Guide to Risk Strategy on Construction Projects

Guide to Risk Strategy on Construction Projects

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  A GUIDE TORISK STRATEGY ON CONSTRUCTION PROJECTS SARAH FOX 500 Words Ltd
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  Page 2 ©500 Words Ltd, 2015 Risk on Construction Projects A guide to help you understand risk strategies In Managing Risk in Construction Projects1 the authors warn that risk management “is beset by a dark cloak of technology, definitions and methodologies, often maintained by analysts and specialist consultants, which contributes to the unnecessary mystique and lack of understanding.” This Guide seeks to dispel some myths and clarify the process. What is Risk? “Risk is defined by HM Treasury as uncertainty of outcome, whether positive opportunity or negative impact. Some amount of risk-taking is inevitable, whatever the project. There has to be a deliberate acceptance of some degree of risk because the value to the business makes it worthwhile.”2 A risk is any uncertainty which may cause a construction project to deviate from its proposed plan, whether a liability, vulnerability, or opportunity. Risk tends to refer to events rather than hazards.3 Risk doesn’t only refer to negative connotations associated with ‘risky events’, ‘risky manoeuvres’ (like the Red Arrows) or ‘risky behaviours’. Risk events may include:  Events which can only produce negative deviations or consequences from the desired plan or objective (sometimes called pure risk);  Events which can produce both positive and negative deviations, i.e. a danger of both loss or gain (sometimes called speculative risk);  Events which can only produce positive deviations and a chance of gains (these are often not identified as ‘risk’ events).4 Risks are inherent in construction projects - it is in the nature of these projects that clients, contractors and the design team cannot avoid all risks. One of the aims of engaging in a construction project is ‘to take calculated risks.’5 “Some amount of risk-taking is inevitable, whatever the project. There has to be a deliberate acceptance of some degree of risk because the value to the business makes it worthwhile.”6 Risks cannot be eliminated so they must be managed, monitored, minimised and mitigated. Risk strategy involves both practical steps: creating a risk matrix, including risk on monthly project meeting agendas, and adopting Plan B when a risk event occurs; and legal steps: ensuring the contracts on your project reflect the agreed risk responses, include procedures which encourage pro-active risk reporting and management, and requiring relevant insurances to be held.
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  Page 3 ©500 Words Ltd, 2015 Risk Management “Risk management includes all activities required to identify and control the risks relating to the preferred project option.”7 “Risk management is critically important to project success; it involves identifying and assessing risk, assigning the right risk owners and continually managing, monitoring and reporting on key risks. Value management checks that the project delivers value to the business by probing the assumptions on which the project is based and seeking opportunities to add value.”8 There are four9 key elements to administering risks on construction projects:  risk identification:  establishing uncertainties or risks that might impact on your project  creating and maintaining a risk register  risk analysis:  analysing (qualitatively and quantitively) the possible time and cost consequences of specific risks on your project  reviewing the probability (likelihood) of each risk occurring  risk response:  involving all project team members in agreeing an appropriate allocation of risk  addressing potential risks before any consequences occur  creating procedures for actively managing, monitoring and mitigating risks  reducing risks to an acceptable level (maximising opportunities while minimising threats)  risk review:10  updating risk information throughout the life of the project  ensuring control of risks by planning how risks are to be managed through the life of the project to contain them within acceptable limits. Principles of Risk Management A leading lawyer, Max Abrahamson, in a paper to a conference in 1982, outlined what are now referred to as the ‘Abrahamson principles’ for risk allocation.11 He recommended that a project team member should bear a construction risk where:  the risk is within that member’s control; 12  the member can transfer the risk through insurance or as a premium on its services, and this is the most economic and practical way to deal with the risk;  the economic benefit of handling a risk rests with the member bearing the risk;  the placing of risk on that member is in the interests of efficiency;13  if the risk eventuates, the loss falls on that member first. Many construction projects, and their contracts, allocate risk to the contractor and its subcontractors and consultants. This reflects the desire of funders and their borrowers – the client or employer – to obtain a risk-free position, wherever possible.
