Replacing EPC with a collaborative contracting model in Australia

Out-Law Analysis | 22 Jun 2020 | 10:16 am | 5 min. read

Fixed price engineering, procurement and construction (EPC) contracts are used for the bulk of Australian major projects, despite the inappropriate contractual risk allocation, lack of effective collaboration and poor project management that often accompanies them.

The evidence is growing that effective risk identification, management and collaboration between interested parties leads to the best project outcomes. While a pure 'alliancing' model may be a departure too far for Australian market standards, the time is right for a hybrid approach, which fuses the best elements of traditional fixed price procurement with a collaborative and more efficient way of project delivery.

The Australian market view

It has become all too common for major public-private partnership (PPP) projects in Australia to be ravaged by delay, cost overrun and disputes. Notable examples include the Perth Children's Hospital, Sydney Light Rail, the Southern Cross Station in Melbourne and the Royal Adelaide Hospital. In fact, with most PPP dispute processes being private, it is likely that the projects not impacted in this manner are the exception.

Contractors consistently fail to meet their financial targets in Australia's 'mega' infrastructure projects. Alarmingly, research suggests that head contractors on completed mega projects experienced a loss of 16%, or a total of A$6 billion in losses (US$4.13bn) between 2000 and 2015. This is clearly unsustainable, and we are already beginning to see tier 1 contractors less willing to bid for these types of projects or even withdrawing from tenders altogether.

While this unfortunate trend is partly due to the increasingly complex and difficult risk profiles contained in project documents, it doesn't help that popular contracting models require the contractor to accept the majority of the construction risks with very little consideration given to which party is in the best position to do so.

Effectiveness of EPC contracting

Project owners are understandably concerned with cost certainty and risk minimisation - something which, on the face of it, an EPC contract provides. Under a typical EPC contract, the project owner engages a head contractor who becomes fully responsible for project delivery. Aside from a few basic obligations - such as paying the contract price, providing access and obtaining project-level approvals and insurances - the risks of delivery of the project by a specific date, and to a specified standard, transfer wholesale from the project owner to the head contractor.

However, many so-called 'fixed price' EPC contracts do not survive shovels hitting the ground. Conditions at the site may be vastly different to what was anticipated or represented by the owner. Wholesale risk transfer of the type promoted by most fixed price EPC contracts is not an appropriate substitute for the careful identification and management of risks and opportunities – and, importantly, the assignment of responsibility to the party in the best position to manage the identified risks.

It is not hyperbolic to describe a typical fixed price EPC contract as a 'battle plan' to deal with an enemy. A typical contract is fundamentally adversarial, rewarding self interest without being conducive to innovation or cooperation. The contractor may be, but is not always, entitled to relief in the form of extensions of time and delay costs, although these are invariably limited in scope and subject to onerous 'time bar' notice requirements. The consequences of a lack of trust between contracting parties is clear - not least that research shows that contractors commonly price contractual risk at a higher rate where they do not have a relationship of trust with the counterparty.

An accountable collaborative alternative

There is no shortage of literature proposing alternative contracting models, although none have found universal traction in the Australian market. Alliancing seems to be gaining some modest usage on some major projects - however, this model represents a radical departure from market standards in Australia and would be anathema to many project owners. Similarly, the use of contracts like NEC4 - a collaboration-focused standard form contract used successfully around the world – is slowly gaining traction in the market, but is far from being considered mainstream in Australia.

The potential lack of strict contractor liability of delivery under the NEC4 and alliance models is potentially a bridge too far for many Australian owners - and their financers - who require the 'security blanket' of fixed price contracts

What is needed here is a hybrid model, which combines the beneficial elements of an alliancing-style contract with the hard obligations and liabilities of a fixed price EPC contract. We will call this the 'accountable collaborative contract' model.

Some of the key features of the model we envisage include:

  • incentivised pricing – replacing the 'fixed' price with an incentive target cost with a pain/gain share element. A target cost will be agreed by the parties at the outset of the project. The contractor's costs in carrying out the project will be reimbursed in full with its fee - the profit component - fully at risk. If the contractor manages to deliver the project for less than the target cost, a 'stepped' incentive payment will be made by the owner. Conversely, if the contractor's actual costs overrun the cost target, the owner may deduct a portion of the cost overrun from the contractor's fee. This way, the parties share the risk of cost overruns equitably, while the contractor is incentivised to deliver the project on budget;
  • performance targets – measures which the contractor must strive to meet or exceed during the performance of the works. They may include delivering the project on time, meeting certain safety standards and achieving any performance guarantees. If the contractor exceeds the performance targets, the project owner will pay a bonus. If it does not meet the targets, the owner may make a deduction from the contractor's fee;
  • collaboration – effective management of risk throughout the project. A set of guiding principles will be agreed at the outset of the project, contractually binding the parties to perform their obligations and make decisions in accordance with these principles. A steering committee, with equal representation from each party, should be established to oversee progress;
  • notices – an early warning notice process and strict compliance regimes, with reasonable notice periods for contractor claims and the possibility of forfeiture of rights for non-compliance. Strict compliance with notice provisions will ensure owners are kept up to date with progress, and any potential issues are detected early and resolved in a collaborative manner;
  • rapid dispute resolution – while the contract's emphasis on collaboration and risk sharing aims to avoid disputes, any issues that do arise must be dealt with expeditiously and without resort to formal litigation or arbitration. Disputes should be discussed and resolved by the steering committee in the first instance, and the early warning notice requirements will promote such a process. After that, a rapid alternative dispute resolution mechanism – expert determination or a dispute avoidance board - should be adopted, with a mandate to resolve disputes within 10 or 15 days of referral.

A similarly collaborative process will also need to be adopted at the tender stage as, even with such a model, target costs must be properly tested but reasonable. Open communication and an acceptance by both client and contractor in ensuring costs are reasonable will be essential.

The broad principles of the accountable collaborative contract can be shaped and crafted to suit the specific needs of each project, using more fixed costs mechanisms where risks are known and understood and a more flexible pricing regime where project risks are unpredictable and difficult to quantify.

Co-written by George Varma and Toby Evans of Pinsent Masons, the law firm behind Out-Law.