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IMPROVING MEGAPROJECT PERFORMANCE BY MICHAEL FILIPPICH

I INTRODUCTION

The track record for Megaprojects in Australia and overseas has been abysmal

and shows no signs of improving. Only one Australian resource project in the last 7

years with a cost of more than $2 billion has achieved targeted production on time and

within budget.1 This project was ConocoPhillips’ $3.3 billion Darwin Liquefied Natural

Gas plant that came online in 2006. More recent oil and gas developments such as

Woodside’s Pluto LNG project in Western Australia and ExxonMobil’s Kipper-Tuna-

Turrum development in the Bass Strait have experienced cost overruns in the billions of

dollars and schedule delays of almost 2 years. Large mining and infrastructure projects

have performed no better with BHP’s multibillion dollar Ravensthorpe Nickel Project

being deemed uneconomic despite the fact that $3 billion had already been invested in

constructing a processing plant and an entire town to service it.2 A number of cross city

toll tunnels delivered as Public Private Partnerships have also had to undergo major

financial restructuring as a result of incorrect demand forecasts.

The poor performance of Megaprojects occurs despite the fact that they are

typically executed by experienced principals and contractors under Lump Sum Turnkey

arrangements. In many cases the principal and contractor both lose significant sums of

1 Matt Chambers and Damon Kitney, Resource mega-projects hit by $8bn cost blowout The Australian http://www.theaustralian.com.au/business/mining-energy/resource-mega-projects-hit-by-8bn-cost-blowout/story-e6frg9df-1225984651422 at 7 May 2011. 2 Dr Alison L. Browne, Prof. Daniela Stehlik and Dr Amma Buckley, ‘The mega-projects paradox and the politics of risk, hope and mistrust: Capturing localised impacts of the boom/bust cycles of Australian mining.’ (2009) Sustaining Gondwana Issue 21.

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money on the project indicating that it would have been better for the economy if the

project was never built in the first place. This paper will focus on the reasons for the

poor performance of Megaprojects and the contracting strategies that can be used to

improve their results. Particular attention will be paid to the non-technical risks that

come into play on Megaprojects and how conventional construction contracts should be

revised to address them. It will also be shown that there is limited benefit in identifying

and allocating risks if they cannot be managed or controlled by the responsible party. A

far more effective solution is to allocate the risk to the party that is best able to manage it,

even if that means leaving the risk with the principal.

II THE MEGAPROJECT PARADOX

Megaproject is a term used to describe projects with a value in excess of $1

Billion. The threshold of what constitutes a Megaproject is rapidly increasing as many

of the large resource and infrastructure projects currently underway have budgets in

excess of $10 billion. In addition to their enormous capital costs Megaprojects typically

involve long development timelines and tend to stretch resources, skilled labour, and

equipment to the limit.3 Often Megaprojects will use new technology or extend existing

technology to an unprecedented scale. Decision making and planning often involves

multiple stakeholders and complex interfaces between the government, private sector and

local community. Many Megaprojects are located in remote areas that require basic

infrastructure such as ports, accommodation, water treatment and power generation to be

3 Edward C Merrow, Understanding the Outcomes of Megaprojects: A Quantitative Analysis of Very Large Civilian Projects (1988).

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established before the project can commence. The political and social climate in these

countries can also be challenging and present a considerable risk to the project.

The main drivers for undertaking Megaprojects are to meet the energy and

infrastructure requirements of the world’s rapidly growing population and to improve

efficiency by achieving greater economies of scale. Many of the Megaprojects currently

underway are in developing countries such as China and India where there is a need for

better civil infrastructure such as roads, railways and bridges as well as improved energy

infrastructure such as base load power generation (coal, gas fired and nuclear) and

liquefied natural gas (LNG) receiving terminals. The Megaprojects currently underway

in Australia are largely aimed at providing the raw materials to these developing

countries such as coal, iron ore and LNG. A successful Megaproject can spur economic

growth for companies and even the entire country, while failure can set development

back for many years.4 Such large sums of money are invested in Megaprojects that

government and corporate balance sheets can be severely impacted if they are not

executed correctly. The success of these projects is so important to their sponsors that

governments and private companies can collapse if they fail. Startup delays on Hong

Kong’s $20 billion Chek Lap Kok airport in 1998 cost the local economy $600 million

USD over 9 months and had a noticeable effect on the country’s gross domestic product

for that period.5

4 Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (2003). 5 Ibid.

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Despite the huge sums of money at stake, Megaprojects have a history of

significant cost and schedule overruns and revenue and benefit shortfalls.6 Projects often

fail to provide a return to the local community and environmental impacts are usually

worse than initially predicted. Revenue generated by the project can be well below what

was originally forecast during the feasibility stage and many projects require government

or private sector bailouts in order to remain in operation. A study completed by the Rand

Group in 1998 on 52 Megaprojects in the process industry found that only 4 projects

came in on budget.7 The average cost overrun was 88% and the combined cost overrun

of 47 projects exceeded $30 billion USD. A similar study completed on 111 large capital

projects in the transport, power generation, mining, oil and gas, aerospace and defense

industry found that only 25% of projects were within budget. 68% of projects were

between 0 to 100% over budget and 7.2% had cost overruns ranging from 100% to

300%.8 A more concerning finding from this study was that cost and schedule overruns

had not reduced at all over the last century despite significant advances in engineering

and technology.

