Using incentives to drive contractor behaviour

Out-Law Analysis | 04 Dec 2019 | 2:27 pm | 5 min. read

Employers will continue to want to incentivise contractors to reduce costs and time and improve quality regardless of the shift away from traditional contracting relationships to more collaborative contracting models.

Before deciding on how to incentivise, it is fundamental to fully understand the objectives for the project. From there, the behaviours and performance necessary to achieve those objectives can be established. It is only once that is understood that an appropriate incentive regime can be developed in order to motivate the behaviours and performance necessary to achieve those objectives.

What is incentivisation?

Incentivisation is a term that seems to be used more and more frequently but with little consistency as to what people mean.

At its most basic level, incentivisation is incorporating incentives into an arrangement in order to motivate the parties to it. Incentives can be either financial or non-financial, but as non-financial incentives are often reserved for the incentivisation of individuals as opposed to commercial entities this article will focus on financial incentives.

It is a common misconception that incentives are positive in nature and anything negative is instead a penalty. Some view incentives as the platitudinal ‘carrot’ as opposed to its antithesis, the ‘stick’. However, by their definition, incentives are simply things that motivate or encourage someone to do something and can therefore be either positive or negative in nature. Perhaps the most obvious negative incentive in a construction context is liquidated and ascertained damages (LADs) for late completion or failing to achieve some other contractual requirement.

If the parties to an arrangement can be motivated by either positive or negative incentives, the challenge comes in establishing the best way to incentivise. If the threat of the traditional negative incentives of LADs for delays to completion and cost overruns being a contractor risk are in fact the most powerful motivator, there would seem to be little need to incorporate positive incentives into a contract at all. The employer would simply be offering up and awarding positive incentives to achieve something that would have been achieved anyway as a result of the threat of the penalty.

Studies of incentivisation

Although there are many studies on the effect of positive versus negative incentives in a number of contexts, their applicability to the construction industry is limited.

For instance, studies by childhood psychologists have suggested that positive incentivisation rather than negative incentivisation drives the best behaviours. However, workplace studies have found that employees were more averse to having to pay a penalty than they were to the threat of not receiving a bonus.

Studies by economists on the impacts of positive incentives versus negative incentives in employment contracts divided employees into two groups: one subject to ‘bonus’ contracts and the other to ‘penalty’ contracts. The contracts were equally economically advantageous if the targets were achieved.

The studies found that, on the whole, employees preferred the bonus contracts and saw them as the most fair. However, employee preference and perceived fairness seemed to be where the advantages of the bonus contracts ended. Better results were produced by those under the penalty contracts in order to avoid paying the penalty than they were by those seeking to earn a bonus under the bonus contracts. It is because of this loss aversion tendency that economists argue that people are more driven to avoid being the subject of an actual loss than we are to seek to achieve conditional benefits.

However, that loss aversion tendency does not seem to travel to the world of commerce - or at least not in the construction industry. In 1986, the Construction Industry Institute of Austin Texas carried out research in relation to incentives in construction contracts and found that direct negative incentives - such as LADs or other methods of “penalising” contractors for their failures - had either no effect on performance or, in some cases, had a negative effect. That research found that, when used alone, direct negative incentives make no difference to performance. Perhaps this is simply a factor of such negative incentives being so commonplace in the industry that the risk of their application is simply factored by contractors into their prices and ultimately borne, in large part, by the employer anyway?

On the other hand, that same 1986 research found that direct positive incentives can increase performance in relation to certain aspects. However, it also found that direct positive incentives come with drawbacks. In particular, with more detailed incentivisation regimes comes the need for more detailed contract mechanisms which the research found gave rise to more disputes between the parties - although it is not clear whether these were truly more detailed contract mechanisms or simply new and unknown mechanisms.

Although incentivisation is a subject of discussion in the construction industry, other than this historic research - and corroboration, some ten years later, by the Construction Productivity Network in a paper on incentive-based contracts - there seems to be little further construction industry specific, publicly available, empirical research on the topic. Much of the industry understanding of incentives comes from knowledge obtained in practice on what appears to have worked and not worked so well historically on projects.

Construction standard form contracts and incentivisation

Perhaps in recognition of the historic industry research on the topic, the NEC4 Alliance Contract has sought to strike a balance between positive and negative incentivisation.

Published in June 2018, the NEC4 Alliance Contract is the new kid on the block in relation to collaborative contracting. The New Engineering Contract (NEC) has always seen itself as one of the industry leaders in championing collaboration and incentivisation, so it is worth exploring its approach a little further.

Under the Alliance Contract are “alliance objectives”, which are defined as “an aspect of performance by the Alliance … for which a performance target is stated in the performance table”. These may include key performance indicators and other things of importance to the client, such as completion dates. The Alliance Manager assesses the Alliance’s performance against the alliance objectives in the performance table and if performance exceeds the identified target, then an amount stated is paid by the client: a direct positive incentive. If the target is not met, then the stated amount is paid to the client: a direct negative incentive.

This covers two of the employer’s ‘holy trinity’: time and quality. On cost, the Alliance Contract uses a ‘pain-gain’ mechanism: again, creating a model that includes both direct positive incentives and direct negative incentives. At pre-agreed intervals set out in the performance table, the Alliance Manager assesses the difference between the “Alliance Cost” and “the proportion of the budget for the work which has been completed”. If the budget is greater than the Alliance Cost then the amount stated in the performance table is paid by the client. If the Alliance Cost exceeds the budget, the amount stated in the performance table is paid to the client.

The NEC4 Alliance Contract goes further than other standard forms have to date and introduced what is potentially quite a neat way of bringing incentives into project contracts. It creates a performance testing regime so that if the defect is also a failure to achieve an alliance objective the defect is not corrected. The Alliance pays a “penalty” by reference to the performance table. Regimes of this type have previously been solely punitive in nature and this approach also potentially avoids lengthy testing and retesting at commissioning.

Robert Parry is a construction procurement expert at Pinsent Masons, the law firm behind Out-Law.