Allocation of Risks in Construction Projects

By Mr. Ho Pun-hing

Abstract
Risk encompasses the connotation of undesirable outcome and the strategy is to reduce its odds in our favour. Risk management is to analyze all foreseeable risks qualitatively and quantitatively, and to seek out means to avoid its likelihood of occurrence or reduce its impact by mitigating, transferring, sharing and retaining the risk. Review is made of some clauses in the Government General Conditions of Contract for Building Works whereby the risks are shared between employer and the Contractor. It is suggested that the principle of control and capability be equitably applied in allocating risk in contract document which is served as the vehicle for procurement of projects.

1. Introduction The term risk management carries unpleasant feelings of caution and timidity. It is a way to gain power over events that can change our life. It can also help us seize opportunity not to just avoid danger. Good risk management can mean the difference between wealth and poverty, success and failure, life and death. The risk experts or software can help you but we cannot escape the responsibility of being the chief risk manager of our own life. Only we know what we really want and what we actually believe. We will be the one to suffer more from bad decisions made on our behalf. (Dan Borge, 2001) 2. Risk and risk culture In project management, risk events are classified as either threats or opportunities. We would like to reduce the probability and impact of a threat and increase the probability and impact of an opportunity. Risk is not synonymous with uncertainty, the latter being applicable when the outcome is variable such as a project cost. Risk is a combination of the probability (extent to which the event is likely to occur) and its consequence (outcome of an event). (A Risk Management Standard, 2002) 3. Risk strategies and management Risk management means that taking deliberate action to shift the odds in our favour increasing the odds of good outcomes and reducing the odds of bad outcomes. From a more practical perspective, this can be translated into coordinated activities to direct and control an organization with regard to risk. (A Risk Management Standard, 2002) The sources of risks are unlimited. There are sources external to the construction project such as inflation, market trends, exchange rates and government regulations.

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These are referred as threats to differentiate them from those that are not within the project teams responsibility area. The major components of risk management are as follows: (a) Risk Identification A risk management team is formed consisting of core team members and other stakeholders. The team uses brainstorming or other problem identification techniques to identify potential problems. (b) Risk Assessment Different techniques are available in the market and used to assess each risk qualitatively and quantitatively in terms of : - ( e.g. Decision Analysis in Projects: Monte Carlo Simulation) The undesirable event All the outcomes of the events occurrence The severity of the events impact Probability of the event happening When the event might occur in the project Interaction with other parts of this or other projects (c) Risk Response Development Responses to risk can be classified as mitigating, transferring, sharing or retaining. (i) Mitigating risk The most obvious strategy is to prevent or avoid unwanted risks. This method is not practicable. In order to avoid economic loss, the contractor could refuse to bid for any unattractive tenders. The end result would likely be getting no or little work to do. Because if we do not take any risk, we cannot expect any reward. There are two strategies for mitigating risk (a) reduce the likelihood that the event will occur and/or (b) reduce the impact that the adverse event would have on the project. In general, through careful and detailed designs or more thorough pre-contract investigation and planning, it is possible to mitigate most possible risks. (ii) Transferring risk Passing risk to another party is common; this transfer does not change risk. Passing risk to another party almost always results in paying a premium for this exemption. The employer should decide which party can best control the risk and which party can absorb the risk.

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The building contracts serve as instruments for transferring risk from the employer to the suppliers or contractors for delivery of projects. The choice of contracts may take different forms designed for specific purposes such as economy of prices, fast track programme, budgetary uncertainties, mitigation of claims for disturbance and delay, multiple of small projects. Some examples of contracts are: Design and build contracts Build-operate-transfer contracts Domestic sub-contracts Nominated sub-contracts Term contracts for multiple minor works Joint venture contracts Contractors all risks insurance, employees compensation insurance, third party insurance, liquidated damages, performance bonds, warranties and guarantees are typical examples where risk has been transferred to the party (insurer) best able to manage it. In principle, the employer can transfer the risk to the contractor but if the premium allowed by the contractor is not sufficient to absorb the risk either by mistake or due to intense competition, the contractor will exhaust all means to minimize its losses and transfer the excess responsibility back to the employer, resulting in a lose/lose situation. Or if the contractor may subsequently become insolvent and go to liquidation due to financial predicament, the employer has to face the dilemma of re-nominating a new contractor to finish uncompleted works of the project at a higher cost with unavoidable loss of time. In other words, the employer is in the end the party suffering from the risk, a victim of his own decision. (iii) Sharing risk Risk sharing allocates proportions of risk to different parties. Sharing risk has been seen as a motivation for reducing risk and cutting project cost. One of the recommended measures put forward by the Construction Industry Review Committee in January, 2001 advocates the more extensive adoption of relationship contracting in the form of partnering. Partnering between employer and contractors has the incentive to nurture continuous improvement on procedures, to encourage contractors to suggest innovative ways for project implementation. This requires changing traditional relationship to a shared culture without organization boundaries. This relationship is based on trust, dedication to common goals, and understanding of each others individual expectations and values. Expected benefits include improved efficiency and cost-effectiveness, increased opportunity for innovation and the continuous improvement of quality products and services. (In Search for Partnership Excellence)

