IMPROVING MEGAPROJECT PERFORMANCE

BY MICHAEL FILIPPICH
I INTRODUCTION The track record for Megaprojects in Australia and overseas has been abysmal and shows no signs of improving. Only one Australian resource project in the last 7 years with a cost of more than $2 billion has achieved targeted production on time and within budget.1 This project was ConocoPhillips $3.3 billion Darwin Liquefied Natural Gas plant that came online in 2006. More recent oil and gas developments such as Woodsides Pluto LNG project in Western Australia and ExxonMobils Kipper-TunaTurrum development in the Bass Strait have experienced cost overruns in the billions of dollars and schedule delays of almost 2 years. Large mining and infrastructure projects have performed no better with BHPs multibillion dollar Ravensthorpe Nickel Project being deemed uneconomic despite the fact that $3 billion had already been invested in constructing a processing plant and an entire town to service it.2 A number of cross city toll tunnels delivered as Public Private Partnerships have also had to undergo major financial restructuring as a result of incorrect demand forecasts.

The poor performance of Megaprojects occurs despite the fact that they are typically executed by experienced principals and contractors under Lump Sum Turnkey arrangements. In many cases the principal and contractor both lose significant sums of

Matt Chambers and Damon Kitney, Resource mega-projects hit by $8bn cost blowout The Australian http://www.theaustralian.com.au/business/mining-energy/resource-mega-projects-hit-by8bn-cost-blowout/story-e6frg9df-1225984651422 at 7 May 2011. 2 Dr Alison L. Browne, Prof. Daniela Stehlik and Dr Amma Buckley, The mega-projects paradox and the politics of risk, hope and mistrust: Capturing localised impacts of the boom/bust cycles of Australian mining. (2009) Sustaining Gondwana Issue 21.

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money on the project indicating that it would have been better for the economy if the project was never built in the first place. This paper will focus on the reasons for the poor performance of Megaprojects and the contracting strategies that can be used to improve their results. Particular attention will be paid to the non-technical risks that come into play on Megaprojects and how conventional construction contracts should be revised to address them. It will also be shown that there is limited benefit in identifying and allocating risks if they cannot be managed or controlled by the responsible party. A far more effective solution is to allocate the risk to the party that is best able to manage it, even if that means leaving the risk with the principal.

II THE MEGAPROJECT PARADOX Megaproject is a term used to describe projects with a value in excess of $1 Billion. The threshold of what constitutes a Megaproject is rapidly increasing as many of the large resource and infrastructure projects currently underway have budgets in excess of $10 billion. In addition to their enormous capital costs Megaprojects typically involve long development timelines and tend to stretch resources, skilled labour, and equipment to the limit.3 Often Megaprojects will use new technology or extend existing technology to an unprecedented scale. Decision making and planning often involves multiple stakeholders and complex interfaces between the government, private sector and local community. Many Megaprojects are located in remote areas that require basic infrastructure such as ports, accommodation, water treatment and power generation to be

Edward C Merrow, Understanding the Outcomes of Megaprojects: A Quantitative Analysis of Very Large Civilian Projects (1988).

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established before the project can commence. The political and social climate in these countries can also be challenging and present a considerable risk to the project.

The main drivers for undertaking Megaprojects are to meet the energy and infrastructure requirements of the worlds rapidly growing population and to improve efficiency by achieving greater economies of scale. Many of the Megaprojects currently underway are in developing countries such as China and India where there is a need for better civil infrastructure such as roads, railways and bridges as well as improved energy infrastructure such as base load power generation (coal, gas fired and nuclear) and liquefied natural gas (LNG) receiving terminals. The Megaprojects currently underway in Australia are largely aimed at providing the raw materials to these developing countries such as coal, iron ore and LNG. A successful Megaproject can spur economic growth for companies and even the entire country, while failure can set development back for many years.4 Such large sums of money are invested in Megaprojects that government and corporate balance sheets can be severely impacted if they are not executed correctly. The success of these projects is so important to their sponsors that governments and private companies can collapse if they fail. Startup delays on Hong Kongs $20 billion Chek Lap Kok airport in 1998 cost the local economy $600 million USD over 9 months and had a noticeable effect on the countrys gross domestic product for that period.5

Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (2003). 5 Ibid.

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Despite the huge sums of money at stake, Megaprojects have a history of significant cost and schedule overruns and revenue and benefit shortfalls.6 Projects often fail to provide a return to the local community and environmental impacts are usually worse than initially predicted. Revenue generated by the project can be well below what was originally forecast during the feasibility stage and many projects require government or private sector bailouts in order to remain in operation. A study completed by the Rand Group in 1998 on 52 Megaprojects in the process industry found that only 4 projects came in on budget.7 The average cost overrun was 88% and the combined cost overrun of 47 projects exceeded $30 billion USD. A similar study completed on 111 large capital projects in the transport, power generation, mining, oil and gas, aerospace and defense industry found that only 25% of projects were within budget. 68% of projects were between 0 to 100% over budget and 7.2% had cost overruns ranging from 100% to 300%.8 A more concerning finding from this study was that cost and schedule overruns had not reduced at all over the last century despite significant advances in engineering and technology.

