The Projects and Construction Review: Relationship Contracting
The construction industry has long suffered from poor productivity growth and high levels of disputation. The causes of poor productivity growth are many, and include extensive regulation, site-specific complexities, fluctuating demand for construction services, inexperienced buyers, the fragmented nature of the industry and underinvestment in technology. But perhaps the most significant cause of inefficiency and the high levels of disputation in the construction industry is the misalignment of interests between project owners and other project participants caused by traditional contracting methods.
Traditional contracting methods typically involve the non-owner participants tendering a lump-sum price or rates based on the owner's proposed allocation of responsibilities and risks. Each non-owner participant has strong incentives to perform well the responsibilities allocated to it, but is far less invested in how other participants perform their responsibilities. The project becomes a collection of sub-projects, with each non-owner participant rewarded by reference to the timely completion, within budget, of its sub-project, rather than the performance of the entire project.
Indeed, late or poor performance by one participant will often excuse other participants from the need to strictly fulfil their obligations, or entitle them to claim additional money from the owner. Accordingly, when things go wrong, the participant's financial interests are often served by blaming others and defending contractual positions, rather than working collaboratively to overcome the problem.
Further, when a non-owner participant is paid via a lump-sum price or rates, it is financially motivated to minimise the cost of performing the agreed scope or activity to maximise its profit. This is so even if doing more would reduce the owner's total costs or otherwise result in better outcomes for the owner. If the owner wants a participant to do more than the bare minimum required, to overcome a problem or achieve a better outcome, the owner will typically have to compensate the other participant for its additional costs, to restore its profit margin. There is little in a traditional construction contract to incentivise outstanding performance in areas that deliver value to the project owner. Traditional contractual incentives, such as liquidated damages and performance security, provide only negative incentives to ensure compliance with minimum requirements.
Finally, traditional procurement prefers a sequential approach to project scoping, design and construction. The scoping and design of conventionally procured projects is generally completed, or well progressed, before the owner calls for tenders from constructors. Engaging a constructor to provide input during the scoping and design process, to try to make the project easier and less costly to build, or to fast-track the project by overlapping the scoping, design and construction phases, can result in that constructor being seen to have 'the inside running' for subsequent tenders of the construction work. This can adversely affect the owner's ability to run a highly competitive tender process for the construction work, and result in the owner paying a higher construction price. It can, however, enable work to commence more quickly on site, which can be important for governments looking to create jobs quickly .
It was out of these commercial realities that the concept of collaborative contracting (also referred to as relationship contracting) was born. The concept embraces a wide and flexible range of approaches to overcome the misalignment of interests associated with traditional contracting, including the following:
- contractual commitments to cooperate and act in good faith;
- early warning mechanisms, designed to alert other participants to emerging issues, so that solutions can be developed and agreed before the issue worsens;
- early involvement of the main contractor and key specialist subcontractors in the scoping and design process;
- governance arrangements that facilitate collective problem-solving and decision-making;
- payment arrangements that financially motivate each participant to act in a manner that is best for the project, rather than best for the participant; and
- each participant waiving its right to sue other participants for mistakes, breach or negligence (other than wilful default).
Further, as governments navigate through the uncertainty of covid-19, one thing is clear: the economic vehicle leading their response will be powered by the engine of infrastructure investment. Specifically, governments want 'shovel-ready' construction projects where work can commence immediately to create new jobs. Collaborative contracting provides a mechanism that allows more immediate progression, since it can bypass the lengthy procurement process that is symptomatic of traditional fixed price contracting methods. Its flexibility allows for a project's scope to be a work in progress, contractors to be selected based on experience and capacity, and work to commence. Projects that would not otherwise be 'shovel ready', can become 'shovel ready' quicker. This flexibility means that collaborative contracts take many forms. For example, some try to facilitate greater collaboration by merely incorporating obligations to cooperate and early warning mechanisms within a traditional contracting framework. Others recognise the obstacles to greater collaboration that are inherent in the traditional contracting framework and incorporate more radical approaches.
