Creating Sustainable Resilience In Long Term Investments
(A challenge shared by hard hats and geeks)
By Suhrita Sen and Dan McClure
It’s hard to build something substantial that’s durable enough to last a long time. It’s harder still to create an ecosystem of actors, resources and business models that supports the continuing use and evolution of such big investments.
Long term assets are only valuable if they continue to serve the ongoing needs of their users. This is true of any investment, whether it’s a highway serving commuters trying to get home from work, or enterprise software application serving business executives trying to survive in a competitive marketplace. Major investments are made in assets specifically because they are expected to deliver strategic value for many years.
That promise of long term value is simple to make when the programs are just plans on a drawing board. There are indeed long term benefits to well-conceived upfront investments in assets. Yet, in a world where both the frequency and scale of change is accelerating, how do organizations manage these investments to continue delivering value? Fundamental changes in stakeholder priorities, new technologies, shifts in demographics, or new social behaviors all have the potential to cascade through an asset’s supporting ecosystem. Keep in mind that just 20 years ago, there was no Internet. If viable self-driving smart cars enter the market, what happens to the assumptions underlying investments in transportation, technology, energy, safety and security?
Creating resilience in a changing world requires embracing a healthy mix of prescriptive and adaptive processes. The prescriptive ones can be predicted and controlled based on our historical experience, the adaptive ones cannot be predicted and hence have to be shaped collaboratively within an acceptable framework. Fortunately there are tools at hand for this work. Resilience can be provided through the way the program is managed, the way the actual assets are designed, and how funding/financing and contracts are handled.
We get an added advantage from looking at two different industries, physical infrastructure and business technology, that are facing the same underlying issues. Some of the following strategies are applied in both fields, others are still dominant in one or the other; however, they all address the root challenge of sustaining the viability of complex long lived assets in a changing world. In the end, the goal is to support a complex ecosystem of people, assets, functions and finances that are responsible for making sure the big investment continues to deliver value over time.
A First Step: Align Incentives Across Functional Responsibilities
Sustainable resilience of an asset’s entire support system consisting of various functions like design, construction and operations, is key to the strategic value of any long term investment. The first challenge is the historical tendency to break these programs up into sequential phases. A waterfall of different contractors, each performing one step in a sequential process, designs, builds and maintains the asset. In this fragmented arrangement there is a natural incentive for each participant to optimize their work around their own self interests, pushing costs and problems down the road.
To counter this every-man-for-himself calculus, there has been a steady move toward a more holistic approach for creating long term assets. In the case of public private partnerships (P3s), public infrastructure projects combine the design and construction of physical assets with their ongoing maintenance and operation. We celebrate this as ‘life cycle costing’ or ‘bundling’. Combining the stages of development and the subsequent operation under one party aligns the incentives across the entire program.
Under P3’s no one participant gets to save at the expense of someone else. When work moves from a model of highly fragmented specialists, to an approach that combines the key phases of development under one team, an engineer may no longer simplify their work up front at the cost of someone else’s additional design time and effort during construction. Likewise shortcuts in materials and craftsmanship during construction may lower the cost to develop an asset but the strategy isn’t profitable if that later pushes up the cost for maintenance. With the right alignment of incentives over functional responsibilities, cost saving innovative acts can be induced.
Similar issues exist in software technology development where short cuts in design and development can materially accelerate the delivery of software system, but increase the cost of future support. This “tech debt” quickly accumulates like a series of makeshift highway patches, until the system is effectively beyond the possibility of support and repair. Full lifetime ownership of technology allows intelligent ongoing tradeoffs of efforts that reduce tech debt against their own future savings.
While it may seem that technology changes quickly and therefore is naturally built for frequent replacement, this is not true for some of the biggest technology investments. Large long term assets that provide the foundation for business operations exist for years. It has been decades since any new system was written using COBOL a software language originally developed in 1959, but IBM estimates that over 200 billion lines of this antiquated code are still in use[i]. Since these big strategic systems can cost billions of dollars to replace, there is little appetite for throwing them out with each new shift in the world around them.
The Second Step: Align Incentives Across Time, In The Face Of Change
Even with a single responsible party, there must be an additional premise; incentives must be aligned over time. The financial model takes this as far as possible by quantifying the known knowns and anticipating the known unknowns. The return on investment is calculated assuming that the present and the future will play nice.
Yet changes happen over time. The business models of even committed vendors can become deeply dysfunctional when its fundamental assumptions are invalidated by a changing world. And in the absence of a decision mechanism to find equilibrium, opportunistic behavior surfaces.