Strangely this poor performance record has not reduced the frequency, magnitude and complexity of Megaprojects that are currently being sanctioned by governments and companies across the world. This situation has been termed the Megaproject Paradox by Dutch researcher Bent Flyjvberg and refers to the fact that more and more

6 Bent Flyvbjerg, Survival of the unfittest: why the worst infrastructure gets built and what we can do about it (2009) 25 Oxford Review of Economic Policy, 344. 7 Edward C Merrow, above n1. 8 Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, above n4.

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Megaprojects are being built despite their terrible track record.9 The root cause of the paradox appears to be a combination of political interference, delusion and deception from project sponsors, a lack of accountability for project outcomes and the inadequate evaluation and management of risk by governments and the private sector. With such substantial resources at stake Megaprojects should not be undertaken without access to world class technical expertise, sophisticated legal and financial structures,

comprehensive development and contingency planning and accurate economic forecasts to support the projects viability under a range of different circumstances. Sadly this is often not the case and many large projects progress through the development stages without even the basic systems and structures to manage the problems that potentially lie ahead.

III THE RISK PROFILE OF MEGAPROJECTS Due to their scale and complexity Megaprojects have a different risk profile to conventional design and construct projects. Risks that are particularly important for Megaprojects to manage include political and regulatory risk, environmental risk, psychological risk in the form of delusion and deception, technological risk, macroeconomic factors, unplanned events and organisational challenges. According to the Rand Group study, political and regulatory risk was by far the biggest contributor to Megaproject cost and schedule overruns.10 Megaprojects are typically of state

significance and are highly visible to the general public and therefore run the risk of political interference.
9

10

Ibid. Edward C Merrow, above n1.

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Megaprojects can be affected by a number of political factors including approval delays, variations in government standards or regulations and changes to taxation and royalty regimes. The timing of government approvals can be particularly important. Some jurisdictions require all environmental and technical documentation to be fully developed before construction work can start making it difficult to fast track the procurement of long lead items or commence early ground works and site preparation. There is strong economic justification for streamlining approval processes and reducing duplication in regulatory functions. In the case of the English Channel Tunnel project, each year of approval delays resulted in an average cost escalation of 4.64% per year or $1 million per day.11

Another political risk that is particularly common in overseas projects is government control over project labour and procurement practices. Countries will often specify minimum requirements for local content even if the necessary skills or equipment are not readily available within the country. These requirements will not cause major problems so long as plans are put in place to manage cultural differences and local skills shortages. An example of a Megaproject that successfully managed this risk was the construction of the Union Carbide Ponce Petrochemical Complex in Puerto Rico.12 Key project personnel from the USA were given intensive Spanish lessons to improve communication with the local workforce. Training programs were established long

before construction started which enabled a majority of the workforce to be hired locally

Bent Flyvbjerg, Policy and Planning for Large Infrastructure Projects: Problems, Causes, Cures (Working Paper No. 3781, World Bank, 2005). 12 Edward C Merrow, above n1.

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reducing labour costs. As a result of these initiatives the project had minimal industrial relations problems and no conflict with the local government or other stakeholders.

Changes to government regulations and policy can also have a significant impact on project economics and overall viability. Due to their long development timelines, Megaprojects are particularly susceptible to changes in health, safety and environmental regulations. Extensive rework or additional equipment may be required to comply with these new requirements resulting in cost and schedule overruns. Governments may also attempt to revise the projects fiscal arrangements by increasing taxes or royalties or by claiming a greater share of production or stake in the project company. In some extreme cases the entire project may be expropriated or nationalised by the government leaving the original owner with little or no compensation. These regulatory risks are not only limited to developing countries as evidenced by the Australian Governments recent proposal to introduce a Carbon Tax and Minerals Resources Rent Tax.

Environmental risk is another important consideration for Megaproject sponsors and is often linked to political and regulatory risks. Due to their scale, Megaprojects have the potential to significantly alter the environment around them. Environmental impact assessments are often completed too late in the design phase leading to delays in environmental approvals and last minute changes to the project design. Initial

assessments also have a tendency to significantly underestimate environmental affects which can cause the regulator to stop the project once construction is underway or lead to protests from the local community. Far better outcomes are achieved when a project

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develops and implements a comprehensive environmental management plan from the start of the project. The environmental management plan should be a live document that is adhered to and improved throughout the course of the project. A process should also be in place to continuously monitor the projects environmental performance so that any problems can be resolved before they impact the wider community or require intervention from the regulator.

Delusion and deception by project stakeholders is a form of psychological risk that is particularly common in Megaprojects. Deliberately or not, project stakeholders will often systematically underestimate project risks, schedule and costs and overestimate benefits. When forecasting the outcomes of risky projects, people have a tendency to underestimate task completion times and costs even when they know that the vast majority of similar tasks have run late or gone over budget.13 Delusion refers to

situations where project sponsors rely on overly optimistic assumptions instead of quantitative data to justify the feasibility of a project. This leads to projects being developed that would otherwise have been cancelled if they were assessed against a more objective set of criteria. Often projects are estimated on the basis that everything goes according to plan which leads to insufficient contingency being added to the budget and schedule to account for potential problems. Even when project risks are realised, the project sponsors have a tendency to further underestimate their cost and schedule impact. A study of 44 chemical process plants found that the actual construction costs were

Bent Flyvbjerg, Design by Deception: The Politics of Megaproject Approval (2005) Harvard Design Magazine, 50.

