M a n a g e m e n t o f e n gi n e e r i n g P rojects

Chapter 9 ! overview
A contract is a legally binding, enforceable and reciprocal commitment governing the collabora-
tion between two (or more) parties.
In this chapter the focus is on the development and execution of fit-for-purpose contractual
arrangements between owner and contractor, characterised by an equitable allocation of risk.
Such an arrangement needs to be robust; i.e. it needs to be effective throughout contract exe-
cution despite changes that will inevitably occur. The main streams in contract theory and
their application in practice are discussed. The development of an optimal contracting strategy,
breaking up the project work scope into contract packages, is considered in the light of owner
capability. The main forms of remuneration and their application are described, together with the
tendering and award process as well as subsequent contract management.
Throughout this chapter relevant terms and conditions are used to illustrate how the various
concepts are formalised in the contract.

Chapter 9 ! outline
9.1 What constitutes a contract?
9.2 Contract theory
9.3 The contracting framework
9.4 Strategy development
9.5 Forms of remuneration
9.6 Sourcing and contract management
9.7 The Wind Farm

156

925836-02_174_17-Feb-15_08:43:06_walter
 the scene and money at work

Chapter 9
Contracting
by Kees Berends

9.1 ! What constitutes a contract?

Contracts mean different things to different people. To a lawyer, a contract is a reciprocal commit-
ment between two (or more) parties that is legally binding and enforceable; the contract defines
the rights and obligations of the parties involved. In economic terms a contract is primarily a
bilateral coordination arrangement that sets out how parties will work together. Here, contracting
is discussed from a project management perspective, considering economic and legal aspects
relevant to the practitioner, but with a focus on contracting as a tool to achieve effective project
control. With this in mind, the following definition will be used:

A contract is a legally binding, enforceable and reciprocal commitment

governing the collaboration between two (or more) parties.

In project management the term contracting (contract, agreement) is often used for services
(e.g. engineering, construction) and the term procurement (purchase order) is used for goods
(e.g. bulk materials and equipment items). From a legal perspective however there is no distinc-
tion; they are contracts. Essential elements of contract formation are (Buchem-Spapens, 2011):
a) The intent to create a legal relationship and the legal capacity to act
b) An offer and an acceptance; and
c) Compliance with established practice and the law.

In economic transactions an underlying assumption is that a party’s declared intent corresponds

with the actual intent. This means that even in the case of an error by one party, a contract exists
if the other party had good reasons to rely on that declaration. In principle all adults and ‘legal
entities’ (e.g. corporations) have the capacity to enter into a contract, but the number of people
authorised by a company to do so will be limited. If an unauthorised person has entered into a
contract on behalf of a company, a contract will still exist if the other party had good reason to
believe the signatory was authorised to represent the company.

157

925836-02_175_17-Feb-15_08:43:08_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

Scope

Tendering
&
Award

Price Terms

Figure 9.1: Contract triangle

The concept of offer and acceptance is at first sight simple and straightforward. In practice, how-
ever, complications arise on a regular basis. A statement can only be qualified as an offer, if it
defines the following main elements: (i) Scope of work; (ii) Price and payment provisions; and
(iii) Terms and Conditions. As illustrated in Figure 9.1, these elements are interrelated. In the
contract a fit-for-purpose balance is established through an iterative process of qualifications
and negotiation during the tendering and award process. An offer is revocable, unless explicitly
defined otherwise; e.g. ‘this offer is valid until ….’. The most important consequence of such an
irrevocable offer is that the offering party cannot withdraw the offer during the specified period.
An offer which is free of engagement or without obligations on the other hand, can be revoked
by the offering party at any time. Acceptance is sometimes also complicated. For instance, it
is quite common to ‘accept the offer subject to the following qualifications …’. This constitutes
a counteroffer rather than acceptance and the contract is not established until the counter-
offer has been accepted without qualification. Finally it is worth mentioning that the moment at
which the contract is established is not always obvious. Here the main rule is that the declaration
of intent becomes effective upon reaching the party addressed. Whether or not it has come to
the other party’s attention is irrelevant (Dop, 2013). This illustrates that people are key in con-
tracting procedures; e.g. if the letter in which the offer has been accepted has not been opened
by the recipient, the contract has still been established.

The term ‘offer’ is typically used by lawyers whereas contracting professionals tend to speak of
‘tender’ or ‘bid’. Here these terms are used interchangeably.

In principle, parties have freedom of contract which means they can stipulate anything they like
in their contract, provided it does not contravene the law and it is feasible. A contract to build a
perpetual motion machine for instance would not be possible. Contracts are only binding on the
contracting parties and generally not subject to any format. This means they can be oral as well
as written. Obviously, the main problem with oral contracts is that it can be hard to prove what
exactly has been agreed. This is the main reason why contracts are usually written.

158

925836-02_176_17-Feb-15_08:43:10_walter
 the scene and money at work

9.2 ! Contract theory

9.2.1 Origins of contract theory

Contract parties are economic entities and consequently economists have taken a keen inter-
est in analysing contracting through economic models. The starting point is the basic model
of a business enterprise called the theory of the firm. Initially, the primary goal of the firm
was thought to be (short-term) profit maximisation. Later on this was broadened to incorpo-
rate uncertainty and time. The behaviour of the firm in economic models is governed by value
maximisation. The practical application of the initial models developed in the 1930s based on
the theory of the firm, was limited due to the underlying restrictive assumptions such as a per-
fect equilibrium between prices and quantities at all times, parties being equally and completely
informed, perfect verifiability by an external party (e.g. arbiter or judge). Within the context of this
book, there is no room for a comprehensive review of the relevant economics literature however
some of the most salient developments are outlined below.

