Different projects and situations demand different contracting strategies. Pipeline owners may enter into a particular strategy depending on the specifics of a project.

A number of issues can be faced when entering into a contract. These concerns can stem from the allocation of risk between owner and contractor, timing, the method of payment, the stage of design of the project and the specific owner-contractor relationship.

A company might choose a contract based on corporate constraints such as funding, objectives, reporting, in-house resources and capability; or market constraints such as the availability of resources and equipment, the level of market activity, and other external influences.

Traditional contracts

Traditionally a proponent would identify a project, compile information and following this, source contracts: a contractor would be chosen based on price and a lump sum contract arranged. This approach sees the contractor take on the risk of price because the amount remains the same regardless of the final project cost.

Stephen Callaghan from Stephen Callaghan & Associates says that this was “a very them and us design – it was confrontational.”

EPC

Engineering, procurement and construction (EPC) contracts are usually a lump sum arrangement, but can be based on a schedule of rates. A schedule of rates refers to a price set for various works and decided upon when the amount of work is unknown. The risk is allocated to the contractor in regard to rates and to the owner in regard to quantity of work.

The owner may only participate in front-end engineering and design (FEED) and leave the engineering, procurement and construction activities to the contractor. This in turn passes the risk on to the contractor.

Bob Otjen from Queensland Hunter Gas Pipeline notes that under this method the owner also takes on a risk in handing the project to another party.

Alliance

An Alliance refers to an arrangement whereby the owner, contractor and designer agree to build a project. The methodology creates a ‘no blame culture’ where decisions are made on a best-for-project basis. When entering into an Alliance, there is an uncertainty about the quantity of works and an uncertainty about the price of the project. The owner takes on the risk of price, governance and how the project works. Alliancing is good for high risk/immediate projects because it provides maximum flexibility. There is low potential for dispute and the owner has a high say in the subcontractors and suppliers chosen.

However, because an Alliancing strategy is open-ended, costs cannot be fully predicted, which can leave owners paying for inefficiencies and mistakes. Value for money can also be an area of contention since the project would not have been through a competitive bid process, as with other forms of contracting.

Graeme Hogarth from Hogarth Project Management says that this is not necessarily the case. Mr Hogarth worked on the North Queensland Gas Pipeline, which was successfully delivered using an Alliance contracting strategy.

“Firstly, lowest cost is not always best value,” he says. “Secondly, the very nature of an Alliance with increased productivity and lower risk inherently means best value Alliance cost estimates are benchmarked and scrutinised more than most other bid costs. The estimate includes input from all parties so has the most broad and considered inputs. History says that Alliance outturn costs are generally in a range of 0 – 5 per cent below the initial estimate. Hard dollar contracts are historically 10 – 30 per cent above the initial contract amount.”

Mr Hogarth says that an Alliance contract with the right commitment and people will always outperform any other contract method because it:

1. Allows people to be involved and deliver in a team environment; 2. Is the most productive and efficient approach as there is no requirement to ‘watch out’ for what the other party is doing; and, 3. Is the ultimate method to identify risk and enable the appropriate party to manage the risk in the most effective way possible which means it will have best outcomes.

ECI

Early contract involvement (ECI) is a method of procurement for entering into a contract, rather than a form of contract itself. As a result of the ECI process, a lump sum, schedule of rates or cost reimbursable contract can be entered into. Under a cost reimbursable contract, the contractor gets paid after the work is done, for works completed.

ECI has traits of an Alliance but the builder, designer and owner work on the planning phase and then a hard dollar, or bankable/traditional contract is entered into.

The contractor is involved in the project at the constructability/design phase. Often ECI is chosen when the project is driven by time constraints or for a high risk project and is a good method if the owner is unsure what they require. The method provides more price certainty than an Alliance.

Mr Hogarth says “ECI is a very valuable tool in understanding risk. It allows all parties to discuss and value risk and apportion risk in the contract. It raises awareness of issues to a level that most of the unknowns and their impact on the contract should have at least been considered.”