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typically twice as large as the original estimate.14 When the capacity of these plants was increased some years later, the expansion costs were once again grossly underestimated despite the fact that the project sponsors had comprehensive cost and schedule data from the first phase of the development.

Deception occurs when project stakeholders deliberately misrepresent the feasibility of a project. Many politicians, planners, project sponsors and contractors strategically underestimate costs and overestimate benefits in order to increase the likelihood that their project will be approved. Consultants stand to benefit from ongoing work if they can demonstrate that a project is viable. Most reputable consultants will write off poor projects immediately however even the best companies have a tendency to try and justify projects that are on the borderline of being feasible to ensure that work proceeds. Likewise, construction contractors may quote a low price for a project

knowing that they will be able to reclaim their profit margin by raising variations or completing follow on work. Politicians have a tendency to focus solely on the political benefits of major projects and often view these developments as part of their governments legacy. Local governments in particular, are notorious for distorting

estimates of benefits and costs in order to increase their share of state and federal funding.15

14 15

Ibid. Ibid.

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A classic example of project deception was the construction of the Sydney Opera house in 1959.16 The initial budget tabled to New South Wales Parliament by Premier Joe Cahill was $7 million which was less than 15% of the $50 million budget originally estimated by the projects architect Jorn Utzon. The Premier also fast tracked the start of construction, despite the fact that drawings were unavailable so that it would be more difficult for the Opposition to cancel the project if the Labour Government lost the next election. When the Opera House opened in 1973, 10 years behind schedule, the original design had been scaled back and construction costs had blown out to $102 million. This equates to a cost overrun of more than 1400% which gives the Sydney Opera House the dubious honor of holding the world record for the largest cost overrun by percentage for a construction project.17 A further $45 million was spent in 2002 to bring the design of the Opera House up to Utzons original specifications.

Some project sponsors argue that if the true cost of projects such as the Sydney Opera House and English Channel Tunnel were known from the start that these landmark developments would never have been undertaken in the first place and that society would be worse off. These people focus on the projects iconic value or nation building status to justify their poor cost and schedule performance. This argument does not however carry much weight as many other iconic buildings and important pieces of infrastructure have been constructed on budget and schedule and generated strong returns for the government or private investors. These projects include the Empire State Building,

16 17

Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, above n4. Ibid.

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Guggenheim Bilbao Museum and Eiffel Tower.18 Relying on delusion or deception to justify a project often means that it gains approval at the expense of a better project that has been accurately estimated. The scale of the Megaprojects being proposed at the moment means that choosing the wrong development option could seriously affect the economy of the sponsor country and place a significant burden on the community for many years to come. For example an economic analysis of the English Channel Tunnel concluded that the net present value of the project to the British economy was minus $17.8 billion USD with an internal rate of return of minus 14.45%. These results indicate that the British economy would have been better off if the project in its present form had never been built in the first place.19

There are a number of techniques that can be used to decrease the likelihood of delusion and deception affecting the results of project feasibility studies. One technique is to adopt the policy that the company performing the feasibility study and initial cost estimate can have no further involvement in the project once it is approved. This will reduce the likelihood of bias as the company has no vested interest in seeing the project go ahead. Instead they will be more concerned about their professional reputation for future consultancy work. Another option is to introduce financial incentives for

companies that provide accurate cost, schedule and benefit forecasts for projects. Additional bonus payments could be made when projects come in on or under budget. Likewise the company could be required to put a percentage of its profit or fees at risk in

18 19

Bent Flyvbjerg, above n6. Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, above n4.

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the event that the projects underperformance can be attributed to blatant errors in their feasibility study.

The results from feasibility studies should be subject to independent peer review and benchmarking against other similar projects. Many consultants take a bottom up approach to project estimation where the total installed cost is determined based on the approximate quantity of labour and materials required. Contingency and other escalation factors are then added to the base estimate to account for known and unknown risk factors. This approach can be highly subjective and is largely dependent on the

individual experience of the estimator and the level of design detail available at the time. Comparing a project cost estimate to a reference class of comparable projects will highlight any pricing errors, unrealistic assumptions or bias. If the estimate for a

particular project is significantly less than the actual cost of similar projects then the consultant should be required to explain the discrepancy. A more extreme proposal for dealing with deception in project forecasting is to introduce civil and criminal penalties for false or misleading estimates. Lawmakers in the US have called for criminal charges to be introduced for blatant cases of project misrepresentation, similar to what has already been put in place for corporate accounting practices under the Sarbanes Oxley (SOX) legislation. In Australia it is likely that a case could be made under the Trade Practices Act against a consultant that engages in false and misleading conduct when preparing a feasibility report and project cost estimate.