In 1937, Coase was one of the first to introduce the concept of coordination mechanisms and
cost. Building on this early work, in the 1970s Williamson developed the transaction cost theory,
focusing on parties’ inability to compose complete contracts in the face of (i) Incomplete and
asymmetric information; and (ii) Limited enforceability due to independent arbiters not being
able to verify contract performance reliably and in a timely fashion (Brousseau et al., 2002).

In recent decades, game theory has attracted a lot of attention. The most important event in
its early development was the publication in 1944 of the book Theory of games and economic
behaviour by Von Neumann and Morgenstern. In the early 1950s Nash developed the concept
now known as the ‘Nash equilibrium’ and the game theory of bargaining, which proved to be
an important building block. A famous early game, the ‘prisoner’s dilemma’, was contrived by
Dresher and Flood around the same time, involving two players where the self-interest of each
player leads to both being worse off than if they had collaborated.

An important milestone in the development of incentive theory, which is such a large part of
the contracting economics literature today, is the concept of moral hazard (from the insurance
market) introduced by Arrow in the 1960s. This incorporates the notion that individual actions
may damage the general welfare and cost to society as a whole (Macho-Stadler, 2001). In 1964,
Scherer published his seminal paper on contractual incentives when the Department of Defence
in the USA started to use these extensively (Scherer, 1964). In 1970, Akerlof described the hidden
characteristic problem in the market for used cars. Owners of new cars often place these on the
market when expensive repairs start to appear frequently; they are ‘lemons’. Consequently the
market for used cars contains a disproportionate number of lemons. This depresses the price of
used cars, discourages good quality cars being put on the market, which decreases the equilib-
rium price and so on.

The theories described above focus entirely on material incentives and their impact on indi-
vidual and corporate decisions. In the 1970s, Kahneman and Tversky introduced psychological
research into economics, particularly regarding judgement and decision making under uncer-
tainty, leading to what is currently known as behavioural economics. This builds on the work
of Arrow, acknowledging that contracting is a human process where individual biases affect

159

925836-02_177_17-Feb-15_08:43:10_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

corporate decision making. These biases include the representative heuristic (favouring salient
data), availability heuristic (reference to examples) and the anchoring and adjustment heuristic
(bias in favour of existing beliefs, initial estimates, etc.). These heuristics do not mean people are
irrational but rather that their behaviour is governed by ‘bounded rationality’. In most cases the
available information is incomplete and the time for analysis limited, which impacts the decision
making process at individual as well as corporate level.

An early example of operationalising economic theory is the work of Friedman on competitive

bidding in the 1950s (Friedman, 1956). However despite the enormous advances in contracting
economics during the last 40 years, the interaction between theorists and contracting practition-
ers remains limited. The latter tend to rely on best practices and standards based on operational
experience as for instance described by Clough and Sears in their reference work which has
been used in the industry for over 45 years (Clough et al., 2005). Fortunately, the value of an
interdisciplinary approach, operationalising theoretical concepts from contracting economics is
increasingly recognised (Berends, 2007).

9.2.2 The principal – agent model

The prevailing model in contract theory today is the ‘principal-agent’ paradigm, which draws on
the theories discussed above. The principal (i.e. the owner) is the party that proposes the contract
and the agent (i.e. the contractor) is the party that has to accept or reject the contract. The main
concepts in the principal-agent model are:
a) Hidden information; and
b) Hidden action.

Hidden information and hidden action are frequently referred to as ‘adverse selection’ and ‘moral
hazard’ respectively.
A hidden information problem exists when the contractor has characteristics or knowledge that
are not known to the owner prior to contract award and that affect the contracting framework
and contractor selection. This can relate to the financial status of a contractor, his workload or
technical capability. The owner engages the contractor because the latter has technical capabil-
ities and or resource capacity the owner does not possess. This inherently means that in many
cases the owner does not have the competence or the capacity to carry out a comprehen-
sive assessment. After issuing the invitation to make an offer (invitation to tender), but before
acceptance (contract award) ‘signalling’ by the contractor may occur (e.g. the type and num-
ber of contract qualifications and the resourcing plan) revealing his hidden characteristics. It is
important that the owner interprets these signals correctly, taking into account possible biases of
the staff involved, to ensure the right contractor is selected.
Hidden action pertains to a situation where (i) The owner cannot verify whether the contrac-
tor has executed the work properly; or (ii) The contractor obtains certain relevant information
after contract award without sharing this with the owner. On engineering and construction
projects, the description of the scope of work will never be ‘complete’ and usually there are time
constraints as well. Also the owner may not be able to assess the quality of the work in a timely
fashion as certain defects may only become apparent after completion of the work or during
operation. Also it may not be possible for a third party (e.g. arbiter or court) to verify the work
in which case the contract will effectively be non-enforceable. In this context, it is important to
realise that the interests of the contractor and the owner are different. For the owner, the project

160

925836-02_178_17-Feb-15_08:43:13_walter
 the scene and money at work

is a means to realise an asset that will generate revenue over a long period. The contractor’s rev-
enue is linked to the execution of the project. Consequently the bargaining (negotiating) position
of the owner after contract award is in many cases weak as the consequences of poor quality
and delays in completing the project are much bigger for the owner than for the contractor.