Statistics reveal that many P3 contracts have been renegotiated to a new equilibrium (mostly to the private parties’ advantage) globally. But, when a long term contract is renegotiated, the premise that the short term is on equal footing with the long term is fundamentally violated. It is also a violation or failure of the sanctity of the bid and award process, which is the public sponsor’s primary responsibility (tax payer’s monies) in a P3 process. While weaker institutional frameworks and lack of public sector foresight resulted in many of these challenges, it is fundamentally difficult to align incentives over time. Can the bid and award process that extracts a fair market pricing through a competitive process today be fair in a variable tomorrow? When considering long term contracts for long term assets, should the impact of changes be adjusted to restate the promised equilibrium or restate a new equilibrium? How will we define fairness tomorrow?
When considering long term contracts for building and operating strategic assets, the fundamental big question becomes, can we really make iron clad contracts and irrevocable decisions in the face of uncertainty? The problem with the intent to contractually lock down the impact of change is that it is still impossible to prevent the source of the new and novel change. The world changes regardless of the lawyers best efforts. While radical change may not be the daily norm for large assets like highways, ports, airports and enterprise software, when it does occur the effects are deeply disruptive in unpredictable ways. More importantly, incremental changes in our worlds create new business contexts that generate obsolescence in existing business structures; which if not managed well, will eventually lead to discontinuity.
The solution cannot be to resist change or even anticipate it with ever more rigorously designed structures. With each failure, while it is possible to add new criteria to the agreement, each addition creates the need to manage conflicting risks, and bloated contracts end up reducing flexibility in the name of containing risk.
Several years ago Dan had the opportunity to observe a large global manufacturer as it made a strategic move to consolidate its software development and support operations under one very large contract. It was awarded through a bruising bid process and seemed to align with the goal of bringing ownership of long term assets under one provider. Unfortunately, as the global software market rapidly matured the underlying assumptions that high quality, low cost technology talent would be available were invalidated, as growing worldwide demand stressed even the large resource pools of India and China. Facing a financial no win situation, the vendor began delaying work and escalated the scope of small tasks to make up for an untenable financial reality, effectively freezing the software development of key technology initiatives. There was little hope in holding the vendor’s feet to the fire. The world in which the original contract was negotiated no longer existed.
The following structural features leverage contractual white spaces to create resilience:
Delay Irrevocable Decisions: Delay irrevocable decisions until uncertainty is reduced. If undertaken with care, and aided with an appropriate governance process, such just-in-time decisions can mitigate risks and manage complexity. For project risks that are fully retained by the public sponsor, ‘Compensation’ clauses in Project Agreements provide the opportunity to make new decisions or alter decisions in the face of complexities and changed circumstances. If these retained risks (like environmental, unknown ground conditions or right-of-way acquisition) alter the time or cost of delivery of the project, a ‘compensation’ or price is paid for the deviance. ‘Termination for Convenience’ and ‘Extended Force Majeure’ clauses are also examples of provisions for exercising flexibility. These contractual white spaces can be utilized in changing circumstances and can be nested to fit within the broader contractual equilibrium. For sponsors, these generate contingent liabilities for fiscal accounting purposes and should be managed accordingly with separate fiscal provisions.
Replace Prescriptions with Options: Agreements that reduce choice over time, undermine future options like new public policies or strategic responses to changing conditions. Creating options and alternatives with a price for participation, is a useful solution to the problems of inflexibility. An appropriate combination of prescriptive and adaptive processes is key. However, such flexibility cannot be a synonym for opportunistic behavior. Adaptive choices need to be monitored to assure that there are a) no additional benefits to either party to the transaction; and b) no reduction in the developer’s overall incentive to enhance efficiencies and contain life cycle costs. ‘Financial Model Adjustment’ clauses in Availability Payment P3 Agreements may revert to ‘No better — no worse’ positions, on key financial metrics for restoring the original equilibrium between parties. Cost benefits that accrue from refinancing or innovative construction means and methods may also be shared in a predetermined manner to incentivize parties to the contract. Big ticket items may be competitively bid instead of bilaterally negotiated. Variable term contracts are good options for assets with demand risks — the contract term remains variable until the revenue required to achieve base case IRR is achieved; always making sure that the rate of return does not exceed the actual level of market risks encountered. Demand risks are better shared than allocated.Management of a long term process and partnership also merits additional thoughtfulness and sophistication around some not so uncommon issues:
Reward Innovations in Resilience: Every complex system has its own risks and vulnerability to change. Recognize the value of building in resilience into the structure of the project. Integrate this approach in the upfront strategic planning for the project, as well as use evaluation criteria that encourages resilient thinking in bids. Evaluating and selecting bids for best value will reward innovations in resilience.
Risk Management: Theoretically, contracts protect all parties optimally and provide an allocation of risks that incentivizes project engagement. However, risks are merely allocated and transferred to the party that (theoretically) has the best experience of mitigating them. They do not go away. For example, many construction risks may be structurally impossible to mitigate because of the complex mix of exogenous and endogenous challenges that are inherent in the industry. Financial security packages are merely a buffer for the lender, and are activated when the risks have already realized. As a result, active prevention remains key — irrespective of the assigned party’s ability to mitigate risks, the approach to designing and building long term assets should work so that they are not realized in the first place.
