This blog post will provide an overview of the primary areas of risk associated with construction projects, in addition to outlining the various methods to manage these risks. We’ll also investigate contract structure and procurement strategy, which includes the essential decision on what form of contract to use.
TYPES OF RISK IN CONSTRUCTION CONTRACTS
Construction contracts involve multiple types of risk. These risks can range from financial to legal and health and safety risks. Contractors might also be at risk of disputes with clients, suppliers, or subcontractors. All of these potential problems can have a significant impact on the completion and cost of a construction project.
It is essential to analyze the numerous available risks in construction projects and classify them accordingly. Unfortunately, such analyses are scarcely done. Generally, the wide range of risks can be construed into a few standard categories like time, cost, performance/quality, health and safety and environmental risk. The following examples provide insight into multiple risks.
- Management, direction, and supervision may be marred by greed, ineptitude, ineffectiveness, favouritism, unreasonableness, insufficient communication, mistakes within the paperwork, malfunctioning designs, inadequate guidance briefings or the identification of stakeholders; non-compliance with statutory requirements; unclear stipulations, incorrect selection of contractors or consultants; and variations in requirements.
- The land, any man-made barriers, the climate: all of these factors play a role in physical work.
- Faulty materials or craftsmanship; assessing and examples; onsite organization; lacking staff, labour, machinery, items, period or funds.
- Delay and disagreements about the ownership of the site, as well as procrastination in providing information and inefficiencies in carrying out tasks, have all been causes of delays that were outside both parties’ control. Layout has also been an area of dispute.
- Negligence or breach of warranty can cause damage to persons and property, and some matters such as accidents, uninsurable risks and consequential losses may be excluded from insurance cover due to exclusions, gaps or time limits.
- The external environment can significantly impact operations. Environmental regulation, government policy on taxes, labour, safety and other laws, planning approvals and financial constraints can all affect the business. Additionally, energy or pay restraints, price increases due to war or civil commotion, malicious damage may also need to be taken into consideration.
- Intimidation and labour disputes are two unfortunate realities in the workplace. These conflicts can cause strife between workers, employers, and unions, leading to potentially hazardous outcomes.
- Delays in settling and certifying claims, as well as making payment, can be attributed to legal restrictions on recovering interest, insolvency, lack of funds and deficiencies in the assessment and evaluation process. In addition, fluctuations in exchange rates and inflation are also influencing factors.
- Law and arbitration are both processes that aim to resolve disputes, yet can often be marred by lengthy delays, injustices and uncertainty due to inadequate recordings or unclear agreements. Furthermore, the cost of getting a decision made and then enforcing that decision is not always predictable. Changes in statutes and different interpretations of common law can make this even more complicated.
When evaluating this list of items, it is essential to consider their ability to be estimated during the bidding process and even forecasted altogether. Still, empirical data has demonstrated that, in actuality, contractors do not usually perform thorough analyses as they prepare bids for their regular tasks.
The development of a good risk management strategy is based on assessing and responding to risks. Extensive research has been done in this area, which resulted in the practice of creating ‘risk registers’ being widely adopted as a measure of good practice. Risk registers list potential risks and allocate either a numerical or qualitative probability and magnitude to each one – if numbers are used, multiplying them will give an indication of the risk score. These measures should greatly affect how risks are responded to.
A risk register is meant to identify steps taken to mitigate the phenomena and any contingency actions needed in case it occurs. Who is responsible for such actions and when they should be taken are also common items noted. This practice, however, is often accepted uncritically; Drummond (2011) notes that even so, risk registers cannot eliminate surprises but rather, provide an illusion of control. Furthermore, only those risks that are not already allocated in the contract are likely to be included on a contractor’s risk register, which can lead to it being more a means of communication from the contractor to the project manager about residual risks than an effective list of how risks will be managed or who is responsible for them. In this sense, risk registers may simply contain low frequency/high value risks instead of what was initially promised.
Dealing with risks
It is commonly believed that no one wants to take risks, and this is called risk aversion. But dealing with uncertainty is an issue that must not be overlooked, as the very point of getting into construction in the first place is to assume calculated risks. Doing business entails taking on challenges that others may shy away from, so it is important to acknowledge these potential perils and make them manifest in order to stay ahead.
Rational commercial decisions can be made determining who should bear risks, and by taking on several risks, the degree of uncertainty becomes less of a factor.
Having a clear grasp of this concept helps construction advisors to counsel their customers on how to assign the risk. The objective of selecting a contract should always be to delineate responsibility for risks unambiguously. Regrettably, the industry has long neglected this imperative, leading to an abundance of claims and legal disagreements.
Following the convention of risk registers, there are three steps to managing contractual risk: first, assessing the potential issues; second, addressing those concerns; and finally, monitoring any changes.
