Is unfair risk allocation really to blame?

Bell Gully | View firm profile

The purpose of this article is to test whether the current state of the industry has primarily resulted from a collective failure to fairly allocate risk, or whether other factors are also culpable to a greater or lesser degree.

In the first article​ of this series, we examined the concept of fair risk allocation in construction contracts. Aided by the views of our panellists, we concluded that the theory that risk should be "allocated to the party best placed to bear it" does not automatically create fair risk allocation in practice. 

To achieve objectively fair risk allocation, it is necessary to move beyond a blanket application of the Abrahamson principles and look at risk allocation project by project in a realistic, transparent and informed way.

Given the current dynamics at play in the market, this necessarily requires a resetting of behaviours. There are some good initiatives that are already underway in this space.

The purpose of this article is to test whether the current state of the industry has primarily resulted from a collective failure to fairly allocate risk, or whether other factors are also culpable to a greater or lesser degree. This is particularly pertinent because of the sharp focus on risk allocation in the current public debate about the state of the construction industry.

What is the current state of the market?

Perhaps if anything to do with the construction market is beyond contention, it is that the industry is in a poor state of health, characterised by failed projects, delayed projects, insolvent contractors and unpaid subcontractors. A lot of the pain has been felt by those in the middle of the market: Ebert Construction, Arrow International, Accent On, Corbel Construction, Stanley Group and others. To the outside observer, there is an obvious question: how can this be happening in what appears to be a bull market? There is clearly more than enough work to go around and basic economic theory suggests that demand should equal profit.

The pain is not isolated to the vertical building market. In the infrastructure sector, David Jewell, director and owner of BondCM, observes that “while the failures in the commercial building sector have in some instances been high profile, there are signs of trouble in the infrastructure sector as well, albeit less visible. Many large civil projects are currently failing to meet their financial targets, and while there is no current evidence that the construction companies themselves are failing, these project losses and overruns are of concern to clients and contractors alike."

Interestingly, similar dynamics are being experienced across the ditch in Australia. Krista Payne, partner at global law firm Ashurst, notes that in spite of the record levels of government commitment to infrastructure spend, it is still difficult for some contractors to turn a profit. “There is much talk about a "profitless boom" and some of the big players are losing money on key projects", says Krista. “This outcome is seemingly counter-intuitive as the volume of work should mean there is plenty of work to go around, which should reduce competition and enable contractors to price work at a higher level to when there is only a handful of projects in the market."

Of course, not all market participants fare the same when presented with similar market conditions explains Craig Wheatley, head of legal at HEB Construction. “Yes, we have seen some high-profile projects run into trouble, but there have been many more medium to large jobs that have gone very well. In Auckland for instance, with the CRL group of projects many contractors and subcontractors are experiencing periods of unprecedented growth. What can't be denied though is that we are seeing higher than average rates of SMEs in the construction industry struggle."

Is it all down to unfair risk allocation?

Undoubtedly principals have successfully sought to allocate considerable project risks to contractors over the last decade or so. Combine this with a predisposition on the part of many principals to favour lowest price bids and it is unsurprising that losses are being realised at all levels of the contracting chain. “In the last decade we have seen main contractors presented with extremely onerous provisions by both public and private clients," says Craig. “This has often led to some of those risks being passed down to parties ill-equipped to handle them (like small subcontractors and suppliers) and we have seen some disastrous consequences arising from that."

A similar view is shared by Glen Heath, CEO and general counsel at Mansons TCLM: “I think unfair risk allocation is one of the biggest contributors to the poor current state of the New Zealand construction industry. And banks, head contractors and developers are all to blame. Head contractors create the expectation in developers that the developer can get these developer-favourable terms (because they've all been agreeing to them!), developers can't resist the natural temptation to take the best terms on offer regardless of the wider impact on the specific project or subsequent projects (which are affected if contractors fail), and banks actually insist on such terms as a condition of the development funding."

For all the rhetoric in the market about principals (and, in particular, public sector principals) being responsible for unfair risk allocation, risk allocation is not effected via a unilateral process. A construction contract allocates a risk to a party by making that party responsible for particular consequences which arise if that risk eventuates. But that allocation only becomes effective once a party accepts the risk by executing the construction contract and binding itself to the terms of that contract. Simply providing in a construction contract that a party to a contract will be responsible for the consequences of an uncertain event arising does not of itself create manifest unfairness.

In the world of commercial contracting, where considerations of undue influence, duress, unconscionable conduct and the law of consumer rights are generally absent, it is incumbent on each party to make sure it properly scopes and understands each risk allocated to it. A prudent party should only accept a risk if it accepts the consequences of that risk on an informed basis. If the commercial drivers of a party are such that it is willing to accept an unwise risk allocation, it does not wash to later point the finger at the counterparty. Primacy has to be given to self-accountability.

