Risk allocation reset for transport projects
Introduction
This post makes the case for a risk allocation reset on our transport infrastructure projects. It does so by:
outlining our current approach to risk allocation on transport projects and the problems it creates;
explaining why it’s not just a problem for contractors, but is also a problem for governments and other project owners; and
offering some views on what the risk allocation reset should look like.
Major project risk allocation is broken
Our current approaches to risk allocation on major transport projects are not serving us well.
The default method for allocating risks is for the project owner to divide the project into one or more work packages and then call for tendered fixed prices for work package based on the owner’s preferred contract.
Sometimes the project owner will decide it wants to contract with a single entity that assumes responsibility under a single contract for the design, construction, financing, operation and maintenance of the project. Other times, the project owner may decide to separately contract each of these activities, and break the construction works into several work packages. And there are lots of contracting and packaging models in between.
Whatever contracting model the owner chooses, the default approach to risk allocation is usually the same – the owner prepares a draft contract setting out its preferred risk allocation and asks the market to tender a fixed price for delivering the work package under that risk allocation.
The draft contract that the owner prepares will typically have started its life as an industry standard form, but will have been amended and added to – often progressively over many years – to make the risk allocation more favourable to the owner.
The owner will typically expect the contractor’s fixed price to cover a range of risks that could have dire consequences for the contractor including:
unexpected ground conditions;
interfaces with utilities and other infrastructure owned by third parties;
interfaces with the owner’s other contractors
change in law risk;
industrial relations issues.
Tenderers are asked to make sufficient allowance in their fixed price for the potential cost consequences of the risks that the owner is seeking to allocated to them. Indeed, the draft contract will typically include a warranty from the contractor that its price includes sufficient allowances for the risks that the contractor bears.
But what will happen if the tenderer adds an allowance to its price to cover the additional costs that it could incur in a worst case scenario if one of these risks eventuates? It’s price will be uncompetitive and it will lose the tender to one of its competitors.
Contractors soon learn that they won’t win the job if they ‘fully price’ the worst case scenarios. Rather, if they want to win the job, they have to take a punt that these worst case scenarios won’t occur (or that they’ll be able to recover the additional cost by through variation claims and the like). So, other things being equal, the tenderer who takes the most optimistic view of the risks will win.
Put another way, the tenderer who under-prices the risks the most will win
Government agencies and other project owners understand this dynamic and use tender processes to obtain the best value for money outcome, which usually means awarding the contract to the tenderer that offers the lowest price and/or pushes back of the owner’s preferred risk allocation the least.
This looks to be a pretty good outcome for the project owner. The owner has just extracted from the market the best possible price and transferred a stack of risk to the contractor. Why would it want to do things differently?
This is an important question, because project owners won’t do things differently unless they see very good reasons to do so. The current approach is low risk for the government procurement team. No one is going to criticise them for adopting this approach. It’s a safe and well-worn path. It’s consistent with government procurement policies, and is easily defended.
But is it the best path – the optimal path – for the owner to take? It is suggested that it isn’t, for the reasons that follow.
As already explained, the tendering process favours the tenderer who take the most optimistic view of the risks. Tenderers that include an allowance in their price to cover all potential costs associated with the occurrence of a particular risk won’t win the tender, if a competitor is prepared to take a more optimistic view.
We know from experience that even during periods of unprecedented demand for civil engineering services, like the last few years, that plenty of contractors are prepared to take very optimistic views on risk in order to win their next job.
But what are the odds of these optimistic views being correct?
In the days of smaller and less complex major projects, perhaps the odds weren’t so bad. But today’s major projects are now called mega projects for good reason. The value of the construction works is often in the billions.
The projects are not just bigger – they are also 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.
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[1] 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 (i.e. almost the same amount again). In dollar terms that represented an average loss of $215 m for every mega project since 2000.
For the 22 remaining projects in the sample that were not then complete, the projected losses were even worse. On average, those projects were projected to lose their average tendered profit margin plus almost double that amount again
Several of the companies that won roles on these mega projects no longer exist. 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.
Why should project owners approach risk allocation differently?
There are many reasons, but they boil down to the following:
Firstly, contracts that under-price the risks are not financially sustainable. And whilst the burden of this falls firstly on the contractor, many owners ultimately end up sharing the financial pain of this unsustainability.
Secondly, fixed price contracts result in misaligned commercial interests. The commercial interests of the owner are opposed to the commercial interests of the contractor, resulting in a relationship that is inherently adversarial. One wins at the others expense, and vice versa. This misalignment of interests results in sub-optimal outcomes for the owner.[2]
Because it is financially unsustainable, which will also end badly for the owner
The woeful financial results of the mega projects in the abovementioned study demonstrates that the approach that contractors have adopted to the pricing of risks is unsustainable. Mega-project contractors 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 is this a problem that governments and project owners need to worry about?
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 project. But for project owners, like governments, that are constantly contracting with the mega-project contractors across multiple projects, 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 turn up and simply say to the owner that unless you agree to settle my claim for extra money, I’m afraid I’m going to have to declare myself insolvent. If you are an owner faced with that prospect, then whether the contractor has a valid contractual basis for its claim can cease to matter. If the additional costs and losses you’ll incur in completing the project with a replacement contractor will exceed the amount the current contractor says it needs to stay in business, you’ll want to settle the claim. At this point, the risk transfer that you achieved under your 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.
