Billions of dollars are wasted annually on megaprojects because of execution inefficiency, lost production and disputes. The purpose of contracts – and the consequences of poorly-designed contracts – are rarely explained clearly, let alone understood. Contracts focus too much on who to blame and too little on how to get the job done, writes Ben Crossley
There is an old saying: “The best place for contracts is in the bottom drawer.”
Some projects work that way – until a dispute arises. Then, the contract is retrieved and interrogated for favorable interpretations.
Sound familiar? Contracts are misused and misunderstood. They are thought to have no relevance to the business of building projects and are believed to have the narrow function of ‘minimizing liability’.
This is important for governance, but only required after the project has gone wrong. In the real world, legal words will not protect clients from failure.
A contract’s purpose is preventative medicine. First, to underpin project governance: high-level assurance that a project will meet its objectives. This includes allocation of sufficient time and resources, taking only commercially prudent risks and liabilities, and setting control measures. Poor governance in “toxic contracts” causes bankruptcy.
Second, to underpin project management discipline: the contract form determines project relationship, high-level performance obligations and risk. The contract contents determine scope, time and quality, HSE compliance, all execution conditions, requirements and restraints.
These provisions in every major construction contract mirror the required Body of Knowledge of every project manager.
Clearly, the place for contracts is not in the bottom drawer.
The purpose of contracts and consequences of poorly-designed contracts are rarely explained clearly, let alone understood. Contracts focus too much on who to blame and too little on how to get the job done. An awareness of the current situation and the imperative to improve contracts is trending within innovative parts of the business the legal communities.
For example, General Counsel at GE Aviation recently lamented: “For the most part, the contracts used in business are long, poorly structured, and full of unnecessary and incomprehensible language.”
After business culture change, executives and project management can restore their ownership over well-designed contracts.
Recent outcome data from EY on 100 power and utility megaprojects points to major overruns in either cost, time, or both. It found an average 35 per cent cost overrun and 25 months delay (57 per cent and 64 per cent of cases respectively). These average cost overruns range by technology, from the lowest gas turbine average of 10 per cent, through T&D, renewables, oil, nuclear, coal, to the highest hydropower average of 64 per cent.
The International Energy Agency has forecast annual $73 billion global capital cost overruns, based on the above reported overruns. Based on an analysis of past project close-out data, I have quantified three overrun components: Additional work (10 per cent of overrun total, which are classed as “nice to have changes”; Under estimate (50 per cent of total): “must have changes”, due to incomplete definition of design; Execution inefficiency (40 per cent of total): “absolute waste”, due to interruptions to the work sequence.
Return-on-investment loss from delayed commercial operation date can be astronomical. Therefore, contract terms include waivers of consequential loss, and limit contractors’ liability to capped liquidated damages, normally 10 per cent of contract price.
Disputes occur on most failed projects, including EPC lump sum fixed price: complex and poorly-prepared contracts are open to interpretation. The contractor seeks a way out of liquidated damages and cost overruns (reported average 35 per cent vrs 5 per cent pre-tax margins). The client having compensated expressly instructed changes, maintains that fixed price, means fixed. I estimate that approximately 1 per cent of project capital cost for low-intensity disputes without third-party intervention ($3.2 billion annually), and up to 5 per cent in arbitration.
Legal words will not protect clients from failure consequences. Some clients believe it is enough to simply have EPC lump sum contract terms: “If the project fails contractor is responsible … we won’t pay more than the contract.”
The lost output scenario and others show that in the real-world, clients have most to lose. Reported data shows major overruns on 62 per cent of EPC lump sum projects, which as explained above generally leads to dispute. Clients should restrict EPC lump sum contracts to appropriate cases.
The global $30 billion annual capital cost inefficiency, plus ROI production loss, plus dispute cost is an ‘absolute waste’. Clearly, both clients and contractors have a compelling business case to seek “preventative medicine.”
Overrun root causes
Twenty years ago, Martin Cobb advised the Canadian Treasury investigating IT project failures. His well-known paradox is still valid today. The “medicine” applied over decades is not working. He said: “We know why projects fail; we know how to prevent their failure-so why do they still fail?”
The increasing scale, complexity and one-off nature of megaprojects are not the overrun root cause. Megaprojects seem overwhelming at first sight: scores of companies, hundreds of engineers, thousands of documents, tens of thousands of workers.