9.3 ! The contracting framework

9.3.1 Contracting in context

Whilst a contract is only binding for the parties to the contract (i.e. owner and contractor), it exists
and operates within a context of related contracts and stakeholders, as indicated in Figure 9.2.

The authorities play an important role through the applicable law, rules and regulations as
well as requirements on participation of local companies, subsidies, etc. Non Governmental
Organisations (NGOs) may also play a role. The interests of these stakeholders are in many cases
(but not always) aligned with those of the local community. Their role pertains to the boundary
conditions for project execution and early engagement with them is critical to project success.
Insurers and lenders facilitate the execution of the project, they play a more direct role in the
contractual relationship between owner and contractors (incl. licensors).

Licensors

3
Insurers Community
4

Contractors 5 Owner 2 Shareholders

7 6 1
Lenders Authorities Contracts

Influence

1 Legal requirements 5 Engineering, Procurement and

2 Shareholders’ agreement Construction (EPC) contracts
3 License agreement 6 Loan agreement
4 Construction All Risk (CAR) insurance 7 Direct agreement

Figure 9.2: Contracting map

9.3.2 Liabilities and guarantees

On most projects the design depends to a certain extent upon information provided by the
owner; this is commonly called rely-upon-information. The owner needs to identify those
design elements for which it is responsible under the EPC contracts and to examine the recourse
that it has to third parties (e.g. process licensors). It will also be important to address the question
as to whether the design obligations of the contractor are absolute, like ‘fitness for purpose’ of

161

925836-02_179_17-Feb-15_08:43:13_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

the asset, or less stringent like ‘best endeavours in accordance with accepted industry standards’
or the use of ‘reasonable skill and care’.

The profitability of the project (and possibly the owner’s ability to repay its loans) depends upon
the facility fulfilling certain performance criteria. If the process technology is obtained from a third
party licensor, the license agreement will stipulate: (i) Rights of the owner to use the technology
for the project; (ii) Warranties of the licensor with respect to any patent infringement; and (iii)
Performance guarantees with respect to the process technology. The performance guarantees
will be subject to the plant being constructed in accordance with certain design specifications
included in the license agreement. The liability of the licensor is typically related to a percentage
shortfall in performance (e.g. production capacity) and is limited to a percentage of license fee.

In the event of physical defects or damage to the work, the contractor will be liable for compensatory
damages to the owner. For an equitable contract, the contractor’s liabilities should be related to the
contract value; i.e. the revenue of the contractor and the risks associated with executing the work.
Compensatory damages can be difficult to determine exactly and therefore, so-called liquidated
damages may be included in certain contracts. These constitute a fixed amount per week’s delay
in completion and/or percentage shortfall in plant performance, that are payable by the contractor
to the owner for damages suffered, up to a certain maximum. The word ‘liquidated’ in this instance
merely signifies that the precise amount of the owner’s damages has been established by agreement
up front. Liquidated damages also are a way of limiting the liability of the contractor. It is normal to
include an overall cap on the liability of the contractor and to limit the length of the defects liability
period. Consequential loss (i.e. indirect losses such as loss of income or profit, loss of production,
etc.) is in most cases excluded. An important exception to limiting liability are claims resulting from
gross negligence and wilful misconduct of the contractor where it would be unjustified for the
contractor to act in this way and then hide behind the limitation of liability in the contract.

The payment provisions in the EPC contracts may include retentions that the owner may hold
back subject to completion of (part of) the work. The owner will wish to assess the adequacy of
the bank guarantees or other bonds given by institutions on behalf of the contractor(s). Where
the contractor is a subsidiary, the owner will often require a parent company guarantee.

Insurance is in many cases a key issue, particularly regarding deductibles. In case of project
financing, the loan agreement will contain detailed requirements in relation to insurance and
the lenders will usually wish the project insurances to be taken out by the owner rather than by
the contractor. In the case of a major loss or damage, the lenders may also require a provision
that insurance monies be available to repay the loan rather than continue with the project in the
event of a substantial loss.

9.3.3 Financing the project

The structure of the project financing arrangement needs to be fit-for-purpose and may involve
a number of different lenders with different lending terms and with different priorities in terms of
access to the security provided by the owner. The risk analysis for the lenders is in many ways
similar to that for the owner but their interests are not the same. The main difference is that
the lenders’ return is fixed. The lenders will generally not have an equity interest in the project
and therefore will not benefit from the success of the project beyond their fixed return. On the

162

925836-02_180_17-Feb-15_08:43:13_walter
 the scene and money at work

other hand, if the owner becomes insolvent, the lenders face a substantial loss and will have the
administrative burden of enforcing and realising their security. Consequently, lenders tend to be
more risk averse than the owner.

The lenders will first seek to ensure that each risk has been clearly accepted by one of the other
stakeholders in the project. Secondly, the lenders will wish the risk borne by the owner to be
minimised, although this may involve costs (e.g. insurance) that the owner considers to be
uneconomic. Finally, where a risk is to be borne by another stakeholder (e.g. a contractor), the
lenders will need to be satisfied that the stakeholder concerned has the resources to bear the
additional cost which could arise if that risk materialises.

A key issue for the lenders will be the nature of the security given by the owner. Where the
owner defaults on its repayment obligations, the lenders will wish to be able to take over the
project and dispose of it to a third party. This will involve having appropriate security interests in
all the assets and contracts of the owner, necessary to execute the project (and also sometimes
over the shares of the owner).

