Developments in two-stage contracting and early contractor involvement

Is the UK construction industry now ready to embrace a procurement model based on two-stage contracting and early contractor involvement, on the basis that it gives the parties the best chance to properly investigate, assess and manage construction risk on the most complex of infrastructure projects?

Recent experience within the UK construction industry has led project stakeholders, including the UK Government, to question whether the previously widespread use of a single, lump-sum, turnkey contract to procure complex infrastructure assets, via a limited recourse project financing, is in everyone's best, long-term interests.

Those funding or sponsoring such projects have tended to adopt the default position that the use of a single turnkey contract (pursuant to which the contractor accepts global responsibility for the engineering, design, construction, testing and commissioning of the asset) was the only appropriate procurement choice, unless they were unable to find a contractor willing to wrap that risk. Looked at from a purely legal perspective and standing in the shoes of a risk-adverse project sponsor or lender, it was difficult to counsel against such a conclusion.

However, just as it seems that the rest of the world is beginning to embrace the limited recourse project financing models developed in the UK over the last 20 years, the UK is changing direction. While it may not be unusual for the UK to start heading off in a different direction to everyone else, there is perhaps good reason for that change in direction.

There is a perception that significant recent events in the UK (ie the demise of Carillion last year and the difficulties which have led Interserve to exit the energy from waste sector) have demonstrated the potentially disastrous consequences of a single entity wrapping the entire project delivery risk without properly understanding the nature of that risk and making appropriate allowance for it.

As a consequence of this perception, there appears to be a developing consensus within the UK that the client side of the industry needs to engage earlier and better with the whole of its supply chain in order to properly understand and manage the particular construction risks on any given project. Stepping down the whole of that risk to a single contractor who has priced that risk in a highly competitive environment, may no longer be seen as representing value for money (and may be considered unwise in certain technologically challenging sectors).

We believe that this consensus will lead to the more widespread use of a delivery model which has been promoted by the UK Government for some years now. It is based on a standard form contract (the NEC/4 Engineering & Construction Contract) and it entitles the contractor to reimbursement on a "cost plus (fee)" basis. A two-stage tender process (which provides for early contractor involvement (or "ECI") during the initial design stage) and an attendant outturn construction cost incentive scheme are then used in order to:

• interrogate, understand and manage out construction risk before the parties commit to a lump sum or a target price for the second, construction stage; and
• manage the cost escalation risk that is inherent in any "cost plus" contract.

This procurement model has been used and refined by those involved in the structuring of some of the largest and most complex infrastructure projects within the UK over the last ten years, where there was no market appetite for a single, turnkey wrap (eg Crossrail, Thames Tideway Tunnel, Hinckley Point C and High Speed 2).

Structuring a two-stage tender process

Lump sum and/or cost reimbursable?

One of the first procurement decisions to be made on any project is how many principal Works packages there will be and which of the following pricing structures is most likely to deliver value for money for the client:

• fixed price, lump sum, under which the fixed price is only adjusted in respect of agreed compensation events; or
• cost plus, under which the contractor will be reimbursed those costs which it reasonably incurs in carrying out and completing the Works, plus an additional fee to cover its overheads and its profit entitlement, calculated as a percentage of those allowable costs.

Fixed price/lump sum contracts

If the client's basic engineering design solution and technical requirements for the Works can be sufficiently developed prior to contract, so that the contractor can properly define and price the consequent Scope of Work without an undue risk margin allowance, then a lump sum, fixed-price contract may still deliver costs certainty and value for money for the client. In those circumstances either the FIDIC Silver Book or the NEC/4 Engineering & Construction Contract (Option A) would be the most commonly used standard form contracts within the UK.

Cost reimbursable contracts

However, if:

• programme constraints dictate that a significant element of the client's technical requirements for the Works package can only be developed post contract; or
• there is little or no market appetite to accept (or sensibly price):
  
   – the risk of an uncertain or technically challenging design; or
  
   – the interface risk on a multi-contract construction management procurement,

then a cost reimbursable contract is likely to represent better value for money for the client. It may also be the only available procurement option, if there is a lack of competitive tension within the relevant market (something that we are currently seeing within certain sectors of the UK market for the reasons referred to above).

