Gold Plated Construction Contracts and Gold Plated Prices – Where is the Value for Money?
Updated: Mar 12, 2020
Are GCC governments and government agencies obtaining value for money from public private partnership (PPP) programs? One of the key attractions of a PPP scheme is the fact that the government agency procuring the project is not required to make an up front capital payment for the asset. Instead, the private sector project company constructs and finances the construction of the asset. In return, the procuring agency takes responsibility for payment of the service on a monthly basis over a lengthy period of time. These payment begin on completion of construction and can last as long as 20 to 30 years.
Rather than procuring a power and water plant for US$2 billion or a state of the art hospital complex for US$200 million, the same asset can be procured on an amortised payment basis without significant damage to the government’s balance sheet. The payments over the full life of the project may ultimately be greater than the value of an up front lump sum payment, but the amortization, by definition, spreads the procurement costs, thus allowing the procurement of multiple projects at the same time. Provided value for money can be achieved, the longer term higher costs can be justified.
So far, so good. However, the real question is whether additional value for money can be achieved by passing less risk to project companies and their construction contractors? If that can be achieved, will procurement agencies pay less for PPP projects on the basis that a significant portion of the contractor’s risk premium can be removed from the total cost of the project?
The capital costs of a project derive from the amount that a third party construction contractor will charge the project company. The amount agreed between the project company and construction contractor will be passed into the tariff or unitary charge under the concession agreement on an amortized basis. The contract price of the construction contract will very much depend on the amount of risk the construction contractor assumes under the construction contract. The greater the risk, the higher the contract price. The higher the contract price, the higher the tariff or unitary charge.
The procuring agency will often stipulate, in outline, some of the key risks that the construction contractor is expected to assume. The question is whether contractors are being asked to assume too much risk, particularly were there is, arguably, a remote prospect of the risk materializing.
When the private sector decides to put together a bidding consortium and appoints a construction contractor, there is invariably a tension between the consortium and the construction contractor. The bidding consortium will want to submit a compliant bid with the construction contractor satisfying the minimum requirements of the procuring agency and at the same time quoting the lowest possible price so that the bid is successful. This creates a tension between compliance and competitiveness. The construction contractor will often believe it is being asked to assume too much risk and the bidding consortium will take the view that the quoted contract price is too high. The construction contractor will offer to reduce the price on the basis that the risk burden is lightened, but the bidding consortium will be concerned that a failure to assume the minimum RFP risk requirements will render the bid non-compliant. This creates a real dilemma for the bidding consortium. It wants to satisfy the minimum requirements of the government agency and submit the lowest tariff or unitary charge. The two objectives are mutually exclusive, creating a misalignment and, quite often, a dynamic of mistrust. Even though the consortium’s bid might be successful, the project company and construction contractor run the risk of finding themselves in dispute during the construction period.
The following are five examples where the procuring agencies should ask whether there is in fact a need for the risk to be borne by the construction contractor.
The construction contractor is typically expected to provide forms of security to protect the project company in the event of non-performance by the construction contractor. This typically comprises an advance payment guarantee, performance guarantee, retention guarantee and defect correction guarantee.
The advance payment guarantee guarantees the construction contractor’s performance against the payment of the advance payment by the project company to the construction contractor. The performance guarantee guarantees performance from service of the notice to proceed up to commercial operations or service commencement. On the date of commercial operation or service commencement, the construction contractor will either provide a defects correction period guarantee or alternatively, the life of the performance security will be extended to cover the defect correction period. Finally, a retention guarantee is sometimes provided in lieu of the project company making a retention against milestone payments to the construction contractor. If a retention guarantee is provided, the project company is unlikely to insist on a defect correction period guarantee, provided the retention guarantee is maintained by the construction contractor throughout the defect correction period.
With such an extensive security package, is too much security being provided and is it worth the price? The question is posed because the concession agreement between the procurer and the project company is likely to contain a requirement for the project company to provide its own performance security covering the performance of the project company. This is often for the period up to commercial operations or services commencement, but in some cases, it extends into the defect correction period under the construction contract. If there is a default at the construction contract level, that default is likely to trigger a default at the concession contract level and a liability of the project company to pay damages to the government agency. That liability can be satisfied by the project company executing the performance security at the construction contract level. This effectively means that the government agency will receive damages without having to execute the performance security that it holds at the concession agreement level. Yet the cost of providing the concession agreement performance security has been included within the tariff or unitary charge and is being paid for by the government agency. Provided the construction contractor provides a comprehensive package of security from banks with an adequate credit rating, it is arguable that regional procuring authorities should adopt the same approach taken by similar procurers in other parts of the world where PPP projects are implemented without a concession agreement performance security.
Defect Correction Period
The defect correction period is the period following the completion of construction, commissioning and testing. It commences on commercial operation or service commencement, during which any defects discovered by the project company must be rectified by the construction contractor at the cost of the construction contractor. The defect correction period might be 12 months, 18 months or 24 months. Because the construction contractor has a continuing contingent liability during the defect correction period, the risk of the liability crystalising will be priced into the construction contract. In turn, this will be priced into the tariff or unitary charge by the project company and paid by the procuring agency. The longer the period, the greater the contingency and the higher the tariff or unitary charge.