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  Page 4 ©500 Words Ltd, 2015 Risk Identification “the lifeblood of any business is to make money by dealing with risks that others do not want to bear. Therefore rather than shy away from them, we should make risks explicit so that rational commercial decisions can be taken about who should bear them.”14 A research paper from Australia15 identified 20 major risks, from the perspective of the project team members and other stakeholders: Risks related to clients Risks related to consultants Tight project schedule Variations by client High performance/ quality expectations Incomplete approval and other documents Design variations Inadequate program scheduling Incomplete or inaccurate cost estimate Inadequate or insufficient site information Risks related to contractors Risks related to others Unsuitable construction program planning Variations of construction programs Lack of co-ordination between project participants Unavailability of sufficient professionals and managers Unavailability of sufficient skilled labour Disputes Serious noise pollution General safety accidents Subcontractors: low management competency Government bodies: excessive approval procedures and bureaucracy External factors: price inflation of construction materials For your project, you need to identify the generic risks that apply as well as any unique to your project, project team, location, jurisdiction, economic situation etc. A PESTLE analysis16 can provide more information about the broader context. Risk Analysis “…the project may be alluring. But the risks of injury to those engaged in it, or to others, or to both, may be so manifest and substantial and their elimination may be so difficult to ensure with reasonable certainty that the only proper course is to abandon the project altogether. Learned Counsel for BICC appeared to regard such a defeatist outcome as unthinkable. Yet circumstances can, and have at times arisen, in which it is plain commonsense and any other decision foolhardy. The law requires even pioneers to be prudent.”17 Once risks have been identified, you need to analyse and estimate what will happen if you need to adopt Plan B (willingly or not). This helps the project team to understand and be aware of the impact of the identified risks. It may also help the project team and stakeholders to ‘fine tune’ the project brief. Although there are many different means of analysing risks, one common approach is to consider (1) the probability of a risk occurring and (2) its impact on time, cost or other project objectives. A risk matrix may be used for this process. This can result in the risks being prioritised according to their probability, impact and influence on project objectives.18 There is a growing trend towards the early identification, allocation and management of risks on construction projects. The global economic downturn has brought risk issues into sharper focus - risks are occurring which have not been analysed adequately for years. Risks such as contractor insolvency, suspension or abandonment, withdrawal of funding, and land value crashes, which have happened during this recession, significantly impact on the profitability and viability of a construction project.
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  Page 5 ©500 Words Ltd, 2015 Risk Response “There are cases where the loss should be shared, and there are cases where it should be wholly borne by the employer. There are also those cases which do not fall within either of these conditions and which are the fault of the contractor, where the loss of both parties is wholly borne by the contractor. But in the cases where the fault is not that of the contractor the scheme clearly is that in certain cases the loss is to be shared; the loss lies where it falls.”19 Risks, once identified, should be responded to. Risk responses are critical - the purpose of risk management is to make better decisions for the future of the project: “Sometimes that decision may be to abandon the project.” 20 Risk response can be divided between:  allocation21 (transfer, share or retain) and  mitigation (avoidance or reduction).22 Tolson (2006) proposes that the allocation of risk should be “motivational” i.e. the allocation to a particular party should have the effect of motivating that party to deal with it in the most effective and efficient way. So the risk taker should be able to influence its magnitude, control the effects once it has occurred, and has an incentive to control the risk and its effects. Risk Review The Byatt report (2001)23 recommended: “…a new approach to risk. The key issue is not how risk should be allocated but how it should be managed. The trade-offs between risk and reward should be assessed, recognising that continuing in old ways carries its own risk. This should be coupled with strategies for dealing with what could go wrong and avoiding the culture of blame.” (my emphasis) Risk management is generally referred to as being pro-active where it is dealt with in the contract, and reactive where it is dealt with ‘on the ground’. Risk management is not simply a one-off pre-contract process but incorporates regular planning on how to manage risks all the way through the project, a review of what risks have occurred, and an agreed flexible approach on how the risks can best be managed by all the parties to achieve the project objectives and minimise any negative impact. Risk management can be improved by contract processes that support regular and early reporting of events, adopting a collaborative approach to problem-solving, as well as a fair allocation of the consequences of those events. Adversarial contracts, where the parties are in opposition to one another, do not facilitate risk management, but create mistrust and a blame culture. Contracts are not just an excellent risk allocation tool. Contracts can assist with minimising the ‘risk’, or the likelihood, of an event occurring and the consequences/ effects on the parties and the project once the risk event has occurred.