Choosing the correct contract conditions

So, if the client does decide to adopt a cost reimbursable approach for its project, how will it best manage the risk of significant costs escalation to which it will then be exposed? Within the UK, the current consensus is that the NEC/4 (Option C) Engineering & Construction Contract will give the client the best means of doing so. It contains all of the project management tools that are most commonly used to manage the risk of unnecessary costs escalation. While the recently updated FIDIC Red, Yellow and Silver Books do now include some of these project management tools, they do not provide for:

• a two-stage ECI tender process; and/or
• a Target Price pain/gain share incentive regime,

both of which are included as standard Optional Clauses within NEC/4.

Facilitating proactive construction management

It is also commonly said that effective costs management, particularly where the project is to be procured on a construction management basis (ie where the client retains responsibility for managing the interface risk between several different Works packages), will depend upon strong and proactive construction management. So the client will need to give itself the project management tools which it needs in order to properly manage that risk. The NEC/4 conditions of contract do this by:

• only allowing for the reimbursement of "Defined Costs" and not "Disallowed Costs" (thereby encouraging the contractor to be efficient in the management of its supply chain);
• obliging the contractor to comply with a key dates regime, an information release schedule and a site access protocol (thereby assisting the client in its management of interface risk);
• promoting transparency between the parties through the use of a risk register, disclosure of the contractor's pricing contingency allowance and agreement between the parties on float allowance and ownership; and
• facilitating good project management via the use of early warning notices, risk reduction meetings and programme updates.

Some (but not all) of these project management tools have also now been adopted within the 2018 Edition of the FIDIC contracts.

Control of costs escalation under a cost reimbursable contract

Target price incentive schemes

In order to ensure that the contractor is incentivised to work efficiently, in the best interests of the project, those tendering for a "cost plus" contract will usually be asked to bid a target price for the Works. The successful tenderer will then share an agreed percentage of any resultant "pain" or "gain", ie the amount by which the actual outturn construction cost is more or less than the target price bid by the contractor.

Where this type of incentive scheme is adopted, most of the negotiation between the parties will usually concern:

• the list of compensation events that will entitle the contractor to an adjustment to the Target Price;
• the percentages at which and the bands within which any pain and gain is shared between the parties;
• the circumstances in which the fee (ie the contractor's overheads and profit) is not applied to any cost (and is therefore not payable to the contractor); and
• the extent (if any) to which the contractor's pain share counts towards any limit on its aggregate liability under the contract.

The two-stage tender/ECI process

However, a properly constructed, two-stage ECI tender process is likely to represent the parties' best opportunity to (a) reduce their exposure to "pain" risk on a Target Price contract or (b) achieve value for money on a lump sum, turnkey contract (on the basis that asking the contractor to price an uncertain design solution is unlikely to represent value for money).

Pursuant to the Secondary Option Clause X22 (ECI), which is designed for use with the NEC/4 Main Option C Target Contract, the client initially only appoints the contractor for a specified period of time, to undertake a limited scope of design development (Stage One). Thereafter the client will have the option of appointing the contractor to finish the detailed design development and execute the Works (Stage Two).

If properly constructed, this process should enable the client to:

• manage out some of the potential pain share risk by investigating and developing the contractor's proposed design solution during Stage One:
• retain some control over the process by which the design solution is developed and adopted for the project (thereby avoiding the danger of significant reputational damage that could occur if an inadequate design solution is adopted by a package contractor with no interest in the operational performance of the project);
• maximise the opportunities for value, engineering and innovation, thereby minimising both capex and opex costs for the project; and
• integrate design development with construction planning at the earliest possible stage of the project, thereby allowing more time for the parties to plan for critical events and prepare a fully detailed construction programme.

However, the client should also safeguard against the risk of programme slippage and a gradual erosion of its bargaining power as Stage One progresses by:

• including clear programme and Scope of Work requirements for Stage One within the Invitation to Tender;
• including clear programme and Scope of Work requirements for Stage One within the Invitation to Tender;
• providing clearly for the client's right to withdraw from the process without penalty at the end of Stage One (and to proceed with the next best bid);
• requiring agreement on the Stage Two conditions of contract as a condition precedent to the Stage One appointment; and
  
  – maintaining competitive tension within the tender procedure by:
  evaluating change to the Stage 2 Target Price using the competitive pricing information included within the contractor's original bid submission; and
  
  – allowing the contractor to share in any saving between (a) the Initial Target Price included within the contractor's original bid submission and (b) the sum of the revised Target Price fixed at the end of the Stage One process and the amounts paid to the contractor during Stage One (with payment of any such saving held over until completion of the Works and the assessment of any outturn pain share payable by the contractor at that stage).