This chapter focuses on three contemporary approaches: alliancing, the managing contractor and the delivery partner model.
Alliancing (sometimes referred to as integrated project delivery) represents the high-water mark of collaborative contracting in respect of the design and construction of new infrastructure. An alliance is a collaborative structure in which the parties share risks (rather than allocate them) and work together to deliver agreed project outcomes.
Alliance contracts, in their purest form, depart from traditional contracting strategies in five fundamental respects.
i Risk and remuneration regime
First, alliance contracts fundamentally alter the remuneration arrangements and risk allocation found in traditional contracts by replacing the lump-sum price with a performance-based remuneration regime that seeks to closely align the commercial interests of the parties, by embracing a 'we all win or we all lose' mentality. The remuneration of each non-owner participant (NOP) essentially comprises three limbs:
- limb 1 – reimbursement of the NOP's direct costs on an open-book basis;
- limb 2 – a fee to cover the profit and contribution to corporate overheads they would expect to receive for business-as-usual outcomes; and
- limb 3 – a gainshare or painshare regime that shares the rewards of outstanding performance and the pain of poor performance between the owner and non-owner participants.
The gainshare or painshare regime is built around the project outcomes that will deliver value to the owner. Typically these will include a target out-turn cost (TOC), a target completion date and quality measures. Other key performance indicators (KPIs), such as environmental or safety outcomes and satisfaction of community expectations, may also be included, depending on what creates value for the owner.
If the project achieves a better than business-as-usual outcome against a KPI, this will result in a gainshare payment by the owner to the NOPs. Conversely, if the outcome against a KPI is worse than business-as-usual, it will result in a painshare payment by the NOPs to the owner. A share of any cost under-runs is usually added to the maximum potential gainshare payment. The maximum potential painshare payment of each NOP is usually capped at an amount equal to its limb 2 fee.
At first sight, the requirement for the owner to pay all the costs incurred by the NOPs – regardless of whether the project comes in over or under the TOC – might seem to suggest the owner solely bears the risk of increased or unforeseen costs. However, the risk is in fact shared as any cost overruns will cause the actual out-turn cost to exceed the TOC, thereby reducing the gainshare payment or increasing the painshare liability, and hence reducing the profit derived by the NOPs.
The absence of a guaranteed maximum price or cap on the reimbursement of direct costs (limb 1) is also fundamental to avoiding a claims mindset. As soon as a guaranteed maximum price is introduced, the NOPs will want to be able to make claims in respect of events beyond their control that increase their costs. Dealing with such claims diverts the attention of the parties from solving problems and achieving outstanding performance against the KPIs.
ii Virtual organisation
Second, an alliance contract requires the creation of a virtual organisation known as the integrated project team, comprising the individual team members provided by the project owner and each non-owner participant, rather than separate owner and contractor teams. The UK Institution of Civil Engineers refers to this virtual organisation as an enterprise.
iii Early and continuous involvement
Third, an alliance requires the continuous involvement of all non-owner participants (including designers, contractors and key suppliers) from the moment the contractual relationship is formed, usually very early in the project scoping and design process, until project completion.
iv No blame
The fourth key feature is the no-blame regime. Each party agrees that it will have no right to bring any legal claims against any of the other participants, except in the very limited circumstance of a wilful default. By preventing the participants from recovering loss through making claims against one another, the commercial interests of each participant are best served by assisting one another to solve the problem in the way that will maximise the performance of the project against the agreed KPIs, regardless of who is at fault. This principle also encourages the NOPs to take sensible risks in the pursuit of outstanding performance, without fear of being sued if they get it wrong.
v Unanimous decision-making
The fifth key feature is the requirement for most, if not all, decisions regarding a project to be made by way of unanimous agreement between the owner and all other participants. The requirement of unanimity fosters a culture of compromise throughout the project and a creative and collaborative search for solutions, as stalemates that result in inaction will adversely affect the gainshare entitlements and painshare liabilities of the NOPs.
