Private sector perspectives on Infrastructure risk
First published on LinkedIn on 20 May 2021
I was invited this week to present a private sector perspective on risk allocation in the infrastructure sector to a symposium on Infrastructure Project Delivery hosted by the Australia Government’s Infrastructure and Project Financing Agency. Below is a summary of my presentation. The audience was Commonwealth agencies involved in infrastructure delivery, so the presentation was tailored accordingly. I focused on the civil engineering market (roads, railways etc) as it is one of the more interesting parts of the market at the moment, and the market I’m most familiar with.
Introduction
There are three key messages that I’d like to leave you with today:
The first is that the infrastructure market is becoming much more difficult for government and other project owners, and that there are significant risks for government agencies that assume that procurement practices that have worked in the past will serve you well in today’s market. They probably won’t, for reasons that I’ll explain.
The second is that optimum results will come to those procuring agencies that listen to the market and respond accordingly. This will likely mean doing things differently, so you’ll need to be ready for that, and develop strategies to manage your internal stakeholders and bring them on the journey. I’ll share with you some insights on how to do this.
Third, infrastructure procurement is a high stakes activity. Mistakes can be costly – very costly – and potentially career ending. So, you need to be able to ask the right questions, to satisfy yourself that the risks are being appropriately managed. I’ll give you a heads up on the questions you should be asking.
1. A difficult market for government and other project owners
Australia’s infrastructure market is currently stretched. Demand for infrastructure design and construction services is exceeding supply.
The issue isn’t so much at the on-site labour level. Rather it is at the experienced, senior project manager level. Good senior project managers are scarce, so their employers only put them on the most lucrative opportunities, where the organisation can get the best returns.
Consolidation at the top end of the market has left us with just three truly top tier players in the Australian market, and are all foreign owned. Our three top tier civil contractors are:
CPB (formerly known as Leighton Contractors), now owned by the ASX listed CIMIC Group (formerly Leighton Holdings), which is majority owned by Hochtief which is, in turn, owned by the Spanish company ACS Group, which also has a significant presence in many other countries including Germany, India, Brazil, Chile and Morocco;
John Holland, a former member of the Leighton Group but now owned by the Chinese (CCCI); and
Acciona, who have moved into the top tier in Australia as a result of its acquisition of Lendlease’s engineering business, which acquired and the swallowed up the Abigroup and Baulderstone Hornibrook brands back in 2013.
There are, of course, a number of other major players in the Australian construction market including
BMD
Fulton Hogan
Downer
Thiess
UGL
Seymour White
Macmahon, and
McConnell Dowell,
as well as international players that have entered the Australian market, such as:
Laing O’Rourke, from the UK;
Webuild and Ghella, from Italy
Bouygues, from France
GS E&C and Samsung C&T from Korea
Dutch contractor BAM; and
Gamuda, from Malaysia
Ferrovial and Dragados from Spain, the latter of which is also owned by the ACS Group.
But none of these other players have the track record in the Australian market that the big three have. It’s very rare for a contract worth more than $1bn to be awarded to a company that isn’t a tier 1, or to a joint venture that doesn’t include a tier 1 (as shown in the Grattan Institute graph below). And billion-dollar contracts have become commonplace in the Australian market.
Significantly, for Australian governments and project owners, the big three, and about half of the other companies I mentioned, are all foreign owned, and generally operating internationally. So, our biggest contractors are no longer focussed solely on the Australian market. Australian projects now need to compete against project in other countries for the attention of these companies and, more importantly, for their “A teams”, i.e the senior experienced project managers with a demonstrated track record of delivering billion dollar plus projects.
If you approach the market with a big, sexy project but:
it’s not fully funded; or
it’s undercooked in terms of the project planning phase;
it’s not well socialised; or
you want to them to provide a fixed price for the management of a bunch of hard to price risks, like ground conditions, utility relocations, or the integration of multiple complex systems from different suppliers,
then don’t be surprised if your procurement process fails to deliver an attractive offer within your budget, because your chances of securing such an offer aren’t great.