Strangely this poor performance record has not reduced the frequency, magnitude

and complexity of Megaprojects that are currently being sanctioned by governments and

companies across the world. This situation has been termed the ‘Megaproject Paradox’

by Dutch researcher Bent Flyjvberg and refers to the fact that more and more

6 Bent Flyvbjerg, ‘Survival of the unfittest: why the worst infrastructure gets built and what we can do about it’ (2009) 25 Oxford Review of Economic Policy, 344. 7 Edward C Merrow, above n1. 8 Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, above n4.

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Megaprojects are being built despite their terrible track record.9 The root cause of the

paradox appears to be a combination of political interference, delusion and deception

from project sponsors, a lack of accountability for project outcomes and the inadequate

evaluation and management of risk by governments and the private sector. With such

substantial resources at stake Megaprojects should not be undertaken without access to

world class technical expertise, sophisticated legal and financial structures,

comprehensive development and contingency planning and accurate economic forecasts

to support the project’s viability under a range of different circumstances. Sadly this is

often not the case and many large projects progress through the development stages

without even the basic systems and structures to manage the problems that potentially lie

ahead.

III THE RISK PROFILE OF MEGAPROJECTS

Due to their scale and complexity Megaprojects have a different risk profile to

conventional design and construct projects. Risks that are particularly important for

Megaprojects to manage include political and regulatory risk, environmental risk,

psychological risk in the form of delusion and deception, technological risk,

macroeconomic factors, unplanned events and organisational challenges. According to

the Rand Group study, political and regulatory risk was by far the biggest contributor to

Megaproject cost and schedule overruns.10 Megaprojects are typically of state

significance and are highly visible to the general public and therefore run the risk of

political interference.

9 Ibid. 10 Edward C Merrow, above n1.

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Megaprojects can be affected by a number of political factors including approval

delays, variations in government standards or regulations and changes to taxation and

royalty regimes. The timing of government approvals can be particularly important.

Some jurisdictions require all environmental and technical documentation to be fully

developed before construction work can start making it difficult to fast track the

procurement of long lead items or commence early ground works and site preparation.

There is strong economic justification for streamlining approval processes and reducing

duplication in regulatory functions. In the case of the English Channel Tunnel project,

each year of approval delays resulted in an average cost escalation of 4.64% per year or

$1 million per day.11

Another political risk that is particularly common in overseas projects is

government control over project labour and procurement practices. Countries will often

specify minimum requirements for local content even if the necessary skills or equipment

are not readily available within the country. These requirements will not cause major

problems so long as plans are put in place to manage cultural differences and local skills

shortages. An example of a Megaproject that successfully managed this risk was the

construction of the Union Carbide Ponce Petrochemical Complex in Puerto Rico.12 Key

project personnel from the USA were given intensive Spanish lessons to improve

communication with the local workforce. Training programs were established long

before construction started which enabled a majority of the workforce to be hired locally

11 Bent Flyvbjerg, ‘Policy and Planning for Large Infrastructure Projects: Problems, Causes, Cures’ (Working Paper No. 3781, World Bank, 2005). 12 Edward C Merrow, above n1.

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reducing labour costs. As a result of these initiatives the project had minimal industrial

relations problems and no conflict with the local government or other stakeholders.

Changes to government regulations and policy can also have a significant impact

on project economics and overall viability. Due to their long development timelines,

Megaprojects are particularly susceptible to changes in health, safety and environmental

regulations. Extensive rework or additional equipment may be required to comply with

these new requirements resulting in cost and schedule overruns. Governments may also

attempt to revise the project’s fiscal arrangements by increasing taxes or royalties or by

claiming a greater share of production or stake in the project company. In some extreme

cases the entire project may be expropriated or ‘nationalised’ by the government leaving

the original owner with little or no compensation. These regulatory risks are not only

limited to developing countries as evidenced by the Australian Government’s recent

proposal to introduce a Carbon Tax and Minerals Resources Rent Tax.

Environmental risk is another important consideration for Megaproject sponsors

and is often linked to political and regulatory risks. Due to their scale, Megaprojects

have the potential to significantly alter the environment around them. Environmental

impact assessments are often completed too late in the design phase leading to delays in

environmental approvals and last minute changes to the project design. Initial

assessments also have a tendency to significantly underestimate environmental affects

which can cause the regulator to stop the project once construction is underway or lead to

protests from the local community. Far better outcomes are achieved when a project

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develops and implements a comprehensive environmental management plan from the

start of the project. The environmental management plan should be a live document that

is adhered to and improved throughout the course of the project. A process should also

be in place to continuously monitor the project’s environmental performance so that any

problems can be resolved before they impact the wider community or require intervention

from the regulator.

Delusion and deception by project stakeholders is a form of psychological risk

that is particularly common in Megaprojects. Deliberately or not, project stakeholders

will often systematically underestimate project risks, schedule and costs and overestimate

benefits. When forecasting the outcomes of risky projects, people have a tendency to

underestimate task completion times and costs even when they know that the vast

majority of similar tasks have run late or gone over budget.13 Delusion refers to

situations where project sponsors rely on overly optimistic assumptions instead of

quantitative data to justify the feasibility of a project. This leads to projects being

developed that would otherwise have been cancelled if they were assessed against a more

objective set of criteria. Often projects are estimated on the basis that ‘everything goes

according to plan’ which leads to insufficient contingency being added to the budget and

schedule to account for potential problems. Even when project risks are realised, the

project sponsors have a tendency to further underestimate their cost and schedule impact.

