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Every risk must be allocated to one or other of the two parties to a contract, i.e., the employer or the contractor. A risk cannot be not allocated to one or other of the parties – a risk cannot “be left hanging in the air”. An overriding principle is that the most beneficial distribution of risks is to allocate each risk to the party that is best able to deal with and handle that particular risk. Such risk distribution will in general lead to the lowest contract price.
This principle, however, is not always easy to follow as it can be difficult to determine which party can deal best with a certain risk. Nevertheless, in all construction and engineering contracts the contractor certainly is the best placed to deal with all risks concerned with the planning and execution of the work, for example, the provision of labour, materials and construction equipment, and all risks that may arise therefrom, such as the quality of materials and workmanship, the safety of site operations and so on. All risks arising from design are obviously borne by the party responsible for the design, and similarly all financing risks are borne by the parties providing the finance. The employer clearly has to take the risks of providing the site and seeing that it is available for the contractor to carry out his work, and usually all risks arising from information he has collected about the site and other information contained in the tender dossier. Traditionally, the
employer will choose to bear the risks of unknown or unforeseeable circumstances.
Practice over many years and a great many projects has shown that a sensible, balanced risk sharing between the contractor and the employer results in the lowest overall total cost for completed projects. Balanced risk sharing follows the mentioned principle that the party most suitable to bear a particular risk is allocated that risk. Thus the contractor takes all the risks associated with his business of contracting, while the employer takes the risks, inter alia, of the unforeseen and unexpected, i.e., items that are difficult or impossible to price accurately in advance. Consequently, the employer only pays the extra costs incurred when an unforeseeable event or circumstance actually occurs – he does not have to pay what the contractor would have allowed for in his price to cover himself for the risk of that event or circumstance eventuating.
It is to be noted that “risks cost money”. The party allocated a risk is responsible for the consequences if an undesirable event or circumstance actually occurs as a result of that risk. Therefore, from the employer’s point of view, the fewer risks he asks the contractor to bear, the lower the contract price will be.
At the one end of the scale, where a cost-plus or reimbursable type of contract is used, the employer carries the bulk of the risks, and the initial contract price is low. On such contracts whenever an unexpected undesirable event occurs the contractor is reimbursed his extra costs by the employer.
The result is that the final contract price is often much higher than the initial price.
At the other end of the scale, where a fixed price or turnkey type contract is used, the employer seeks to pass over as many of the risks as possible to the contractor, and the initial contract price is high. The aim in this case is that the employer will not pay any extra – although invariably some
extra will be payable – but the final price will anyway be close to the initial price. A sensible and fair sharing of risks between the employer and the contractor produces over the long run the lowest final contract prices, considerably lower than is the case for either of the extremes mentioned above, i.e., reimbursable type versus fixed price, turnkey type.
This is the route that FIDIC has traditionally followed, and there is a balanced risk-sharing between the employer and the contractor in the FIDIC Construction Contract and the FIDIC Plant and Design-Build Contract. There is, however, the likelihood that the final price may be higher than the accepted contract amount at contract signature, and that also the time for completion may be longer than expected. In the FIDIC EPC/Turnkey Contract, more risk is placed on the contractor, to try to ensure a final price and time, fixed from the outset.
In the latter type of contracts, where the contractor takes all or most of the responsibility for both design and construction and, consequently, most of the risks, completion
3 .12.2 Contract price
3 .12.1 Risk allocation
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All parties will try to reduce exposure to their risks as far as is possible. To this end it is normal for the parties to arrange for insurance to the extent that such is available on reasonable terms.
Normally an employer will make it a condition in the tender dossier that the contractor takes out
insurance to cover several categories of risk. The reason is that if an event occurs, for which the contractor is responsible, which has expensive consequences, the contractor may not have the finances to cover them. The contractor and/or the employer could then be
reimbursed from the insurance company. The insurances should be taken out in the names of both the contractor and the employer. In effect the cost of the insurances will be met by the employer, as it will be reflected in the contractor’s prices. It is therefore not wise for the employer to demand an unreasonable level of insurance from the contractor.
The categories of risk for which an employer usually requires the contractor to insure against are:
- loss or damage to the works, plant, materials, and contractor’s documents, and to the contractor’s equipment;
- third party liability for loss, damage, death or bodily injury to any physical property or any person;
- liability for injury, sickness, disease, or death to any person employed by the contractor.
The applicable law may also require the contractor to have other insurance cover, for example, insurance for the use of motor vehicles is compulsory, almost universally.
The insurances are to be in place before the contractor commences work at the site. The contractor is responsible for the care of the works until they are handed over to the employer on or after completion.
Thus, if a fire or another event causes loss or damage at any time during the construction period the contractor
will be responsible for the consequences. If a fire destroyed the works at an early stage in their construction, the damage would be relatively small.
However, if the damage occurred later it would be more severe, with maximum possible damage immediately before hand-over of the completed facility. The works insurance will mean that both the contractor and the employer will be covered for the costs of replacing or repairing the loss or damage.
It is important to keep in mind that the amount of the works insurance cover shall be the current
replacement value. On a contract stretching over several years, the replacement value of a destroyed facility may be considerably larger than the original construction price. The insured value should also include the costs of demolition, removal of debris, professional fees, and profit.
When setting the amount of the third party insurance cover, it is useful to try to consider what the maximum damage to third parties that a catastrophic accident could cause. For example, if the contract is for work on an airfield, perhaps the maximum damage might occur if one of the contractor’s trucks was crossing the runway and was hit by a landing aircraft.