To achieve better project outcomes, by better aligning the contractor’s commercial interests with the owners’
As already mentioned, 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, stakeholder and other outcomes that it gets for its fixed price, even if this means additional costs and therefore reduced margin for the contractor. So any ‘wins’ that either of them obtain, generally come at the other’s expense.
In this commercial framework, disputes are almost inevitable.
It gets worse. If the owner has engaged multiple contractors to deliver different work packages, it will want each contractor to cooperate with the others so as to achieve the best possible whole of project outcomes. But cooperating will be contrary to the financial interests of each contractor if doing so 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. This creates 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, the solution that suits the relevant contractor may create new problems for the other contractors.
Fixed price contracts also 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 under-pricing 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, and so an incentive for the non-owner participants to minimise the cost of variations becomes important.
Stepping back
Stepping back from all this, if a project owner is confident that:
the contractors with whom it is dealing have the financial strength to absorb the risks that they under-price; and
the owner can otherwise manage the contracts in a way that avoids the need to order any variations,
then the current approach to risk allocation will work fine, and there is no need the change it.
Accordingly, there will always be a place for tendered fixed price construction contracts – we are 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 preconditions won’t be met, and that 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.
What should the risk allocation reset look like?
There are many things that governments and project owners could do differently, but I’ll mention just five.
1. Commercial framework
As already suggested, in the scenarios mentioned above, the owner’s interests would probably 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 margins 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 the owner wants or needs a fixed price, then the interests of owners can be better served by giving the contractor clear entitlements to extra money and extra time for those risks that contractor is unlikely to fully price in a competitive tendering environment.
Such risks would include:
unexpected ground conditions
unplanned work arising from utility relocations or third party interfaces
unforeseen changes in law, whether in response to a pandemic or otherwise; and
unexpected increases in the cost of key materials such as concrete and steel
3. Greater risk sharing by equity investors
For privately financed projects, an opportunity exists for the equity investors to play a greater role in the sharing of construction risks.
This of course would mean the project company established by the equity investors will need to have more equity and less debt, which will increase its cost of capital.
The higher cost of capital will result in a higher service payment for the government, so governments would need to see the value for money in paying more in return for the transfer of some construction risk to the equity investors.
But there is potential for private sector equity finance to be combined with an alliance style risk allocation in a PPP contract – where the equity investors share the pain of construction cost overruns via a reduction to the Quarterly Service Payment which delivers a worse than usual equity return, with the government taking the balance of the owner participant’s risks in the alliance. Conversely, if the construction phase of the project is delivered under the target cost, the equity investors could share in the upside by way of an uplift to the Quarterly Service Payment that delivers a better than usual equity return.[3]
4. Shorter and simpler contracts
Project owners should start using shorter and simpler contracts.
The forms of contract that government transport agencies are currently using are incredibly long and complex. They take days to read from one end to the other, and can only be navigated by highly paid lawyers that live and breathe these contracts every day.
The D&C Contract that RMS issued for the Rozelle Interchange project runs for almost 300 pages, plus another 450 pages of schedules. That’s 750 pages, which doesn’t include the Scope of Works and Technical Criteria or the other Exhibits to the contract.
The RFP version of the PPP Contract for the North East Link project in Melbourne is longer again. It runs for over 1500 pages, once the performance specifications are included. It will be even longer once the winning tenderer’s bid submissions are added.
It wasn’t always this way. It might surprise you to learn that the PPP Contract for the Eastern Distributor project, which was signed in 1997, was just 100 pages in length, including the schedules.
It’s time to discard our existing template contracts, and replace them with a new templates that avoid unnecessary complexity. Less than 100 pages for the legal terms and conditions for a PPP contract 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 the same provisions in a template D&C Contract dealing with the design and construction process can’t be used in our template contracts for other delivery models such as a PPP contract, or a Delivery Partner 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.
Australian Governments could do even better than NEC, and create a suite that not 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 without the assistance of expensive, highly skilled lawyers.
It is astonishing that despite the commitments given by governments in 10 point plans and the like that Australian governments haven’t been able to develop such a suite. Such a lost opportunity.
Conclusion
There is a compelling case for a risk allocation reset for future transport infrastructure projects. The current approach to risk allocation is not serving us well.
It is financially unsustainable for contractors, the consequences of which will ultimately be felt by governments and project owners.
It also results in sub-optimal outcomes for project owners, because of misaligned commercial interests.
Accordingly, Governments and project owners that are constantly contracting with the contractor market on major transport projects would be better served by entering into alternative commercial frameworks that better align the commercial interests of contractors with those of the owner. There are also significant benefits to be obtained by developing a new suite of contracts that Australian Governments can use on construction and infrastructure projects that builds on and improves the optionality found in the NEC suite.
[1] Ryan, Peter and Duffield, Colin, ‘Contractor Performance on Mega Projects – Avoiding the Pitfalls’, Working Paper Series, Proceedings of the EPOC-MW Conference | Engineering Project Organization Society | Published : 2017, available at https://findanexpert.unimelb.edu.au/scholarlywork/1214768-contractor-performance-on-mega-projects-%E2%80%93-avoiding-the-pitfalls. See also Ryan, Peter, ‘Unlocking the key to mega project delivery, PhD thesis, 2017, available at: https://minerva-access.unimelb.edu.au/handle/11343/192905.
[2] See Collaborative Contracting and Procurement, 2020.
[3] For further detail on this potential, see Hayford, O, “New risk sharing models for privately financed infrastructure’, LinkedIn, October 2020, available at https://www.linkedin.com/feed/update/urn:li:activity:6720160031444217856/