A study of 44 chemical process plants found that the actual construction costs were

13 Bent Flyvbjerg, ‘Design by Deception: The Politics of Megaproject Approval’ (2005) Harvard Design Magazine, 50.

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typically twice as large as the original estimate.14 When the capacity of these plants was

increased some years later, the expansion costs were once again grossly underestimated

despite the fact that the project sponsors had comprehensive cost and schedule data from

the first phase of the development.

Deception occurs when project stakeholders deliberately misrepresent the

feasibility of a project. Many politicians, planners, project sponsors and contractors

strategically underestimate costs and overestimate benefits in order to increase the

likelihood that their project will be approved. Consultants stand to benefit from ongoing

work if they can demonstrate that a project is viable. Most reputable consultants will

write off poor projects immediately however even the best companies have a tendency to

try and justify projects that are on the borderline of being feasible to ensure that work

proceeds. Likewise, construction contractors may quote a low price for a project

knowing that they will be able to reclaim their profit margin by raising variations or

completing follow on work. Politicians have a tendency to focus solely on the political

benefits of major projects and often view these developments as part of their

government’s legacy. Local governments in particular, are notorious for distorting

estimates of benefits and costs in order to increase their share of state and federal

funding.15

14 Ibid. 15 Ibid.

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A classic example of project deception was the construction of the Sydney Opera

house in 1959.16 The initial budget tabled to New South Wales Parliament by Premier

Joe Cahill was $7 million which was less than 15% of the $50 million budget originally

estimated by the project’s architect Jorn Utzon. The Premier also fast tracked the start of

construction, despite the fact that drawings were unavailable so that it would be more

difficult for the Opposition to cancel the project if the Labour Government lost the next

election. When the Opera House opened in 1973, 10 years behind schedule, the original

design had been scaled back and construction costs had blown out to $102 million. This

equates to a cost overrun of more than 1400% which gives the Sydney Opera House the

dubious honor of holding the world record for the largest cost overrun by percentage for a

construction project.17 A further $45 million was spent in 2002 to bring the design of the

Opera House up to Utzon’s original specifications.

Some project sponsors argue that if the true cost of projects such as the Sydney

Opera House and English Channel Tunnel were known from the start that these landmark

developments would never have been undertaken in the first place and that society would

be worse off. These people focus on the project’s iconic value or nation building status

to justify their poor cost and schedule performance. This argument does not however

carry much weight as many other iconic buildings and important pieces of infrastructure

have been constructed on budget and schedule and generated strong returns for the

government or private investors. These projects include the Empire State Building,

16 Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, above n4. 17 Ibid.

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Guggenheim Bilbao Museum and Eiffel Tower.18 Relying on delusion or deception to

justify a project often means that it gains approval at the expense of a better project that

has been accurately estimated. The scale of the Megaprojects being proposed at the

moment means that choosing the wrong development option could seriously affect the

economy of the sponsor country and place a significant burden on the community for

many years to come. For example an economic analysis of the English Channel Tunnel

concluded that the net present value of the project to the British economy was minus

$17.8 billion USD with an internal rate of return of minus 14.45%. These results indicate

that the British economy would have been better off if the project in its present form had

never been built in the first place.19

There are a number of techniques that can be used to decrease the likelihood of

delusion and deception affecting the results of project feasibility studies. One technique

is to adopt the policy that the company performing the feasibility study and initial cost

estimate can have no further involvement in the project once it is approved. This will

reduce the likelihood of bias as the company has no vested interest in seeing the project

go ahead. Instead they will be more concerned about their professional reputation for

future consultancy work. Another option is to introduce financial incentives for

companies that provide accurate cost, schedule and benefit forecasts for projects.

Additional bonus payments could be made when projects come in on or under budget.

Likewise the company could be required to put a percentage of its profit or fees at risk in

18 Bent Flyvbjerg, above n6. 19 Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, above n4.

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the event that the project’s underperformance can be attributed to blatant errors in their

feasibility study.

The results from feasibility studies should be subject to independent peer review

and benchmarking against other similar projects. Many consultants take a bottom up

approach to project estimation where the total installed cost is determined based on the

approximate quantity of labour and materials required. Contingency and other escalation

factors are then added to the base estimate to account for known and unknown risk

factors. This approach can be highly subjective and is largely dependent on the

individual experience of the estimator and the level of design detail available at the time.

Comparing a project cost estimate to a reference class of comparable projects will

highlight any pricing errors, unrealistic assumptions or bias. If the estimate for a

particular project is significantly less than the actual cost of similar projects then the

consultant should be required to explain the discrepancy. A more extreme proposal for

dealing with deception in project forecasting is to introduce civil and criminal penalties

for false or misleading estimates. Lawmakers in the US have called for criminal charges

to be introduced for blatant cases of project misrepresentation, similar to what has already

been put in place for corporate accounting practices under the Sarbanes Oxley (SOX)

legislation. In Australia it is likely that a case could be made under the Trade Practices

Act against a consultant that engages in false and misleading conduct when preparing a

feasibility report and project cost estimate.

