YIGAL GABRIEL and NIHARIKA DHALL discuss categories of risk in construction contracts and recommend ways to deal with them.
Globally, the construction industry is regaining strength after a long period of sluggishness caused by the financial crisis. In actual value terms, the total output of the construction industry globally reached $8.5 trillion in 2015, a significant increase from $7.5 trillion in 2010, and is expected to grow to $10 trillion in 2020.
In India alone, the estimated investment required for urban infrastructure till 2030 is about $0.58 trillion. Meanwhile, a large amount of this investment (about $10.5 billion) is tied-up in disputes.
In light of these figures, it is critical that stakeholders in construction projects effectively determine the specific risk factors that can reasonably be expected to affect the project and manage the same effectively to prevent unforeseen delays and cost overruns in projects. The end goal is to mitigate the likelihood that a particular risk will occur, and/or reduce the impact of such event if it does indeed occur.
Needless to mention, where a risk cannot be transferred (to the other party), insured, eliminated, avoided or mitigated, such a risk must simply be accepted by one party or the other for the project to be completed.
In classic turnkey EPC contracts, the contractor generally takes full responsibility for the care and custody of the works till completion and handover of the project to the owner and, therefore, shares a large proportion of the risk with the owner. This risk can be managed through a structured process of assessment based on the probability of the event and its consequences. The aim of this article is to discuss the various categories of risk and suggest mechanisms for their effective management.
Project risks can be categorised as follows:
Management risks: These refer to the risks associated with the actual management of the project. For example, in a large number of construction projects, parties are exposed to risks because of (i) the contractors´ ignorance and/or lack of understanding of the intricate terms of the contract with respect to notification of claims, management of subcontractors and running bills; (ii) failure of the contractors to strictly adhere to contract provisions; (iii) lack of understanding of the law and its direct impact on the works, especially with respect to labour, insurance and the contractual terms; (iv) change in law or regulatory policy; and (v) lack of awareness about risk management techniques.
Financial risks: These refer to risks associated with cash flow in the project, for example, fluctuations in foreign exchange rates, delays in release of payment, inflation in cost of materials or labour and change in taxation regimes (notably the impact of GST).
Engineering risks: These refer to the risks associated with the engineering works in a construction contract and include, inter alia, risks associated with failure to verify the FEED (front-end engineering and design), design failure, change in project specifications, etc. The engineering works may be performed by the same contractor who is responsible for construction or the engineering works may be subcontracted to a different contractor by the owner. In the latter scenario, the risks are borne by the owner with respect to the contractor undertaking the construction works.
Procurement risks: These refer to the risks associated with the procurement of raw materials, technology, labour, water, electricity, etc. In our experience, examples of events that have caused problems in construction projects are delay in procurement from countries owing to political instability, logistical failures, procurement from unapproved vendors, improper planning with respect to long lead items, and failure to properly install, inspect and test the products.
Construction risks: These refer to risks associated with actual construction work. In a large number of projects, the work is either performed by multiple contractors or a consortium, and this becomes a risk factor that needs to be evaluated by the stakeholders. Other issues that may arise are soil and site-bed problems that are generally a risk factor passed on to the contractor, weather conditions (for example, the torrential rains in Chennai in 2015), delay in receipt of free issue material from the owner, health and safety concerns, labour issues, etc.
Commissioning risks: These refer to the risks associated with commissioning and PGTR (performance guarantee test run) in EPC projects. The exposure generally comes from the failure of the parties to understanding engineering parameters and changes in quality of inputs or raw materials that may affect the PGTR.
Some risks can be insured by the contractor and owner respectively. One of the other mechanisms to manage most, if not all, the risks discussed above is an effective communication protocol for the project, which is agreed between all the parties; that is, the owner, the project management consultant or engineer-in-charge and the contractor. This ensures that:
It is also advisable to establish a clear documentation control mechanism so all communications are properly filed and recorded.
Thus, given the dynamic and complex nature of construction projects, the industry remains highly risk-prone and risk management is a constant challenge. Notwithstanding that, the most effective tool for risk management is timely completion of the project. While project delays and cost overruns are a result of high-impact risks, they are also more likely to expose the project to further risks.
"The most effective tool for risk management is timely completion of the project."
About the authors:
Yigal Gabriel is an Associate Partner and Niharika Dhall is an Associate with the Construction Law and Disputes Practice at Khaitan & Co.
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