The Tug of War: Fixed Price Contracting in Major Infrastructure Projects
Fixed price contracting has long been a staple in the world of capital projects, particularly in major infrastructure developments. However, with the growing complexity of such projects, the challenge of quantifying and mitigating risks has intensified.
For major engineering firms, this can translate to significant monetary losses and entanglement in tedious legal battles over cost overruns.
Quantification of Risk
As projects grow in complexity, unforeseen challenges arise. For engineering firms, assessing all potential risks from the outset can be daunting, if not impossible.
Cost Overruns
Any unexpected event, be it geological surprises in mining or hidden defects in old infrastructure, can result in expenditures that weren’t part of the initial budget.
The Alluring Alternatives
Many alternate contracting models have emerged to provide more flexibility and risk-sharing between clients and contractors:
Cost Plus Contracts
These offer reimbursement of expenses to the contractor, plus a profit. This model allows for flexibility but can lack cost control, leading to potential budget inflations.
Guaranteed Maximum Price
This sets a ceiling on the cost. While the contractor absorbs overruns, savings under the maximum can be shared between both parties.
Design-Bid-Build
Clients manage two separate contracts in this traditional model: one for designing and another for building. It’s transparent but can lead to delays.
Design-Build
A unified contract for both design and build. It offers time savings but can cause design compromises.
EPC (Engineering, Procurement, and Construction)
This comprehensive approach has the contractor manage every aspect. It offers simplicity for the client but also places significant risk on the contractor.
PPP (Public-Private Partnership)
This collaborative model shares risks and benefits between public and private entities.
T&M (Time & Materials)
Costs are determined by labor time and materials used. It’s transparent but lacks cost certainty.
Target Cost Contracts
Both parties share cost savings or overruns around a target cost. This can encourage efficiency.
Alliance Contracts
A ‘win-together, lose-together’ model promoting collaboration and transparency.
A Glimpse Into Their Trade-offs
Considering the trade-offs in contracting models requires a balanced approach, much like weighing the scales of risk and reward. It’s essential to not only gauge the immediate benefits but also anticipate potential pitfalls, ensuring that the chosen model aligns with both the project’s objectives and the inherent uncertainties it may face.
Deciphering the Core Tenets of Negotiation
Unpacking the key elements of a negotiation is akin to peeling back the layers of an intricate puzzle. Each component, from defining the scope to setting performance benchmarks, must be meticulously dissected, understood, and agreed upon.
This not only ensures clarity and alignment but also fosters trust, setting the stage for a collaborative and mutually beneficial relationship.
Scope of Work: Picture a roadmap. Without clear paths and destinations, you’ll either meander endlessly or hit a dead end. The scope of work is that roadmap — outlining the journey’s specifics.
Change Orders: It’s akin to rerouting midway on a trip. A clear process needs to be in place to adjust the course without losing the journey’s essence.
Risk Allocation: Every adventure has its challenges: harsh weather, unexpected detours. Who navigates through them? Defining risks is like prepping for the expedition’s unknowns.
Payment Terms: Think of it as setting the milestones for a journey. When is each installment due? After a particular leg or at the journey’s end? Clarity here avoids future detours.
Performance Guarantees: This is like assuring the journey will meet its intended highlights. What benchmarks must the contractor meet? And what if they fall short?
Termination Clauses: Not all voyages go as planned. It’s vital to define the conditions under which one can abandon ship or reroute.
Dispute Resolution: Like every journey, there might be disagreements. How are they tackled? Through dialogue, intermediaries, or a more formal process?
Dispute Resolution Location: Where will disputes be settled if they go to arbitration or court? This can have significant implications, especially in international contracts.
Liabilities and Indemnities: If a journey goes awry, who bears the responsibility? Who shoulders the weight of unexpected events?
Warranties: Assurances that the path taken will hold its promise. How long is the work guaranteed for, and under what conditions?
Warranty Retention: Holding back a portion of the payment until the warranty period expires can be an effective way to ensure the contractor addresses any post-completion issues.
Intellectual Property: In any endeavor, the methods and innovations used can hold immense value. Who gets to claim them?
Intellectual Property Licensing: Beyond ownership, if there’s shared IP, how is it licensed? Are there royalties involved?
Incentives and Penalties: Beyond basic performance guarantees, you can structure incentives for early completion or exceeding performance metrics and penalties for delays or subpar performance.
Force Majeure: These are unforeseen events like natural disasters, wars, or pandemics. How are these handled? Who bears the risk? Clearly defining ‘force majeure’ events can help mitigate disputes during such circumstances.
Limitations of Liability: Establish caps on liability. For instance, a contractor’s liability might be limited to the value of the contract or a predetermined amount.
Confidentiality Agreements: Especially relevant when proprietary technology or methodologies are involved. Both parties might need assurance that sensitive information remains protected.
Escalation Clauses: In long-term contracts, especially, there can be provisions that account for inflation or increased costs over time.
Subcontracting Clauses: If the contractor plans to subcontract some of the work, this needs to be addressed. What’s the approval process? How is quality maintained?
Insurance Requirements: Specify the types and amounts of insurance the contractor must maintain, protecting both parties from potential risks like accidents, damages, or lawsuits.
Hidden Strategies for Negotiations:
Understand the Other Side
It’s essential to understand the other party’s pressures, motivations, and constraints. This can reveal opportunities for win-win solutions.