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Technological risk is another factor that requires careful consideration when

managing Megaprojects. A large portion of the Sydney Opera House’s cost and schedule

overrun can be attributed to its unique and complex design. The equipment and

techniques required to build the Opera House’s characteristic curved roof did not exist at

the time of construction and needed to be developed by the project at considerable

expense. Megaprojects often involve innovative design features that require a large

amount of engineering to be completed prior to construction. They also have a tendency

to apply existing technology and equipment to new frontiers or extend them to larger

scales. Project sponsors need to be aware of the potential risks that new technologies

introduce and should be confident that the overall benefits significantly outweigh the

potential development problems.

Studies have shown that there is a strong correlation between the level of

innovation in a project and cost and schedule overruns.20 Increasing the scale of an

existing technology has a tendency to result in performance shortfalls. Megaprojects are

not the appropriate vehicle for experimenting with new technology. Instead they should

be based on proven construction techniques and equipment to minimise the risk of cost

increases and schedule slippage. If a Megaproject is not financially viable using

conventional technology then it is unlikely that new technology will improve the overall

economics. If new technology is going to be used in a project then it should be done so

in incremental stages. For example it is often best to trial a new industrial process in a

pilot plant and then increase capacity rather than going straight to a full scale

development. 20 Edward C Merrow, above n1.

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Megaprojects are capital intensive endeavors and are therefore much more

susceptible to macroeconomic factors than conventional design and construct projects.

Changes to labour and raw material costs, interest rate fluctuations, inflation and

exchange rate variations can all have a significant impact on a project’s financial

viability. The effect of these macroeconomic factors is further compounded by a

Megaproject’s long duration as it is difficult to forecast costs 5 or 10 years into the future

when construction is likely to be completed. Often construction cost estimates are done

by engineers who fail to make adequate allowances for financial factors. Megaprojects

are particularly susceptible to changes in exchange rate as they are often undertaken by

companies whose primary base of operation is outside the area of the project and involve

the procurement of large amounts of specialist equipment from overseas vendors. It is

only recently that Principal’s and Contractors have started to engage the necessary

financial expertise to effectively hedge against these macroeconomic factors and reduce

the overall financial risk to the project.

The cost and schedule impact of unplanned events is an area where Megaprojects

are less susceptible than smaller projects. The long duration of Megaprojects means that

it is unlikely that a single unplanned event will have a significant impact on the overall

project cost and schedule. Unplanned events include extreme weather, wars, strikes, civil

unrest and other unforeseen circumstances that are outside the control of the project

participants. Megaprojects are large enough to absorb delays arising from unplanned

events by adjusting their construction program to minimise the effect. This is not to say

that multiple incidents or sustained events will not have an overall impact on the project.

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The construction schedule of Victoria’s Desalination plant was significantly affected by

one of the wettest summers on record in 2010. These delays and other cost overruns has

resulted in the project’s head contractor Leightons writing off approximately $280

million on the job.21

The final risk factor affecting Megaprojects arises from organisational issues.

Megaprojects typically have complicated organisational structures with multiple

stakeholders or joint venture partners. The situation is made even more difficult when

the government is also a partner in the venture. Decision making in Megaprojects can

require multiple levels of approvals which can take time and prevent the project from

responding quickly to changing circumstances. Retaining staff can also be a problem for

Megaprojects due to their long durations. Often people are reluctant to stay in the same

role for the 5 to 10 years required to deliver the project. The long project timeline also

means that there is a lack of experienced senior project managers as many people will

only be able to execute three or four megaprojects over the course of their career.

To address these problems a Megaproject should function like a standalone

company. Comprehensive human resource polices and training plans should be put in

place to provide project staff and contractors with an opportunity for career development.

The organisation structure should be developed early in the project planning phase and be

continuously updated as the project progresses. Key positions necessary to construct,

operate and maintain the project should be identified and brought onboard long before

21 Inside Business, Construction Companies Struggle With Risk ABC Online www.abc.net.au/insidebusiness/content/2011/s3193702.htm at 7 May 2011.

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they are required in the field. The organisation should be structured in such a way that it

can function effectively without the individual. For example an incompetent construction

supervisor may lead to poor productivity in a particular area but provided the

organisation is adequately planned and governed the shortcomings of a single individual

will not affect the project as a whole.

IV CONTRACTING STRATEGIES FOR MEGAPROJECTS

In order to effectively manage risk, Megaprojects require more sophisticated

contracting strategies than those used for conventional design and construct projects.

Megaprojects are typically executed under Engineering, Procurement and Construction

(EPC) contracts or Engineering Procurement and Construction Management (EPCM)

contracts. EPC contracts are normally awarded on a fixed price or lump-sum turnkey

basis and place a majority of the project risk onto the construction contractor. Lump-sum

turnkey is an industry term used to describe the situation where the EPC contractor

designs, constructs and commissions the plant for a guaranteed price and then effectively

hands over the keys to the facility once it is up and running.

