How to choose the best contractual strategy for the construction of major projects

This risk-reward equation between the principal players associated with construction projects is extremely important.

If the market fails to price risk properly and, as a result, principals pay too much or contractors earn too little for the risk assumed, this will lead to market failure. Principals may fail to commit to new projects or, perhaps worse still, contractors will become insolvent because they have taken too much risk for the agreed price. Ultimately, this will lead to a drop in competition and an associated increase in price.

The recent collapse of RCR Tomlinson is but one example of a significant contractor having suffered a succession of losses on projects in the order of half a billion dollars or more. This is not sustainable and will either result in the failure of more contractors or the withdrawal of contractors from the market. The effect will be the same – an increase in price and loss of competition in a macro-economic sense, which is, in the long term, unsatisfactory.

Accordingly, it is necessary to review risk allocation in contracts to ensure that the market operates properly and, ultimately, the consumer gets the required product at a sustainable market-tested price. The alternative is serious disputes and market failure.

Contracts allow the risks associated with the construction of a major project to be transferred from the owner of the project to various counterparties for a price. In some cases, notwithstanding the high price, extensive risk transfer is appropriate. In other cases, it is not. Therefore, choosing the appropriate contractual strategy requires careful consideration of a number of factors.

For example, if the owner intends on funding the project using project finance, then it should seek to allocate as much risk away from itself to a construction contractor as possible, with a robust balance sheet. Such an approach will be favoured by the banks and may also allow the debt to equity ratio to be increased.

For those funding the project with equity or corporate finance, however, such an approach may not suit, particularly if the owner of the project has significant in-house expertise. This is because an effective risk transfer to a construction contractor usually carries with it a shift in control from the owner to the construction contractor.

Owners with high levels of expertise may wish to have very high levels of control over the detailed design and methods of construction to ensure that the design will:

• suit its preferred method of operation;
• have sufficient redundancy to ensure that the required level of reliability is achieved; and
• meet overall whole of life costs that are appropriate for the project.

Where owners have sufficient experience and expertise, such an approach is likely to produce the best outcomes. The lowest risk is achieved by the owner taking control and dictating exactly what it wants.

A good example of a project of this type would be the construction of a refinery by a major oil company. Such companies have enormous internal expertise and experience. As a consequence of owning other refineries (and having been in the business for over 100 years) they will be fully aware of the way they prefer their facilities to be operated. They also know the desired level of reliability and whole of life costs they want to achieve, having regard to the economic trade-off between capital cost on the one hand and operating costs and reliability on the other.

The loss of control is less important for those owners who do not have sufficient internal expertise and are likely to be relying on the contractor’s expertise to deliver the project to the required standard. Such an owner usually also needs the comfort of a fixed-price, fixed-time contract to secure the funding of the project.

The examples discussed above are the extremes of the spectrum. In between those extremes lies a continuum of alternatives, all of which are suitable for projects. The trick is to identify which strategy is best for the specific project and then consider the state of the relevant market to see whether the contractors in that market are willing to contract on what the owner considers is the optimum risk allocation.

To the extent that the market will not accept the owner’s preferred risk allocation, it is necessary to tailor the approach to obtain the best risk allocation possible in the circumstances.

One must also examine how proportionate liability legislation and the ability to enforce the contract – against both domestic and international counterparties – can affect the risk allocation agreed between the parties. It does not matter how well the contract is drawn or how complete the risk transfer is if the contract cannot be enforced in an economical way. Accordingly, to protect the value of a well-drawn contract, that contract must have appropriate drafting to deal with proportionate liability and enforcement.

For complex engineering projects, it is worth considering an arbitration clause. Where the contract involves an international counterparty, international arbitration is likely to provide the best solution from a cultural and enforcement point of view.

In the context of a process engineering project, the allocation of risk in relation to time, cost and quality depends on the delivery method. However, the detailed drafting of the final contract can give surprising results. The consequences of misunderstandings and errors regarding insurance are especially severe.

Even if the parties have agreed on the allocation of risks in principle, the contract must contemplate legal barriers to benefiting from that risk allocation. Proportionate liability legislation and the difficulties of efficiently enforcing contracts against domestic, and especially international, counterparties are just some of those barriers.

The central message is that a practically enforceable allocation of legal risk requires much more than good sentiment and in principle agreement between the parties.