The additional cost implications of the new government contracts have been masked by the fall-off in tender prices. Tomás Kelly at Davis Langdon looks at these contract areas where costs are most vulnerable

The government decided in May 2004 to reform the approach to procuring public works projects with a suite of six new Forms of Construction Contracts for Public Works including two traditional (employer designed) contracts for civil engineering and building works and two design and build contracts for civil engineering and building works.

A fifth contract for minor works contracts (traditional approach for building works and civil engineering) valued at e5 million or below and a sixth Short Form for works under €500,000 were added.

The contract conditions aim to provide for optimal risk transfer and achieve greater cost certainty, better value for money and timely and more efficient delivery of projects.

What has been the reaction of the construction industry? It could be described as mixed with a considerable amount of scepticism however this is not surprising as the introduction of major change to any industry will generally provoke a reaction of fear and uncertainty.

The really important question is: will they achieve their objective? This of course will only be able to be answered definitively after the passage of time and analysis of completed contracts.

A more valid question, which can be asked and analysed at this stage, is whether the new contracts will impact on the construction costs of projects?

The analysis below relates principally to the Building and Civil Engineering contracts for Major Works over €5 million.

The new contracts contain a number of new provisions or new approaches to the management of costs. In addition there are a number of other changes which will indirectly impact on potential costs.

A summary of the key provisions and their possible impact are given below:

Pre-Contract
A core principle of the new contracts, and the procurement reforms generally, is that projects should be fully designed prior to going to tender.

This is a change from the previous arrangements where Provisional Sums, Provisional Quantities and Contingencies were permitted. The finalisation of the design covered by these items was then done in tandem with the works on site.

The requirement to have all design complete prior to tender will lead to an increase in the pre-contract programme duration. In normal circumstances where construction inflation is +4% or similar the extended duration for design will have an impact on the project cost.

It has to be said of course in the current climate this is unlikely to be an issue however in the medium and long term it is a factor to be considered.

Post-Contract Thresholds
A new provision in the contracts is the inclusion of time thresholds which contractors must include for in their tender price and programme. These are effectively time contingencies should they be required by the employer however they are non-retrievable if they are unused.

Considerable caution should be exercised in setting these time thresholds. Whilst clients get the benefit of tendering the cost of the delays, if they over provide for threshold days and they are unused then they are potentially paying for time that is not required and may not be maximising value for money.

On the other extreme if they under provide for threshold days they may find contractor’s pricing strategies will change accordingly and may not get very competitive pricing of delays.

Inflation on Client direct costs
The programme implications of the additional design time pre-contract and the extended post-contract period arising from inclusion of thresholds will push out some expenditure on client direct costs and this may incur additional inflation costs on these items.

FIXED PRICE PREMIUM
The treatment of fixed price tenders has changed also with the introduction of Price Variation Clauses which only come into effect for projects over 30 months (there is provision for hyper inflation in exceptional circumstances).

The effect of this is that the vast majority of projects tendered will be on the basis of Fixed Price, thus the premium that was previously required to be negotiated on projects over 11 months can now be tendered competitively.

This should lead to a significant cost saving on this element for projects in this category. The contracts clearly set out what are the only permissible grounds for Delay and Compensation Events.

These are listed in Section K of Schedule 1 of the 21 Events, and the ones below are at the client’s discretion as to whether they are to be compensation events:

Bill of Quantities
The client has the option of passing the risk with regard to errors in the Bill of Quantities. The default position tends to be to pass this risk to the contractor; however there are a couple of exceptions to this rule of thumb.

Where this risk is passed, contractors are likely to do a number of checks and make an assessment of the risk. It is probable that they will make some cost provision to price this risk.

Ground Conditions
The risk of an archaeological occurrence on a project may be small however if it arises the potential impact can be very significant in terms of delay and costs.

This is particularly the case in civil engineering projects such as roads and drainage schemes.

As a result the risk assessment and decision with regard to risk allocation is very important in finding the balance between value for money and cost certainty. Similar to Archaeology, ground conditions can particularly impact on civil projects.

Detailed pre-Contract site investigations can reduce the risk premium that contractors may apply where this risk is allocated to them.

Utilities
The presence of underground services in the ground have been notoriously difficult to define with certainty due to the lack of accurate records.

This risk can be reduced by detailed surveys pre-tender and then the option exists to pass this risk to the contractor. The dependence on third parties to a contract can impose risks of delay and consequent loss.

In contrast to the other optional delay and compensation events this one is typically retained by the client.

Weather
The right to claim for delay arising out of the weather is set down as a 10 year event subject to certain contract conditions. It is not a compensation event.

All contractors will have to carefully consider the likelihood of being delayed by weather versus the probability of being unable to successfully obtain an extension of time.

This assessment may result in the inclusion of a cost by the contractor in his tender for acceleration to maintain programme during the course of the works.

Insurances
The client has the option under these contracts to seek additional insurances such as Professional Indemnity Insurance and extended all risks to other properties etc.

If required by the Client these will incur additional costs and they may not be matched by credits in the Client’s own insurances where they already have them in place.

Cashflow
Provisions in these contracts, not present in the previous government contract, allow for the deductions from monies due to the contractor if he fails to provide progess reports and/or collateral warranties as stipulated. These deductions, if applied, could seriously affect a contractor’s cashflow and finance costs.

Site possession
Another more subtle change has been that contractors no longer get exclusive possession of the site. This could result in more than one contractor on the same site at the one time.

Project Administration
The new contracts include onerous provisions with regard to time limitations on contractors seeking additional sums over and above the contract sum.

These time constraints are condition precedent meaning if they are not followed the contractor loses the right to recover any such costs.

This provision, combined with others such as the requirement for detailed progress reports and programmes (or face penalties as described above under cashflow), will mean contractors will likely have to increase their quantity surveying/administration overheads and in turn include for same in their tenders.

Market Reaction
Last but not least is the question of the market reaction. Certainly the sentiment of the market reaction has been sceptical. Because of this sentiment, initially the consensus was that projects under these forms of contract, quite apart from the cost factors mentioned above, would attract a cost premium.

However sentiment has been replaced by reality and the downturn in the construction industry has been so sudden in the last 12 – 18 months it has meant that contractors have had to ignore sentiment when pricing and the genuine additional costs arising from the contract changes have been camouflaged by the severe drop in tender prices.

Client out-turn costs
Traditionally the risks that are now incorporated in the contract sum would have given rise to variations during the contract resulting in increases in outturn costs (not always the case).

Will the additional costs built into the contracts to cover these risks now result in a reduced variance between contract and outturn costs and hence greater cost certainty?

It is uncertain because traditionally there were provisions such as provisional sums, provisional quantities etc within contract sums to deal with these eventualities whereas now no such provision exists. n

Davis Langdon PKS are currently preparing Guidance Notes for the Department of Finance in relation to Design and Cost Control Procedures as part of the overall Capital Works Management Framework