Of course, if a significant number of project sponsors are only ever prepared to contract on terms which are essentially 'risk free' it will force the hand of the contracting market – either bid on our terms or do not bid at all. Contractors depend upon winning construction contracts in order to generate revenue and derive profit (in that order). In turn, subcontractors depend upon the main contractor to win contracts in order to award subcontracts and so keep the entire contracting ecosystem alive. If a contract is awarded primarily on the basis of price, then this amplifies the potential for greater loss to be passed through. Risk and loss wind their way hand-in-hand down the contracting chain.

In this environment, better quality contractor participation in contractual negotiations and increased rigour in the assessment and acceptance of risk by contractors at all levels is critical. Smart principals are responding in kind, recognising that building a trusting relationship with the contracting market is a must if they want a successful project now, or to have successful tenders in the future. Arguably (and hopefully) the penny seems to have dropped that what needs to change is collective market behaviours and dynamics which have allowed, and indeed fostered, poor practice around risk allocation.  

Insufficient profit and poor pricing practices

In its recent report on NZS Conditions of Contract, the Infrastructure Transactions Unit highlighted a perception in the market that the public sector does not properly understand the difference between lowest value and value for money procurement. The report notes the existence of a “lowest price culture", leading to “the cost of transferring the risk to the contractor being discounted when assessing tenders."

An unhealthy emphasis on lowest cost procurement is not isolated to the public sector. Perhaps the most telling perspective is that offered by Glen. “At Mansons, we are both the developer and the head contractor," he explains. “There is no way we would contract to deliver a project for another developer – the head contractor's margins do not justify the risks the current market expects the head contractor to absorb."

Over the last few years Bell Gully has advised on or negotiated standard form-based construction contracts with a collective contract value of more than $2.5 billion. These contracts range across public and private sector projects, and utilise different standard form conditions of contract. This has given us a wide perspective on the rate of recovery of off-site overheads that is being achieved across the market and for different asset types. Although we have seen off-site overheads exceed 10 per cent of the contract price in some isolated instances (and noting this is arguably reflective of a premium being properly priced for risk acceptance), the average remains well below that at circa 5-6 per cent of the contract price. Take out the actual cost of off-site overheads and most contractors will tell you that actual profit is closer to 1-2 per cent of the contract price. Whatever your view is on what constitutes a reasonable return, such slim margins are obviously a questionable consideration for the level of risk being accepted by contractors. It does not take much for any 'profit' to disappear into a loss.

As with the issue of fair risk allocation, to properly understand the reasons for loss of profits and insolvencies in the current market, it is necessary to look beyond lowest cost procurement towards inaccurate pricing and poor cost modelling. David points out that in the infrastructure sector, one of the key factors leading to underperformance and loss is inadequate risk valuation, arising from a lack of understanding of the nature and extent of the risk exposure, and amplified by “optimism and the desire to win".

A similar comment is made by Glen in the context of the vertical build market. “It is as simple as head contractors committing to fixed price and tightly programmed contracts, then finding their expectations of subcontractor pricing and availability are being exceeded due to the excess demand over supply in the industry. Those costs are absorbed by the head contractor, who see their relatively small margin quickly disappear leading to solvency issues for themselves and eventually and by definition their subcontractors."

Krista explains that “there have been a number of examples where head contractors have not sufficiently locked in their subcontractors and pricing" in the Australian market. “Given the heated market, the subcontractors have then found themselves in a position where they can push for bigger margins or better terms when the bid is won because there is a shortage of supply."

A house of cards

Even with best practices in place, there will inevitably be project losses that need to be absorbed by market participants. Tight availability of bank funding aside, there are relatively few stories of principals unable to pay contractors. A rise in availability of mezzanine lending has helped. These days we rarely, if ever, see a principal's bond being required under a construction contract.

On the flipside, many contracting businesses are being run on a low-equity model. When profits exist they are largely being taken out of the company. With margins tight, the popular strategy appears to be to win as much work as possible with a view to creating greater revenue and spreading out risk – the notion being that a loss on one project can be absorbed by the profit on another. Suffice to say, liquidators are kept busy when that strategy does not work as intended.

In 2014, the Queensland Government introduced a minimum financial requirements licensing regime. It requires certain contractors to satisfy minimum financial thresholds, including net tangible assets, based on the value of the work they are undertaking. Satisfying these requirements is a pre-requisite to obtaining a licence to carry out building work. The information that must be provided depends on what category the contractor falls into. There are nine categories based on annual turnover ranging from AU$200,000 to AU$30 million. Contractors with maximum annual revenue greater than AU$30 million are also required to report any decreases of more than 20 per cent in net tangible assets.