Identifying the risks is paramount before beginning a project. The list presented in the blog serves as an illustrative checklist to facilitate discussion of any potential dangers. As part of this process, clients should be clearly informed on their priorities for the project. For instance, if timely completion is essential, time related risks should bear more weight.
The second step in the process is to analyse each of the risks – examining their probability of occurring, how often they are engaged with, the potential severity of their impact and the range of possible values. This can be fairly subjective, but it is crucial for raising awareness about risk exposure. Some risks may need more detailed quantitative analysis than others since they have higher priority; however, due to their lower priority, many are dealt with more subjectively. A word of warning must be offered with regards to analysing risks: many projects have gained off-ground momentum due to an ‘optimism bias’, whereby risks, costs and programmes are typically undervalued.
Respond to the risk: To identify the optimal contract strategy, the previous steps provide a basis on which to consider the client’s priorities and any major risks. The next step is to determine who is best equipped to handle such risks – employer, consultant, contractor or insurer. Any decision about relinquishing responsibility must take into account both how often an event might occur and how much premium will be paid for shifting it. It is also essential that control over a risk should be assessed. For example, designers would be most capable of mitigating design-related risks; as such, liability for design flaws is usually allocated to them. Furthermore, diverse procurement options allocate different levels of accountability to subcontractors’ associated risks.
It should be obvious that it’s pointless to dispute which standard-form contract or procurement system is superior; each has its place depending on the situation. A consultant who routinely suggests one option too quickly, without evaluating any potential hazards isn’t fulfilling their duties as a professional.
We can now look closer at the range of potential responses to contractual risks; transfer, acceptance, avoidance, insurance or even not taking any action.
Transfer of risk
The transfer of risk occurs when responsibility for the goods is passed from the seller to the buyer, who then assumes all risks associated with the delivery of the goods. The responsibility will pass upon arrival at the designated location and this should be clarified in advance by both parties.
The inevitability of risk means it cannot be entirely eradicated; however, it can be shifted. In line with the fundamental maxim, this usually requires payment of a fee. Therefore, attempting to impose unmanageable risks on other parties is ill-advised.
Understanding the transfer of risk is a critical factor when studying building contracts. To comprehend the extent of risk allocation, one must evaluate the legal position enabled by contractual clauses — both with and without them. This book’s purpose is to assist in developing such an understanding, which is a fundamental requirement of this field.
It is not prudent for employers to try and transfer a risk that is difficult to evaluate. Reliable, proficient contractors will factor in these risks into their bids while careless ones may skirt around them, leading to an unwelcome surprise down the line. Should this occur, they may try and reclaim the cost through the employer. If unsuccessful, it might put them into bankruptcy, which won’t benefit anyone in the end.
Acceptance of risk
The risk of loss is accepted by the parties, and they agree that neither of them will hold the other liable for any damage or injury caused by said risk. They acknowledge that the responsibility of evaluating and managing risk lies with them both, and they hereby agree to accept said risk.
Clients should be careful not to put too much or unfair risk upon contractors. Stealing an advantage over them in this way is bad business practice. Taking risks may seem profitable in the short term if they don’t have to pay a premium, but eventually someone has to suffer the consequences. In the long run, this could result in creditors being taken on by those who have been overloaded with risk and unable to cope. This could also mean that fewer contractors will be able to tender for work due to their competition’s collapse.
The employer should bear any risks which cannot be managed or reduced by project participants, as any attempt to shift them may incur costly premiums. Conversely, if a client continues to engage in development procurement, they are essentially paying extra for someone to take on an unnecessary risk. Therefore, it is more sensible for the employer to assume highly uncertain and badly calculable risks.
Risks that can’t be predicted or estimated, like those of war, earthquakes and invasions, are defined risks. Without considering these variables in the tender process, you may end up with results that are too high to accept.
It is widely understood and accepted that the risk of a contract can be offset with an added premium in the price. However, Shash (1993) found that even if a project’s risk profile impacts contractors’ mark-ups, it does not appear to influence their willingness to bid. Even more shockingly, Laryea and Hughes (2011) concluded estimators don’t consider the operational risks when formulating bids for construction work. Moreover, contractor must bid without knowing who the competition is, and therefore do not know if the opposing company has professionalism or experience to set a reasonable price for risk. As a result, this creates a threat of contractors losing out due to pricing their work too high as part of an effective risk related bidding strategy.
Avoidance of risk
Once the risks have been identified and evaluated, it may be deemed that some are too high to accept. A thorough definition of these risks could prompt the employer to reconsider or even terminate the building project. Examining the financing limits of a project and potential outcomes of more probable risks can determine if a project is viable. An alternative way to avoid risk is by redefining the venture. If finance for the endeavour depends on a particular government grant and there is possible legislation that could end this subsidy, then reconfiguring the project to no longer rely on it could be advantageous.
