Another one bites the dust
On 17 January, UK infrastructure giant Carillion announced it was going into liquidation. Its collapse was caused in part by cost overruns on some of its large contracts. In particular, three construction contracts that it had been awarded by the government: the £350m Midland Metropolitan Hospital in Birmingham, the £335m Royal Liverpool University Hospital, and the £745m Aberdeen bypass. The impediments to delivering these contracts on time and within budget ranged from asbestos challenges to unforeseen delays due to HVAC systems and slow progress with earthworks removal pushing out completion dates.
The scale of this collapse is yet another wake-up call for the construction sector on many levels, but none more than on the need to manage contracts effectively, in particular, to monitor closely and assign responsibility to the appropriate stakeholder when design changes are made post contract award. In my experience working across the global oil and gas industry, failing to allocate and charge-back design change costs to the investor or operator is a key area where contractors lose money. This failure is often due to inadequate contract management systems that are frequently not integrated with materials management solutions and the design software tools.
In July 2017 when the potential overrun on these contracts was reported, this aspect of poor contract management was highlighted by Keith Cochrane, the respected engineering industry veteran who was parachuted in as Interim CEO at Carillion. Mr Cochrane commented on the challenges saying "Tenders have been accepted with a high degree of uncertainty about key assumptions; our ultimate success has been contingent on the performance of others not under our control and we've agreed design changes without agreeing incremental cost and value."
McKinsey research identified that during project execution, the key risks for the sponsor or developer relate to contractual default, claims, keeping public political stakeholders aligned, and monitoring for any mismanagement by the contractor. The research concluded that “the interface with the contractor is therefore the most critical element.” Clearly, to have holistic picture of the health of the contract as it is executed, project stakeholders must have systems in place that actually report on the health of the contract.
PwC’s analysis of 36 companies across multiple sectors revealed that, following a public announcement of a capital project delay or shutdown, most companies experience a steady decline in share price. By the three-month mark following such an announcement, the decline averages 12%. As a result, organisations competing for these investment dollars, to finance their complex capital projects, often sensibly look for proven risk mitigation mechanisms such as advanced contractual risk management software to help them to generate the confidence required to secure these funds. In Carillion’s case, its share price dropped 39 per cent last year after it said a review of its contracts had persuaded it to write down the value of those three government projects by £845m.
There is a strong case to embed and enforce proven contractual risk-management discipline to mitigate these risks and better manage this essential interface with the contractor. And if implemented properly, then surely such ventures should command lower risk premiums and therefore lower cost of capital to fund their projects.
Sensible owner operators proactively manage the contractor and the contract risk using best-of-breed Contract Risk Management solutions with Early Warning Indicators that flag potential risks in time to take corrective action. As such, they truly merit a lower cost of capital than those that are negligent in this regard.