The lenders will also want direct agreements, with the main parties contracting with the owner.
Such direct agreements have become a standard requirement of lenders in project financing.
The main purpose of these direct agreements is to ensure that if the lenders enforce their secu-
rity, the project can continue either under the control of the lenders or, after disposal, under the
control of a third party purchaser.

The loan documentation is likely to contain a large number of detailed obligations on the part
of the owner in relation to project management. These provisions may include (i) An obligation
not to alter the project contracts without the consent of the lenders; (ii) An obligation to enforce
those contracts; and (iii) Rights for the lenders to monitor and inspect the status of the project.
The shareholders of the owner may also be required to give certain undertakings. Breach of the
undertakings may give rise to the right of the lenders to call a default, enforce their security and
take over the project.

All in all, project financing will create significant contractual complications and it is important to
consider possible implications at an early stage.

9.4 ! Strategy development

9.4.1 Generic considerations

The contracting strategy defines the breakdown of the scope into contract packages and how
these will be contracted out. Key elements in establishing this breakdown are:
a) Marketability and commerciality of the packages
b) Project management considerations; and
c) Project specific constraints.

Some parts of the scope may be contracted out through competitive tendering, in order to obtain
offers (bids) at a commercially acceptable price. Here the availability of sufficient, competent

163

925836-02_181_17-Feb-15_08:43:16_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

bidders is an important consideration. Other packages may be contracted out through (exist-
ing) frame agreements or single source negotiation. From a project management perspective,
packaging scope elements can be attractive to minimise the number of interfaces. However the
contractor responsible for a certain package may contract a large part to sub-contractors with
the ‘single point responsibility’ and reduction of interfaces being a fallacy. Other considerations
relate to construction sequencing, which will have an impact on the time when contracts for
the various packages have to be placed. Project specific constraints may include the boundary
conditions imposed by the various stakeholders (see also 9.3). To take all these considerations
into account, it is essential to carry out a proper assessment of the requirements of all relevant
stakeholders in a timely fashion. After generating a number of credible ways for a breakdown into
contract packages (strategy options) the optimum strategy is selected based on certain criteria
(derived from the overall project objectives).

9.4.2 Developing contracting strategy options

For the development of a contracting strategy, project activities are typically broken down into:
• Front End Engineering Design (FEED)
• Detailed design and engineering
• Procurement of materials and equipment
• Fabrication and construction; and
• Commissioning and start-up.

When generating options, it is useful to start with the two archetypes, described schematically
below as strategy (a) and (b) and to subsequently develop a number of hybrids. The various
options can be visualised in the form of a so-called ‘contracting quilt’. In Figure 9.3, the contract-
ing quilts of two archetypical contracting strategies are depicted, with a breakdown into five asset
elements (general facilities, utilities, process plant 1/2 and storage tanks). The various blocks each
represent a contract. In reality the breakdown will be more detailed and capital cost estimates for
the various asset elements may be included to establish the size of the various packages.
Commissioning

Commissioning
Construction

Construction
Procurement

Procurement
Engineering

Engineering
FEED

FEED

General facilities

Utilities

Process plant 1

Process plant 2

Storage tanks

(a) (b)
Figure 9.3: Strategy archetypes

164

925836-02_182_17-Feb-15_12:16:24_walter
 the scene and money at work

Under strategy (a) the owner awards a contract for FEED and subsequently a contract for
Engineering, Procurement and Construction (EPC). The contractor has an obligation to deliver
the asset specified in the FEED package and in many cases the EPC contract will be on the basis
of a lump sum / fixed price (see also 9.5). Commissioning and start-up activities are usually car-
ried out by the owner, with assistance from the EPC contractor.

Strategy (a) inherently creates a hidden information problem. Whilst the contract sum is relatively
small, FEED is critical for project success and therefore the owner will strive to select the most
competent contractor. The latter will also want to participate in the execution phase (commer-
cially the most interesting part of the project). Precluding the FEED contractor from participating
in the tendering for execution may result in competent contractors being unwilling to perform
FEED. On the other hand, allowing the FEED contractor to participate in competitive tendering
for the EPC will provide them with an unfair information advantage versus the other bidders.
Also, there is a risk of ‘gaming’ by the FEED contractor (i.e. manipulation of the FEED) to improve
its commercial position during EPC tendering. This may even lead to a situation where other
prospective bidders refuse to compete against the FEED contractor which participates in the ten-
dering process, because they do not believe they have a realistic chance of winning. Hence the
owner is at risk of finding itself at the end of FEED in a situation where strategy (a) is not market-
able with no other option than to negotiate single source with the FEED contractor. A ‘hostage’
situation where the contractor, having just executed the FEED work, will in most cases be better
informed about the project than the owner. This is particularly relevant in a constrained market,
with ample prospective contracts for contractors. It is therefore critical to collect reliable market
intelligence in a timely fashion. This may include pro-active engagement with the market and
maintaining the established relationships during FEED by keeping prospective bidders informed
about the status.

An alternative is to create a level playing field by having multiple contractors perform the FEED
in parallel, with all contractors submitting a proposal for execution at the end of FEED. This min-
imises the risk of not having a competitive tendering situation for the EPC work but results in
extra cost and an additional burden on the owner for managing multiple FEED processes.

