Options for mitigating and allocating risks

This Issue This is a part of the Managing risk feature

By and - , Build 177

It is widely agreed that the New Zealand construction industry needs reforming. In part, this includes improving the way risks are allocated to maintain good relationships between owners, designers and contractors and reducing delays and disputes.

FROM THE first spade in the ground to the official ribbon-cutting ceremony, construction projects can take years to complete.

Risk in construction contracts

A construction contract is simply a contract between a contractor and owner where the contractor agrees to construct a building or facility for the owner for an agreed amount and in an agreed time. However, anyone involved in the industry knows that projects are rarely simple.

Projects are usually high value, highly technical and complex, with many factors that can change over time.

To improve the prospect of success, construction contracts become highly complex as parties attempt to manage risks. These can include weather, faulty materials, faulty workmanship, design, pricing and scheduling errors and more specific risks relating to the nature of the project and site conditions.

Allocating risk fairly

Who should bear that risk? The need for fair risk allocation in construction contracts has become a hot topic.

To achieve fair risk allocation, it must be done project by project in a realistic, transparent and informed manner. There is often a temptation to allocate high-value risks and those risks that are more likely to come to fruition to the contractor.

As often happens, risks are allocated based on the party with the stronger bargaining position. Inequitable risk allocation may, however, result in adverse consequences that ultimately affect the success of the project. The owner may end up bearing the cost through increased construction or maintenance costs.

There are several initiatives for mitigating and allocating risks that must be carefully assessed to ensure reform is directed where it is most effective. Here, we look at some currently being discussed.

Construction Sector Accord aiming to change behaviour

The Construction Sector Accord is a partnership between the government and construction industry that seeks to trigger the transformation of the construction sector for the benefit of all New Zealand. The Accord promotes principles-based behavioural change across all industry participants to improve leadership, business performance, workforce capability, regulation and risk.

The aim of these policy initiatives is to achieve fundamental industry reform, but to do so will require the whole sector to consider and implement changes during contract negotiation and administration.

While it will be a valuable initiative for the industry, the Accord requires maximum industry buy-in to assist implementation.

The Accord launched its Transformation Plan at the end of January – the first important step to realising the changes that the Accord aims to achieve. This includes a plan of action set over 3 years beginning in June 2020, focusing on enacting change in the six core areas of:

  • leadership
  • business performance
  • people development
  • health, safety and wellbeing
  • regulatory environment
  • procurement and risk.

It will require strong leadership and industry support if it is to succeed in implementing the Accord’s broad and ambitious principles.

Introduction of a certification scheme

A certification scheme will set minimum financial and competency standards. This could be similar to a scheme used in Queensland in which contractors must be licensed as a prerequisite to undertaking most types of building works.

An inherent risk of any certification scheme will be whether it creates a barrier to entry.

A tiered certification scheme

In a competitive industry where participants are pitching for the same projects, margins are already being chipped away due to the risks that contractors have to bear.

This has resulted in contractors operating on an economies of scale basis – lowballing bids for contracts in an attempt to win as much business as possible to generate high revenues. Contractors can then spread their risks across several projects. The old saying ‘you win some, you lose some’ has inadvertently crept into many operating models.

This is not to say that this is a contractor’s problem alone. When realisable margins are being depleted, it is unfair to expect contractors to simply accept this. For contractors to satisfy the standards for a certification scheme, equity needs to be retained and margins need to improve.

Otherwise, it has been suggested that the introduction of a scheme would leave as few as three contractors in the market. Less competition leads to price increases and less chance of improving quality or incentivising innovation.

A tiered certification scheme for New Zealand would ease the barrier-of-entry burden and assist owners to identify the most suitable contractor for their project.

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Bonds and guarantees currently widely used

It is also worth noting that the provision of bonds and guarantees from contractors is currently the most common arrangement used by owners to mitigate credit risk.

Significant persuasion would be needed to encourage industry participants to change their approach to managing credit risk.

New approach to consultants’ limits of liability needed

The industry needs to reconsider its approach to the level of liability placed on a design consultant.

As projects become increasingly technical, a significant risk contractors face is the design risk burden.

It is standard practice to limit a design consultant’s liability usually to three times the consultant’s fee charged for the design services. This is often considered disproportionate to the level of design risk involved in a project. In contrast, contractors have historically been expected to have unlimited liability.

This has started to change, and it is becoming standard practice in the industry for contractors to limit their liability. Until that transition takes place, a delta will remain between the risk that the design consultant will bear and the risk that the contractor ends up bearing following the design risk transfer.

Through our engagement with the industry, we are aware that contractors consider the level of liability placed on a design consultant as one of the most imbalanced aspects of construction contracts.

With contractors often having no liability caps – unless they negotiate one with the principal – and standard form design agreements containing liability caps at values far less than the size of loss, the way is paved for the delivery of defective design.

Early contractor involvement to improve buildability

Consider engaging contractors early so that buildability can be assessed at an early stage.

Buildability involves assessing the design from a construction perspective to ensure it is capable of being built within programme and budget constraints. Responsibility for buildability is different to design responsibility. It involves taking into account a range of on-site and off-site activities taking place in a certain sequence for delivery against the design requirements.

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Traditionally, design risk moves to contractor

The traditional method of contracting often involves owners engaging design consultants during the preliminary stages. At this stage, the owner and the design consultant are focused on the aesthetics and quality of the end result. However, following contractor procurement, the design consultant may be transferred to the contractor.

The contractor then assumes the design risk which was previously the owner’s responsibility. Novation of design then results in the owner having one avenue of recourse for errors in design and construction – the contractor. The dynamics of the team naturally change, as the contractor is focused predominantly on minimising costs and delivering the project on time. This can often create discord between owner and contractor priorities.

Many contractors have identified problems with this traditional method. They suddenly find themselves responsible for ensuring the design can become a reality, and any design oversights become their responsibility. Contractors then spend a significant amount of time verifying buildability against the design.

Novation of design is not a silver bullet for this issue, and owners need to carefully consider whether transferring the design risk to contractors by way of novation ultimately provides for the best project outcome.

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BIM – a better solution?

As design and buildability are by their nature inextricably linked, the better solution may be for owners to go against tradition and retain design risk while also involving contractors earlier on in the design phase.

Building information modelling (BIM) can deliver many of the perceived benefits of novating design. It leads to early detection of design errors and gives consultants greater certainty around buildability. BIM can reduce uncertainty for contractors, which may ultimately lead to price reductions.

Adopting a federated BIM model with a proper and workable feedback loop can produce several benefits including earlier design coordination and development, better ability to detect and avoid clashes and better estimation.

Industry reform

The initiatives currently being discussed among industry participants suggest a willingness to promote and implement reform. The first step towards this is for parties to recognise that, for a project to succeed, we need to allocate typical risks efficiently. Any failure to do so will inevitably create acrimonious relationships between owner and contractor, resulting in delays and increasing the chance of future claims and disputes.

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For more

For further information, read the Bell Gully articles A critical review of risk in the New Zealand construction market and Challenges ahead for the construction sector Transformation Plan, available at www.bellgully.com/publications.

Bell Gully offers a range of comprehensive legal services to the construction industry. For further information, contact www.bellgully.com/expertise/construction.

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