However, understanding projects, it becomes clear that project core drivers are repeated. For example, the largest component of construction manhours (35 to 45 per cent) and the schedule critical path always involve piping shop and field welding and installation. That is standard technology unchanged over decades. Megaprojects are not destined to fail, they are big and complex, requiring disciplined project development and execution.
Two respected consulting firms recently reported similar overrun root causes: unachievable cost and time commitments; incomplete definition of design or execution conditions; execution team unprepared; inadequate skills; project not set up for delivery with appropriate procedures and digital infrastructure; inadequate contract and commercial structures; poor supply-chain integration; and inappropriate risk allocation and management.
All these causes are ‘internal’ to the project, could be cured by well-designed contracts (FIG 1-3), and the related project development wrapped into the contract. Overruns from unavoidable and external events such as change in law are negligible in context.
The reported causes are really symptoms of failure. Like every good paradox, Cobb’s apparent contradiction expresses a deeper truth. The reported symptoms are valid.
However, based on understanding megaprojects, case examples show that competent project professionals already know all the reported symptoms, and they know the established “preventative medicines” that should be applied.
Lessons are not learned – case example, excessive field changes due to incomplete designs occur repeatedly: the root cause is deeper than the reported symptoms.
The root cause of major overruns is business culture characterized by prevailing behaviors and beliefs. This finding has been neatly stated as follows: “Modest project ‘screw-ups’ are mostly the fault of project execution; Colossal ‘screw-ups’ are almost always caused by the business.”
When present, business culture failings, particularly on client-side, that cause overruns include:
• Grasping short-term gains including perceived “savings” on competent personnel or accepting lowest commercial bids without sufficient technical evaluation; over long-term foresight.
• Lacking the grit for getting down to the “devil in the detail”, or for facing brutal realities of project development and execution allowances.
• A “fear impulse” seeking insulation from blame or responsibility, avoiding tough decisions, remaining frozen to the perceived safety of the status quo.
When faced with challenging business environments and contracting implications are not understood, these cultural behaviors are in respects sane and rational.
The required business culture for successful projects is long-term, smart, strategic thinking, collaborative, innovative, tough-minded, brutally honest and down-to-earth. It is hard but fair, which is more efficient in the long-term.
Example: unduly using market leverage to impose undesirable contracting arrangements leads to higher dispute costs. It incubates the single-minder objective of preparing a robust business case at the outset – if necessary, killing off unfeasible projects. It remains relentless committed to achieving all project success criteria. It understands what must happen, why, and when. It gets down to the fundamentals including well-designed contracts. Enlightened members of current management circles already practice the required culture and are ready for widespread change.
Improved contract planning and preparation requires competent project professionals empowered by the business, applying appropriate techniques. Some fundamentals are summarized with a project management emphasis.
The Project Contracting Strategy (PCS) is the contract planning and preparation keystone. The PCS defines what scope is proposed in vertical and horizontal work packages, how to motivate performance and manage risks with “best fit” contract forms and incentives, who is available in the market with necessary capabilities Smart PCS starts in Phase-2 planning the Phase-3 contracts for basic design and technical requirements.
The Contract Development Schedule (CDS) manages the PCS decision gate milestones. Second, it manages contract preparation milestones for procurement invitations to bid, and negotiation and award of contracts.
A robust CDS is critical to manage tensions between the increasingly short times to market, the time windows to leverage full procurement value from the market, the internal resource availability, and integration of contract preparation with the overall project development.
The core of the Contract Development Team (CDT) needs to form at the latest in Phase 2 to develop the PCS. Full strength team is needed in Phase 3 to prepare contract documents for bid packages.
The CDT team leadership comprises: the project manager as principal stakeholder in a well-designed contract; contract manager as specialist in contract strategy and content; engineering and construction managers as specialists in the technical requirements where most overrun causes originate; project controls manager as specialist in timelines; legal advisor and business manager as specialists respectively in terms and conditions and commercial requirements.
Having CDT personnel follow through into contract negotiation and worksite execution delivers benefits of building the all-important expert, committed and collaborative “project team.”
A robust business case is undoubtedly a priority. Effective execution of that case requires a “best fit” environment, and that will be determined by the contract form.
Clients need to make smart “best fit” choices. Project specific considerations include: work scope, and risk factors described in the PCS above, the market activity of providers, the required schedule, the client team’s capability, the flexibility to optimize value engineering or technology adoption potential.
There are four fundamentally different contract forms and each define four attributes of a business agreement: different performance obligations; payment principles; “first-order risk” allocation; and different working relationships.
“First-order” risk allocation is achieved selecting the contract form above.