That strategy may have worked for governments in the past, but it is a high-risk strategy in the current market.
That’s point one – the current infrastructure market is a difficult one for government, and traditional procurement strategies are high risk, or “very courageous” as Sir Humphrey used to say.
2. Listen to the market, respond accordingly, and bring your stakeholders with you
On to my second key message – listen to the market and respond accordingly, and bring your stakeholders with you.
I’ve already mentioned the shift my owner clients are seeing in the market away from the past practice of major contractors underpricing risks in order to win work. Risks that could have a really material impact of the cost of a job have historically been underpriced by contractors, in order to win the work. Contractors have understood that if they were to fully price such risks, they wouldn’t win the job, because one or more of their competitors would be prepared to assume the best and take their chances, in order to win the work, hoping that they could manage such risks on a portfolio basis (ie across their work book), or via subsequent variations and claims.
But the current market conditions, which I have already described, have changed this. Will it revert to the historical trend in due course? – yes. But in the meantime, owners need to respond if they are to manage the current risk of insufficient or expensive tenders due to lack of hunger in the market.
So, how do you respond?
You need to think of different ways to manage the difficult to price risks, because asking the contractor to take the risk in return for a fixed price is proving to be very expensive in the current market.
The usual approach that owners adopt is to carve such risks out of the fixed price and give the contractor an entitlement to claim the extra costs the contractor incurs if the risk eventuates. The basic problem with this approach is that there is no financial incentive for the contractor to minimise the additional costs.
You can draft the contract to say you’ll only reimburse the additional costs that are reasonably incurred, and impose an obligation on the contractor to use its best endeavours to minimise the additional costs, but that’s unlikely to stop most contractors from using the entitlement to extra money as an opportunity to improve its profit margin – because, at the end of the day, that’s the contractor’s primary objective – to increase its profit margin.
You probably won’t be criticised by the auditor general or others for adopting the usual approach, but smarter project owners are taking the opportunity that the current market has created to rethink how they engage commercially with the market, in order to obtain better outcomes.
What do I mean by this? What are the smart owners doing?
The smart owners understand and accept that accept that their contractor will do whatever it legitimately can to maximise its profit margin on the job, and they use this fundamental truism to their advantage. How do the smart owner do that? They do it by rewiring the contract and changing the way it delivers profit margin to the contractor.
Under a fixed price contract, the way the contractor maximises its profit margin is by fulfilling its obligations at the lowest cost. Minimising its costs, becomes the contractor’s objective. The contractor has no incentive to incur $1 of extra cost, even if that will deliver benefits to:
the owner,
the owner’s other contractors, or
even the contractor’s own subcontractors,
because every dollar of additional cost for the contractor means one less dollar of profit, under its fixed price contract.
As the project owner, if there are various outcomes that you are wanting to achieve (as is usually the case), you should rewire the payment regime in your contract so that the profit margin that the contractor is entitled to is set by reference to how the project performs against the desired outcomes.
The project outcomes that deliver value to the project owner if done well, or that that destroy value if done poorly, might include:
Minimising the costs you incur in getting to completion, or optimising the costs that you will incur over the life of the project once operating and maintenance costs are accounted for;
Timely or early completion of construction;
Happy stakeholders;
Better than business-as-usual (BAU) sustainability or environmental outcomes;
Better than BAU training, skills development and diversity outcomes;
Better than BAU involvement from local industry, or Aboriginal owned businesses.
If you link the contractor’s profit margin to optimising its performance against these outcomes, rather than minimising its costs, then the contractor will be incentivised to do the former.
I say optimise, rather than maximise, because the desired outcomes often compete against one another. Better performance against a non-cost outcome, is often achieved to the detriment of the cost outcome. So the objective for the contractor is work out the overall outcome that will maximise its profit margin and aim for that.
