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Managing Risks in Major Construction Contracts

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Title: Managing Risks in Major Construction Contracts


1
Managing Risks in Major Construction Contracts
  • Professor Rudi Klein, Barrister
  • Chief Executive, SEC Group
  • AUDE Conference
  • 4th April 2007

2
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.

3
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

4
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

5
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.

6
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.

7
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.

8
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).

9
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
10
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
11
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.

12
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.

13
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.

14
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15
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

16
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.

17
  • 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

18
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.

19
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.

20
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21
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.

22
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.

23
Design Risks (4)
  • The case of Nottingham Cooperative Society v.
    Henry Boot reinforces the risks associated with
    inherited design.

24
  • 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

25
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.

26
Design Risks (6)
  • Moreover the design process is not seen as a risk
    management process.

27
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.

28
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.

29
Payment Risk
30
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.

31
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.)

32
Actions to Improve Risk Management
33
Action 1 Everything starts with getting the
Procurement Strategy right
34
Wembley
They cant quite believe that the keys have
been handed over
35
Construction Industry v The Rest
5 minutes into the Game it is 0 - 50
36
Construction Industry v The Rest
4 more players are brought on. Rate of scoring
slows down. 30 minutes into game score is 0 - 90
37
Construction Industry v The Rest
Two more players are brought on before Half Time.
38
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
39
Procuring the latest Aircraft Carriers (Queen
Elizabeth II Prince of Wales)
40
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)

41
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.

42
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

43
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

44
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.

45
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?

46
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

47
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)

48
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)

49
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
50
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

51
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.

52
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
53
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.

54
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.

55
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.

56
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.

57
JCT Constructing Excellence ContractRisk
Allocation Schedule
58
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

59
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)

60
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.

61
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.

62
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

63
Action 11 Select Firms that have Objectively
Demonstrated their Competence to Deliver Can
Deliver against Value Criteria
64
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

65
  • If you do first what is necessary, then what
    is possible, suddenly you will find you are
    achieving the impossible.
  • St. Francis of Assisi
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