governments haven’t been able to develop such a suite.
It’s such a lost opportunity.