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  Page 6 ©500 Words Ltd, 2015 Using Contracts for Risk Allocation “The selection of an appropriate contract matched to the needs of the parties is...best understood as part of a risk strategy. If risk is to be managed then attention should be paid to the clear unambiguous drafting of contracts so that they record exactly what the parties intend.” 24 Latham confirms: ‘…risk assessment for clients is crucial. It determines contract strategy.’ 25 Contracts are based on procurement strategies, payment strategies, project and client type as well as risk strategies. Each standard form contract reflects a different degree of risk transfer26 to the contractor. The objective of identifying alternatives, evaluating them and final selection should be to states “…work from declared principles rather than undeclared and perhaps unconscious prejudices” (Abrahamson). A critical feature of any contract - not just a construction contract - is that it represents an agreed balance between the risks allocated and the rewards offered. For a standard form contract, the combined terms and conditions often represent a fair allocation between the rights and interests of the relevant parties. However, few standard forms provide the structure for a pro-active risk management strategy. They do not allow the parties to ‘embrace’ risk as a form of compromise, make no attempt to identify risks for specific construction projects, and rarely outline procedures for what the parties should do if those risks occur. They are a form of risk management short-cut. Your contract can, and should, be specific to you, your project and the risks associated with it. Summary Although this Guide has outlined best practice in risk management: “The reality is that as a result of inequality in bargaining power and the desire of contractors in a competitive market to secure the project, risks are not always allocated to the party best able to manage them…” 27 One commentator said that the current approach to clauses on risk could be compared to ‘rearranging the deckchairs on the Titanic.’ So there is still scope for improvement! The Author Sarah Fox (500 Words Ltd) developed this Guide. She has trained many construction professionals on standard form contracts, some of whom have little understanding of risk strategy. She is a speaker and trainer who helps construction specialists write simpler contracts and understand complex ones. She is also author of the 500-Word Contract™. To find out how Sarah can help your contracts meet your preferred risk strategy call her mobile: 07767 342747 or email: sarah@500words.co.uk
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  Page 7 ©500 Words Ltd, 2015 Footnotes 1 Smith, Merna and Jobling, 2 nd edition. 2 See OGC Achieving Excellence in Construction Procurement Guide (4) Risk and Value Management, page 5. For alternative definitions, see BSI ISO 31000:2009, where risk is defined as “the effect of uncertainty on objectives” both negative and positive, and AS/NZS 4360:2004 where risk is the “chance of something happening that will have an impact on objectives”. Many texts and parties only consider risk in the negative, adverse sense. 3 BS4778 defines risk as ‘a combination of the probability or frequency of occurrence of a defined hazard and the magnitude of the consequence of its occurrence’ which combines events with qualitative analysis. 4 See Bunni (2003).Risk and Insurance in Construction. Spon, London; Chapter 2. 5 Murdoch and Hughes (2007). Construction Contracts: law and management. p84. 6 See OGC Achieving Excellence in Construction Procurement Guide (4) Risk and Value Management, page 5. 7 See OGC Achieving Excellence in Construction Procurement Guide (4) Risk and Value Management, page 5. 8 See note 1 to section 6.6.6 at page 20 of BS8534:2011. 9 Taken from UK HM Treasury model. 10 Also referred to as risk treatment in BSI ISO 31000:2009. 11 Abrahamson M. (1982) Risk Management, Paper Presented to International Construction Law Conference, Sydney, 19-21 October 1982. Also cited as ‘Risk Management’, Max W.Abrahamson [1983] ICLR 241 12 Another way of considering this is whether the events which may lead the risk occurring are best controlled by the party. 13 Efficiency refers to cost efficiency (so will the additional costs payable be reasonable and/or proportionate), overall risk efficiency (as the retention or transfer of this risk may prevent the re-allocation of other risks) and/or management efficiency (the party bearing the risk should also be actively involved in managing the relevant events or the risks. 14 Murdoch and Hughes (2007). 15 Zou, Zhang and Wang (no date). Identifying Key Risks in Construction Projects: Life Cycle and Stakeholder Perspectives. Available from www.prres.net/papers/ Zou_risks_in_construction_projects.pdf 16 My PESTLE checklist is available from http://www.slideshare.net/sarahjvfox/pestle-checklist. 17 IBA v EMI 1980 Lord Edmund-Davies in HL. 18 For more information see Smith, Merna and Jobling (2006). Managing Risk in Construction Projects. Blackwell. 19 Henry Boot Construction Ltd v Central Lancashire New Town Development Corp (1980) 15 BLR. 20 Managing Risk in Construction Projects (cited above) p3. 21 Strictly speaking, it is not the risk which is ‘allocated’ to the party; rather it is the obligations and rights arising as a consequence of the risk event happening that are ‘allocated’. See charrett D (2010) Is Contractual Risk A Zero-Sum Game In Construction Contracts? 38 BDPS News 12. 22 For a detailed paper (299 pages) on these ideas amongst others see Ceric, A 2003, A framework for process-driven risk management in construction projects, PhD thesis, University of Salford, UK. Available from http://usir.salford.ac.uk/2184/. 23 Byatt (2001). Delivering Better Services for Citizens, A review of local government procurement in England. London: HMSO. 24 Tolson, SJA (9 Sept 2006) Design Risk, Defective Buildings and The Damages Seesaw IBC Construction Law Available on-line. Paragraphs 7-8, p2. 25 See tables 2 & 3 from the Latham Report for their analysis of the use of various procurement strategies to meet client objectives. 26 When we talk about a risk being transferred to the contractor, what we mean is that some or all of the consequences of that risk occurring in terms of time and cost have been transferred to the contractor. 27 Current trends in risk allocation in construction projects and their implications for industry participants Const LJ 2007, 23(1), 23-45.