EPCM contracts are typically awarded to a project house or engineering

consultancy on a reimbursable or risk reward basis. The EPCM contractor is responsible

for the overall project design, management and execution but will normally not perform

any construction work themselves. Instead the EPCM contractor enters into fixed price

contracts with various subcontractors, material suppliers and vendors to complete the

works on behalf of the principal. Any variations in these subcontracts or the EPCM

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contractor’s management costs are passed on to the principal. The main difference

between an EPC contract and an EPCM contract is that under the EPCM model the

owner retains more control over the project design and how it is executed. This control

comes at the expense of the principal retaining significantly more risk than they would

under a traditional fixed price EPC contract. It should be noted that EPC and EPCM are

just labels for describing a particular contracting strategy and risk allocation. Depending

on the precise terms of the agreement an EPCM contract can be drafted to carry the same

level of risk as an EPC contract and likewise an EPC contract could be performed on a

reimbursable basis. The decision on whether to use an EPC or EPCM contracting

strategy is dependent on a number of factors including the specific technical details of the

project, the willingness of contractors and sub-contractors to take on risk, the preference

of the project sponsors and the requirements of the financiers.

Under a conventional lump-sum turnkey EPC contract the principal transfers the

performance, cost, technological and schedule risk to the EPC contractor. The EPC

contractor acts as a single point of responsibility for the project and pays for all

equipment, materials, labour and specialist contractors using their own funds. As a

result, the EPC contractor is liable for any defects or design deficiencies that may arise

regardless of whether it is their fault or the fault of one of their subcontractors or

suppliers. Under a fixed priced arrangement the EPC contractor also bears the risk of any

cost overruns and benefits from any cost savings. Banks and other financiers prefer to

lend to projects with fixed price EPC contracts as they are considered to provide a greater

level a cost assurance. It should be noted that any costs arising from omissions in

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contract scope, delays in regulatory and environmental approvals, political risks or

unplanned events are usually passed onto the principal so the fixed price for a project

rarely remains unchanged.

One of the key disadvantages of an EPC contract is that once it is awarded, the

construction contractor has the freedom to design and construct the project whichever

way it chooses so long as the final facility complies with the principal’s performance

specifications. Any ambiguities in the specifications can result in the principal not

receiving the equipment or design features they intended. The fixed price nature of EPC

contracts often drives contractors to look for any gaps in the project specifications that

allow them to raise variations or save money by reducing scope or using cheaper

materials and equipment. This can often result in a final product being handed over to

the principal that is fully functional but not up to their expectations. EPC projects often

suffer from reliability issues and high maintenance costs as the overall project life cycle

is rarely taken into consideration when designing the facility. Another problem that often

arises in EPC contracts is that the plant feedstock may not be available at maximum

capacity during startup meaning that the facility cannot be commissioned to its full

nameplate rating prior to handover. As production ramps up it is common for bottlenecks

in the process design to be identified that weren’t evident at reduced operating rates. In

this situation the principal is unable to transfer all of the commissioning and performance

risk to the EPC contractor and therefore loses the benefit of the price premium it has

paid.22

22 Eric L. Nelson, Unique Considerations for Lump Sum EPC Projects Smith, Currie & Hancock LLP www.smithcurrie.com/news-articles-181.html at 7 May 2011.

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EPCM contracts address these deficiencies by providing the principal with greater

control over the project design and execution. They are often used for projects involving

new or proprietary technologies as EPC contractors are unwilling to take on a large

amount of technological risk. The EPCM contractor will normally work alongside the

principal to develop the optimum design solution before the project is divided up and

tendered as separate lump sum packages for construction. The EPCM contractor acts as

the agent of the principal when establishing the sub-contracts or purchasing materials and

equipment. Orders are typically placed using the Principal’s funds and without the

EPCM contractor charging any markup. Instead the EPCM contractor is paid a service

fee to establish and administer these contracts on behalf of the Principal.

The main advantage of an EPCM contract is that it allows work to commence

before the project concept is fully developed. In order to establish an EPC contract the

Principal must have a clear understanding of the project requirements or else they run the

risk of incurring a large number of scope variations. EPCM contracts also generate cost

savings by allowing principals to engage vendors and sub-contractors directly and at a

later stage of the project when the design is well established. This reduces contingencies

built into contract prices and minimises the risk of re-work. EPCM contractors are not

driven to complete the project in the quickest and cheapest way possible and are therefore

able to look for solutions that maximise value to the Principal and minimise the overall

life cycle costs.

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The main downside of an EPCM contract is that any cost and schedule impacts

are directly incurred by the principal. Risk and reward schemes are often used to reduce

the EPCM contractor’s professional services fee in the event of poor project performance

however these amounts are often insignificant compared to the costs incurred by the

principal. EPCM contracts tend to suit projects sponsors that have the expertise and

experience to manage big projects and the balance sheet to retain cost and schedule risk.

The Principal’s project team needs to be adequately resourced in order to hold the EPCM

contractor accountable for its reimbursable costs. EPCM does not normally suit small or

inexperienced companies that are new to the industry. These companies would normally

achieve better results by engaging an EPC contractor to provide them with a turn-key

solution based on a standard design template.

A number of EPC construction companies have adopted a hybrid approach to

executing Megaprojects.23 Under this arrangement the preliminary engineering phase of

the project is completed on a reimbursable basis similar to an EPCM contract while the

detailed design, procurement and construction is executed under a lump sum turn-key

contract. This allows the principal to engage an EPC contractor before the detailed

project specification is developed which shortens the project delivery time. During the

reimbursable phase, the principal retains more control over technical decisions and

equipment selection and is able to work with the EPC contractor to optimise the project

design.

23 Michael Wilkinson, ‘Comparison of Project Delivery Mechanisms Focusing on EPC and EPCM’ (Paper presented at AMPLA Ltd. Third Annual Conference, Sydney NSW, 28th of October 2009).

