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Seeking solutions for construction’s ‘profitless boom’

They are calling it the “profitless boom” - a prolonged construction sector upswing which, far from promoting building company strength and stability, has instead sparked widespread industry collapse. Mainzeal, Ebert, Corbel, Orange H and Stanley Group, plus any number of other building companies, have all been “victims” of a boom that’s been going on since the Christchurch rebuild started.

As companies fail, it has become evident that one key factor in problems in the construction industry is unfair or unwise risk allocation. It might be companies that are competing for business and take on more risk than they should. It could be small companies being burdened with an unfair share of the risk. It might be a lack of transparency around risk during bidding and procurement processes. Or it could be questions over who shoulders the financial burden when something goes wrong. Unexpected ground conditions, for example, or extreme weather; labour or materials costs overruns.

But experts believe pinning the woes of the industry exclusively on unfair risk allocation in construction contracts is too narrow a view. Issues have emerged from a complex reality to which many poor market behaviours are contributing, including an adversarial approach and a focus on short term self-interest.

While these issues may be relevant in many industries, they are particularly pertinent in construction because construction is big, difficult and important. The building sector is New Zealand's fourth-largest employer, accounts for 7 percent of GDP and, in 2017, contributed nearly $15 billion to the economy.

Onerous contracts

Finding better ways of mitigating and allocating risk has become a priority for government, local councils, construction industry players, and a plethora of experts. And at last things appear to be moving in the right direction.

But they had to get worse before they got better, says Craig Wheatley, Head of Legal at Auckland-based HEB Construction. Wheatley, who moved to New Zealand 10 years ago, says he was shocked by the contracts both public and private sector organisations were expecting their contractors to sign for the Canterbury rebuild.

“A lot of those contracts were the most onerous I’ve seen, perhaps because there was a need to get these projects right,” Wheatley says. “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."

Glen Heath, CEO and general counsel at Mansons TCLM, believes unfair risk allocation has been one of the biggest contributors to the parlous state of the New Zealand construction industry. And he says banks, major contractors and developers should all shoulder their share of the blame.

“Head contractors create the expectation 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."

It’s something Ian Becke, a construction specialist and partner at law firm Bell Gully, has seen all too often.

“A prudent party should only accept a risk if it accepts the consequences of that risk on an informed basis,” he says. But in the real world, that’s not always possible.

“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 of do not bid at all.” And contractors and their subcontractors need business.

“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.”

It’s not just contractors who miss out when risk allocation is badly managed, says David Jewell, owner-director of Bond Construction Management. It can sometimes backfire for clients too. Take a simple example of a company contracted to construct a road, and has taken the risk on the suitability of the underlying ground conditions.

If ground conditions turn out to be worse than expected, the new road construction will not have the longevity originally expected, so the contractor will hope it lasts until the end of the defects liability period.

“Which it inevitably does. Just. The client is then left holding the baby and possibly having to rebuild that pavement two or three years later. The clients end up paying more because of the transfer of risk.”

Fair risk allocation was the subject of a panel discussion in Auckland last month. Panellists (L-R): Ian Becke, Glen Heath, Krista Payne, David Jewell, Craig Wheatley. Photo: Supplied.

Abrahamson principles

There is a well-known international model for fair and equitable allocation of risk in a construction project. Established in 1973 and known as the ‘Abrahamson principles’ after law expert Max Abrahamson, the model suggests (among other things) that risk should be allocated to a party only if the risk is within the party’s control, and that the party can economically transfer the risk - through insurance, for example.

Abrahamson’s principles have led to the ubiquitous statement that ‘the risk should be borne by the party best placed to bear it’.

The trouble is, that in practice these guidelines don’t always produce fair outcomes, says Krista Payne, a partner at global law firm Ashurst. For example, contractors may not take enough time or care before signing a contract to make sure they understand the risk they are taking on. Or competition pressures or procurement deadlines may mean a contractor takes on more risk than they should.

Relationships support success

Payne, who works in Australia, says it’s important that principals (who are often local or central governments) build relationships with contractors, take time for one-on-one interactives before a contract is signed, and make sure everyone understands the risks involved.

“It’s about building trust and being collaborative. After issues with projects not going well in New South Wales, the government there has recognised this and has taken some steps to rebuild those relationships.”