It should be noted that amendment to the NEC/4 Secondary Option Clause X22 will be required in order to reflect any of the above arrangements. (Most significantly, it appears that the intention of the NEC/4 Secondary Option Clause X22 is to incentivise the contractor to interface effectively with any other package contractors, by entitling the contractor to share in any saving between the outturn costs paid for the whole project and the budget cost for the whole project.)

Alliancing schemes on multi-contract procurements

We find the drafting of the NEC/4 Secondary Option Clause X22 (ECI) strange, given that the NEC/4 Secondary Option Clause X12 (Multiparty Collaboration) is also clearly designed to promote collaboration across different Works packages in order to facilitate the achievement of a common set of objectives set by the client, ie a Project Target Price, a Planned Date for Project Completion and/or the achievement of other Key Performance Indicators.

The scheme is based on three fundamental principles:

• a successful incentive regime depends upon a successful alliance;
• an alliance can only exist where there is consensus; and
• the alliance parties can only be incentivised to achieve an outcome if they are able to influence that outcome by their own performance.

Accordingly, it should be noted that:

• there is no contractor exposure to any Project Target Cost pain or any Project Programme overrun;
• the client has the right to add new incentives to the scheme (or revise existing ones if their achievement can no longer be influenced);
• the alliance is managed by consensus, ie by a Core Group within which each partner is equally represented and decisions are made on a unanimous basis; and
• if any participant wishes to withdraw it may do so without penalty (provided it has acted in good faith).

Clearly, the effectiveness of such an alliance scheme will depend upon a continuing consensus between all of the participants, driven by the collective gain share. It should be noted that, from a legal perspective, the Owner has very little power if the incentive for collaboration no longer exists and consensus breaks down. In such circumstances the client will have no claim against the individual participants (unless they have acted in bad faith).

The NEC Alliance Agreement

The NEC has also published an Alliance Agreement. The intention is that all of the parties to the alliance enter into the Agreement, instead of several package contracts, thereby removing the individual Target Price pain/gain share incentive schemes referred to above.

We are not aware of any project which has used the NEC Alliance Agreement and we have reservations about the dispute avoidance and termination provisions within it; in particular how they will actually work in the event that the incentive scheme breaks down.

However, most significantly, we do not see why the time and expense of negotiating an Alliance Agreement between several different package contractors, who have never been party to such an agreement before, could justify the replacement of a two-tier incentive regime based on:

• an NEC/4 Secondary Option Clause X12 (Multiparty Collaboration) target price gain-share incentive, applied across the whole project; and
• an NEC/4 Option C target price pain/gain share incentive within each Works package contract (which would survive any termination of the project-wide incentive regime).

EPC Feed Agreements

Similar to a contract which provides for a two-stage ECI process, a "front-end engineering and design agreement" or "FEED Agreement" will usually provide for the development of front-end engineering and design proposals, to the extent sufficient to facilitate the obtaining of necessary project approvals by the client and the establishment of an indicative investment cost for the project. The FEED design process will also focus the technical requirements which will comprise the Employer's Requirements for the purposes of an EPC Contract.

The perceived advantages of a properly constructed FEED process are very similar to those of a two-stage ECI tender process. It should:

• enable risks to be properly identified, assessed, priced and mitigated;
• reduce the costs of tendering, as only one design process is undertaken;
• facilitate the achievement of value for money through early contractor involvement in the design and pricing of the Works, on a transparent basis; and
• optimise construction efficiencies and reducing operating costs.

However, to deliver these benefits, a FEED process will usually need to recognise and embrace the following key principles:

• it should facilitate outturn capex savings by an up-front, initial investment in value engineering.
• it should recognise the need for relevant designer technical expertise;
• it should require and facilitate early O&M contractor and other stakeholder involvement;
  
  – the services Scope of Work and deliverables will vary, depending upon the nature of the Works package and/or project; and
  
  – it should recognise the need to provide for whole life project and systems changes/requirements.