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The contractor also benefits from the hybrid approach as they are able to gain a

better understanding of the project risks before entering into the fixed price phase of the

contract. This reduces the amount of contingency that needs to be built into the

contractor’s price and therefore the cost to the principal. In order to keep the pricing

pressure on the contractor, a hybrid arrangement is normally established on the basis that

the contractor’s detailed cost estimate for the fixed price phase will be provided to the

principal for review along with supporting quotations from major vendors and

subcontractors. Once the estimate is approved, a pre-agreed margin for profit and risk is

added to the project price which is then fixed. The project then runs like a conventional

EPC job with minimal principal involvement and the contractor liable for cost and

schedule overruns but also able to benefit from any savings.

Another strategy that can be used to award contracts for Megaprojects is to run a

design competition.24 This technique is particularly common in large public

infrastructure projects such as bridges, stadiums and tunnels and is also used in the

selection of process technologies for liquefied natural gas plants. Many construction

consortiums are willing to compete for the chance of winning the contract for a

Megaproject given the long term revenues and prestige that they can generate. A design

competition allows tenderers to propose innovative engineering solutions that maximise

value to the principal. To start a design competition the principal typically issues a high

level performance specification for the project which contains targets for safety,

24 Matthew G. McKenna and Herve Wilczynski, Capital Project Execution in the Oil and Gas Industry - Increased Challenges, Increased Opportunities Booz&Co http://www.booz.com/media/uploads/Capital_Project_Execution_in_the_Oil_and_Gas_Industry.pdf at 7 May.

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reliability, operability and cost instead of specific technical requirements. The Contractor

then proposes their most cost effective design solution that meets or exceeds these

requirements. The most difficult part of any design competition is selecting the winner.

Bids are normally evaluated using a set of weighted selection criteria in order to

normalise differences between the proposals. The bidder that gains the highest score in

the design competition is then awarded the contract to complete the project.

V SCOPING ISSUES

Even though Megaprojects are typically executed using sophisticated EPC and

EPCM contracts, they still incur significant cost and schedule overruns. According to a

2008 report into project scoping prepared by law firm Blake Dawson, scoping

inadequacies resulted in 26% of the projects surveyed with a value over $1 billion being

more than $200 million over budget.25 These scoping inadequacies are largely due to the

fact that conventional contract documents and project specifications often fail to address

the broader non-technical risk factors that affect MegaProjects. The contract for a

Megaproject should focus on more than just legal matters. Instead it should be a

comprehensive suite of documents that addresses the technical, commercial,

environmental, regulatory and organisational requirements for delivering the project.

One area where conventional contract documents are often deficient is in dealing

with environmental and regulatory risks. If principals and contractors applied the same

level of detail to specifying environmental and regulatory requirements as they do to

25 Blake Dawson, Scope for Improvement 2008 Report Blake Dawson http://www.blakedawson.com/Templates/News/x_news_content_page.aspx?id=53637 at 7 May 2011.

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technical and commercial matters then project outcomes would be greatly improved. The

contract for a Megaproject should include a comprehensive environmental management

plan that clearly defines the roles and responsibilities of each of the parties in relation to

environmental approvals. Compliance with this plan should be audited on an ongoing

basis by the Principal. Timelines for environmental and regulatory approvals should be

clearly identified in the overall project schedule to ensure they have visibility to the

project team. Where possible principals and contractors should try and obtain broad

environmental approvals so that minor changes to the project design do not need to be re-

submitted for regulatory approval.

The contract documents should also include a government and external relations

plan that clearly outlines the regulatory regime governing the project and each party’s

compliance obligations. Any specific requirements or exemptions the project has in

relation to local content, customs and duties, industrial relations and taxation should be

summarised in plain English. The contract’s government and external relations plan

should not only address the project specific infrastructure but also complementary

infrastructure required for construction. For example significant cost overruns and

schedule delays could arise if the government is responsible for building an access road,

power line or water pipeline to the site and this is not delivered in time. Likewise if

upgrades are required to the local port to receive construction equipment and materials

then these will need to occur on schedule or else the principal will be forced to make

alternative arrangements at considerable cost to the project. Where possible any

arrangement with the government should be captured in a formal legislative instrument

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such as a State Agreement. Although these can be unilaterally changed by the Parliament

there is a much greater political focus on any variation.

Another major deficiency in conventional contract documents is that they often

include numerous clauses to deal with negative project outcomes such as defects,

disputes and deficiencies but very little guidance on how to avoid them in the first place.

Greater emphasis should be placed on the operational phase of the contract and the

systems and tools that will be used to ensure the project runs efficiently. The contract

documents should clearly state how the contractor fits into the overall project

organisation and how they will interface with other contractors and stakeholders.

Contractors should be required to align their internal business processes with those of the

project organisation. Comprehensive human resource management, training and

industrial relations plans should be developed by each contractor to demonstrate how

they intend to manage their workforce. A strategy should be put in place for attracting

and retaining staff in a highly competitive labour market and a formal handover process

established to retain knowledge when people leave the project. Formal dispute resolution

procedures are required to resolve contractual issues in a timely and cost effective

manner. The payment process should also be streamlined to prevent cash flow issues

affecting the project schedule.