Under strategy (b) the owner awards one contract for FEED and services for Engineering,
Procurement and Construction Management (EPCM). As the FEED/EPCM contract is awarded at
a time when the level of scope definition is limited, a reimbursable form of remuneration (see
9.5) will generally be used. Certain scope elements like storage tanks may still be contracted out
on an EPC basis as they are executed by specialised companies, providing an integrated supply
chain solution. Procurement of the other materials and equipment and construction activities is
executed by the contractor ‘for-and-on-behalf’ of the owner. Effectively the contractor carries
out the same activities as under strategy (a) but now at the owner’s risk with subcontracts in
the name of the owner. Strategy (b) potentially offers significant continuity and schedule bene-
fits (with FEED rolling into detailed engineering), but requires a (relatively) large and competent
owner’s team, particularly regarding progress/cost control and contract management. A disad-
vantage for the owner is that it has to select a (main) contractor very early in the project lifecycle.
However with EPCM services constituting only 10 - 20 % of total cost, the commercial exposure
is generally limited.

165

925836-02_183_17-Feb-15_08:43:20_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

The two strategies described above are archetypes and in practice many ‘hybrid’ forms will exist.
As a variation of strategy (a), execution can be broken up into separate EPC contracts. This may
be prudent to increase the marketability, but creates a coordination issue between the various
packages. Similarly a variation of strategy (b), would be free issue of materials and equipment
to a single construction contractor. This will facilitate a phased contracting approach, but it also
means that the owner is responsible for (i) Timely completion of accurate construction drawings;
and (ii) The quality and timely delivery of materials and equipment. Any problems in these areas
will lead to claims of the construction contractor.

A concept that has received considerable attention during the last decades is ‘partnering’, where
owner and contractor seek to create a collaborative relationship, based on trust between the
parties rather than a formally structured arrangement; it is generally a non-binding process.
Sometimes used interchangeably with partnering arrangements is the term ‘alliances’ which per-
tains to a construct whereby owner and contractor share risk and rewards. This is often realised
through some form of incentive arrangement linked to target cost. In the domain of public
procurements, Public Private Partnership (PPP) projects are gaining ground (e.g. Commissie
Private Financiering van Infrastructuur (Commission Private Financing of Infrastructure), 2008).
This covers a variety of contracting frameworks that create a long-term relationship between the
public and private sector, including private financing of public service or infrastructure projects.

9.4.3 Selecting a fit-for-purpose solution

The criteria for selecting the optimum strategy have to be fit-for-purpose and are generally
derived from the overall project objectives; but they are not the same. Only those objectives that
are influenced by the contracting strategy are relevant. As indicated above, schedule for instance
is influenced by the contracting strategy and is therefore a selection criterion. Safety is not as this
is not primarily driven by the contracting strategy.

Various techniques are available for selecting the optimum contracting strategy. A common
approach is to carry out a Strengths, Weaknesses, Opportunities and Threats (SWOT) analysis. A
more quantitative technique is the Analytical Hierarchy Process (AHP) described by Saaty (Saaty,
2001). A comprehensive description of decision-making techniques and processes is beyond the
scope of this book. However, it is strongly recommended to follow a process with a balanced
group of decision makers to avoid personal biases like the latest experience of the key project
team members (see 9.2). This will involve professionals from project management, contracting,
cost estimating/control, scheduling and selected technical disciplines.

9.5 ! Forms of remuneration

9.5.1 The allocation and pricing of risk

The form of remuneration is an integral part of any contracting strategy, defining the pricing
and allocation of risk. Under a contract, the contractor will have an obligation to: (i) Achieve a
certain result (deliver an asset); or (ii) Use its best endeavours in providing services. The former is
generally associated with a lump sum/fixed price and the latter with a cost reimbursable form of
remuneration. For construction work so-called unit rate contracts are often used.

166

925836-02_184_17-Feb-15_08:43:22_walter
 the scene and money at work

The main difference between these contracts lies in the allocation of risk and the time at which
risk is ‘priced’. With a lump sum/fixed price contract, the contractor is required to provide a price
guarantee; i.e. the contractor is acting as a ‘quasi-insurer’ whilst in most cases it is ill placed to
bear the consequences of risk materialising (Ward et al., 1995). With a reimbursable contract the
owner initially carries the overall project (capital) cost risk and in the course of project imple-
mentation this is (gradually) transferred to suppliers and construction contractors (see Figure 9.4).
Many different variations exist within these two groups. Here, only the ones most commonly
used for FEED, EPC, EPCM and construction are discussed.

Contractor’s risk

Lump Sum Unit Rate Reimbursable

Owner’s risk

Figure 9.4: Forms of remuneration

9.5.2 Lump sum/Fixed price

With a Lump Sum/Fixed Price (LSFP) contract the contractor is responsible for executing and
completing the work as defined in the scope of work for a fixed price; i.e. the contract sum is
established at the start of the contract. The risk of the actual cost exceeding the contract sum is
borne by the contractor. If the actual cost of the work exceeds the contract sum, the contractor
has to accept a reduced profit or even a loss. This provides an inherent incentive for the contrac-
tor to execute the work efficiently. The premium associated with the contractor carrying the risk
of cost and schedule escalation is included in the contract sum. The size of this risk premium is
dependent on the contractor’s assessment of the risks and on market conditions (i.e. competitive
pressure).

Usually a reimbursable remuneration scheme is included for pricing any changes. LSFP con-
tracts are generally used for EPC and construction work. Sometimes the term turnkey is also
used, but this refers to a contract where the contractor provides a comprehensive service to
owner (e.g. project financing, land purchase, EPC, commissioning and start-up); the remunera-
tion basis does not have to be LSFP. Payment under an LSFP contracts is made against a series
of milestones (based on completion of a certain event) and/or on a monthly basis against value
of work done.