Hybrids and long-term alliances
As with any contractual model, there are always variations. For example, there are alliance contracts that do not fully embrace the no-blame concept, or that allow decisions to be made other than by way of unanimous agreement. These 'impure' alliances have come to be referred to as hybrid alliances.
It is important to recognise, however, that these hybrids are no less valid than a pure alliance model. They simply reflect the fact that there is no one-size-fits-all option when it comes to contracting strategies. What is important is that the parties understand the nature and the limitations of the particular contracting model that they are adopting.
Alliance principles can be applied to a single project or longer-term programmes covering a series of projects. The principles can also be applied to longer-term arrangements for the operation, or the through-life support, of an owner's infrastructure investments.
II THE MANAGING CONTRACTOR
The managing contractor is an innovative structure that shares some of its characteristics with design and construct (D&C) contracts and others with the agency relationships and project management roles seen in the construction management models.
The model originated in Australia and has been used extensively by the Australian Department of Defence and a variety of private sector owners. The managing contractor is responsible for the design and construction of the project from feasibility right through to the commissioning stage. The arrangement usually involves the owner entering into one contract with the managing contractor, which then subcontracts all its design and construction obligations.
This differs from the construction manager model in which the owner contracts with a manager to provide project management services only, and then contracts directly with each of the other project participants. Under the managing contractor model, the managing contractor is legally accountable to the owner for the delivery of the project, not just for managing its delivery.
The managing contractor can be distinguished from a more conventional lump-sum D&C contractor in two key aspects: role and risk.
Although the managing contractor accepts legal responsibility for the design and construction of the project, its key role is project management, as it is usually obliged to subcontract all its design and construction obligations. The only services carried out by the managing contractor itself, using its in-house resources, are the management and advice services provided throughout the project, and the provision of on-site preliminaries such as hoarding, plant and sheds.
A key difference between this model and a conventional D&C contract lies in the degree of control that an owner retains over the selection of subcontractors. While a D&C contractor has autonomy to appoint subcontractors of its choosing, a managing contractor must undertake subcontracting in close consultation with the owner, who will retain the ultimate authority to approve or reject tenderers. This right is consistent with the obligation falling upon the owner to reimburse the managing contractor for costs incurred in the design and construction.
Another important difference between a managing contractor and a conventional D&C contractor is the point in the project development process at which they are engaged by the owner – the managing contractor is appointed much earlier.
The project would normally proceed as follows. First, the owner invites tenders from potential contractors for management services and defined common site facilities. Once a successful tenderer has been chosen as managing contractor, it will coordinate the feasibility stage of the project, including hiring any consultants required and providing advice to the owner as needed. If the project does not progress past the feasibility stage, the contract may be terminated.
Next is the design phase; this will be carried out by the managing contractor, from design brief through to detailed documentation. Throughout this process, the managing contractor will consult closely with the owner, who has the final say on all decisions made. First, the managing contractor will prepare a design brief that must be approved by the owner. Then tenders for the design subcontract will be invited. Although the managing contractor can recommend a candidate, again the final decision is subject to the owner's approval.
When the successful tenderer has completed the design, this must again be approved by the owner before construction can begin. This procedure differs from a conventional D&C arrangement, under which the owner minimises its involvement in the design phase to avoid diluting the D&C contractor's design liability and affecting any warranty for fitness for purpose.
During the construction phase, the managing contractor has a variety of responsibilities, which include:
- advising on the appropriate contract strategy for each package;
- managing the tender process and award of packages;
- engaging subcontractors to execute the construction work;
- programming and timetabling the construction work;
- supervising the construction to ensure it accords with design specifications;
- managing and administering the subcontract;
- instituting a system of cost control;
- managing community relations; and
- managing industrial relations on the project.