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Technological risk is another factor that requires careful consideration when managing Megaprojects. A large portion of the Sydney Opera Houses cost and schedule overrun can be attributed to its unique and complex design. The equipment and

techniques required to build the Opera Houses characteristic curved roof did not exist at the time of construction and needed to be developed by the project at considerable expense. Megaprojects often involve innovative design features that require a large amount of engineering to be completed prior to construction. They also have a tendency to apply existing technology and equipment to new frontiers or extend them to larger scales. Project sponsors need to be aware of the potential risks that new technologies introduce and should be confident that the overall benefits significantly outweigh the potential development problems.

Studies have shown that there is a strong correlation between the level of innovation in a project and cost and schedule overruns.20 Increasing the scale of an existing technology has a tendency to result in performance shortfalls. Megaprojects are not the appropriate vehicle for experimenting with new technology. Instead they should be based on proven construction techniques and equipment to minimise the risk of cost increases and schedule slippage. If a Megaproject is not financially viable using

conventional technology then it is unlikely that new technology will improve the overall economics. If new technology is going to be used in a project then it should be done so in incremental stages. For example it is often best to trial a new industrial process in a pilot plant and then increase capacity rather than going straight to a full scale development.
20

Edward C Merrow, above n1.

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Megaprojects are capital intensive endeavors and are therefore much more susceptible to macroeconomic factors than conventional design and construct projects. Changes to labour and raw material costs, interest rate fluctuations, inflation and exchange rate variations can all have a significant impact on a projects financial viability. The effect of these macroeconomic factors is further compounded by a

Megaprojects long duration as it is difficult to forecast costs 5 or 10 years into the future when construction is likely to be completed. Often construction cost estimates are done by engineers who fail to make adequate allowances for financial factors. Megaprojects are particularly susceptible to changes in exchange rate as they are often undertaken by companies whose primary base of operation is outside the area of the project and involve the procurement of large amounts of specialist equipment from overseas vendors. It is only recently that Principals and Contractors have started to engage the necessary financial expertise to effectively hedge against these macroeconomic factors and reduce the overall financial risk to the project.

The cost and schedule impact of unplanned events is an area where Megaprojects are less susceptible than smaller projects. The long duration of Megaprojects means that it is unlikely that a single unplanned event will have a significant impact on the overall project cost and schedule. Unplanned events include extreme weather, wars, strikes, civil unrest and other unforeseen circumstances that are outside the control of the project participants. Megaprojects are large enough to absorb delays arising from unplanned events by adjusting their construction program to minimise the effect. This is not to say that multiple incidents or sustained events will not have an overall impact on the project.

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The construction schedule of Victorias Desalination plant was significantly affected by one of the wettest summers on record in 2010. These delays and other cost overruns has resulted in the projects head contractor Leightons writing off approximately $280 million on the job.21

The final risk factor affecting Megaprojects arises from organisational issues. Megaprojects typically have complicated organisational structures with multiple stakeholders or joint venture partners. The situation is made even more difficult when the government is also a partner in the venture. Decision making in Megaprojects can require multiple levels of approvals which can take time and prevent the project from responding quickly to changing circumstances. Retaining staff can also be a problem for Megaprojects due to their long durations. Often people are reluctant to stay in the same role for the 5 to 10 years required to deliver the project. The long project timeline also means that there is a lack of experienced senior project managers as many people will only be able to execute three or four megaprojects over the course of their career.

To address these problems a Megaproject should function like a standalone company. Comprehensive human resource polices and training plans should be put in place to provide project staff and contractors with an opportunity for career development. The organisation structure should be developed early in the project planning phase and be continuously updated as the project progresses. Key positions necessary to construct, operate and maintain the project should be identified and brought onboard long before

Inside Business, Construction Companies Struggle With Risk ABC Online www.abc.net.au/insidebusiness/content/2011/s3193702.htm at 7 May 2011.

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they are required in the field. The organisation should be structured in such a way that it can function effectively without the individual. For example an incompetent construction supervisor may lead to poor productivity in a particular area but provided the organisation is adequately planned and governed the shortcomings of a single individual will not affect the project as a whole.

IV CONTRACTING STRATEGIES FOR MEGAPROJECTS In order to effectively manage risk, Megaprojects require more sophisticated contracting strategies than those used for conventional design and construct projects. Megaprojects are typically executed under Engineering, Procurement and Construction (EPC) contracts or Engineering Procurement and Construction Management (EPCM) contracts. EPC contracts are normally awarded on a fixed price or lump-sum turnkey basis and place a majority of the project risk onto the construction contractor. Lump-sum turnkey is an industry term used to describe the situation where the EPC contractor designs, constructs and commissions the plant for a guaranteed price and then effectively hands over the keys to the facility once it is up and running.

EPCM contracts are typically awarded to a project house or engineering consultancy on a reimbursable or risk reward basis. The EPCM contractor is responsible for the overall project design, management and execution but will normally not perform any construction work themselves. Instead the EPCM contractor enters into fixed price contracts with various subcontractors, material suppliers and vendors to complete the works on behalf of the principal. Any variations in these subcontracts or the EPCM

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contractors management costs are passed on to the principal. The main difference between an EPC contract and an EPCM contract is that under the EPCM model the owner retains more control over the project design and how it is executed. This control comes at the expense of the principal retaining significantly more risk than they would under a traditional fixed price EPC contract. It should be noted that EPC and EPCM are just labels for describing a particular contracting strategy and risk allocation. Depending on the precise terms of the agreement an EPCM contract can be drafted to carry the same level of risk as an EPC contract and likewise an EPC contract could be performed on a reimbursable basis. The decision on whether to use an EPC or EPCM contracting

strategy is dependent on a number of factors including the specific technical details of the project, the willingness of contractors and sub-contractors to take on risk, the preference of the project sponsors and the requirements of the financiers.

