Procurement, Risk & Russian Roulette

November 10, 2013

Article is cover story in Irish Construction Industry Magazine, November 2013.

RISK:

Russian Roulette

 
Arguably, if there is a single issue that is central to most disagreement and discontent within the ‘new’ Public Works Contract forms and the concepts described in the CWMF guidance notes, it is Risk.
 
A very broad section of the Construction Industry believe that the risk being transferred to them under these contracts is wholly unfair, as in order to accurately price risk it must be accurately described in the invitation to tender documents. This in many cases can lead to contracting authorities (and the design teams they employ) being accused of ‘risk dumping’ and issuing of incomplete and inadequate tender documentation from which risks cannot reasonably be identified.
 
From the Contracting Authorities’ side the formula is simple – risk is transferred from the public sector to the private sector for an invited premium priced in an open, transparent, competitive market. And so, the contract forms remain unchanged and the risks continue to be transferred: But can the private sector bear these risks? Can a building contractor operate effectively as his own insurance company? These, among others, are questions that the GCCC must ask as the Contract is reviewed.
 
The Public Works Contract forms have been in use for six years, and it seems that the situation has reached a nadir.  Anthony Hussey of Hussey Fraser Solicitors, in the excellent CIF-run seminar of March this year; ‘Public Procurement in Ireland’, described some provisions within the contract as not just unfair, but “immoral.” Indeed the depth of feeling within the industry is so acute that the CIF ran a workshop for its members advertised on their events calendar as “Loopholes for contractors in the public sector contracts”.
 
“Loopholes?”; do the CIF believe the contract provisions to be so biased that it is perfectly acceptable to run a seminar on ways to subvert them? Is it that different from, say, the AA running a seminar entitled “Loopholes for drivers in the Road Traffic Act 2010”? These contracts were, after all, put in place by the Government for the benefit of the public purse; the taxpayer and the country as a whole: And the construction industry is part of that whole. So how is it that such scorn for these contracts exists?
 
The premise of the Construction Procurement Reform was - at the risk of oversimplification - that the Government would accept a price premium on all contracts in exchange for transfer of (almost) all risks of cost and programme overruns associated with a construction project to the tendering Contractor.
 
Ok, the term used in the Guidance Notes is ‘optimal’, but optimal transfer of risk depends very much on which side of the divide you’re standing.
 
 So what’s the problem? A bidding contractor takes a view on all of the potential risks associated with a given job when tendering, and builds this into his price.
 
As for the question of inadequate information and risk-dumping; despite frequent claims that the information being issued by the Contracting Authorities is inadequate, the Public Works Contracts openly require the contractor to include & price for unforeseeable events. This places a large hole in the argument of inadequate information. Unforeseeable risks cannot be effectively described – if they are, then by definition they are no longer unforeseeable.
 
… “what is the message there? The message is that there are known knowns; there are things we know that we know. There are known unknowns. That is to say there are things that we now know we don't know. But there are also unknown unknowns. There are things we do not know we don't know. So when we do the best we can and we pull all this information together, and we then say well that's basically what we see as the situation, that is really only the known knowns and the known unknowns. And each year, we discover a few more of those unknown unknowns.
It sounds like a riddle. It isn't a riddle. It is a very serious, important matter
Donald Rumsfeld  - Press Conference at NATO Headquarters, Brussels, Belgium, June 6, 2002
 
So the question becomes whether it is fair to ask prospective contractors to price (and be bound to that price of) ‘unknown unknowns’? Is this even possible for a bidding contractor to assess?
 
Before we all clamour to shout “No,” consider; the contracts are designed to transfer risk to the private sector and the private sector can, and does, price unforeseen risks. Insurance companies do it every day. They assess a policy based on a number of relatively generic factors, look at previous risk outcomes in terms of costs to their underwriters, and then average out the potential exposure (plus a margin for error) across the premiums that they charge.
 
And here is the nub of the matter. Contractors price drawings and specifications. In the past if there was a contingency sum for unforeseeable events the design team put one into their documents and that price was added to a contractor’s bid; but now, under these forms, bidding Contractors are required to price contract documents and take an actuarial view on a very broad spectrum of potential, unforeseeable cost and programme overruns.
 
And in truth most bidding contractors know this. They just don’t think it’s very fair.
 
So why does it not work?
 
The most obvious issue is competition. The collapse of tender return prices since 2007 is detailed extensively elsewhere, and does not require illustration here. But the simple outcome is that a Contractor who was realistically pricing the risk under these contract forms would win no work in a lowest price tender competition.
 
The less obvious problem is perhaps more important, as it isn't simply generated by economic circumstance. It is a more subtle question of scale and, strangely, of perception.
 
The ‘actuarial’ model of risk buy-out is one that thinks of the private sector as buying the risks, and the public sector paying for the associated certainty. But the private sector, and within it the construction industry, is not monolithic. It is not the case that the ‘private sector’ can assess the risks in an actuarial fashion. This task falls to every individual contractor and company, from the largest international operators, to the smallest man-and-a-van outfits, bidding for public work.
 
The actuarial model requires a certain scale to work effectively – without a critical mass the statistical variation in outcomes is too unpredictable. Simply, if it were possible for individual companies to price and cover unforeseen risks, insurance companies would not need to exist. The largest Contractors in this country would struggle to evenly distribute historical cost overruns across its future tender bids, be sure that sufficient margin existed to cover all unforeseeable risk events, and still submit a competitive price. For a small or medium sized builder, the task is nothing short of Russian roulette.
 
In this context I believe that there is a reasonable argument here that the ‘private sector’ is not best placed to manage the risks that it is buying under these forms.
 
This is only a personal view however. An Employer’s Representative does not have the luxury of deciding whether the terms under which a builder offered to carry out a contract are fair. An ER can only form a fair and reasonable view of those terms. A contractor that did not include a contingent price for the unforeseeable risks being transferred to him on the gamble that they will not materialise has obviously gained advantage over another more cautious/prudent contractor. If none of the risk events materialise, then the contract runs smoothly. If sufficient risk events do materialise, and the costs accumulate, then the contractor has no option but to fight, and the much used dispute clauses are activated. Clearly there is an issue of moral hazard here.
 
So the issue with risk transfer is not simply a lack of ‘good quality’ information. A risk outcome that is detailed and described accurately is not a risk; it is a measureable item. The problem is how the CWMF anticipates risk should be transferred to, and managed, by the ‘private sector’. I would argue that this requires a scale that most of the Irish construction industry does not have. Qualifying thresholds aside, this manner of attempting to price unforeseeable risk in the case of an SME is simply too … well, risky.
 
The plain truth is however, that this view cannot change the ER’s obligations to administer the contract per the terms of that contract. An ER has a responsibility to both the Contractor and the Employer, but they cannot compensate a Contractor for having made what is, at its core, a bad business decision. Moreover, the ER needs to be aware of the moral hazard associated with tender bids that do not price all of the ‘unknown unknowns’ being transferred to them under the contract terms. ‘Fairness’, if it is outside the terms of the contract, cannot be a factor.

 

 

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