167

925836-02_185_17-Feb-15_08:43:23_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

Table 9.1: LSFP/EPC Contracts

Strengths/Opportunities

Relative cost certainty Market feedback and commitment (in case of competitive tendering)

Simple arrangement Single point of responsibility; contractor accepting the cost and completion risk

Performance incentive Cost (inherently); schedule and plant performance through Liquidated Damages

Small owner’s team Progress monitoring and change management; limited executive decision points

Bankable Preferred contractual arrangement for project financing

Weaknesses/Threats

Scope definition Good definition required, with limited ‘rely-upon’ items

Sufficient tenders Approach only effective when sufficient credible tenders can be obtained

Risk premium Contractor not well placed to bear the consequences of cost escalation

Schedule Significant tendering period to enable risk pricing and FEED verification

Limited flexibility Requirements need to be agreed at the start of contract

The strengths/opportunities and weaknesses/threats of LSFP/EPC contracts are summarised in

Table 9.1. One of the main reasons why many owners prefer this approach is that it provides
relative cost certainty (in the form of an LSFP/EPC bid) at the time of the investment decision. It
should be noted that this certainty is not absolute, particularly on engineering and construction
projects with a long project execution time and changing market conditions. Hence, the ‘fixed
price’ under a lump sum contract may prove to be illusory if risks materialise and lead to change
orders and claims. Also, many lump sum contracts nowadays contain exclusions or limitations of
the contractor’s liabilities, particularly with respect to risks that are beyond its control (e.g. wage
increases, steel price, etc.) to limit the risk premium included in the contract sum.

9.5.3 Cost reimbursable contracts

A large number of different forms of cost reimbursable or Cost Plus Fee (CPF) contracts exist. All
of them have in common that the owner reimburses the contractor for (i) All costs, reasonably
incurred and directly associated with the project; plus (ii) A certain fee for the services provided.
CPF contracts are typically used when the scope of work cannot be defined accurately upfront
like FEED and EPCM services. The total contract sum remains unknown until completion of the
work, because payment to the contractor is made on the basis of work actually done.

The strengths/opportunities and weaknesses/threats of CPF/EPCM contracts are summarised in

Table 9.2. Differences between CPF contracts pertain to the way the fee is established. With a

168

925836-02_186_17-Feb-15_08:43:25_walter
 the scene and money at work

Table 9.2: CPF/EPCM Contracts

Strengths/Opportunities

Marketability Service contracts are attractive when project risks are high

Risks allocated to the party best placed to carry the risk

Risk allocation
Optimum timing of contract award, when work packages are defined

Lowest cost Limited risk premium

Continuity Continuity between FEED and detailed design and engineering

Flexibility Changes during execution can easily be accommodated

Weaknesses/Threats

Cost uncertainty No overall ‘fixed’ contract sum at the investment decision

Performance incentive No inherent performance incentive

Complex arrangement Extensive control required by the owner

Bankability Additional guarantees from the owner may be required

Cost Plus Percentage Fee (CPPF) contract the fee is calculated as a percentage of the man-hour
cost of the EPCM services. This can also take the form of an all-inclusive hourly rate. A major
disadvantage of a CPPF contract is that it effectively provides an incentive for the contractor to
increase the overall project scope, as the amount of services (and the contractor’s profit in abso-
lute terms) is related to the overall scope. This requires extensive owner involvement to control.
An alternative is a Cost Plus Fixed Fee (CPFF) contract whereby a single, fixed fee is agreed for
all services. This means that when the number of service hours increases, the contractor’s profit
margin (i.e. fee divided by the service hour cost) decreases, which discourages it from unduly
inflating the number of hours. Another alternative is to make the fee (in part) subject to perfor-
mance against a number of criteria defined at the start through a Cost Plus Incentive Fee (CPIF)
contract. This can indeed provide a mechanism to align the interest of owner and contractor
through the contractual arrangement. In practice however, it is often difficult to define crite-
ria and set performance targets that are meaningful and robust. Many incentive schemes are
‘over-engineered’. Whilst they have a place in the toolkit of the contracting professional, they are
generally only used on large projects and after careful analysis and modelling of the fee potential
versus the expected outcome of the criteria.
An inherent problem with CPFF and CPIF contracts is that the actual cost and fee (profit) for
the services have to be separated. This is in many cases not easy and requires specific financial
(owner) competencies to establish whether the cost build-up (salaries, payroll burden and over-
heads) is fair and reasonable.

169

925836-02_187_17-Feb-15_08:43:25_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

9.5.4 Unit rate or bill of quantities

Unit rate contracts are typically used for construction work. The units used (e.g. in a tunnelling
contract: a cubic meter of material excavated or a meter of tunnelling completed) and prices are
specified in a schedule of unit rates or ‘bill of quantities’. Unit rate contracts can be used when the
overall scope of work is unknown at the time of contract award, but the scope of each unit can
be defined. Therefore they require less scope definition at the outset than lump sum contracts,
although a reasonable estimate (by the owner) of the quantities is important for having an effec-
tive tendering process. With a unit rate contract, the contractor carries the ‘productivity risk’ of
executing the work as the owner is paying a fixed price for each unit. The owner carries the risk
of the quantity of work and must ensure it has the resources to carry out measurement of the
actual quantities executed. Tendering of unit rate contracts requires a significant effort from both
owner and contractor and is therefore only used on large projects or an existing production site
where it can be applied for a number of smaller projects and maintenance work.