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(iv)

Retaining risk Some risks are so large that it is not feasible to consider transferring or reducing the event (e.g. an earthquake, terrorism, flood, etc.). The employer takes on the risk because the chance of such an event occurring is slim. In other cases, risks identified in the budget reserve can simply be absorbed if they materialize.

1. Risk Identification Analyze the project to identify sources of risk

2. Risk Assessment Severity of impact Likelihood of occurring Controllability

3.Risk Response Development Strategy to reduce possible damage Contingency plan

4. Risk Response Control Implement risk strategy Monitor and adjust plan for new risks Change management

The Risk Management Process (Project Management Gray & Larson) (d) Risk Response Control A risk management team made up of experts should be set up to monitor the execution of risk response strategy, initiating contingency plans, and watch out

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for new risks which need to be analyzed and incorporated into the risk management process. Hope for the best but prepare for the worst. is the motto for the team.

4. Review of some controversial clauses on allocation of risk in the Government General Conditions of Contract for Building Works (i) Unforeseen ground conditions Clause 13 requires the Main Contractor (Contractor) to take responsibility for unforeseen ground conditions, such as artificial obstructions or physical conditions, which could not have been foreseen at the time that the parties enter into the contract. To the extent the information provided by the employer about the ground conditions being inaccurate and insufficient, the Contractor is not allowed to claim additional time and money if he encounters difficulties in overcoming problems on site. Obligation is placed on the Contractor to sustain all losses and damages arising from unforeseen ground condition that results in delays in completion of the contract. Arguably, it is the employer who is in the best position to take the risk of unforeseen ground conditions and carry out site investigation (e.g. bore holes, soil resistivity.) prior to the award of contract rather than to expect individual contractor to undertake at his own cost similar soil investigation 6 8 weeks before the submission of tender. Recognizing the deficiency in this clause, Government suggested in June 2003 that a trial on reallocation of risks will be undertaken on four pilot projects whereby Government takes on the risks of unforeseen ground conditions. If the Contractor shall encounter site conditions which could not reasonably have been foreseen by an experienced contractor at the tender closing date, the Contractor has the right to lodge his claim on additional cost to overcome the conditions and the extent of the anticipated delay. (ii) Changes in law Besides compliance with all enactments and regulations, Clause 29 requires the Contractor to pay all licenses, levies, premiums or other fees required by any regulations in relation to the execution of the works. Any additions or amendments or any new enactment of regulations might pose the possibility of increase of the contract sum such as the introduction of minimum wages for workers, or minimum working hours in a week, etc. Government has decided in 2004 to pass the risk of changes in law related to construction from the Contractor to the employer by the introduction of additional clause 30A which allows the final contract sum be adjusted to take account of any increase or decrease in cost, less overheads, to the

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Contractor in the execution of the contract resulting from any changes in law. (iii) Pay when paid It cannot be over-emphasized that withholding payments for whatever reasons by the Contractor is the biggest risk faced by E&M subcontractors. Under clause 15.5 in domestic sub-contract (DSC) or clause 69 for nominated sub-contractor (NSC), the Contractor shall pay the subcontractor after receipt of payment from the employer. Normally, the employer shall not pay the Contractor for the following reasons: (1) Delay in construction or defective material and work by the Contractor (not due to sub-contractors). (2) Delay in construction or defective material and work by the subcontractors. (3) Default of the employer. There is no argument on item (2), because it is reasonable for the Contractor to penalize the sub-contractors for their own faults. However, there is no express provision that pay when paid is not applicable when condition (1) arises. It is certainly neither reasonable nor fair for the Contractor to withhold payments due to the sub-contractors through no faults of their own. In common law, one important principle affirms that one party should not benefit from his own mistakes (i.e. the Contractor does not pay the sub-contractors). In U.K. there was a court case Durabella Ltd. v Jarvis & Sons Ltd. (2001) CILL 1796 that clearly underpins this principle. (Allocation of Risks in Building Contracts in Hong Kong) But when condition (3) occurs, it sparks off endless controversial disputes. In the event that the employer fails to pay the Contractor due to his own financial problem or delay in completion by the latter, dispute would then pinpoint on which party should bear the risk. As there is no contractual relationship between the sub-contractor and the employer, it is virtually impossible for the sub-contractor to recover payments from the employer through court proceedings. The apathetic Contractor will just look on from the side-line, giving little comfort to the sub-contractors. With regard to NSC, the Contractor could claim he was forced to enter the relationship under the terms set out by the employer and hence disclaim any responsibility for non-payment under such circumstance. It cannot rule out the fact that sub-contractors should be paid for their work done. For security of payments, the Federation of E&M Contractors has hitherto been a strong advocate to the set-up of a trust fund or introduction of mandatory ordinance but to no avail. Governments response is indifference and does not want to be dragged