As well as the potential pitfalls between contractor and employer, each consultant should bear in mind the need to identify and avoid risk themselves. Cecil (1988) suggests that a RIBA report on avoiding risk for architects is to make sure that the responsibilities, payment, and expenses are all agreed on and understood at the start of any project. This will help consultants avoid many issues later on.
Insuring against risk
It is important to mitigate potential losses by having an insurance policy in place. Taking out a policy can provide protection against unexpected events and avert financial difficulty if something goes wrong. It is prudent to ensure that you have coverage for any potential risks associated with your business. Insurance provides peace of mind and safeguards against possible mishaps, ensuring that you are covered in the event of a disaster or crisis.
When managing ‘acceptance of risk’, insurance and laying off risks have similar outcomes. Insurance is an available option in some scenarios, and many standard contracts demand a form of insurance. Common insurable risks are protecting against third party injury claims and fire. It is also possible to insure against losses due to liquidated damages or other forms of consequential loss. Before deciding on the correct type of insurance for any project, it should be thoroughly thought out and consulted on. For instance, consultants will usually get professional indemnity insurance in order to protect themselves and their clients from potential failures in completing tasks with the necessary skill and care.
Doing nothing about risk
Not acting on risk is the same as exposing oneself to danger. Ignoring the potential harm that can come from not dealing with risk can have serious consequences. Therefore, it is important to not overlook any risks and take steps to manage them accordingly.
It’s common for project teams to overlook risks from the get-go. If clients are not well-informed, and advisors fail to take into account any risks that may arise, then any disasters that materialize are a total shock. However, consultants may choose to stay quiet and do nothing even if they’ve considered the balance of risk and deemed it’s best left with those who can manage them. It could look like the same course of action in either case, but it’s advisable for those involved to make their decisions clear so they can be debated openly.
A further instance of omission occurs in the standard-form contracts. It is easy to assume that such occurrences are not addressed by these documents, however, this does not mean the parties are absolved from risk. In fact, the contract does assign it – even if unintentionally. This can be problematic as misunderstandings and uncertainty may arise, which can inevitably lead to litigation and claims.
Allocating risk through methods of payment
Payment methods can be used to allocate risk between the buyer and seller. Using different payment methods can help determine who carries any potential risk associated with the transaction, either the buyer or seller.
One of the key elements when apportioning risk is how prices are calculated. This encompasses deciding who takes responsibility for discrepancies between estimated and actual prices. Typically, construction contracts involve pricing related to costs with an addition for overhead and profit. The contractor’s work is usually quantified in a bill of quantities that he/she is expected to quote on. Two kinds of prices are generally used: ‘fixed price’ or ‘cost reimbursement’. Both categories have different implications and must be understood before the contract is signed.
Fixed price items are paid for on the basis of a contractor’s predetermined estimate, including risk and market premiums. The employer pays the estimated rate and it does not matter what amount the contractor spends.
Cost reimbursement items are those charged based on the amount the contractor expends while completing the job.
It is unusual to find a contract that is exclusively fulfilled with one method. Generally, both methods will be used together, with one being more dominant. This can be seen by the items in a bill of quantities for a JCT SBC/Q 2011 job – most are fixed priced and need to be multiplied by the quantity listed in the bill.
In terms of an NEC3 Option B contract, payment is based on the contractor’s estimate and the rate in their bill, multiplied by the quantity fixed. This kind of contract is known as a fixed price one, but may have cost reimbursable components such as fluctuations linked to actual changes in market prices.
A fixed fee prime cost contract establishes provisions for payment according to the contractor’s expenses. While that portion of the contract is cost-reimbursable, the contractor’s attendance and profit margin are determined by a pre-set ratio of the prime cost, not related to actual costs, thus resulting in a fixed price format. This shows how each type of agreement incorporates aspects of the other.
When considering the sharing of risk, it is essential to bear in mind that in fixed-price contracts, the contractor agrees to provide an estimation for their work and be held accountable for it. In this case, any amount saved will be beneficial for them, whereas any excess spending will not. On the other hand, with cost reimbursement arrangements, any variance from the original estimate will be carried by the employer; they would gain from reductions but must pay for increases.
When considering cost-based pricing in construction contracts, it is important to consider the context. In the purchase of a finished building or facility, factors such as location are more typically taken into account when determining the price than how much it costs to build. This is also observed in other markets, such as those for cars, computers, furniture and plant and equipment, where value rather than cost decides the price. Therefore, distinguishing between cost, price and value is essential; cost refers to the expense of obtaining something; price determines what must be paid for it; and value reflects its worth to the buyer. For successful transactions, the manufacturer or contractor must balance price so that it is higher than cost but lower than value delivered, thereby satisfying both parties involved.
In this context, firm price contracts should be distinguished from fixed price ones; the former often lack a fluctuations clause, making it more likely that the tender sum and the ultimate cost are one and the same.