The New Zealand government is also trying to address the problems of risk allocation in its own construction projects, which make up 18 percent of all large-scale building work.

The jury is still out on what will happen in practice - industry commentators say government and local government have in the past been some of the worst offenders in terms of focusing largely on price and pushing risk away to contractors.

But new government construction procurement guidelines, which came into force on October 1, are intended to focus on reducing financial risk for industry players, says Building and Construction Minister Jenny Salesa. LINK: https://www.beehive.govt.nz/release/new-rules-help-construction-companies

“We are helping boost the resilience of construction companies by being more transparent in contracting about what risks exist and who is liable for managing them,” Salesa says. “This allows for fairer pricing, fairer margins, and less likelihood of unexpected financial shocks. It considers the whole-of-life value to the public of construction, not just the initial costs.”

A complex web of factors

In a market where there is strong demand but supply of factors like labour and materials are constrained, there is a need to look beyond risk allocation to the accuracy of pricing and cost modelling. Head contactors working to fixed prices can quickly find themselves having to absorb costs if their assumptions around subcontractor pricing and availability are too optimistic.

In Australia, says Payne, there have been a number of examples where subcontractors were able to push for bigger margins or better terms even after a bid was won, because of supply shortages in a heated market.

Turning the tap on labour, by incentivising greater uptake of trade qualifications, is one answer many agree on but, it too remains one strand in a complex web of factors contributing to current outcomes.

Becke notes many contracting businesses are run on a low-equity model where if profits exist they are largely taken out of the company. A popular strategy amid tight margins has been to win as much work as possible with the idea being that greater revenue will spread risks from multiple projects and a loss in one project can be absorbed by a profit in another. “Liquidators are kept busy when that strategy doesn’t work as intended,” he says.

But to leave profit in businesses or invest in resources there is a need for certainty around the timing and scope of future projects, particularly out of the public sector. Craig points to the lack of opportunity to plan coherently as one reason for the state of the industry, with the election cycle sometimes driving a ‘pendulum’ in priorities which can discourage participation.

Contractors have a responsibility too

It’s not just clients at fault, says Mansons’ Glen Heath. Everyone has a role.

“They’ve all got to grow up and be brave. Contractors have to say no to ridiculous requirements from developers, developers need to do their research and go with the contractor that can deliver their project sensibly, even if it costs a bit more, and banks need to be responsible too.”

Wheatley says change is starting to happen. “The market and principals are recognising that what looks good on paper won’t necessarily lead to the right result. This is why we’re coming back into an upward swing.”

In particular, there has been a noticeable shift towards what could be called ‘alternative contracting models’. These include ‘early contractor involvement’, and ‘alliancing’, where different parties in a construction project come together to take collective ownership and equitable sharing of risks associated with the delivery of the project.

It seems to be working, Becke says. “In the last 12 months we have been involved in a number of projects where the parties have engaged early and openly in conversation to try and appreciate different perspectives and risk sensitivity.

“When we look at successful projects, and in spite of everything, there are still quite a few out there, the common elements are alignment of objectives and intent, transparency in all dealings and appropriately-tailored risk allocation which is properly understood… If the underlying relationship between principal and contractor is sound, then the prospects of achieving compatibility, and therefore a contractual risk allocation which each party considers fair, increase considerably.

One example of the alliance model in New Zealand is the Wynyard Edge project on Auckland’s waterfront. Auckland Council, MBIE, McConnell Dowell, Downer, Beca, and Tonkin + Taylor got together earlier this year to build the infrastructure for the 2021 America’s Cup. This includes demolishing storage tanks, removing tonnes of toxic soil, and building temporary challenger bases.

Nine months on and the work is on-budget and on-schedule.

Wheatley says when he first started working on alliance-type projects, he was sceptical about ideals like collaboration, ‘best-for-project’ and a no-blame culture.

“But my experience over the last few years is that they work. In most cases, they work well,” he says.

The views in this article were canvassed in a panel discussion hosted by law firm Bell Gully in Auckland last month.

Bell Gully has also published a series of three articles on fair risk allocation. Find them here.

Bell Gully is a foundation supporter of Newsroom.co.nz.

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