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into any financial dispute, which is seen as a commercial squabble between the Contractor and his sub-contractor. (iv) Financial risks - Contract price fluctuations In accordance with clause 89, for contracts having contract periods over 21 months, the employer will assume the risk of fluctuation of labour and materials. The increase or decrease in interim payments depends on any changes in the index figures listed in Index numbers of costs of labour and materials used in public sector construction projects. Regrettably, only direct or NSC in electrical installation will have the provision of contract price adjustment. As most E&M installations are now DSC, E&M sub-contractor has to brace himself to bear the brunt of appreciation of currency and interest rates as evidenced by recent spate of surges in prices of raw materials. A new approach is being contemplated by Government to abolish the above price adjustment but supplemented by a contingency arrangement in which the labour price adjustment will be invoked in case of high inflation/deflation condition (a change of CPI over 20% against the tendered price). (v) Insurance Currently the Contractor takes out insurance against physical loss for the works under a Contractors All Risks (CAR), together with Third Party Liability insurance (TPL) in addition to Employees Compensation Insurance (ECI). Previously, the Contractor would simply cascade the responsibility down to their sub-sub-contractors. It is obvious that repercussions can spread when one party evades the obligation of effecting the insurance for his works. The findings of a consultants study on construction related insurance instill changes in Governments mindset on risk allocation. The current CAR and TPL policy wording is not supportable in current insurance market due to restrictions imposed on the underwriters via the international reinsurance market. (AON Construction Insurance Consultancy) The choice of procurement of insurance depends on the needs of the contract as follows: Major contracts and multi-discipline in nature In view of the complexity, the employer is in a better position to take out CAR and TPL insurance under an Owner Controlled Insurance Programme. Minor works and term contracts Primary insurance up to say $10M (above which insurance coverage will be by Owner) should continue to be taken out as the Contractor Controlled Insurance Programme. Formerly,

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the premiums for TPL can be disproportionately high if the contract value of the work involved is relatively small. The suggestion will provide the Government with significant savings whilst ensuring adequate insurance protection is in place. All other contracts The Contractor should take out CAR and TPI in the traditional approach.

Overview When an employer is considering the most suitable vehicle best suited for delivery of his projects, he needs to understand the full range of procurement strategies and the benefits and pitfalls of risk allocation. Men are risk averse and bureaucracy is stereotyped as such. Contract documents are one of the key instruments used to share risks between the employer and the Contractor. Principle of control suggests that the party which has the better ability of control be given the risk. Principle of capability transfers risk to the party which is most capable to absorb it. The two principles are not mutually exclusive. For controllable risks such as changes in design and extent of work, quality management, dispute resolution, etc. the principle of control comes to play whereas for uncontrollable risks such as natural disasters, inclement weather, changes in law, currency fluctuations, etc. the Principle of capability is more suitable to apply. For partially controllable risks, both principles should be considered. For every risk, there is a price tag of premium attached. The premium must be assessed if it is reasonable and acceptable. In the event that the risk runs out of control and goes beyond the financial capability of the Contractor, it would take its toll on the employer as the final victim of his own decision. As an employer, the Government is poised to mitigate and has a better capability to deal with the risk. It is reasonable to look upon Government to be the party to shoulder more risks. The aim is to reshape the traditional adversarial relationship between the employer and the Contractor and to introduce ingredients of cooperative culture that are conducive to the success of the construction projects.

Bibliography: 1. Project management, Clifford Gray & Erik Larson. 2. Risk Management in Projects, Paul Morris 3. Airport Projects in the PRC, Geoffrey Chan 4. Partnering and Collaboration in Project Management, C. S. Wong & B. S. Choy 5. Allocation of Risks in Building Contracts in Hong Kong, Cheung Kwok Kit 6. Scope and Model of Allocation of Risk in Standard Building Contracts, H. Y Wong & K. L. Tam

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7. Management of Risk and Disputes in Waterworks Construction, Prof C. G. Ko 8. General Conditions of Contract for Building Works, 1999 edition 9. Standard Form of Domestic Sub-contract, The HK Construction Association 10. Report of Construction Industry Review Committee, H. Tang

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