Managing change is another area where traditional contract documents are often

deficient. Contracts typically include boiler plate clauses to deal with variations. These

focus primarily on the cost and schedule implications of a change without taking into

consideration the overall risk or benefit of the change to the project. Many projects fail

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to assess the cumulative impact of multiple changes or their wider regulatory and

environmental consequences. Changes are often made on site with minimal engineering

input or consideration for how the change will affect other parts of the project. The

reasons for making a particular change are rarely documented and drawings are not

always updated to reflect the as constructed installation.

To address these deficiencies, the contract documents should require the

contractor to establish a formal management of change procedure to document and

review any proposed variations. Major changes should be risk assessed and undergo a

cost benefit analysis before being approved. The impact of the change on other

contractors and project stakeholders should also be considered and a process put in place

to ensure that the details of the change are communicated to all affected parties. The cost

and schedule implications of a change are often poorly assessed particularly when the

work is being done on a reimbursable basis. Changes need to undergo the same level of

cost and schedule scrutiny as the original project estimate. Many companies have had

their reputation and share price severely damaged by failing to accurately estimate and

manage the effect of major project changes. Woodside’s Pluto LNG development in

Western Australia is one example of a project that has had to revise its cost and schedule

estimate multiple times as a result of a single design variation.26

26 This variation related to the redesign of a large flare tower that was not cyclone rated and had to be dismantled and re-constructed at considerable expense to the project.

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Detailed contract governance requirements are another important tool for

managing project outcomes. Contract documents should clearly define the requirements

for tracking and forecasting cost and schedule performance. This is particularly

important for a project completed on a reimbursable basis. Reliable up to date

information is essential for good decision making. The software tools to be used for

planning and cost control and the reporting frequency required should be specified in the

contract. In addition to regular cost and schedule reports, Key Performance Indicators

(KPI’s) should be developed to measure the contractor’s performance and the overall

health of the contract. Throughout the course of the project regular meetings should be

held at both an operational and corporate level to review the KPIs and the cost and

schedule performance. A continuous improvement plan should be put in place to respond

to negative trends in KPI’s and generate greater efficiencies from processes that are

performing well.

V WHO SHOULD TAKE ON THE RISK?

An essential component of any Megaproject contracting strategy is determining

an appropriate risk allocation between the parties. This process is particularly

challenging given the wide range of technical and non-technical risks that Megaprojects

are exposed to and the huge costs that can arise should a risk event occur. The traditional

design and construct approach of trying to transfer as much risk as possible to the

contractor and consultant is rarely effective in a Megaproject. Many contractors are

unwilling or unable to take on such a high level of risk. In situations where the contractor

does agree to take on some of the risk their liability is usually capped at an amount that is

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insignificant when compared to the consequential loss experienced by the principal or the

cost premium paid to transfer the risk. It is also difficult to put a price on the reputation

loss to the Principal if they fail to meet their commitments to the project’s buyers.

In order for the principal to benefit from the transfer of risk, the party taking it on

must be able to effectively control and manage it. Transferring excessive or unlimited

risk onto contractors and consultants can lead to lengthy legal disputes or one or all of the

parties filing for bankruptcy. The outcome of this situation is that the principal is left

with an unfinished project and no project team to complete it. Lengthy delays will be

incurred if the project is handed over to a new contractor. Design consultants in

particular lack the financial capacity to take on project risk. Megaprojects have a large

number of technical challenges that require innovative and sometimes unproven

solutions. Consultants are rarely willing to accept any liability for their services or at best

will only take on liability to the value of the services provided. This is particularly

controversial given that design errors in Megaprojects can potentially cost the principal or

contractor 100’s of millions of dollars to rectify in the field. Even if consultants were

willing to take on more risk it is unlikely that this would provide much benefit to the

principal. Most consultants have a limited asset base meaning that any liabilities not

covered by their professional indemnity insurance will inevitably fall back on the client

as the consultant would simply file for bankruptcy. This is not to say that consultants

shouldn’t be held accountable for the quality of their work. Making the consultant

complete design re-work at their own cost or without profit is usually sufficient to ensure

they perform their services with the appropriate level of care and diligence.

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Far better project outcomes are achieved when risks are allocated to the party that

is best able to manage them. This approach to risk allocation is often referred to as the

Abrahamson Principle after the international construction lawyer that first applied it to

complex offshore oil and gas projects in the UK North Sea. It is difficult to establish

generalised rules for achieving the optimum risk allocation as the requirements will vary

depending on the specific details of the project. Project participants should therefore

perform a comprehensive risk assessment during the planning phase of the project to

identify and acknowledge the main sources of risk. Where possible these risks should be

reduced or eliminated all together either by changing the project design basis or

execution strategy. If this is not possible, then the risk should be allocated through a

consultative process so that all parties are clear as to who exactly is taking on the risk and

what their strategy is to proactively minimise the threat and maximise opportunities. In

situations where none of the parties are happy to take on the risk, alternative methods of

mitigation will need to be investigated such as insurance or other financial instruments

such as hedging.

A comprehensive risk register and risk management plan should be incorporated

into the contract to document how the risk has been allocated and what procedures will

be followed in the event that a risk materialises. Regardless of the commercial and

contractual arrangements between the parties it is important that a robust risk mitigation

strategy is put in place that provides for a system of early intervention and rapid decision

making to minimise the overall impact of an event. Contractors should be encouraged to

propose alternative design and execution strategies to reduce the overall risk to the

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project even if these changes slightly increase the capital cost. Contingency plans should

be developed so that the project is able to quickly respond to an incident with a

predetermined course of action. Acknowledging the presence of risk and developing

formal procedures for managing it is an important first step in delivering a successful

Megaproject.