Now if, as the procuring authority, you have broken the project up into a number of separate contract packages, which is an increasing trend with the rise of mega-projects, you will generally be interested in the outcomes at a whole of project level, rather than in relation to each contract package.
You won’t be happy if Contractor A delivers its package in a way that is good for Contractor A, but is detrimental to the project as a whole – eg causes delay to another contractors which delays completion, or results in additional costs for other contractors that you as owner have to pay.
In this scenario, you need to try to link the profit margin of each of your contractors, not to how that contractor performs in respect of its contract package, but rather how the project as a whole performs against the whole of project outcomes you are seeking. Only by doing this will you get each contractor to make ‘best for project’ decisions. Each contractor can be trusted to make ‘best for contractor’ decisions, so by linking each contractor’s profit margin to the whole of project outcomes you are seeking, you financially incentivise them to do what’s best for the project.
I don’t have time today to go into the detail of how to create a payment regime that links the profit margin of each of the project participants to the project outcomes that the Commonwealth is seeking, but I’d be happy to do so subsequently.
Finally, with point 2, responding to the market is likely going to mean doing things differently. Which means you are going to need to bring your internal stakeholders with you. So you’ll need to take the time to explain to your stakeholders why you want to do things differently to what they have seen in the past, and convince them that that’s the most sensible thing to do in the circumstances.
They will want to know that you have considered all the other viable alternatives, and why the approach that you propose is the optimal one. This will take time and effort on your part, so you need to plan for that, and be ready to answer the questions that your stakeholders will have.
That’s point 2 – Listen to the market, respond accordingly, and bring your stakeholders with you. Let me now wrap up with my third and final message
3. Questions you (the Commonwealth) should be asking
As mentioned earlier, infrastructure procurement is a high stakes activity. Mistakes can be very costly – and potentially career ending. So you need to be able to ask the right questions, to satisfy yourself that the risks are being appropriately managed.
Depending on which agency you are from, the reason you may be asked to look at a proposal for the Commonwealth to participate in or facilitate an infrastructure project will differ. So I’ll talk in very general terms.
More often than not, the proponent for an infrastructure project will be a state or territory. That’s because the services provided by most types of infrastructure are state responsibilities under our constitution – public transport within our cities, education, health, water. For infrastructure projects in these sectors, the role that the state proponent wants the Commonwealth to play is usually a funding role. They want the Commonwealth to help to pay for the infrastructure.
The resources that the Commonwealth has to fund state and territory infrastructure are finite. There’s only so much you can make available at any point in time, without raising taxes, or cutting services elsewhere, so the Commonwealth wants to satisfy itself that its limited funding is being applied to only the most deserving of projects.
Fortunately, the Commonwealth now has an agency with specialist expertise in assessing and prioritising Australia’s infrastructure needs that you can call upon. So use it, and ask whether the project’s business case has been reviewed by Infrastructure Australia. And caution those pushing for the Commonwealth to fund the project to avoid headlines like this one:
If the project is a deserving one, as assessed by Infrastructure Australia, then the next question that I think you should be asking is how the Commonwealth should provide its funding contribution – a grant, a loan, an equity contribution or something else. This is a topic on which our hosts, the team from the the Infrastructure Project and Financing Agency, are experts, so I’d suggest you ask whether they have been consulted.
Conclusion
There’s some very high level private sector perspectives on risk allocation. My three key messages, again, are:
Today’s infrastructure market is particularly difficult for government and other project owners. Don’t assume that procurement practices that have worked in the past will serve you well in today’s market, because they probably won’t.
Two – for optimum results you need to listen to the market and respond accordingly. This will likely mean doing things differently, so you’ll need to be ready for that, and develop strategies to manage your internal stakeholders and bring them on the journey.
Third, infrastructure procurement is a high stakes activity. Mistakes can be costly and potentially career ending. So ask the right questions! If you need help formulating them, and you can’t get in touch with our friends at IPFA, you know where to find me.
