Managing Risks in Major Construction Contracts

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Managing Risks in Major Construction Contracts

• Professor Rudi Klein, Barrister
• Chief Executive, SEC Group
• AUDE Conference
• 4th April 2007

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Meaning Of Risk

• Risk usually refers to circumstances outside the
  direct control of the parties that could have a
  positive/negative impact - usually negative - on
  the performance of the parties and, therefore,
  the project.
• Such risks would include for example, acts of
  terrorism, weather, collapse or subsidence,
  ground conditions, industrial disputes and supply
  problems.

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Meaning of Risk (2)

• However, many risks arise as a result of
  actions/inactions by project participants (e.g.
  insolvencies, delays and disruption, design
  defects and non-payment).
• Risks also arise from lack of clarity or
  definition of roles and responsibilities (e.g.
  extent of design responsibility).
• Traditional fragmented delivery systems and
  hierarchical appointments enhance risk profiles
  more interfaces to co-ordinate

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Meaning of Risk (3)External or Macro Risk Factors
(unrelated to the project or its participants)

• Lack of availability of materials
• Capacity issues lack of skilled labour
• Massive increase in energy costs

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Treatment Of Risk In Contracts

• Generally contracts do not use the word risk
  risk is transferred via express or implied
  obligation
• e.g. Section 113, Housing Grants, Construction
  and Regeneration Act 1996 pay when paid
  provisions passing on insolvency risk.

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Treatment of Risk in Contracts (2)

• There is a distinction between risk and the
  consequences thereof this distinction is never
  brought out in contracts. The liberal and
  widespread use of indemnities ensures that a
  party takes responsibility for all the
  consequences.
• The back to back approach to drafting supply
  chain contracts reflects the traditional mindset
  in respect of risk transfer.

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Risk and Procurement

• Procurement strategy tends to be overtaken by
  considerations of contract will the contract
  ensure effective risk transfer?
• Decisions on the deployment of resources (i.e.
  procurement decisions) most likely to achieve the
  clients objectives have a second-place ranking.

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Risk Allocation

• The principle that risk should be allocated to
  the party best able to manage it is an alien
  concept in construction although broadly
  accepted as an economically efficient aim (but a
  few clients such as BAA prefer to absorb all
  risks on the basis that certainty of where risk
  lies is preferable).

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Risk Principle 1 Allocating Risk
Risk, both positive and negative, should be
allocated tan organisation in proportion to the
extent to which it can influence the likelihood
of that risk occurring.
Who can best prevent it?
General Rules
2. If risk can be removed then remove l it 3.
Removal reduction are legal health safety
obligations
1. Ability of organisation to prevent risk
occurring
High
The organisations stake in the consequences of
the risk to motivate the organisation to prevent
the risk happening
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Risk Principle 2 Controlling Risk
Negative risk should be allocated to an
organisation in proportion to the extent to which
the organisation can minimise the consequences if
that risk occurs, with all things being equal,
the second risk principle taking priority
Who can best minimise the consequences of it?
General Rules
2. If risk cannot be removed then control it 3.
For health and safety risks there is a
sequence of controls beginning with design
1. Organisations ability to minimise the
consequences
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Risk The Cost

• Can risks be priced? often an unreal
  expectation since it assumes that risk and its
  consequences are defined at the outset.
• The waste associated with inappropriate or
  unclear risk allocation and consequent disputes
  is incalculable - contingencies probably run
  into billions of pounds.

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Risk The Cost (2)

• Since each party along the supply chain is adding
  a contingency the resultant cost to the ultimate
  client is likely to be enormous.
• Risks and/or their consequences often change
  during a project but, traditionally, exploitation
  of the opportunities for claims tends to override
  effective risk management.

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Risk The Cost (3)

• It is an erroneous assumption that success in
  transferring risk has no adverse implications for
  the transferor he (and others) may have to deal
  with the repercussions of inappropriate risk
  transfer.