Under a conventional lump-sum turnkey EPC contract the principal transfers the performance, cost, technological and schedule risk to the EPC contractor. The EPC contractor acts as a single point of responsibility for the project and pays for all equipment, materials, labour and specialist contractors using their own funds. As a result, the EPC contractor is liable for any defects or design deficiencies that may arise regardless of whether it is their fault or the fault of one of their subcontractors or suppliers. Under a fixed priced arrangement the EPC contractor also bears the risk of any cost overruns and benefits from any cost savings. Banks and other financiers prefer to lend to projects with fixed price EPC contracts as they are considered to provide a greater level a cost assurance. It should be noted that any costs arising from omissions in

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contract scope, delays in regulatory and environmental approvals, political risks or unplanned events are usually passed onto the principal so the fixed price for a project rarely remains unchanged.

One of the key disadvantages of an EPC contract is that once it is awarded, the construction contractor has the freedom to design and construct the project whichever way it chooses so long as the final facility complies with the principals performance specifications. Any ambiguities in the specifications can result in the principal not receiving the equipment or design features they intended. The fixed price nature of EPC contracts often drives contractors to look for any gaps in the project specifications that allow them to raise variations or save money by reducing scope or using cheaper materials and equipment. This can often result in a final product being handed over to the principal that is fully functional but not up to their expectations. EPC projects often suffer from reliability issues and high maintenance costs as the overall project life cycle is rarely taken into consideration when designing the facility. Another problem that often arises in EPC contracts is that the plant feedstock may not be available at maximum capacity during startup meaning that the facility cannot be commissioned to its full nameplate rating prior to handover. As production ramps up it is common for bottlenecks in the process design to be identified that werent evident at reduced operating rates. In this situation the principal is unable to transfer all of the commissioning and performance risk to the EPC contractor and therefore loses the benefit of the price premium it has paid.22

Eric L. Nelson, Unique Considerations for Lump Sum EPC Projects Smith, Currie & Hancock LLP www.smithcurrie.com/news-articles-181.html at 7 May 2011.

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EPCM contracts address these deficiencies by providing the principal with greater control over the project design and execution. They are often used for projects involving new or proprietary technologies as EPC contractors are unwilling to take on a large amount of technological risk. The EPCM contractor will normally work alongside the principal to develop the optimum design solution before the project is divided up and tendered as separate lump sum packages for construction. The EPCM contractor acts as the agent of the principal when establishing the sub-contracts or purchasing materials and equipment. Orders are typically placed using the Principals funds and without the EPCM contractor charging any markup. Instead the EPCM contractor is paid a service fee to establish and administer these contracts on behalf of the Principal.

The main advantage of an EPCM contract is that it allows work to commence before the project concept is fully developed. In order to establish an EPC contract the Principal must have a clear understanding of the project requirements or else they run the risk of incurring a large number of scope variations. EPCM contracts also generate cost savings by allowing principals to engage vendors and sub-contractors directly and at a later stage of the project when the design is well established. This reduces contingencies built into contract prices and minimises the risk of re-work. EPCM contractors are not driven to complete the project in the quickest and cheapest way possible and are therefore able to look for solutions that maximise value to the Principal and minimise the overall life cycle costs.

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The main downside of an EPCM contract is that any cost and schedule impacts are directly incurred by the principal. Risk and reward schemes are often used to reduce the EPCM contractors professional services fee in the event of poor project performance however these amounts are often insignificant compared to the costs incurred by the principal. EPCM contracts tend to suit projects sponsors that have the expertise and experience to manage big projects and the balance sheet to retain cost and schedule risk. The Principals project team needs to be adequately resourced in order to hold the EPCM contractor accountable for its reimbursable costs. EPCM does not normally suit small or inexperienced companies that are new to the industry. These companies would normally achieve better results by engaging an EPC contractor to provide them with a turn-key solution based on a standard design template.

A number of EPC construction companies have adopted a hybrid approach to executing Megaprojects.23 Under this arrangement the preliminary engineering phase of the project is completed on a reimbursable basis similar to an EPCM contract while the detailed design, procurement and construction is executed under a lump sum turn-key contract. This allows the principal to engage an EPC contractor before the detailed project specification is developed which shortens the project delivery time. During the reimbursable phase, the principal retains more control over technical decisions and equipment selection and is able to work with the EPC contractor to optimise the project design.

Michael Wilkinson, Comparison of Project Delivery Mechanisms Focusing on EPC and EPCM (Paper presented at AMPLA Ltd. Third Annual Conference, Sydney NSW, 28th of October 2009).

