The outset of any large-scale construction project can be a challenging time for those tasked with guiding the project to completion. It is also a very important time; there are crucial strategic decisions that need to be made by any project owner. In our first client alert of the series we discussed how to select the correct type of construction contract. In this, the second alert, we focus on procurement strategies. Does the Engineer, Procure, Construct (EPC) model (where an owner entrusts his entire project design and construction to one company) remain the trusted solution for owners in this economic climate? What other options are available to owners and might they actually be more appropriate for a trader/producer's purposes?
When asked about what they want for their infrastructure project, owners tell us they want a project which is built:
- on time;
- on budget; and
- in accordance with superb operational specifications.
A trinity of goals well understood, easy to anticipate and yet difficult to achieve; fast project delivery can adversely impact on cost and quality of work, and project cost itself is incredibly sensitive to timing and specification levels. Therefore in reality, savvy owners recognise the tension between these related goals, establish their priorities and adopt a procurement strategy that best serves those priorities.
This client alert aims to inform traders/producers about the procurement models that are available and to arm them with the knowledge to be able to make an informed decision about which course of action is best for their infrastructure project.
Certainty over Speed - Design then Construct
Under the strategy the industry calls 'Traditional Procurement', a design professional performs the design of a project, and subsequently a separate contractor (or number of contractors) is required to execute the works in accordance with that design.
An advantage of having the design completed prior to appointing the contractor is certainty of price and schedule for the owner. As the design has been established, contractors are able and willing to estimate and agree a firm (fixed) price and schedule which will be less open to change.
However, an owner might be less concerned over such certainty; he needs to complete a project quickly to take advantage of market conditions. Also, an owner may be concerned about the division of responsibilities (between designer and constructor) and the potential for each to blame the other for any delays to schedule or deficiencies in the works.
The One Stop Shop, Design and Builder
The Design and Build and the Engineer, Procure, Construct (EPC) models both seek to address the 'division of responsibilities' issue faced when using the traditional procurement route. Both offer a single point of contact for an owner in respect of the design and the construction of his project. Additional specialist involvement, such as design consultants and/or proprietary processes, is engaged by the contractor as subcontractors, which again preserves the single point of responsibility.
By having one entity appointed from the outset to perform the design and the construction, these models allow the design and construction to proceed almost in parallel, which can deliver the project to a quicker time frame than the traditional procurement route might allow.
Design and Build best suits the educated owner with a sophisticated in-house team able to be very specific about project requirements from the outset, which can be clearly defined in the contract, tested and commissioned. Changes to such requirements can be very expensive under this type of contract because they can significantly impact on the contractor's design for and approach to the construction of the works.
The EPC model, by definition, tends to go a step further than Design and Build. Here the owner specifies what he wants by way of the completed project, leaves the contractor to design and build the entire project, commission it and hand over the key to the owner to commence commercial operations. As the intention here is that an owner's involvement during delivery of the project is minimal, project risk is shifted almost entirely onto the contractor. EPC is the informed choice for an owner who wants a price certain, a time certain and limited interaction with the contractor while the project is being built. Albeit that the acceptance of such risk will often come at a higher contract price.
A Word on the True Cost of EPC Contracting
The method of pricing used is another important element of the procurement strategy for a project, being another way by which the parties allocate risk. EPC contracts are commonly priced on a lump sum fixed price basis. When agreeing a lump sum fixed price, the contractor has an opportunity to make a higher profit than with other pricing models - however, whether or not he ultimately achieves this profit is at his risk.
One can see that the EPC lump sum model has inherent dangers, particularly in an inflationary climate such as we've been experiencing. Owners often assume that they have absolved themselves of most risks via an EPC lump sum strategy. Yet contractors make mistakes, they bid too low and they underestimate what is required by a contract and the circumstances in which it is to be completed. The industry has a history of distressed projects that are either of insufficient quality, over-spent and/or late, with claims pending and contractors facing insolvency.
For traders/producers not in the business of construction i.e. without the staffing capabilities to build a project themselves or to comprehensively supervise another company building it for them, the EPC model is perceived to be a good solid choice of procurement model to build what an owner wants and for that contractor to take on the risk of so doing; fixed price with few risks. However, experience indicates that transferring all of the risk in a project to a contractor often drives the wrong types of behaviours and can lead to poor performance and poor outcomes.
The EPC model can work, and its advantages are many for owners, not least its popularity with lenders. However the key to securing the best and stable price for an EPC project is, via careful contractor selection and drafting of an EPC contract, allocating project risks to the party best able to deal with them and then asking the contractor to price according to the risks he has agreed he will (and can) manage. Even in an EPC context, an owner must accept the fact that he has certain risks that he himself must manage, and manage them to the best of his ability or appoint others to do so for him.
The Management Option
When owners are faced with a large and complex project, but limited project management resources, they often turn to Management Contracting or Construction Management as a suitable procurement model. At the heart of each is the reliance on a company to manage (but not carry out) project delivery on behalf of the owner; both design and construction.
Management Contracting typically involves the Management Contractor being responsible for the delivery of the project: albeit he engages others to actually undertake the design and construction of the work. Construction Management typically involves the Construction Manager helping to place and then manage the series of contracts that the owner himself will enter into with the designer and contractor.
Both approaches enable simultaneous and speedy design, procurement and construction, provided that the Management Contractor or Construction Manager has the skill, experience and relationship to co-ordinate and cajole the delivery teams to progress the works to completion.
The Management Contracting approach achieves one point responsibility for project delivery, Construction Management does not.
Be My Partner
A procurement model of increasing popularity globally is that of partnering, whereby an owner will seek to be more 'open' and work with his contractor in a "spirit of mutual trust and cooperation" in order to achieve the construction of his project in a way that realises the commercial interests of both owner and contractor (in contrast with the adversarial approach of other procurement strategies).
This approach requires a change in mindset and a realisation that the typical methods of contracting and work allocation have not promoted collaboration and a drive for efficiency, but rather poor pricing, late delivery, claims and significant disputes.
With partnering the parties will typically try to agree a target cost, being an estimate for the project, against which the contractor is paid on a cost-reimbursable basis but incentivised to save costs via the use of a pain/gain mechanism. In that way the parties share any project cost savings (and, likewise, take a share of the pain of any over-spend).
In addition to a change in attitudes for this approach to work, the design has to be established to a certain degree to allow the target cost to be agreed in the first place. Although a target cost arrangement does tend to accommodate change more easily than other models because of the open-book nature of the project-spend. If managed well, the open-book partnering approach should succeed in driving cost-effectiveness, even if at the outset cost certainty is not achieved. The question is, how certain are the fixed prices agreed under other procurement models, when experience shows us that changes, claims and disputes can render such fixed prices meaningless?
When delivered successfully, a partnered project will deliver better value for the owner, recognise and protect profit margins for the contractors, keep the owner well-informed as to costs and progress, foster innovation and promote a good working relationship between the parties which can continue on to other projects in the future.
Understandably a number of our clients are extremely interested in this approach; it sounds at first sight like a strategy which addresses a number of the shortcomings of other procurement routes. However, we have seen the partnering philosophy fall down where there is a failure by owners to understand the additional risks they may face under this concept. Insufficient management by an owner has potential to render the project a very expensive cost-reimbursable arrangement.
To each his own...
Each of the procurement routes available to traders/producers has its own merits and pitfalls. For every owner it will be a case of evaluating what is most important to him and marrying that with the strategy that will best fit the skills and experience of his business as well as those of the designers and contractors with whom he wishes to work.
Next time, a look at the dangers of contracting with contractor joint ventures...
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
