What is the illusion of risk transfer?

Part of the following is from our book on Leading Megaprojects, A Tailored Approach. It is about the illusion of risk transfer that project owners might experience as a result of fixed-price contracting. We will first address the culture of fixed-price contracting, and next, we will discuss the illusion of risk transfer.

Fixed-Price Contracting

General statement

What we have been observing is that many (if not most) capital and megaprojects, at least industrial projects, are contracted to service providers via a fixed-price contractual arrangement. These are also known as lump sum contracts or lump-sum turnkey (LSTK). If the project conditions are suitable for this type of contract, this contracting strategy would be acceptable and expected. However, we observe a few significant issues with this approach (the compounded factors).

The issues with fixed-price

Conditions

The conditions are not often right for this type of contract.

For example, frequently, the project or product scope is not complete; if complete, it is not fixed, nor is it stable. These types of conditions might be suitable for a cost-plus arrangement, but certain clients insist on the fixed-price for a variety of reasons, as you will see next.

Perception of low risk; lowest cost

The perception by the client organizations (project owners) is that this is a low-risk approach, and some even think it is the lowest cost. However, what clients miss out on is that these contracts might be low risk in terms of the contracted cost since the price is fixed at the beginning.

Market conditions

Fixed-price contracts are suitable in a down market and if the scope is set; fixed, or at least stable scope, which leads to fixed price conditions. The reality is elsewhere. In many fixed-price contracts what we have seen is the original scope is not entirely defined and is not stable. This scenario leads to too many expensive changes that can put pressure on the project owners and even on the contractors. Consequently, even the initial cost growth and produces an overrun situation.

In the case studies part of this book, we will share more specific challenges related to a fixed price and their consequences on the project outcome.

Illusion of Risk Transfer

The illusion of risk transfer to contractors is a common mistake and another way of highlighting the risks associated with the fixed-price culture, which we addressed earlier.

Let us revisit the point of “perception of low risk”.

Once a contractor face cost challenges, the contractor management might decide to optimize the schedule, possibly slowing the project, along with the possibility of sacrificing quality, or even scope. In other words, the initial price might be kept low or fixed, but the project owner ends up paying dearly due to delays, quality matters, or production deficiencies. Further, even the initial price might grow due to costly and disruptive changes.

Benchmarking

Here are the supporting statements from the Industrial Megaprojects book: “The firms that engineer and construct industrial projects are variable cost firm has very little in the way of fixed assets. … They earn by selling the services of people rather than via the production and sales of products. This simply means they cannot possibly carry the kinds of losses that can and do occur on megaprojects.” (Merrow, 2011) As a result, they will do whatever they can to survive, including sacrificing the schedule or quality.

Project owner’s perspective

Here is what I shared on a LinkedIn post today. This is directly related to the above.

If I am a project owner, my interest is the overall risk to the venture and not only the contract risks. Let us look at an example.

An Example

An owner can transfer risks on labor productivity, labor cost, or materials cost to a contractor; in a fixed-price contract.

  • So, let us say, labor productivity is bad and it is costing the contractor 5% in additional cost.
  • This is a risk to the contractor, which will have to absorb and could reduce their profitability.
  • The owner is not responsible to pay this extra cost.
  • However, if, as a result, the project is delayed, then the owner might suffer losses in (1) additional costs to the owner team (extended durations) and (2) lost opportunity in delayed production.
  • Further, if a contractor is behind schedule, they might take shortcuts in scope or quality, which will also affect the owner negatively.

The bottom line is the #illusionofrisktransfer since the contract price is not affected by poor productivity but the owner’s profit is significantly impacted, possibly many times more the cost of additional labor cost.

Closing Comments

We have stressed that fixed-price contracts are an illusion of risk transfer. These contracts are only transferring the implementation cost, mostly in limited to labor and materials, and direct supervision costs. They do not protect the owner against delays. They would not protect the owner from the poor performance of the facility if the contractor caused quality issues that affect production capacity. Sure, there could be liquidated damages, but these are often far from enough compensation.

Call to Action

If project owners want to avoid this illusion, they will need to:

  • Build their organizational competence and capacity to handle capital and megaprojects.
  • They need to ensure that the front end work is done with great due diligence to ensure proper scope definition clarity of objectives.
  • In the end, if the product and project scopes are well defined, fixed or stable, and the market conditions are suitable for fixed-price contracting, then the owner will indeed be transferring a large part of the implementation risks.


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