How do you solve a problem like fixed price construction contracts?
07 June 2023
Fixed price construction contracts appear to be going out of fashion.
Anecdotal evidence suggests that contractors’ appetite to absorb risk, particularly when it comes to major infrastructure projects, is decreasing.
Risk in such projects was hard to forecast even before black swan events like the Covid-19 pandemic, the Ukraine war, and supply chain turmoil came along.
Events with a low probability but high impact are notoriously hard to predict but can send budgets spiralling and blow schedules badly off course.
Contractors’ reluctance to take on risk by signing up to fixed price deals is understandable under such circumstances.
But that leaves clients and investors with a headache: How can public-private partnerships get value for money in the absence of competition? And how can the public sector deliver projects with certainty around the budget and schedule?
Those are some of the questions that a recent event run by the OECD, an intergovernmental organisation that aims to develop better policies, set out to answer.
It gathered together clients, contractors, and experts in procurement in Paris in May to discuss why there was a loss of appetite for fixed price contracts and if so, what could replace them.
Mixed picture from clients and contractors
Public sector clients offered a mixed picture on the question of whether contractors have become less keen on fixed price contracts.
Marcelle Valkenburg, ECI coordinator, Rijkswaterstaat, which is responsible for the design, construction, maintenance of the main infrastructure facilities in the Netherlands, confirmed that this was happening in the country.
And Bjorn Hasselgren, senior advisor, at the government agency in charge of Sweden’s transport administration, Trafikverket noted that even before supply chain disruption, foreign bidders for major projects have been putting in low bids that have discouraged local, large contractors from bidding.
However, Benoit Dupuis, executive director of the Société de Grand Paris, which is in charge of the €36 billion Grand Paris Express megaproject, reported no low bidder issues in recent major tenders, although that project has only just begun.
The company has also set up an indexing clause within its contracts to take account of rising construction input costs and make space for renegotiations within the contracts, in a bid to mitigate the potential risks for contractors.
Meanwhile, two board members of European International Contractors (EIC) who also took part in the discussion – Philippe Dessoy, general manager, Besix and German Grüniger, group general counsel, Implenia – made the point that it wasn’t so much the form construction contracts take that was causing problems.
Instead, they said, it was the fact that the risk allocation in fixed price contracts has changed.
Whereas in the past, construction risk, including adjustments for inflation, in fixed price contracts was distributed more evenly, the burden of risk under certain types of contract, such as FIDIC fixed price contracts, has gradually shifted towards contractors, they argued.
Events like rising inflation, supply chain disruption and high energy costs have brought that situation to a tipping point, where contractors feel that it’s unfair that they should shoulder so much of the burden.
Early contractor involvement ‘not a silver bullet’
A separate panel at the event explored the potential of adopting early contractor involvement (ECI) contracts, given the apparently declining appetite for fixed price contracts.
Countries like the UK and Australia have led the way on innovative contract models involving partnering, alliancing and early contractor involvement. Event attendees considered the idea of exploring such options, given the current lack of appetite for fixed price contracts among contractors.
A two-step process could involve the procuring authority collaborating with contractor, designer and supplier in the initial design stage, potentially with several bidders developing solutions in parallel. That would precede whittling the bidders down to a winner, with the collaborating consortium entering a fixed-price contract.
But the panellists from Sweden, Norway, the Netherlands and the US warned that such an approach would not be a “silver bullet”.
For a start they would require a highly competent public sector client to engage with the private sector.
The approach to their execution would also need to be the right one and would require experience.
And they argued that collaboration could not be used to replace fixed price contracts across the board, instead recommending a more targeted application, which would require good levels of information to facilitate a more science-based approach.
And as far as investors were concerned, when it came to the prospect of two-step ECI, both Darryl Murphy from Aviva Investment as well as Gregg McClymont from IFM investors welcomed it if it proved able to bring greater value to the project and keep contractors interested.
But Rafael Hertz from the Colombian National Development bank warned collaborative contracting likely would not fare well in institutionally challenged environments, amid fear of corruption.
A science-based approach and AI’s potential
The OECD’s own research has found that contracts are “ultimately an agreement on risk allocation”.
It warned that existing approaches to selecting procurement strategies lack a systematic, science-based approach to inform the capabilities of the client and the application of a particular delivery model on each package.
It cautioned against making the assumption that risk and uncertainty is the same across different types of major projects, which can lead to reducing the focus of a procurement strategy to the choice of a delivery model, whether design and build (DB), engineering, procurement and construction (EPC), and ECI.
The OECD recommended focussing instead on the question of which risk allocation principle should be applied on what part of the project scope.
To this end, it has developed a new methodology grounded in science, called STEPS – Support Tool for Effective Procurement Strategies.
Guest speakers professor Juliano Denicol from University College London (UCL) and professor Nuno Gil from the University of Manchester touched on the importance of developing a strong procurement strategy upstream, among clients and other stakeholders.
The event also heard from Dev Amratia, CEO of tech company nPlan, which uses artificial intelligence (AI) and machine learning to study data from past projects and highlight risks and opportunities in new projects.
Amratia explained how nPlan is set to launch an instrument which will offer partial construction risk insurance.
nPlan claims that its method creates value both for the client as well for the contractor, improving biding outcomes as well as project performance.
However, full construction risk insurance is still not available for now.
Following the event, OECD member countries will consider the takeaways of the discussions.