How to best allocate risk in construction contracts

Caroline Watkins is a partner in the construction team at Thomson Snell & Passmore

The benefits of getting the allocation of risk correct in a construction contract are invaluable, with external and sometimes internal influences posing considerable risk.

“The effort put in at the start can offset a considerable amount of grief later on”

Therefore, proceeding without proper consideration of allocation of risk at the outset can result in costs and confusion when those influences rear their heads.

Types of risk in construction contracts

Construction is well-known for hefty associated risks and there are many factors that create uncertainty throughout a project. Force majeure, unforeseen ground conditions, adverse weather, inflation, political events, consents, economic conditions, changes in law and compliance, design defects and discrepancies can all lead to considerable shifts in cost and time after work begins. It is for the parties to determine between them how those risks will be both allocated and managed, and to document the same effectively in the contract terms.

Principles of risk allocation

In deciding on the party with whom the risk should lie, a key consideration is which party is most capable of managing the risk and/or dealing with the consequences.

All risks under the contract should be taken into account when drawing up or responding to the contract terms to ensure that the risk is balanced – the effort put in at the start can offset a considerable amount of grief later on.

Who bears the risk?

Generally speaking, most standard form construction contracts in an unamended form will aim to distribute the risk fairly between the parties. This is not to say that each standard form will accurately set the right balance in every context. There can be a temptation from the client’s perspective to load risk onto the supply chain by way of contract amendments without consideration of the potential outcome.

During the tender process, it is generally the client that is on the front foot when determining how risk will be allocated throughout the contract, because it is the client that habitually sets out the contract terms. Prospective contractors must ensure that the contract terms are scrutinised and assessed to determine the balance of risk, and any items that swing that balance too far must be identified in the tender queries.

The price of the risk

A common consideration of a properly agreed allocation of risk is the effect on the contract price. This manifests in many ways. Additions by way of management fees to lump sums, unit costs per collateral warranty and “pain versus gain” mechanisms are common signs of contracting parties’ efforts to capture risk in contractual pricing methods.

Parties should consider the pricing model at the outset, in parallel to selecting the form and content of the contract. Where relevant, it should always form part of the invitation to tender. There are considerable pricing options for parties wishing to balance risk in a contract, which are usually dependent on the type of project and economic circumstances of each party.

For example, if the project is taking place in a volatile economy, this can be tackled by agreeing adequate fluctuations in price or an indexation mechanism to manage the risk of inflation. Where the parties are comfortable with the predicted cost, a cost reimbursable contract might be suitable for effective cost transparency and fluidity for cashflow.

As a final note, it is important to remember that risk allocation should not be administered just in terms of the two big hitters of cost and delay. The common mechanics of the construction contract should provide for adequate processes to be followed when a risk rears its head (for example retention of title, who insures what, notifications process of delays or design discrepancies). Where the correct balance of allocation or risk has been struck, failure to adhere to the managing processes should not let contractual risk management fall at the last hurdle.

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