Whether or not such a regime would work in the New Zealand market is the question. It has been suggested to us that if a similar regime were introduced here there would only be three contractors left in the market. But it is clear that greater financial integrity would in turn create greater resilience to project losses. We understand that the Registered Master Builders' Association is already looking at a certification scheme that would set minimum financial and competency standards for companies to meet if they want to win jobs above a certain value. Conceivably, for such a regime to succeed in achieving minimum levels of equity and competency, it would need to stretch across the construction industry, capturing both tier one contractors and small subcontractors alike.

You can only work with what you have

There is no doubt that a shortage of skilled labour and a constrained supply chain are both impacting on the fortune of individual projects as well as the health of the industry as a whole. “Poor performance by a contractor is most often a function of staff capability and experience," explains David. “An inability to source appropriately skilled staff when needed leads to poor execution of the works due to a lack of skilled staff."

At Bell Gully's 2018 construction panel event, the panel members unanimously agreed that there needed to be greater policy incentives towards learning of trade qualifications. The point was also made that, as a society, we need to move away from the perception that a trade qualification is somehow subordinate to a professional tertiary qualification.

Sharing his perspective from more than a decade working within New Zealand construction companies, Craig agrees. But he points out that this is just one of a number of factors: “It is difficult to attract top construction talent to New Zealand projects, including project directors, construction managers, engineering managers and others. I have heard many reasons put forward for this – from the cost of living in New Zealand being a barrier to overseas talent to a lack of focus here on training people to have careers in engineering or the trades. Failing to recruit the right people to complex projects means that those projects are likely to struggle right from the start."

Of course this issue is not exclusive to New Zealand, but when we look at the experience in Australia it is apparent that all resourcing will be squeezed even further as demand rises and more complex and consuming infrastructure projects come to market. “There are various examples in the media of contractors referring to labour shortages and constraints around materials," explains Krista. “This has resulted in contractors being very stretched and perhaps not resourcing projects in the same way. Combined with the fact that there are many 'mega' projects in delivery and procurement, and the size of these projects necessitate that only a handful of big players can take the balance sheet risk, creating further resource constraints."

What is the basis for investment?

It is, of course, one thing to advocate for greater retention of equity in the industry and greater investment in resources, but for that there must be a basis for investment. Contractors cannot be expected to leave profit in their businesses or to invest in resources in the absence of any degree of certainty around future revenue-making opportunities or any policy support.

Much has been said recently about the need for certainty around the timing and scope of future public sector projects. “A lack of coherent planning at government level – or rather, the lack of a real opportunity to plan coherently – is one reason for the disjointed state of our industry at present," Craig explains. “New Zealand's three-year election cycle doesn't help with this. We can have one government whose infrastructure focus is on large public transport projects like rail or light rail replaced within three years by one who prefers to invest in large national roads (or vice versa). Then after three years the pendulum may swing again." He says that “this creates a 'jumble' of projects and often competing priorities which can discourage participation and investment from those parties who are best suited to assist."

The establishment of a pipeline of anticipated government infrastructure projects by the Infrastructure Transaction Unit is a step in the right direction. It could help provide those in the industry with the confidence needed to invest, and may also smooth over some of the disruption caused by the short-term electoral that Craig identifies. The pipeline needs to be further developed and its success is contingent on public sector agencies adhering to it. Without that, it is unrealistic to expect industry to rely on pipeline commitments and to invest on the basis of them.

Holding ourselves to account amidst a complex web of factors

To seek to pin the woes of the construction industry exclusively on unfair risk allocation in construction contracts is itself illustrative of the actual fundamental problem: poor market behaviours characterised by adversarial dealings, short term self-interest and a lack of self-accountability. The underlying issue is not the allocation of risk, but rather the consequences of those risks not being properly understood or properly priced but nonetheless accepted time and time again. The challenge, as we identified in our first article, is resetting market behaviours across the board: holding ourselves and each other to account so that this is no longer the norm.

The other challenge is to shift the dial on the current debate. We need to move away from claims that a theoretical notion of fair risk allocation has been transgressed – including by the modification of standard form conditions of contract – to meaningful conversations about what else is wrong and how might we fix it. This is not to discount the need to devise efficient ways in which risk can be allocated on a basis which is transparent and objectively fair, but rather to recognise that will not be a silver bullet. Craig puts it particularly well: “As with many things, there is a web of interconnecting reasons behind the struggles our industry is facing. All levels of our sector (from the highest levels of government to tradespeople) are caught up in it in some way. We mustn't discount unfair risk allocation, and I do think that it is more culpable than other factors for the current state of the industry, but it is by no means the only reason."

David shares a similar view, reiterating the earlier point that much rests on accountability and acceptance. “The reasons for the under-performance of projects are complex. It certainly can't be attributed to inappropriate risk allocation on its own," he says. “In fact, many of the affected projects are being delivered under NZS3910 (largely unmodified) and Alliance agreements where the risk allocation is well known. While it could be that the contractors have undervalued the risks that are allocated to them, it is not the inappropriate allocation that is the issue."

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