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The contractor also benefits from the hybrid approach as they are able to gain a better understanding of the project risks before entering into the fixed price phase of the contract. This reduces the amount of contingency that needs to be built into the

contractors price and therefore the cost to the principal. In order to keep the pricing pressure on the contractor, a hybrid arrangement is normally established on the basis that the contractors detailed cost estimate for the fixed price phase will be provided to the principal for review along with supporting quotations from major vendors and subcontractors. Once the estimate is approved, a pre-agreed margin for profit and risk is added to the project price which is then fixed. The project then runs like a conventional EPC job with minimal principal involvement and the contractor liable for cost and schedule overruns but also able to benefit from any savings.

Another strategy that can be used to award contracts for Megaprojects is to run a design competition.24 This technique is particularly common in large public

infrastructure projects such as bridges, stadiums and tunnels and is also used in the selection of process technologies for liquefied natural gas plants. Many construction consortiums are willing to compete for the chance of winning the contract for a Megaproject given the long term revenues and prestige that they can generate. A design competition allows tenderers to propose innovative engineering solutions that maximise value to the principal. To start a design competition the principal typically issues a high level performance specification for the project which contains targets for safety,

24 Matthew G. McKenna and Herve Wilczynski, Capital Project Execution in the Oil and Gas Industry Increased Challenges, Increased Opportunities Booz&Co http://www.booz.com/media/uploads/Capital_Project_Execution_in_the_Oil_and_Gas_Industry.pdf at 7 May.

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reliability, operability and cost instead of specific technical requirements. The Contractor then proposes their most cost effective design solution that meets or exceeds these requirements. The most difficult part of any design competition is selecting the winner. Bids are normally evaluated using a set of weighted selection criteria in order to normalise differences between the proposals. The bidder that gains the highest score in the design competition is then awarded the contract to complete the project.

V SCOPING ISSUES Even though Megaprojects are typically executed using sophisticated EPC and EPCM contracts, they still incur significant cost and schedule overruns. According to a 2008 report into project scoping prepared by law firm Blake Dawson, scoping inadequacies resulted in 26% of the projects surveyed with a value over $1 billion being more than $200 million over budget.25 These scoping inadequacies are largely due to the fact that conventional contract documents and project specifications often fail to address the broader non-technical risk factors that affect MegaProjects. Megaproject should focus on more than just legal matters. The contract for a

Instead it should be a

comprehensive suite of documents that addresses the technical, commercial, environmental, regulatory and organisational requirements for delivering the project.

One area where conventional contract documents are often deficient is in dealing with environmental and regulatory risks. If principals and contractors applied the same level of detail to specifying environmental and regulatory requirements as they do to

25

Blake Dawson, Scope for Improvement 2008 Report Blake Dawson http://www.blakedawson.com/Templates/News/x_news_content_page.aspx?id=53637 at 7 May 2011.

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technical and commercial matters then project outcomes would be greatly improved. The contract for a Megaproject should include a comprehensive environmental management plan that clearly defines the roles and responsibilities of each of the parties in relation to environmental approvals. Compliance with this plan should be audited on an ongoing basis by the Principal. Timelines for environmental and regulatory approvals should be clearly identified in the overall project schedule to ensure they have visibility to the project team. Where possible principals and contractors should try and obtain broad

environmental approvals so that minor changes to the project design do not need to be resubmitted for regulatory approval.

The contract documents should also include a government and external relations plan that clearly outlines the regulatory regime governing the project and each partys compliance obligations. Any specific requirements or exemptions the project has in relation to local content, customs and duties, industrial relations and taxation should be summarised in plain English. The contracts government and external relations plan should not only address the project specific infrastructure but also complementary infrastructure required for construction. For example significant cost overruns and

schedule delays could arise if the government is responsible for building an access road, power line or water pipeline to the site and this is not delivered in time. Likewise if upgrades are required to the local port to receive construction equipment and materials then these will need to occur on schedule or else the principal will be forced to make alternative arrangements at considerable cost to the project. Where possible any arrangement with the government should be captured in a formal legislative instrument

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such as a State Agreement. Although these can be unilaterally changed by the Parliament there is a much greater political focus on any variation.

Another major deficiency in conventional contract documents is that they often include numerous clauses to deal with negative project outcomes such as defects, disputes and deficiencies but very little guidance on how to avoid them in the first place. Greater emphasis should be placed on the operational phase of the contract and the systems and tools that will be used to ensure the project runs efficiently. The contract documents should clearly state how the contractor fits into the overall project organisation and how they will interface with other contractors and stakeholders. Contractors should be required to align their internal business processes with those of the project organisation. Comprehensive human resource management, training and

industrial relations plans should be developed by each contractor to demonstrate how they intend to manage their workforce. A strategy should be put in place for attracting and retaining staff in a highly competitive labour market and a formal handover process established to retain knowledge when people leave the project. Formal dispute resolution procedures are required to resolve contractual issues in a timely and cost effective manner. The payment process should also be streamlined to prevent cash flow issues affecting the project schedule.