Silence is Golden
Don’t rush to fill the silence. Often, letting the other party speak first or elaborate can give you valuable insights.
Best Alternative to a Negotiated Agreement (BATNA)
Always have in mind what your next best option is if the negotiation falls through. This helps in setting boundaries and knowing when to walk away.
Non-Monetary Perks
Sometimes, offering or asking for benefits that don’t directly impact the contract’s price can lead to favorable outcomes. This could be training, longer maintenance periods, or first rights on future projects.
Build a Relationship
Negotiation isn’t just transactional. Building rapport and trust can lead to smoother negotiations and better long-term partnerships.
Incremental Negotiations
Instead of trying to agree on everything at once, break it down. Secure agreements on smaller points, building momentum and goodwill.
Remember, the art of negotiation is as much about psychology and relationship-building as it is about the nitty-gritty of the contract. Being prepared, understanding both sides, and approaching the process collaboratively can yield better outcomes for everyone involved.
Lessons from the Frontlines:
The Channel Tunnel (Rail and Transit, Europe)
Initially projected at £5.5 billion, this tunnel connecting the UK and France saw costs surge to £9 billion. The fixed price model used led to massive losses for the construction firms and numerous legal disputes.
Muskrat Falls Hydroelectric Project (Energy, Canada)
Estimated initially at CAD 6.2 billion, the project’s costs escalated to CAD 12.7 billion due to unforeseen challenges. The guaranteed maximum price contract here didn’t prevent the ballooning costs.
The Big Dig (Infrastructure, USA)
A massive project that rerouted Boston’s Central Artery into a tunnel. Initially costing $2.8 billion, the Design-Bid-Build model saw expenses rise to $15 billion due to design changes, delays, and unanticipated conditions.
Roy Hill Iron Ore (Mining, Australia)
The initial cost was set at $10 billion. However, the EPC contracting model saw cost escalations due to complexities and delays, pushing the final expenditure further.
California High-Speed Rail (Rail and Transit, USA)
Originally priced at $33 billion, costs have since jumped to over $80 billion. PPP contracting was used, but land acquisition and technical challenges saw budgets soar.
Berlin Brandenburg Airport (Infrastructure, Germany)
With an initial budget of €2.83 billion, costs spiraled to over €7 billion. A mix of fixed price and Design-Bid-Build contracts led to delays and financial overrun.
Gorgon Gas Project (Energy, Australia)
Initially projected at $37 billion, this LNG project saw its costs jump to $54 billion due to logistic challenges and scope changes, despite using the EPC model.
Crossrail (Rail and Transit, UK)
In Europe’s heart, the UK’s ambitious Crossrail project set its sights high, aiming to bolster London’s rail capacity. But even the best-laid plans can face hurdles. Originally budgeted at a hefty £14.8 billion, costs surged to more than £18 billion by 2021. The choice of the Design-Build model didn’t offer the expected smooth sail, with software hitches and the intricate dance of integrating multiple systems causing both delays and budget overflows. Yet, when completed, Crossrail promises to stand as a testament to London’s commitment to transit evolution.
Ichthys LNG Project (Energy, Australia)
Australia’s Ichthys LNG Project set out with grand intentions and a projected budget of $20 billion. But the energy landscape can be unpredictable, leading to final costs rocketing to around $34 billion. Opting for the Cost Plus Contract, the project felt the weight of mounting technical challenges and an ever-evolving scope. The overrun might have been a blow, but the project now serves as a cornerstone of Australia’s gas export gameplan.
Edmonton Light Rail Transit (LRT) Expansion (Rail and Transit, Canada)
The city of Edmonton in Canada embarked on enhancing its transit infrastructure with the LRT Expansion. Initially, the CAD 1.8 billion project seemed under control. Still, with the T&M (Time and Materials) contracting method, labor and material costs posed significant budgetary challenges. Despite these hurdles, the LRT system has emerged as an emblem of Edmonton’s vision for enhanced urban mobility.
Future Growth Project — Wellhead Pressure Management (Oil, Kazakhstan)
The Future Growth Project aimed at spearheading the country’s oil strategy. A project that began with a $37 billion budget soon saw costs nudging to approximately $45 billion. Entrusting their hopes with the Alliance Contract model, both parties shared the risks. Still, the project wasn’t spared from the intricacies of supply chain and technical disruptions. The journey was rough, but the project remains a pivotal force in Kazakhstan’s oil landscape.
A14 Cambridge to Huntingdon Improvement Scheme (Infrastructure, UK)
The UK, with its legacy of groundbreaking infrastructure, added another feather to its cap with the A14 Cambridge to Huntingdon Improvement Scheme. Predicted at £1.5 billion, the project turned heads by completing at £1.3 billion. The Target Cost Contract model, which underpinned this venture, incentivized efficiency across the board, turning this into a shining example of how strategic contracts can indeed lead to project savings.
Navigating Forward
With the turbulent waters of global capital projects, the fixed price contracting model might appear a dated approach. The case studies illustrate that no single model offers a panacea. Instead, a deeper understanding of each project’s nuances and a bespoke contracting model might be the way forward.
Today’s infrastructure challenges demand a balance between risk and reward. As the world moves forward with ambitious projects, may the lessons of the past pave a smoother road ahead.