In the GCC, it is typical to see a defect correction period of 24 months. This is sometimes coupled with a further 24 month warranty on any plant replaced or repaired during the initial 24 months with an ultimate ‘sunset date’ of 36 months. In a project procured along conventional lines, the defect correction period is normally 12 months with a further 12 months for any replaced or repaired parts and a sunset date of 18 months. The difference in price between the two models and the consequential impact on the tariff or unitary charge can be substantial. Although there is clearly a benefit to the procuring authority where there is a longer defect correction period, the real question is whether the price differential justifies the cost? In other words, does it represent value for money?
This is not necessarily a straightforward question to answer, but it is questionable whether a blanket 24 month defect correction period should always apply irrespective of the technology, sector and country. Close analysis of the project and, in particular, the risk allocation, may find grounds for reducing the defect correction period with a direct cost saving to the procuring agency.
Latent Defect Period
Like the defect correction period, the latent defect period commences on the start of commercial operations or services commencement. During this period, the construction contractor is responsible for rectifying any defects that could not reasonably have been detected at the time of completion of construction. A five year period is frequently prescribed for projects in the region. As this is a contingent liability, the risk of it materializing will be priced into the construction contract by the construction contractor. As with the defect liability period, the price will be passed through into the tariff or unitary charge. The question is whether five years, as a blanket approach for all projects, is necessary? If the defect correction period were to be reduced to say 12 months, would the tariff savings from a 24 month latent defect period be worth it? Again, considerations related to the sector, type of technology and country are all very relevant.
Limitation on Liability
Although construction contractors are expected to assume the vast majority of risk associated with constructing and completing an asset, it is normal for the contractor’s liability to be limited by reference to a maximum monetary amount. Liability is typically limited to 100% of the price of the construction contract. Despite the cap on liability, it is normal to exclude or carve out certain risks. Wherever a risk is carved out, the construction contractor will assume unlimited liability with respect to that risk. Procuring agencies will typically list the risks to be carved out in the request for proposals. Carve outs typically include:
· Amounts received in connection with an insured risk.
· Damages arising from abandonment, fraud, wilful misconduct or gross negligence.
· Fines and penalties payable under law.
· The contractor’s obligation to rectify defective works.
· Indemnities relating to:
o breach of law,
o injury to persons
o damage to third party property
o failure to deliver clear title,
o breach of intellectual property rights.
· Payment of liquidated damages.
Carve outs can be split into three categories: risk that the construction contractor can manage, eg through insurance; risks that should be borne by the construction contractor because it has performed badly; and everything else. The indemnities listed above are an example of the first category. If the indemnity liability can be covered by insurance, why should the cap on liability be reduced by such insured amount when it is the insurers who pay and not the construction contractor?
Liability arising from abandonment, fraud, wilful misconduct or gross negligence of the construction contractor are examples of risks under the second category. These are situations where the construction contractor’s performance is so poor, it should be penalized even where the cap on liability has been achieved. In other words, if the contract price is US$250 million and the construction contractor is liable for damages equal to this amount, it should be additionally liable for damages arising out of any separate act of gross negligence.
These might all be good arguments, but why should the construction contractor be liable to the project company above and beyond the cap on liability for liabilities arising out of the obligation to rectify defects, breach of laws and the payment of liquidated damages? Considering that a broad sweeping list of carve outs to the cap on liability will add substantially to the price, do extensive carve outs provide value for money? If the construction contractor is a tier one company with an excellent track record, the procurer may be paying for something it will never use.
Where the concession agreement is breached due to an act or omission of the procurer breach, that breach will likely place the project company in breach of the construction contract. For example, where the procurer denies the project company free access to the site. In such a situation, the construction contract might be terminated by the construction contract which will lead to the project company terminating the concession agreement.
The concession agreement will typically state that the project company is entitled to compensation, including compensation amounts payable by the project company to the construction contractor under the construction contract. The difficulty is that the compensation payable by the procurer under the concession agreement will typically limit the amount payable in relation to the termination of the construction. A particularly harsh provision is the cap relating to the amount payable by reference to work orders placed by the construction contractor, but cancelled as a result of the termination. These amounts are normally capped at a pre-agreed amount. This places the construction contractor at risk of being only partially compensated for a breach by the procurer. Given the size of projects in the GCC, the shortfall could run to tens of millions of Dollars. Although the full risk is unlikely to be priced into the construction contract, a significant risk premium will be. Given the unlikelihood of the termination of the concession agreement, is it worth limiting the compensation that will be payable and paying the associated risk premium?
PPPs, particularly in the utilities space, were not introduced to the GCC in any meaningful way until the end of the last century and beginning of this one. Given the unfamiliarity and vast sums of money at stake, a conservative risk allocation seemed wise at the outset. However, with over 20 years of utilities PPP experience in some Gulf countries, coupled with an oil price under downward pressure, is it now time to pause and assess whether government agencies are gold plating their projects?