On larger projects it is not unusual for the employer to take out an insurance policy that covers much of the contractor’s risks as well as his own. On very large, multi-contract projects, the employer may consider taking out one ‘umbrella’ policy to cover all parties involved, including designers, contractors and subcontractors. Such a policy avoids arguments as to which insurer shall pay if a claim arises, and may be cheaper than having a number of different insurances.
Insurance is a specialised industry. Issues, particularly on large multi-contract projects, can become complex and, in most cases, it is advisable to refer such matters to insurance specialists.
3.13 Insurance
tends to be achieved in a timely fashion. This is mainly due to the closer coordination possible between design and construction teams. However, such contracts are
likely to be more costly than the traditional forms on account of the additional risks carried by the contractor (see Fig. 3.1).
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Experience has shown that, particularly for contracts which include contractor-design, prequalification of tenderers is a highly desirable component of the overall strategy, and will save the employer and the lesser qualified prospective tenderers much time and effort. Prequalification enables the employer to establish in advance the competence of prospective tenderers. He may then select a limited number of companies or joint ventures whom he will subsequently
invite to tender. Restricting tendering to a pre-determined number of tenderers encourages the better qualified to tender in the knowledge that they have a reasonable chance of success.
Procedures for the prequalification of prospective tenderers may be imposed by applicable laws and regulations, or by the requirements of the financial institutions that will be
3.14 Prequalification of tenderers
Employer’s risk is above the original accepted tender sum line Reimbursable type of contract
where the employer carries nearly all the risks, resulting in an unknown and uncontrolled final contract price.
Fixed price type of contract where the contractor carries nearly all the risk, resulting in high tenders, but a known final price.
Fig. 3.1 – Apportioning risk
A sharing of the risks can be a more acceptable solution, resulting in a lower final contract price.
Reimbursable or actual cost plus fee type of contract
Balanced risk by use of the FIDIC Construction or Plant and Design-Build contracts
Fixed price or turnkey type of contract
Contractor’s risk is below the original accepted tender sum line Balanced
risk
Contractor carries risk Employer
carries risk
Final contract price
Original tender sum Original accepted tender sum
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providing funds for the project. Some institutions mandate procedures which do not permit any limit on the number of prequalified tenderers. This is often unfortunate as the employer may be overwhelmed with many tenders, most of which would not anyway be acceptable, and all these tenderers will have been involved in considerable unnecessary and wasted work preparing their tenders. More importantly, the more attractive tenderers will probably have considered it not worthwhile to compete against such a large field.
Typically, the employer initiates the prequalification stage of the project by publishing advertisements which either:
- contain briefly all necessary information on the project, and on how applicants should apply for
prequalification; or
- describe how to obtain a document which contains all the prequalification information and application requirements.
A sound advice to employers is: “Never
prequalify any contractor to whom you would not wish to award the contract.” The time to exclude unsuitable contractors is at the prequalification stage, not after tenders have been received.
FIDIC contracts provide the employer with flexibility in the selection of the most suitable method of paying the contractor and the payment provisions.
The principal payment methods and contract price formats are:
- Remeasurement
The contract price is determined based on the actual quantities of work performed.
- Lump sum
The contract price is the lump-sum amount accepted for the performance of the whole works.
Other formats may also be used such as:
- Reimbursement
The contract price is determined using actual costs as a basis.
- Target price
The contract price is based on a target amount together with a shared proportion of the difference between the target amount and the final amount.
Irrespective of the selected contract price format, the contract price may be subject to adjustment in accordance with the terms of the contract to take account of events that occur during the execution of the works, such as variations, imposition of new taxes, and valid contractual claims.
The format selected for establishing the contract price will impact on the level of risk taken by each party, the amounts to be paid, the administration of progress payments, and the valuation of variations.
An important basic difference between
remeasurement and lump sum is the allocation of risk in respect of the accuracy of the estimated quantities that are used as a basis for the contract price.
3.15 Contract price and payment
The procedures for prequalification are described in Chapter 7 – Prequalification: Consultancy
Appointments and Chapter 8 – Prequalification of Tenderers: Contracts for Works.
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The essence of a lump-sum contract is that the contractor performs and completes the works in return for a lump-sum payment.
Based on the proposed contract documents such as the drawings and specifications included in the employer’s requirements, each tenderer will offer a lump-sum price for completion of the works. On complex projects this may be impractical and not cost effective as the contract price will include for any inaccuracy in the contractor’s tender estimates, and will include amounts for risk and contingencies that may not be encountered.
However, at the time of contract award the employer and contractor know the amount to be paid for the complete works. This may be a significant factor for the financing of the project. On the other hand, the employer will not benefit from any savings that the contractor may be able to make compared to his tender estimate.
The lump-sum accepted contract amount is often broken down into a schedule of rates to facilitate the calculation of progress payments and for use in the valuation
of variations. The schedule of rates may include a list of lump-sum prices for which payment becomes due on achievement of predefined ‘milestone’ events.
The following are some situations for which different formats of lump-sum contracts may be appropriate:
- Lump-sum tender without any supporting details This may be suitable for minor works where variations are not anticipated and the works will be completed in a short time period, perhaps requiring only one payment to the contractor.
- Lump-sum tender with schedules of rates prepared by the tenderer
This alternative may be suitable for a larger contract where variations may occur, and stage payments are required, and the employer does not wish to prescribe the format and content of the schedules of rates.
- Lump-sum tender with schedules of rates prepared by the employer
This is the same as above but the employer prepares a