Managing change is another area where traditional contract documents are often deficient. Contracts typically include boiler plate clauses to deal with variations. These focus primarily on the cost and schedule implications of a change without taking into consideration the overall risk or benefit of the change to the project. Many projects fail

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to assess the cumulative impact of multiple changes or their wider regulatory and environmental consequences. Changes are often made on site with minimal engineering input or consideration for how the change will affect other parts of the project. The reasons for making a particular change are rarely documented and drawings are not always updated to reflect the as constructed installation.

To address these deficiencies, the contract documents should require the contractor to establish a formal management of change procedure to document and review any proposed variations. Major changes should be risk assessed and undergo a cost benefit analysis before being approved. The impact of the change on other

contractors and project stakeholders should also be considered and a process put in place to ensure that the details of the change are communicated to all affected parties. The cost and schedule implications of a change are often poorly assessed particularly when the work is being done on a reimbursable basis. Changes need to undergo the same level of cost and schedule scrutiny as the original project estimate. Many companies have had their reputation and share price severely damaged by failing to accurately estimate and manage the effect of major project changes. Woodsides Pluto LNG development in Western Australia is one example of a project that has had to revise its cost and schedule estimate multiple times as a result of a single design variation.26

26

This variation related to the redesign of a large flare tower that was not cyclone rated and had to be dismantled and re-constructed at considerable expense to the project.

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Detailed contract governance requirements are another important tool for managing project outcomes. Contract documents should clearly define the requirements for tracking and forecasting cost and schedule performance. important for a project completed on a reimbursable basis. This is particularly Reliable up to date

information is essential for good decision making. The software tools to be used for planning and cost control and the reporting frequency required should be specified in the contract. In addition to regular cost and schedule reports, Key Performance Indicators (KPIs) should be developed to measure the contractors performance and the overall health of the contract. Throughout the course of the project regular meetings should be held at both an operational and corporate level to review the KPIs and the cost and schedule performance. A continuous improvement plan should be put in place to respond to negative trends in KPIs and generate greater efficiencies from processes that are performing well.

V WHO SHOULD TAKE ON THE RISK? An essential component of any Megaproject contracting strategy is determining an appropriate risk allocation between the parties. This process is particularly

challenging given the wide range of technical and non-technical risks that Megaprojects are exposed to and the huge costs that can arise should a risk event occur. The traditional design and construct approach of trying to transfer as much risk as possible to the contractor and consultant is rarely effective in a Megaproject. Many contractors are

unwilling or unable to take on such a high level of risk. In situations where the contractor does agree to take on some of the risk their liability is usually capped at an amount that is

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insignificant when compared to the consequential loss experienced by the principal or the cost premium paid to transfer the risk. It is also difficult to put a price on the reputation loss to the Principal if they fail to meet their commitments to the projects buyers.

In order for the principal to benefit from the transfer of risk, the party taking it on must be able to effectively control and manage it. Transferring excessive or unlimited risk onto contractors and consultants can lead to lengthy legal disputes or one or all of the parties filing for bankruptcy. The outcome of this situation is that the principal is left with an unfinished project and no project team to complete it. Lengthy delays will be incurred if the project is handed over to a new contractor. Design consultants in

particular lack the financial capacity to take on project risk. Megaprojects have a large number of technical challenges that require innovative and sometimes unproven solutions. Consultants are rarely willing to accept any liability for their services or at best will only take on liability to the value of the services provided. This is particularly controversial given that design errors in Megaprojects can potentially cost the principal or contractor 100s of millions of dollars to rectify in the field. Even if consultants were willing to take on more risk it is unlikely that this would provide much benefit to the principal. Most consultants have a limited asset base meaning that any liabilities not covered by their professional indemnity insurance will inevitably fall back on the client as the consultant would simply file for bankruptcy. This is not to say that consultants shouldnt be held accountable for the quality of their work. Making the consultant complete design re-work at their own cost or without profit is usually sufficient to ensure they perform their services with the appropriate level of care and diligence.

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Far better project outcomes are achieved when risks are allocated to the party that is best able to manage them. This approach to risk allocation is often referred to as the Abrahamson Principle after the international construction lawyer that first applied it to complex offshore oil and gas projects in the UK North Sea. It is difficult to establish generalised rules for achieving the optimum risk allocation as the requirements will vary depending on the specific details of the project. Project participants should therefore perform a comprehensive risk assessment during the planning phase of the project to identify and acknowledge the main sources of risk. Where possible these risks should be reduced or eliminated all together either by changing the project design basis or execution strategy. If this is not possible, then the risk should be allocated through a consultative process so that all parties are clear as to who exactly is taking on the risk and what their strategy is to proactively minimise the threat and maximise opportunities. In situations where none of the parties are happy to take on the risk, alternative methods of mitigation will need to be investigated such as insurance or other financial instruments such as hedging.

A comprehensive risk register and risk management plan should be incorporated into the contract to document how the risk has been allocated and what procedures will be followed in the event that a risk materialises. Regardless of the commercial and contractual arrangements between the parties it is important that a robust risk mitigation strategy is put in place that provides for a system of early intervention and rapid decision making to minimise the overall impact of an event. Contractors should be encouraged to propose alternative design and execution strategies to reduce the overall risk to the

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project even if these changes slightly increase the capital cost. Contingency plans should be developed so that the project is able to quickly respond to an incident with a predetermined course of action. Acknowledging the presence of risk and developing

formal procedures for managing it is an important first step in delivering a successful Megaproject.