Expect to Be Fair: Long term resilience in a changing world ultimately requires the collaboration of multiple stakeholders. Adversaries make poor agents of resilience. While protracted disputes may be possible around unforeseen change, the more effective approach will be for all parties to play for a win-win outcome. An appropriate governance system should strive to actively collaborate on delivering business value by continuously aligning contractual and working incentives in new contexts. Fair long-term outcomes need resilience, and resilience requires fairness.
The Final Step — Build Resilience into Design Solutions
Long-term assets with extended service lives inevitably exist in unpredictably variable environments. To expect otherwise is wishful thinking. These assets need a design model that allows investment in resilience, anticipating the inevitability of change in both the use and operation of big investments. Rather than being surprised by change, the ability to adjust, adapt and respond must be part of the original approach. Such long term robustness can be designed explicitly, such that the asset can flourish:
Actively Learn and “Pivot”: The desire to lock everything down up front not only forces unnecessarily early decision making about the design of the asset, it abandons the opportunity to learn and adjust as the program progresses. In technical product innovation there has been growing use of an approach labeled “Lean Product Innovation”. This methodology makes learning and responding to change a part of the ongoing design and construction strategy. It asks the teams designing and constructing the asset to intentionally measure performance on an ongoing basis, ask questions about use and effectiveness, and leverage these insights to pivot the design and construction from the original plan.
Delay Engineering Choices to Last Responsible Moment: In the same way that irrevocable contractual choices can be differed, resilience in the asset design can be improved by delaying key design choices “until the last responsible moment”. In technology, this means the point at which key foundational choices must be made in order to support the rest of the design process. This strategy of delaying design choices not only responds the challenge of handling change, it also provides a way of dealing with the uncertainty of known unknowns and unknown unknowns.
It might seem to be that this strategy has limited application in concrete infrastructure projects, but there are big and small examples of where this isn’t true. Building large highway projects in phases, assessing demand with a limited number of lanes initially and then adding additional lanes or even mass transit in response to demonstrated demand helps delay key engineering choices until more real world information is available.
Leverage Flexible Architecture: The variety of potential changes to a design is staggering. Trying to plug the dike in every possible way is hugely expensive. Technologists have tried to do this in the past with big powerful applications that could respond to any kind of change. The systems provided flexibility, but ended up costing a staggering amount to build and maintain. As a result, looking for cheaper forms of flexibility has been a major focus of technologists in recent years.
Modular design has become a favored approach. Modular designs enable different elements of a technical system to be swapped in and out without re-architecting the entire approach. Increasingly, new technology developments are creating a counterpart for this strategy in the world of infrastructure development. Historically, electrification of rural areas was a hugely expensive effort that required extending the electrical grid through new right of ways. More power required a bigger grid. Today, with smart grid technology and the development micro power generation options, it becomes possible to expand the availability of electricity by adding small distributed power sources where they are needed rather than building up the backbone of the power grid. In developing countries, self contained rural solar power systems can jump start electrification with small local investments.
Make the Case for the Cost: Like anything else of value, resilient engineering options come at a cost. A program with greater flexibility may require higher levels of sponsor equity or funding. Often times, the cost for building this resilience, will be incurred early in the design and development of the program, far from when the threat of change will be felt. To make this a rational investment for the project sponsor, it will be imperative to know that any easier outs are denied them. The case must be made that there is ultimately no avoiding immediate costs of preparing for an uncertain future.
Sharing Insights to Master Resilience
Historically organizations have invested large sums in assuring compliance. Similar commitments need to be taken to developing a capacity to manage resilience. It takes tremendous experience and expertise to know which options and decisions to keep open; and an acceptable timeline for taking those decisions, without jeopardizing project outcomes.
This is a complex challenge is rooted in the very nature of long-term assets that operate in a changing world. Major infrastructure programs with decades long operating lives fit this category, but so do many technology projects. Seeing this as a broad issue allows us to step back from the details of a particular business domain, and recognize the shared patterns. This in turn enables us to look for a theory of action that is rooted in an understanding of the underlying problem. It’s a case where road builders and software developers may be able to help each other see more clearly what is at the heart of the challenge of building for change.
Authors from Different Worlds
Suhrita Sen is the Founder and Principal of Infrastructure Advisors LLC, where she is engaged in advising global clients in all stages of infrastructure project development, finance and management. With 25 years in management consulting, she specializes in solutions at the intersection of financial, technical and commercial matters.
Dan McClure is the Innovation Design Practice Lead at Thoughtworks, and international software consultancy, where he is at the forefront of developing original services that unite business, design and technology. Dan specializes in disruptive original ideas and agile execution.
©2016 Suhrita Sen, Dan McClure. All rights reserved.