9.6 ! Sourcing and contract management

9.6.1 Prospective contractors

The sourcing process requires a significant effort from contractors and the associated transac-
tion costs have to be recovered at some point in the supply chain. Therefore it is good practice
for owners to follow a staged process which ensures that contractors do not incur unnecessary
costs in pursuing opportunities which they have no chance of winning. In general terms, the
owner also has an obligation to be clear about its intentions during the contracting process, and
failure to do so will provide the contractor with recourse under law even if the contract has not
been concluded.

The first step in contractor selection is establishing a ‘long list’ of contractors that could poten-
tially carry out the work. Potential contractors will be requested to indicate whether they wish
to participate in the project; the solicitation of interest. This is followed by a pre-qualification
process leading to a ‘short list’ of potential bidders that will receive an Invitation To Tender (ITT).
Whereas the number of contractors on the ‘long list’ and the ‘short list’ will depend very much
on the work at hand, generally these should be 5 - 10 and 3 - 5 contractors respectively. The pur-
pose of the pre-qualification process is to establish whether prospective contractors are suitable
to execute the work, with respect to:
a) Financial health
b) General management and
c) Technical competence.

Contractors will be requested to submit general (e.g. financial data), as well as project specific
information (e.g. track record for this type of work, safety performance). The contracting strategy
will also have to be taken into account. For instance if the work pertains to FEED but the intention
is to ‘roll on’ into EPCM, competences for both have to be considered. The information under
a) and b) is mostly generic and may not be required if the owner frequently does business with
certain contractors.

170

925836-02_188_17-Feb-15_08:43:25_walter
 the scene and money at work

To preserve the integrity of the pre-qualification process, it is important to establish the eval-
uation procedure prior to receipt of submissions. This procedure should define the selection
criteria, the process (avoiding undue bias), the responsibilities of the members of the evaluation
team, ‘checks-and-balances’, timing and a communication protocol. It is acceptable to request
clarification during the pre-qualification process in the case of ambiguity or missing items, pro-
vided a level playing field is maintained. Also, it is good practice for the owner to provide (general)
feedback to those contractors that have not been ‘shortlisted’.

9.6.2 The tendering and award process

As a general rule, the ITT compiled by the owner should be suitable for incorporation into the
final contract with minimum alteration. An ITT typically consists of the following main elements:
• Scope of work
• Admin instructions and
• Draft terms and conditions.

The scope of work describes the deliverable as well as the way the work will be executed and
the timing. For a FEED contract this will include the initial basis of design, standards, the level of
detail required, special studies, calculations and simulations, etc. In the case of an EPCM contract,
requirements regarding project execution (including monitoring, control and reporting) should
be specified as well. For an EPC contract or a construction contract, a FEED package, technical
specification and construction drawings (when available) will be included. Some of this informa-
tion may be ‘rely upon Information’ or information from licensors (see 9.3.2).

The admin instructions specify how the tendering process will be executed; management of
the information flow, clarification meetings, the format of the tender and the submission time.
The tender may be split into a technical proposal and a commercial proposal. The technical pro-
posal contains the deliverables and how the work will be performed. The commercial proposal
contains any qualifications to the draft contract included in the ITT and the pricing information.
It is recommended to evaluate them separately to avoid bias.

Included in the ITT are the terms and conditions proposed by the owner to provide a common
basis of the commercial proposals submitted by the bidders (see also 9.1). The so-called ‘bat-
tle of the forms’ should be avoided, i.e. bidders responding by submitting their own (different)
terms and conditions, as this leads to inefficiencies and difficulties regarding equalising the bids.
Included in the terms and conditions are the payment provisions; the time value of money has to
be considered for any alternatives proposed.

During the tendering period, bidders may be offered the opportunity to visit the site and the
owner will have to manage the process of clarifications, ensuring all bidders receive the same
information to maintain a level playing field. It is important to allow for sufficient time for bid
preparation; not doing so will have a detrimental effect on the quality of the bids and inevitably
lead to delays and cost escalation later on.

The bid evaluation process is in many ways similar to the pre-qualification process but the integrity
issues are more pronounced and the procedures for handling information more strict. Also the
owner will generally as part of the process compile a counter estimate prior to opening the bids.

171

925836-02_189_17-Feb-15_08:43:28_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

After the bid evaluation has been completed, negotiation will start with the ‘preferred bidder’ to
finalise the contract. It is critical that during this period of negotiation the other bids remain valid,
so the owner retains a fall-back position should it not be able to reach conclusion with the pre-
ferred bidder. For major contracts it is customary to jointly sign the contract upon conclusion of
the negotiations to avoid ambiguity regarding the time at which the contract is concluded (see
also 9.1).

9.6.3 Contract management

Starting with the tender and the signed contract, contract execution generates a lot of informa-
tion and documentation. Clear procedures and an efficient contract administration system are
essential for a fit-for-purpose contract management process. The contract management pro-
cedures will define the division of work and responsibilities between contract holder (i.e. the
person responsible for executing the work), contracting and procurement, finance (e.g. invoicing
and payments) and other stakeholders such as the legal department, tax, etc. The administration
system is used to store all relevant documentation and to assist in managing the information
flow. Many commercially available software packages exist ranging from simple database solu-
tions to advanced, integrated and interactive systems (accessible by owner and contractor) for all
contract correspondence (i.e. no communication via Email anymore). It is important however to
recognise that the operation of such a sophisticated system requires serious expertise and align-
ment with other IT systems at the owner’s organisation.