A choice of contract

The choice between ECI and Alliance strategies often comes down to ‘corporate culture’. For example, if the owner has had previous success with an Alliance then they may choose this strategy again, otherwise ECI is attractive if there is time to do basic design before construction and if the corporate culture is not conducive to an Alliance.

Georgina Day from McConnell Dowell says that there are a variety of reasons why ECI and Alliance contracts are more effective than more traditional forms of contracting. “ECI and Alliance contracting often allow for more combined planning between owner and contractor to take place that can significantly reduce the likelihood of unexpected events occurring during the execution of the project.

“Traditional forms tend to be more restrictive, especially with respect to timing of tender periods and general pre-construction work,” she says.

The Queensland water alliances in which McConnell Dowell was involved, were formed because the state government needed the project completed as soon as possible to bolster the state’s water supply, but there was no plan or design for the project. Because immediate action was required, an Alliance method was chosen. An Alliance method is also useful when there is a high level of innovation needed or if the owner isn’t sure how to build the project and there is a high amount of risk involved.

Michael Earwaker from Clayton Utz notes that an Alliance works well if there is an inability to define the scope of the project. He says ECI can be effective, but requires considerable upfront trust to be developed between the owner and contractor.

Risk profile

A risk profile is developed during the feasibility stage of a project, and is intended to identify any risks the project might face and determine who would be best able to manage the risk. For example, responsibility for a cultural heritage risk and land acquisition is best kept with the owner (in-house).

The generalised risk profile is often identified in the request for tenders or the request may ask the contractors to identify which risks they are willing to take on. A tender might include 1 – 5 pages outlining who will take on what and what will be a shared risk.

Matthew O’Connell from Nacap says it is important that the documentation provided in the tender package is clear and precise. “In a typical tender situation, it is not unusual for the owner to develop a project over a number of years, yet it will restrict the constructor to a six to eight week tender period to assess the project requirements and make appropriate allowances in its program and price delivery for the project objectives.”

Ms Day and Mr Otjen say that a difference in opinion about the allocation of risk is a common issue confronted when entering into a contract. “This can be resolved by good scope documentation, discussions, even to the point of doing too much,” says Mr Otjen. He sees ECI and Alliance strategies as resolving this to a point, “but with Alliance you don’t know what is being built so it’s very hard to instil, and ECI is good but there will always be something that the owner hasn’t realised about the project.”

Who should take on the risk?

When those interviewed are asked where the risk should reside when implementing a pipeline project, the answer is unanimous that the risk should reside with the organisation that is best able to manage it.

Mr Callaghan says that risks should be properly allocated because otherwise it will backfire if a party is unable to manage the risk. “If risks are passed down they should be done in a proper fashion …There isn’t any point giving risk to someone who can’t manage it.”

He says that often a contractor will agree to take on a risk because they want to be awarded the job, particularly in a competitive bid process.

Mr Otjen says that the owner always holds the risk, which provides the leverage to develop the project. While the risk of certain elements of the project can be assigned to others best able to deal with them, he says that, ultimately, the owner pays for it. Mr Hogarth agrees but says “Operator expectations vary immensely from a view that all risk can be contracted to an understanding of managing risk.”

He goes on to explain that at the same time operators often do not like to give up control of a project. “The broader the contracting strategy the less control the operator has over the method and expected outcomes of a project, particularly those that involve uncertainty such as pipelines.”

Risk aversion

Mr Callaghan says that contractors by their nature are risk takers, but notes a number of factors over the last five to six years that have made contractors more averse to risk. These include: • Increases in labour costs; • An unprecedented boom; • A shortage of skills; and, • Enormous commodity and oil price increases

“There has been an enormous increase in the cost of carrying out work,” he says.

“Now, contractors are turning towards risk taking if they see opportunities in this – for example, if they can manage a risk and potentially make money out of it they will – if they can’t manage a risk then they will steer away from it.”