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Risk The Macro Cost

• Risk/reward dynamics in procurement are of major
  importance to the industrys capacity. Any
  actions that override the principles of best
  practice or attempts to shift unacceptable risks
  onto suppliers could be counterproductive and
  reduce the ability of the client to procure in
  the construction market.
• Construction Demand/Capacity Study for OGC
  2005-2015, Deloitte June 2006

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NAO REPORT Improving Public Services Through
Better Construction, March 2005

• Departments should have a well developed
  capability to identify and manage construction
  project risks. Departments need to be more adept
  at identifying and considering the potential
  strategic impact of risks to the success of a
  construction project at its outset and how the
  risks should best be managed.

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• Through our workshops we identified that many
  clients viewed risk management as an enforced
  burdensome process, rather than an essential way
  of working, with the emphasis on allocating risks
  to suppliers rather than on genuine mitigation.
• Source NAO Report

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Design Risks
Design consists of a range of activities

• Achieving functionability and form.
• Producing design drawings/details for approval
  and ensuring compatibility.
• Selecting materials.
• Complying with performance specifications.
• Ensuring buildability.

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Design Risks (2)

• The major cause of defects lies in design
  shortcomings due, primarily, to original design
  not working.
• This usually means that the out-turn costs are
  substantially higher than the original price
  (usually 50 higher)
• Available research suggests that over 50 of
  accidents could have been avoided by a change in
  design.

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Design Risks (3)

• Design risks particularly the scope of design
  responsibility and the uncertainty about
  workability of inherited design is usually
  borne by the supply chain.
• This is accentuated by lump sum/GMP bids in
  response to design information which is usually
  incomplete, inaccurate and misleading.

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Example of a GMP Clause

• The GMP shall be the maximum price paid to the
  Sub-Contractor for the execution of the Works
  howsoever the costs of the Sub-Contractor may
  fluctuate or the timing of the Sub-Contract may
  vary subject only to a fair and reasonable
  proportion (as determined by the Main Contractor
  acting reasonably) of additional monies paid or
  time granted under the Main Contract.

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Design Risks (4)

• The case of Nottingham Cooperative Society v.
  Henry Boot reinforces the risks associated with
  inherited design.

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• Ultimately, in my view, someone who undertakes,
  on terms such as those of the Contract., an
  obligation to complete a design (emphasis added)
  begun by someone else agrees that the result,
  however much of the design work was done before
  the process of completion commenced (emphasis
  added), would have been prepared with reasonable
  skill and care. The concept of completion of
  design, of necessity, in my judgment, involves a
  need to understand the principles underlying the
  work done thus far and to form a view as to its
  sufficiency.
• His Honour Judge Seymour in Co-operative
  Insurance Society -v- Henry Boot, TCC, 1July 2002

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Design Risks (5)

• Novation of consultants design to design and
  build contractor design footprint set before
  supply chain appointed often a recipe for
  disaster.
• An ME contractor, for example, is unlikely to
  have seen the assumptions underlying the
  calculations used by the design team.

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Design Risks (6)

• Moreover the design process is not seen as a risk
  management process.

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Performance/Completion Risks

• Supply chain is usually allocated the risks
  associated with unrealistic completion dates,
  programmes and revisions thereto.
• The specified performance is still required even
  though unrealistic (or virtually non-existent)
  time is allocated for testing and commissioning.

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Performance/Completion Risks (2)

• Responsibility for managing and coordinating
  interfaces is usually imposed upon members of the
  supply chain but they do not have the necessary
  authority to discharge such responsibility.
• Unrealistic programmes mean that the potential
  impact of delays cannot be assessed
  realistically.

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Payment Risk
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Payment Risks (2)

• Payment provisions in contacts are usually
  structured so that the supply chain assumes the
  risk of poor payment performance upstream.e.g.
  EPR provisions in PFI Midland Expressway v.
  Carillion.
• Lack of certainty of entitlement and timing of
  payment (e.g. pay what/when certified)
  facilitates flexible management (i.e.
  manipulation) of the payment process.

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Payment Risks (3)

• Risk of upstream insolvencies is normally borne
  by firms lower down the supply chain (s.113.,
  Construction Act).
• Supply chain retentions are always at risk from
  third party default (e.g. architect/engineer,
  other sub-contractors and main contractor
  default.)