VI CONCLUSION Even in the wake of the Global Financial Crisis (GFC) Megaproject spending is the largest it has ever been as a share of world GDP.27 A number of big investments by mining and energy companies are still underway on the back of high commodity prices. Any reduction in private capital has been more than offset by 100s of billions of dollars of government spending in the form of economic stimulus packages. In order for future generations to benefit from this new wave of Megaproject expenditure it must be done properly. Existing EPC and EPCM contracting strategies will need to be improved in order to effectively manage non-technical risks such as regulatory and environmental issues, delusion and deception by project stakeholders, macroeconomic factors and organisational challenges. Contracts should include a comprehensive suite of documents describing the systems, tools and procedures that will be used to ensure that the project is executed successfully. More emphasis needs to be placed on formal risk assessment procedures to ensure that project risk is allocated to the party that is most capable of managing it. Principals also need to realise that there is no point in transferring risk to another party if they lack the financial capacity to deal with an event if it occurs. By

Bent Flyvbjerg, Massimo Garbuio and Dan Lovallo, Delusion and Deception in Large Infrastructure Projects (2009) 51 California Management Review, 170.

27

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improving the way Megaprojects are planned, structured and governed society will be able to receive the benefits of iconic developments such as the Sydney Opera House and Channel Tunnel without the economic or environmental burdens that projects of this scale usually create.

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BIBLIOGRAPHY
1. Articles / Books / Reports Dr Alison L. Browne, Prof. Daniela Stehlik and Dr Amma Buckley, The mega-projects paradox and the politics of risk, hope and mistrust: Capturing localised impacts of the boom/bust cycles of Australian mining. (2009) Sustaining Gondwana Issue 21. Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (2003). Bent Flyvberg, Mette Skarmisholm and Sren L. Buhl, What Causes Cost Overrun in Transport Infrastructure Projects? (2004) 24 Transport Reviews, 3. Bent Flyvbjerg, Massimo Garbuio and Dan Lovallo, Delusion and Deception in Large Infrastructure Projects (2009) 51 California Management Review, 170. Bent Flyvbjerg, Design by Deception: The Politics of Megaproject Approval (2005) Harvard Design Magazine, 50. Bent Flyvbjerg, Survival of the unfittest: why the worst infrastructure gets built and what we can do about it (2009) 25 Oxford Review of Economic Policy, 344. Edward C Merrow, Understanding the Outcomes of Megaprojects: A Quantitative Analysis of Very Large Civilian Projects (1988).

2. Other Sources Blake Dawson, Scope for Improvement 2008 Report Blake Dawson
http://www.blakedawson.com/Templates/News/x_news_content_page.aspx?id=53637 at 7

May 2011.

Bent Flyvbjerg, Policy and Planning for Large Infrastructure Projects: Problems, Causes, Cures (Working Paper No. 3781, World Bank, 2005). David Snashall, Keeping Oil and Gas MegaProjects Moving ERM
http://www.erm.com/Analysis-and-Insight/Articles/Keeping-oil-and-gas-mega-projects-moving--grapplingwith-Non-Technical-Risk/ at 7 May 2011.

Eric L. Nelson, Unique Considerations for Lump Sum EPC Projects Smith, Currie & Hancock LLP www.smithcurrie.com/news-articles-181.html at 7 May 2011. Inside Business, Construction Companies Struggle With Risk ABC Online www.abc.net.au/insidebusiness/content/2011/s3193702.htm at 7 May 2011.

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Luis E. Rey, Unique Aspects of Working In Megaprojects Nielsen-Wurster

http://www.nielsenwurster.com/Email_Announcements/NW_Communique/NW_Communique_2006_JulyTRUNK.html

at 7 May 2011. Matthew G. McKenna and Herve Wilczynski, Capital Project Execution in the Oil and Gas Industry - Increased Challenges, Increased Opportunities Booz&Co
http://www.booz.com/media/uploads/Capital_Project_Execution_in_the_Oil_and_Gas_Industry.pdf

at 7 May. Matt Chambers and Damon Kitney, Resource mega-projects hit by $8bn cost blowout The Australian http://www.theaustralian.com.au/business/mining-energy/resource-mega-projects-hit-by8bn-cost-blowout/story-e6frg9df-1225984651422 at 7 May 2011. Michael Wilkinson, Comparison of Project Delivery Mechanisms Focusing on EPC and EPCM (Paper presented at AMPLA Ltd. Third Annual Conference, Sydney NSW, 28th of October 2009). Office of Government and Commerce (UK), Good practice contract management framework Office of Government and Commerce Website http://www.ogc.gov.uk/documents/Management_Framework_Good_Practice_FINAL.pdf at May 7 2011. Thomas Hundertmark, Andr Olinto do Valle Silva, and Jeff A. Shulman, Managing Capital Projects For Competitive Advantage McKinsey Quarterly
http://www.mckinseyquarterly.com/Managing_capital_projects_for_competitive_advantage_2163

at May 7 2011.

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