VI CONCLUSION

Even in the wake of the Global Financial Crisis (GFC) Megaproject spending is

the largest it has ever been as a share of world GDP.27 A number of big investments by

mining and energy companies are still underway on the back of high commodity prices.

Any reduction in private capital has been more than offset by 100’s of billions of dollars

of government spending in the form of economic stimulus packages. In order for future

generations to benefit from this new wave of Megaproject expenditure it must be done

properly. Existing EPC and EPCM contracting strategies will need to be improved in

order to effectively manage non-technical risks such as regulatory and environmental

issues, delusion and deception by project stakeholders, macroeconomic factors and

organisational challenges. Contracts should include a comprehensive suite of documents

describing the systems, tools and procedures that will be used to ensure that the project is

executed successfully. More emphasis needs to be placed on formal risk assessment

procedures to ensure that project risk is allocated to the party that is most capable of

managing it. Principal’s also need to realise that there is no point in transferring risk to

another party if they lack the financial capacity to deal with an event if it occurs. By

27 Bent Flyvbjerg, Massimo Garbuio and Dan Lovallo, ‘Delusion and Deception in Large Infrastructure Projects’ (2009) 51 California Management Review, 170.

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improving the way Megaprojects are planned, structured and governed society will be

able to receive the benefits of iconic developments such as the Sydney Opera House and

Channel Tunnel without the economic or environmental burdens that projects of this

scale usually create.

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BIBLIOGRAPHY

1. Articles / Books / Reports

Dr Alison L. Browne, Prof. Daniela Stehlik and Dr Amma Buckley, ‘The mega-projects paradox and the politics of risk, hope and mistrust: Capturing localised impacts of the boom/bust cycles of Australian mining.’ (2009) Sustaining Gondwana Issue 21. Bent Flyvbjerg, Nils Bruzelius and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (2003). Bent Flyvberg, Mette Skarmisholm and SØren L. Buhl, ‘What Causes Cost Overrun in Transport Infrastructure Projects?’ (2004) 24 Transport Reviews, 3. Bent Flyvbjerg, Massimo Garbuio and Dan Lovallo, ‘Delusion and Deception in Large Infrastructure Projects’ (2009) 51 California Management Review, 170. Bent Flyvbjerg, ‘Design by Deception: The Politics of Megaproject Approval’ (2005) Harvard Design Magazine, 50. Bent Flyvbjerg, ‘Survival of the unfittest: why the worst infrastructure gets built and what we can do about it’ (2009) 25 Oxford Review of Economic Policy, 344. Edward C Merrow, Understanding the Outcomes of Megaprojects: A Quantitative Analysis of Very Large Civilian Projects (1988). 2. Other Sources

Blake Dawson, Scope for Improvement 2008 Report Blake Dawson http://www.blakedawson.com/Templates/News/x_news_content_page.aspx?id=53637 at 7 May 2011. Bent Flyvbjerg, ‘Policy and Planning for Large Infrastructure Projects: Problems, Causes, Cures’ (Working Paper No. 3781, World Bank, 2005). David Snashall, Keeping Oil and Gas MegaProjects Moving ERM http://www.erm.com/Analysis-and-Insight/Articles/Keeping-oil-and-gas-mega-projects-moving--grappling-with-Non-Technical-Risk/ at 7 May 2011. Eric L. Nelson, Unique Considerations for Lump Sum EPC Projects Smith, Currie & Hancock LLP www.smithcurrie.com/news-articles-181.html at 7 May 2011. Inside Business, Construction Companies Struggle With Risk ABC Online www.abc.net.au/insidebusiness/content/2011/s3193702.htm at 7 May 2011.

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Luis E. Rey, Unique Aspects of Working In Megaprojects Nielsen-Wurster http://www.nielsen-wurster.com/Email_Announcements/NW_Communique/NW_Communique_2006_JulyTRUNK.html at 7 May 2011. Matthew G. McKenna and Herve Wilczynski, Capital Project Execution in the Oil and Gas Industry - Increased Challenges, Increased Opportunities Booz&Co http://www.booz.com/media/uploads/Capital_Project_Execution_in_the_Oil_and_Gas_Industry.pdf at 7 May. Matt Chambers and Damon Kitney, Resource mega-projects hit by $8bn cost blowout The Australian http://www.theaustralian.com.au/business/mining-energy/resource-mega-projects-hit-by-8bn-cost-blowout/story-e6frg9df-1225984651422 at 7 May 2011. Michael Wilkinson, ‘Comparison of Project Delivery Mechanisms Focusing on EPC and EPCM’ (Paper presented at AMPLA Ltd. Third Annual Conference, Sydney NSW, 28th of October 2009). Office of Government and Commerce (UK), Good practice contract management framework Office of Government and Commerce Website http://www.ogc.gov.uk/documents/Management_Framework_Good_Practice_FINAL.pdf at May 7 2011. Thomas Hundertmark, André Olinto do Valle Silva, and Jeff A. Shulman, Managing Capital Projects For Competitive Advantage McKinsey Quarterly http://www.mckinseyquarterly.com/Managing_capital_projects_for_competitive_advantage_2163 at May 7 2011.