An important element of contract management is performance monitoring. In many cases this

will be limited to progress and cost control, but for a large contract other performance indicators
may be established that are tracked on a regular basis (e.g. regarding safety performance). As part
of the payment conditions, the contract may include an advance payment, made at the begin-
ning of construction to assist the contractor with the start-up costs. Payment during contract
execution can be through progress payments, milestone payments or a combination thereof.
These need to be in line with the ‘value of work done’ and milestone events completed in the
field and the contract will contain provisions allowing the owner to hold back payment in cases
of progress falling behind.

The area that requires specific attention – as it is often underestimated – is materials management
and logistics. This includes expediting, inspection and warehousing of materials and equipment
during construction as well as timely ordering of spare parts and handover to operations.

A change order or variation order occurs when during contract execution the owner requires
a change in the scope of work or if other changes occur for which the contractor is not liable
under the contract. For instance, certain technical issues, exchange rate fluctuations, increases
in labour rates, etc. may have been explicitly excluded. If it is not clear whether the contractor is
liable for the latter, the parties need to establish whether (i) The contractor could reasonably have
foreseen these changes or whether these should be considered as an inherent contractual risk;
or (ii) The contractor is entitled to a change/variation order. If the owner and contractor cannot
resolve the issue at working level, the issue is first referred to senior management of the parties.
If the issue still cannot be resolved, the contract will provide for the means of resolving what has
now become a dispute. This can be a form of mediation, a negotiation process facilitated by an
independent party, focusing on the commercial interests of the parties and not their legal rights.

172

925836-02_190_17-Feb-15_08:43:31_walter
 the scene and money at work

Another private dispute resolution process is arbitration, but it differs in that it produces a bind-
ing result which is immediately enforceable. Finally, disputes can be resolved through litigation,
which comprises a public process.

Concluding observations
It is sometimes stated that contracting strategies and lump sum/fixed price forms of remunera-
tion (combined with competitive tendering) lead to a confrontational approach between owner
and contractor. Approaches based on a form of reimbursable contracts, on the other hand are
often believed to be more conducive to collaborative contracting. It is indeed true that in many
cases in the relationship between owner and contractor, both parties pursue their individual
interests rather than working together to maximise the overall value of the project. This mani-
festation of the ‘prisoner’s dilemma’ is however mostly caused by ineffective transmission of
information rather than the contracting strategy or the form of remuneration (see 9.2).

It is important for both owner and contractor to be clear about their expectations and to
acknowledge their different roles. The owner’s objectives are centred around the creation of the
asset (taking into account the various project stakeholders) whereas the contractor’s focus is on
realising value by executing the project. Alignment of objectives and collaborative contracting
is possible through various contracting strategies and forms of remuneration. The purpose
of the sourcing and contract management process is to clarify the parties’ intentions; translating
these into a contract is an outcome rather than an objective.

It is important for owner and contractor to get off on the right footing, building a constructive
relationship between key staff members based on trust and maintaining this relationship during
contract execution. By definition a project constitutes a change management process and during
its lifecycle the scope as well as the business environment (e.g. supply chain) changes. The
owner has to be realistic about what can be achieved during the various phases in the project
lifecycle and the contractual arrangement has to be robust with respect to accommodating these
changes. Also, it is critical that the owner has the competence required to identify and interpret
signals from the contractor. Both owner and contractor have a lot to gain by working together
effectively. Failing to do so comes at a high price and cannot be mitigated by ‘contractual fixes’
like increasing penalties and guarantees or monetary incentives.

173

925836-02_191_17-Feb-15_08:43:31_walter
 M a n a g e m e n t o f e n gi n e e r i n g P rojects

9.7 ! The Wind Farm

A key consideration in establishing the contracting strategy is that Participants
Windenergy Vento (the owner) lacks the expertise required in realising the project
and therefore it is looking to enter into a turnkey contract for execution. With project
development being dependent on the technology (and key equipment) used, Participants
Windenergy Vento may end up in a captive situation versus Allwind Energy. Taking this
into account, the following contracting strategy options can be identified:

a) Alliance
Participants Windenergy Vento and Allwind Energy enter into an (reimbursable) alliance
agreement, covering project development, execution, operation and maintenance. The
alliance agreement will include a performance based (incentive) fee to align parties’
objectives. If at the end of project development a (lump sum / fixed price) turnkey contract
cannot be agreed, the alliance will continue on a reimbursable (‘open book’) basis.

b) Project Management Contractor (PMC)

During project development, the PMC will work together with Allwind Energy and (lump
sum / fixed price) contracts will be concluded for the license and supply of turbines. If
a turnkey contract cannot be agreed at the end of project development, the PMC will
manage project execution, contracting out the separate scope elements, with an operator
being resourced during execution.

Strategy (b) has the disadvantage that it creates an additional management layer. The
PMC can contract out and manage certain scope elements (e.g. foundations for near-
shore turbines). However, the dependency on Allwind Energy will remain with the supply
of turbines being a large part of the scope. Strategy (a) provides good opportunities for
collaborative contracting, but a comprehensive and robust alliance agreement will be
complex. In view of the above, a variation of strategy (a) is recommended, with the owner
engaging a specialist consultant to set up the alliance agreement and to provide advice
during the initial phases.

174

925836-02_192_17-Feb-15_08:43:34_walter