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Actions to Improve Risk Management
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Action 1 Everything starts with getting the
Procurement Strategy right
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Wembley
They cant quite believe that the keys have
been handed over
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Construction Industry v The Rest
5 minutes into the Game it is 0 - 50
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Construction Industry v The Rest
4 more players are brought on. Rate of scoring
slows down. 30 minutes into game score is 0 - 90
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Construction Industry v The Rest
Two more players are brought on before Half Time.
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Construction Industry v The Rest
After half time the whole team is on the pitch
but its too late. Score at full time is 0 - 300
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Procuring the latest Aircraft Carriers (Queen
Elizabeth II Prince of Wales)
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Aircraft Carrier Procurement (A Comparison)
Key User Requirements (or value criteria) Defined
At Outset

• Flexibility (e.g. able to operate different
  aircraft)
• Deployable anywhere
• Able to Sustain Operations
• Available at all times for operations
• Self-Sufficient (able to maintain aircraft in air
  without support from a host nation)
• Interoperability (able to communicate effectively
  within combined operations)

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Appointment of Delivery Team

• Team selected on basis of evidence of ability to
  deliver against user requirements
• Team resolves design outcomes to deliver
  cost-effective whole life solutions
• Team manages risk through the design process and
  own decisions on risk allocation
• Open-book approach is adopted to drive out
  unnecessary costs
• Team has pain/gain share arrangements to keep
  costs under budget
• Manufacture commences once design solutions, risk
  decisions and costs all agreed and, therefore,
  owned.

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Bring the Team on at the Outset!

• Learning Points
• bring all parties together including end users
  and subcontractors, early on in the process, so
  they integrate and work to the same ethos.
  Relationships are important and there needs to be
  the environment of trust where people are talking
  and information is flowing.
• University of Reading Estates Dept. Windsor
  Halls of Residence reported in Building Success
  
• Constructing Excellence

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Action 2 Use Selection Process to Determine
Attitude to Risk

• Selection of members of delivery team should seek
  to identify attitudes to risk
• Process of selection should weed out those who
  have not given proper consideration to risk issues

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Attitude to Risk Problem

• XYZ University Estates Department is seeking
  partners to carry out work on an existing
  building where disruption to occupants has to be
  avoided.

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Attitude to Risk The Responses

• Disruption is inevitable.
• Operations in existing buildings are fraught but
  we can only do our best.
• Innovative working methods materials may help
  to deal with the problem but client must take on
  extra risk.
• Additional resources in design and planning from
  earliest stage should minimise disruption.
• It may be necessary to allow funds for liaising
  with occupants to minimise disruption.
• Which do you prefer?

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Action 3 Integrated Design Teams

• The key premise behind the integrated project
  process is that teams of designers, constructors
  and suppliers work together through a series of
  projects, continuously developing the product and
  the supply chain, eliminating waste in the
  delivery process, innovating and learning from
  experience.
• Sir John Egan, 1998

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Integrated Design Teams

• Where suppliers are involved at an early stage
  the quality of designs is better leading to
  efficient and higher quality construction.
  Departments should involve construction
  suppliers early on in the design process, where
  appropriate paying for their time on a fee
  basis.
• (NAO Report, Improving Public Services through
  better construction, 15 March 2005)

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Integrated Design Teams

• The Environment Agency considers it obtained a
  better engineering solution through early
  involvement of specialist engineering
  contractors that will last up to 20 years longer
  than the initial design, which also has
  significant environmental benefits at a saving of
  1,120,000 (12) cost of the original solution.
  The contractors and consultants considered that
  without the early joint working approach the
  solution and saving would otherwise not have been
  identified.
• Page 22, NAO Report, (Case example 17)

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Key Engineering Inputs are not Integrated
Number of projects on which the firm was
appointed at an early stage to engage in the
design process.
Source SEC Group Survey of Specialist
Engineering Contractors Satisfaction on
Government Projects, October 2005
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Integrated Design Teams

• Key suppliers to be appointed as members of the
  design team to bring production experience into
  risk dialogue.
• Clarity of scope of design responsibility
  Specialist Engineering Alliance publication
• A Design Framework for Building Services
• BSRIA, 2006
• Team to OWN the design.
• Legislative developments new CDM Regs/Part L of
  the
• Building Regs

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Action 4 Design Out Risks

• The design process should be managed so that risk
  is minimised or even designed out.
• This means we must focus on design management
  skills.
• Risk management need not stifle design flair it
  can be a stimulus to design innovation.