Consistent with the philosophy of collaborative contracting, the process of selecting construction subcontractors is performed by the managing contractor in close consultation with the owner. Again, the owner exercises significant control over the decision through its right to finally approve a nominated candidate; this procedure is identical to that used in the selection of a design contractor.
The final stage of the project in which the managing contractor is involved is the commissioning phase, during which the contractor coordinates the handover of the project and ensures any defects that have become apparent during the defects liability period are rectified.
The other feature distinguishing the managing contractor from a D&C contractor is the risk it bears. The managing contractor is exposed to lower risks in terms of both cost and time than a conventional D&C contractor.
In respect of cost, while a D&C contractor is normally remunerated with a lump sum, a managing contractor is generally remunerated on the basis of a combination of lump sum and reimbursable components. The purpose of the lump-sum component is to pay for management services and site facilities, and allows the contractor to extract a profit. The owner separately reimburses the managing contractor for all amounts paid by the managing contractor to subcontractors and consultants. This remuneration arrangement shifts all the project cost risks onto the owner, except those relating to management services and site facilities. The managing contractor is only reimbursed for any costs that it incurs reasonably. Costs incurred from unauthorised variations, rectification of defects, breaches of contract or wrongful acts by the managing contractor that give rise to liability to third parties are usually excluded from the reimbursement regime.
Time-delay risk is often also borne by the owner. The managing contractor will only have a 'soft' time for completion obligation, in the sense that it will be required only to use its best endeavours to achieve a target date. Accordingly, a failure to achieve timely completion will not expose a managing contractor to liability for liquidated or general damages, so long as it tries its best to achieve the target date. However, because the managing contractor is paid a fixed lump sum for its management services, it is clearly in its own commercial interest to achieve completion as early as possible to preserve its profit margins. The incentive for timely completion is not the threat of damages claims but the alignment of commercial interests.
The managing contractor model allows for early involvement of the contractor in the project, with close collaboration throughout. This means that the owner is able to achieve completion of the project in the manner it desires, using a spread of industry involvement and expertise but without the need for high-level management commitment. The owner can share some of the risks associated with a major construction project with a contractor and can achieve maximum flexibility in determining the elements to be included in a project and the design of those elements. At the same time, it provides the owner with the management expertise of a contractor organisation to assist and advise upon the design and construction of the project while planning for and remaining within a target time and cost for delivery of the project.
III The Delivery partner Model
The delivery partner procurement model is a recent emanation of collaborative contracting that combines elements of the managing contractor, alliancing and engineering, procurement and construction management models. The delivery partner model enables a client to supplement its internal project management capabilities by engaging one or more delivery partners to assist the client with project planning, programming, design management and construction management services.
By engaging this expertise, the client is able, with the assistance of its delivery partners, to adopt a 'sophisticated-client' procurement strategy involving direct engagement of suppliers and subcontractors, as opposed to engaging a major contractor to manage this process. This can result in significant cost savings and other benefits for the client.
The remuneration regime for the delivery partners is similar to the three-limb remuneration model for alliance contracting, with reimbursement of actual costs, a fixed fee covering profit and contribution to corporate overheads, and a gainshare or painshare payment. As with alliancing, better than business-as-usual project outcomes (measured against pre-agreed KPIs) will result in a gainshare payment by the client to the delivery partners, and poor outcomes will result in a painshare payment by the delivery partners to the client. Again, the maximum potential painshare payment is usually capped at the amount of the limb 2 fee, or a significant portion of it.
Unlike alliancing but similar to the managing contractor model, the delivery partners are precluded from performing design and construction services, which must be competitively tendered (unless the client specifically agrees otherwise). The client retains control or significant input over the appointment of subcontractors and suppliers, similar to the managing contractor model. But the delivery partners bear less risk in relation to poor performance by subcontractors and suppliers than a managing contractor. The delivery partner's liability to the owner for poor performance by subcontractors and suppliers is limited to any reduction in the gainshare payment (or an increase in the painshare payment) that occurs as a result of reduced performance against a KPI. The owner has a contractual relationship with each subcontractor and supplier, and looks to them directly if they breach their contractual obligations.
