The conventional norm applied in contract risk management is to allocate the risk to the party best able to bear it. This is also advocated in many project guideline documents such as for Public Private Partnerships issued by many government agencies and Development Finance Institutions (DFI’s).
This norm originates from the Abrahamson principles after Max Abrahamson who first advocated for more pro-active and equitable risk allocation and risk management in construction contracts. Its intention was to reduce uncertainty in how risks are dealt with when developing projects.
Although the norm appears sound in theory, its practical application has been problematic. There has been a significant shift over the years to transfer as much risk as possible away from the project owner to a main contractor via fixed-price contracts, with the main contractor serving as the single point of responsibility. This assumes that the contractor is the party that is in the best position to quantify and manage all the risks. However, many risks exists that cannot be quantified or controlled by the contractor such as:
- Unforeseen ground conditions
- Uncertainties in the project scope that can only be finalised with more detailed engineering/investigations.
- Interfaces with other third-party contractors of the project owner
- Dependence on utilities provided by third-parties
- Force Majeure events
- Political risk
This unfair practise has dire consequences for executing projects effectively.
It is common cause that a contractor cannot account for the full quantum of unquantifiable risks in a fixed-price tender, otherwise his bid will be uncompetitive. The bid is therefore usually awarded to the contractor with the most optimistic view of the nature of the risk. Another way of viewing it, is that the bid is awarded to the contractor who under-priced the risks the most.
Project owners will have a false sense of comfort that they have obtained the best price with most of the risk transferred to the contractor. In reality, the project is likely to face serious contractual challenges that will lead to a no-win situation for every party to the contract for the following reasons:
Firstly, in our experience, a written contract is only as good as the willingness of participants to honour it. Challenging contractual obligations may sometimes stem from bad faith or opportunistic behaviour by a contracting party. However, more often, they arise as a natural response from the party that is suffering the financial loss, who will use every means possible to recover losses.
Secondly, a contractual structure where the commercial interests of the project owner and the contracting parties are not aligned, will result in disputes and contractual claims. Where a contracting party has under-priced the project risk, it will hope to recover any losses whenever they occur through claims. Contractors will then actively pursue and uncover any opportunity to claim. This results in adversarial contractual relationships.
Thirdly, project owners may be under the misconception that standard forms of contract will serve as protection against claims and disputes due to the tried and tested nature of the contract clauses. However, the clauses in many standard forms of contracts are not immune to ambiguity and even more so where variations were made to standard clauses for a specific purpose.
Therefore risk allocation as it is currently applied in the industry, does not serve its purpose if the commercial interests of the contracting parties are not aligned.
It is advocated that project owners move away from the risk allocation terminology and focus on a proper risk structuring regime. Risk structuring is a more rigorous negotiation process where key risks are firstly identified and mechanisms deployed to structure risks. The outcome is a contracting structure designed to align the commercial interests of the contracting parties. This results in fewer disputes and more collaboration. Where project finance is involved (typically more complex projects), it will require more advanced risk structuring mechanisms to provide the necessary comfort to project financiers.
Contact us at Camdebo if you want to ensure that your project benefit from the best risk management practises. We apply robust tools to understand and structure risks, paving the way for successful project outcomes.
