Contracts secure the outcome while reducing risk exposure!
The unavoidable dynamics of a project and associated risks.
Every project disregarding the sector is defined by three basic elements: Scope, Schedule and Cost. If one of the three elements fail, the successful outcome of the project is at risk. Historically projects have failed, and such failures have often been accepted by business as a “certain inevitable collateral damage” associated to the complexity or nature of the undertaking. To compensate, executive management has often attempted to inflate costs to cover for losses without recognizing that the organization is becoming less competitive and causing unintentional but certain long-term damage to the organization.
Unless the project is self-performed by the owner, equipment, materials, resources and services are provided by third parties such as vendors and contractors. For example, the design-build of a water treatment plant for a Northwest Canada mining company is contracted to an organization specialized in field of water treatment plants.
After a competitive bidding phase, the project worth of $40M is adjudicated to a EPCM (Engineer-Procure-Contruction and Managment) contractor. The water treatment plant is required to be operational two years from date of adjudication. The system, by then is required to produce 60.000litre potable water every 24h.
For this purpose, the owner will seek to use a well written contract to ensure predictable outcomes and to mitigate risk of failure given there is a budget not to exceed. In addition, if the water treatment plant does not become available on the specified date, the mining operation will not start on schedule incurring additional loses while gradually eroding investors’ confidence.
It seems more than obvious that the owner will seek to establish some form of contract to ensure the outcome of the investment and mitigate risk exposure. Failing to do so would unavoidably end in a catastrophic outcome for the buyer, but more importantly, what about the EPCM contractor, what about its risk?
The EPCM contractor has the highest potential risk exposure within the project environment. Failure of performance arising from its own subcontractors combined with liquidated damages and penalties imposed by the buyer can quickly escalate into a full bankruptcy of the contractor’s organization. The only way to secure outcome and to “shield” the organization from sever risk exposure is through implementing fair high-quality contracts between all parties.
Let’s imagine for instance that the EPCM contractor reached out to a specialized pump manufacturer to provide two main water pumps that should have a guaranteed performance of 50l/min, in range from +5 to +40 degree Celsius at 110psi. The pump manufacturer first overpromised but then underdelivered. The two pumps effectively arrived three months late, and after an extended and painful commissioning phase never delivered more than 45l/min at 80psi. The EPCM contractor had only issued a simple purchase order to the manufacturer and did not implement any contractual limitations and payment terms tied to delivery date or performance. Then the owner also started claiming liquidated damages after the third month of delay both for schedule and for performance aggregating to 15% of the contract value. In this particular case, the EPCM contractor suffered the losses associating with the replacement of the two pumps, the recommissioning, and the liquidated damages due exceeding the contractual finish date with the owner.
All this could have been avoided with ease had there been a clear contract between the EPCM contractor and the pump manufacturer outlining at a minimum:
- Performance guarantees
- Schedule and Milestone dates
- Prices and conditions of payment
- Technical specifications, and clarifications
- Bonding and securities
- Liquidated damages
Summarizing, sever risk arising due performance failure to both the owner and the EPCM contractor can be mitigated through well written and well executed contracts. In addition, projects do have unlimited unforeseen events and changes, in this case the contract can provide clarity and guidance in how to deal with such changes without causing hardship and conflict among the various parties.
To this end, the CCDC which stands short for the Canadian Construction Documents Committee has developed a set of highly valuable and fair standard construction documents and contracts through a consultative process with representatives from all sectors in the construction industry. These documents are well known among both owners and contractors alike and have a high level of acceptance while being known to protect interests of all parties involved.