The model has been employed successfully in the context of publicly funded infrastructure projects and was first used by the UK government in the construction of infrastructure for the London Olympic Games in 2012, where the complexity of the project and time-critical date for completion meant a more traditional delivery model was considered unsuitable. A delivery partner enabled the Olympic Delivery Authority (ODA) to acquire the necessary expertise if ever the ODA did not have the time to find and engage personnel of the required calibre to meet the time requirements. A wide range of infrastructure was required: key Olympic venues such as the velodrome, aquatics centre, media centre and Olympic village, as well as two kilometres of new sewers and 265 kilometres of ducts for new utilities. The project was ultimately a success, being delivered three months early and under budget.
Since then, the delivery partner model has received attention in Australia as a delivery method for government infrastructure projects and is being used to deliver the Woolgoolga to Ballina Pacific Highway Upgrade (W2B) – currently one of Australia's largest regional infrastructure projects. Like the London Olympic venues, the W2B project is a time-critical major project involving the duplication of approximately 155 kilometres of the Pacific Highway to create a four-lane divided road at an estimated construction cost of A$4.36 billion.
The delivery partner model was chosen for the W2B project because it avoided the need for Roads and Maritime Services (RMS) to procure and deliver five separate packages of work sequentially. RMS's business-as-usual procurement models and internal resources would have necessitated the work being divided into five packages, which could be procured and delivered sequentially. It was considered that aggregating the work into a smaller number of larger packages would have resulted in a small field of potential tenderers and sub-optimal competition.
By adopting the delivery partner model, RMS expects, with the assistance of its delivery partners (Laing O'Rourke and WSP Parsons Brinckerhoff), to achieve significant time and cost savings through repackaging the work and tendering packages on a trade or activity basis, responding to a logical sequencing of work across the entire project, unconstrained by package boundaries. Essentially, with the assistance of its delivery partners, RMS was able to implement the sort of sophisticated client procurement strategy that a major tier-one contractor would implement, without having to first engage such a contractor under a traditional D&C contract and pay the associated risk premium that such a contractor would build into its fixed contract price for the management of the procurement and integration risks.
The associated downside of this model, of course, is less certainty about cost and timing when the client contractually commits to the project. The client ultimately bears these risks without the protection that a traditional D&C contract with a tier-one contractor would provide. However, this risk is mitigated by the model's alliance-style gainshare and painshare regime, which financially motivates the delivery partners to help the client manage these risks effectively. The margin paid to the delivery partners for their services is also less than what would have been charged by a tier-one contractor for wrapping the delivery risks, on account of the lower level of risk borne by the delivery partners.
The model is gaining broader acceptance in Australia, having been deployed on a number of significant projects, including the Sydney Metro project and Sydney's second international airport. While the final outcomes of these projects remain to be seen, the model seems to be well suited to major infrastructure projects in which the client desires time and cost outcomes that cannot be achieved via traditional procurement models, and is prepared to embrace and manage the associated integration and other risks with the assistance of capable delivery partners.
In markets such as Australia where industry participants want to 're-set' the way they do business and allocate risks, collaborative contracting provides a range of alternatives to the traditional contracting methodologies. By seeking to align the interests of the parties and develop a culture of collaboration to replace one of conflict, collaborative contracting can create a team of organisations that is engaged and motivated to solve problems and achieve better than business-as-usual results in the areas that deliver value to the project owner and improved productivity growth across the industry. If this heightened engagement and motivation is also applied to create 'shovel-ready' projects, governments will be better placed to revive economic growth from its covid-19 hibernation.
1 Owen Hayford is a partner at DLA Piper Australia.