Specific “second-order risk” allocation, for example change in law, is a specialist topic; in summary: optimize contract allocation to achieve lowest long-term cost; which generally means assigning risk to “natural owners” best able to manage and mitigate or take the benefit and save contingency if risk does not occur.
Choice of EPC lump sum should be limited to projects achieving all the following “EPCLS qualifying criteria” for the potential benefits of this form to be delivered:
1. Clear and stable work scope. Preferably +/-10 per cent basic design; at minimum unambiguous basic engineering inputs (example: certified P&ID), and end states (output guarantees).
2. Clear and stable execution conditions, requirements and restraints.
3. Project risks identified and commercially prudent.
4. Client wants “hands-free” relationship, not intruding on contractor’s right to manage works.
5. Qualified EPCLS providers are interested in the market.
6. Bid time is available and sufficient for stable and competitive pricing.
EPCLS is be the predominant form reported to be used on 53 per cent of projects. Reported data showing 62 per cent major overruns indicates that on many megaprojects it is unrealistic to meet all qualifying criteria. Alternatives to EPCLS are required.
Fortunately, several alternatives to EPC lump sum are available in regular use, as briefly outlined below:
• EPC Management (EPCM): is reportedly used on 25 per cent projects with lower design definition and higher risk. Experience shows that with smart-design of cost-plus formula, contractor’s cost, time, HSE motivations can be aligned with client. Reported data showing 78 per cent major overruns indicates how difficult it is to design an effective formula and use of this form on higher risk cases.
• Early Contractor Involvement (ECI): use is trending with innovative clients including a recent oil major megaproject. Client employs one or more contractors to develop design and execution plan, as basis of second-stage execution. Efficiencies result from leveraging execution expertise in value engineering and advanced work planning in the project shaping stage.
• Mixed engineering and procurement reimbursable (EPR) and EPCLS: is reportedly used on 12 per cent projects with only 8 per cent major overruns. Efficiencies result from reimbursable work scope definition. During EPR client risk is manageable by “open-book” procurement and engineering is only 10 per cent project cost. Second stage EPCLS construction contractors bid on work scope now clearly defined in EPR phase.
International model contracts offer efficiency-promoting advantages over many specifically drafted contracts, including the following: balanced “second-order risk” allocation, usable plain language, less ambiguity after years of fine-tuning, user familiarity, and available off-the-shelf.
Improved contract content needs to be usable by the project team. Well-designed contracts are comprehensive, and yet make complex megaprojects easier to understand and implement.
In essence, contracts need a clear structure mirroring the project activities and to satisfy two simple criteria: For matters where there is certainty, they must offer unambiguous instruction; and for matters that deal with uncertainty, they must offer clear guidance on how it will be handled. It is rarely practical to anticipate every incident or uncertainty.
Contract Terms and Conditions (TC) whether specifically drafted by legal or by a model contract applied to the project will define the contract form.
TC need project team oversight to ensure that the PCS decisions on form, risk, payment principles and relationship are correctly applied.
Contract Technical Requirements (TR) justify the most focus and resource from CDT.
Based on an analysis of past project close-out data, most overruns and disputes stem from TR. The biggest opportunity to improve outcomes lies with better-designed TR.
Business people need practical business instruments that support successful business outcomes.
What someone does not understand s/he will neither plan nor implement. Practical guidelines for well-designed content include following:
1. Contracts should be structured so that users know where to find relevant information. An effective technique is to mirror the main project activity breakdowns and workflow, so it’s logical for project people.
2. Concise so users don’t get lost or distracted. Overdue “house-keeping” is required to clear out unnecessary complexity and consolidate concise standard documents. Case example: engineering document specifications comprised five unlinked sections, totalling hundreds of pages. The result is abundant ambiguity. A series of mid-project workshops are required to determine what is required for hand-over, and what would be burdensome inefficiency.
3. Precise and complete for appropriately described requirements. Requirements shall be expressed in plain-language actionable terms: who does what, when and where; not in abstract legalese.
The business case for simple plain-language contracts is trending within innovative parts of the business the legal communities.
Simple does not mean incomplete or lazy. In fact, it’s the continued use of unmanaged performance inhibiting complex contracts that are lazy and constitute a bigger business risk.
Ben Crossley is Director and founder of Energy Contract Solutions, specializing in contracts and procurement in Singapore.
He provides front-line advice to clients and EPC contractors on power generation, utilities and downstream oil and gas megaprojects.