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Action 5 Genuine Partnering To Encourage Open
Risk Dialogue
Number of projects on which the firm was invited
to enter into a partnering arrangement.
Source SEC Group Survey of Specialist
Engineering Contractors Satisfaction on
Government Projects, October 2005
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Genuine Partnering To Encourage Open Risk Dialogue

• Supply chain to be involved in partnering
  arrangements.
• Partnering arrangements to be based on trust
  partnering bank accounts can generate trust.
• With trust risk becomes an issue for the whole
  team both in avoiding it and in addressing
  consequences should risk materialise.

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Action 6 Improve Risk Management Skills

• Treat risk management as an on-going exercise.
• Have an audit trail to promote active risk
  management.
• Learn from each project.
• Opportunities for long-term relationships help
  improve risk management processes.
• Place focus not only on risk but on opportunities
  put in place supporting management processes
  that shrink risk.
• Carry out regular and realistic risk assessments
  place actions with parties best able to
  mitigate risk.

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Action 7 Use Collaborative Contracts

• There is growing acceptance in the UK that
  traditional contractual arrangements are no
  longer the best basis for managing today's
  high-risk projects.
• Engineering construction risks by PA Thompson
  JG Perry, SERC research project report, 1992.

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Use Collaborative Contracts That Address Risk
Management (eg. NEC)

• Contractor and PM to give early warning of
  matters affecting costs, completion, key dates,
  performance of the works in use.
• The PM or Contractor may instruct the other to
  attend a risk reduction meeting to consider
  progress on managing the risk in the Risk
  Register.
• The Risk Register is regularly updated.

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JCT Constructing Excellence ContractRisk
Allocation Schedule
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Action 8 Project Insurance to Engender Team
Solidity

• Integrated teams enable risk management issues
  to be fully addressed by the whole team in an
  open and transparent manner. Insurance is an
  aspect of risk management. Project insurance
  products should be made available to underwrite
  the whole team to facilitate integrated working.
• Para. 5.18 Accelerating Change, the industrys
  improvement agenda launched by Sir John Egan,
• Sept. 2002

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Project Insurance

• Pursue the case for project-wide insurance, not
  only to reduce costs but also to align behaviours
  with principles of integrated team working.
• (Improving Public Services through better
  construction NAO, March 2005)

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Project Insurance

• Project insurance is an integrated approach to
  insuring risk
• It is financial loss insurance rather then
  liability insurance widely used in Belgium and
  increasing in use across Central Europe.
• At the outset technical control team assesses the
  teams processes for addressing risk.
• Projects are now being piloted to test policies.

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Action 9 Project Bank Accounts to Deal with
Payment Risks

• Treasury/OGC/PSCCF support progressive
  introduction of project bank accounts.
• Payments made from safe receptable direct to
  each member of delivery team.
• Savings of 2.5 to client on project cost.

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Action 10 Be Innovative in Procurement to Reduce
Risks

• e.g. cradle to grave procurement
• so that design/construction or installation/FM/dis
  posals becomes seamless

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Action 11 Select Firms that have Objectively
Demonstrated their Competence to Deliver Can
Deliver against Value Criteria
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A lesson from Wembley

• The overriding conclusion from the research is
  that clients and all parties involved in
  construction projects and contracts benefit
  greatly from reduction in uncertainty prior to
  their financial commitment. Money spent early
  buys more than money spent late. Willingness to
  invest in anticipating risk is a test of a
  clients wish for a successful project.
• Engineering construction risks. PA Thompson
  JG Perry, 1992

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• If you do first what is necessary, then what
  is possible, suddenly you will find you are
  achieving the impossible.
• St. Francis of Assisi