Mr Callaghan goes on to say that there is no reason why contractors shouldn’t be risk adverse in an economic climate where there is plenty of work. Why take on a job with unnecessary risk?

“Contractors will always try to ensure that they do not over expose themselves,” says Mr Hogarth. He says that risk aversion is a loosely-used term and the real problem is often that operators expect contractors to accept risk that they either cannot control or have not built into the pricing of the project.

Mr Earwaker sees the allocation of risk as a pricing exercise. “The contractor has to apply sensible price to take on that risk. Problems arise when pricing involved in allocating that risk does not match up to what it actually costs.”

Mr Callaghan notes that it must be taken into account that an Alliance strategy involves minimal risk for a contractor because it will still get paid regardless of the project’s success. However, he says that a job including risk has the potential to gain more money for the contractor than an Alliance job.

He sees risk as a good thing. “Risk aversion can be detrimental to contractors because they lose their skills set in a no-risk environment. Risk increases the efficiency and performance of a contractor – it hones their skills.”

The price of contracting

It could be said that, when there is market competition to obtain a contract, contractors could be asked to take on a risk at too cheap a price.

Mr Callaghan says that this is almost entirely dependent on the state of the economy. If there is a lot of work available the contractor won’t agree to lower prices, but if there is no work then they are more likely to. “One of the driving factors for contractors – without work they will go broke – comes down to market position,” he says.

Ms Day says that ultimately, contractors must be content with their pricing, although Mr Hogarth sees some contractors as choosing to price too cheaply.

“Almost always these projects end up in dispute because the contractor needs to use a claims process to make up for the low cost. Until there is a uniform culture that all contractors are entitled to make money if they perform this will always be an issue. It becomes a greater issue in low activity markets,” says Mr Hogarth.

Mr Callaghan agrees, saying that contractors will allow price to be driven down but then will want money back once on the job. The contractor’s tender price may differ from the final price, which will come from the growth of the job. He also notes that the more complicated the contract entered into, the more loopholes the contractor may find to make money.

He says “Clients can drive down prices and contractors will accept under duress, but unless everything is squared away the contractor will look to get back money with interest…The best outcome for the owner is to get the right price for the job.”

The current economic climate

The global financial crisis is set to impact on contracting strategies and the ways in which companies approach projects. Mr Callaghan says that both owners and contractors will move toward contracting methods that provide more cost and time certainty, and this will see a reduction in Alliance projects. He says that it is likely that companies will lean toward lump sum contracts or choose ECI over Alliance contracting.

Mr O’Connell notes that this is because financiers are sometimes of the opinion that Alliance contracting does not provide the lump sum protection for the owner. ECI on the other hand provides the owner with the protection of a lump sum price, which gives company boards and financiers a greater level of comfort that the price will be within budgeted targets.

Ms Day says “Any project that is the subject of finance will be constrained by estimates of final project cost. There are many arguments to say which particular contract form gives the highest degree of final cost outcome. Some say that lump sum contracting is the best way to achieve this whilst others say that this is simply the starting price.”

“With the slow down in activity contractors may well be prepared to or forced to consider bidding where there is higher exposure to risk or price,” says Mr Hogarth. However, he points out that this does not necessarily mean the operator is getting better value.

The best contracting strategy

Different contracting strategies provide varying mechanisms for outlining certainty, scope and price for pipeline projects.

All interviewed were in agreement that the best contract or project delivery method aims to be the best value for money while still producing the best outcomes. This generally depends on the circumstances relating to each individual project.

“If a contract is designed around the project parameters (such as risks, culture, drivers, design delivery) and around a risk profile then there is more chance of success,” Mr Callaghan says.

Mr Callaghan says that most of the time the best contract choice comes down to people.

“All the agreement between Party A and Party B is really a schedule of rights and obligation…It is relationships and people that really build successful projects but the contract is the structure in which you do it,” he says.

“Whatever form of contract you adopt…there is a lot of benefit in working in a team. Teaming type arrangements seem to work well.”