Risk

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2  Risk

2.1 How risk may be allocated

The standard form contracts common in international projects contain detailed terms allocating risk. The FIDIC forms provide instructive examples of this. In what follows we shall try to bring out how differently risk might be allocated in different types of project by comparing and contrasting the Red and Yellow FIDIC Books with the Silver Book. This comparison is helped by the fact that, as noted above, the Books largely cover the same topics under the same clauses or sub-clauses.¹

The Red and Yellow Books are recommended where there is a basically conventional project structure of employer, contractor and engineer; the ­differences between the two Books arise mainly from the fact that, with the Yellow Book, the contractor undertakes most of the design. In such an arrangement, risk is allocated to strike a balance between employer and ­contractor, taking into account the extent to which each is responsible for design and other activities, and also each party’s ability to control or prevent particular risks.

The FIDIC Silver Book, on the other hand, is recommended for projects of a very different type from the conventional. These are ‘turnkey’ projects in which there is no engineer; where the contractor undertakes substantially all the design, procurement and construction; and where the overriding need is to ensure completion on time and to budget.² The traditional balanced approach to risk does not sit well with such projects, where the contractor is expected to (and prices for) undertaking a much wider range of risks. With turnkey structures increasingly the norm for major projects internationally, it is particularly important to understand how the construction contract at the heart of such projects typically reallocates risk to the parties.

Let us begin, then, by looking more closely at the ‘traditional’ approach to risk allocation.

2.2 The ‘traditional’ approach to risk

Probably the most traditional or conventional project structure involves an employer who instructs a consultant to design certain work and to administer the contract. The contractor tenders against the designs and specifications prepared by the employer’s consultant. If his tender is successful, he enters into a contract by which he undertakes to carry out the works in accordance with those designs and specifications. The engineer or architect acts as the employer’s agent and certifies milestone stages and payments in accordance with the terms of the contract, as well as deciding such matters as the contractor’s entitlement to extensions of time or additional payment should there be variations, delays or disruption to the work. The contract price will typically be on a firm basis, normally a lump sum, or on the basis of unit prices with provision for re-measurement; provisional sums for items of work which cannot be fixed or defined at the outset might also be included. There will be provision also for assessing the value of any variations duly instructed in accordance with the contract.

The FIDIC Red Book has closely matched this traditional form of project.

The Red Book is recommended for building or engineering works designed by the employer or by his representative, the engineer. The contractor is to construct the works in accordance with a design provided by the employer, although the works could include some elements of contractor-design. The engineer is appointed to carry out traditional roles of administration and certification of the contract, acting as the employer’s agent.

The Yellow Book differs from the Red primarily in that the Yellow Book is intended for use where the contractor is responsible for the design of the work. Reviewing earlier editions of the two Books, FIDIC took the view that the decision whether to use the Red or Yellow Book should rest upon which of the parties was mainly responsible for design, rather than the type of work to be carried out. The Red Book, published in its present form in 1999, was developed to be suitable for building and civil and other engineering works designed by the employer or the engineer, and the Yellow Book was to be suitable for plant and for building and engineering work designed by or on behalf of the contractor. In both cases, the engineer was to perform traditional administration and certifying roles.

In the Red and Yellow Books, the contractor usually bears the risk of delay and additional cost, if he is able to control the relevant events. For example, where physical conditions cause delay or additional cost, the contractor will bear the risk of both if the conditions were reasonably foreseeable; however, if the physical conditions (including ground conditions) were not reasonably foreseeable then the contractor will be entitled (subject to complying with the requirements for making a contractor’s claim under clause 20.1) to additional time and cost resulting from the unforeseeable conditions (clause 4.12).

Where damage or delay to the works results from war or civil commotion, on the other hand, under the Red and Yellow Books the employer bears the risk of delay to the contract and additional costs to the contractor, by clause 17.3/4. The contractor is entitled to recover his costs incurred in rectifying damage resulting from war or civil disorder, and to an extension of time if delay has resulted to the contract works. He will not, however, be entitled to any profit on the costs incurred. The balance struck between contractor and employer in this case is that the employer should bear most of the risk, but the contractor should bear some of it by being disallowed any profit on actual costs incurred. By contrast, if the employer uses or occupies any part of the permanent works, except as may be specified in the contract, then by clause 17.3 (f) the contractor is entitled to reasonable profit on actual costs incurred where he has suffered cost consequences as a result of the employer’s use or occupation of the permanent works, and to an extension of time to the extent that he has suffered a delay.

Many people regard the Red and Yellow Books as seeking to strike a fair balance of risk between employer and contractor. The contractor benefits because he need not price for risks which are hard to evaluate at the outset of the project; while the employer enjoys a lower contract price, and incurs extra cost only where certain defined risk-events actually occur. This even-handed approach to risk was followed in earlier editions of the Red and Yellow Books, and maintained in the current (1999) edition.³

However, with the increasing importance of privately-financed turnkey projects driven by the need to satisfy the demands of financing institutions, such as banks, for certainty of cost, the more balanced approach of the traditional forms was no longer suitable. Before the introduction of the Silver Book it was not unusual for the parties to a turnkey project who wished to use or adapt a FIDIC form simply to modify the terms of the Yellow Book by placing on the contractor all the risks which had been divided between contractor and employer. This was felt to be unsatisfactory, and the FIDIC Silver Book was the result.

We shall shortly be looking in more detail at the Silver Book, but first we should describe the kinds of project for which it was intended.

2.3 EPC/turnkey projects

The Silver Book is intended to provide conditions of contract for ‘EPC/­tumkey projects’. ‘EPC’ stands for ‘Engineer-Procure-Construct’, and indicates the range of services the EPC contractor is meant to perform. The contractor in such a project is responsible for the engineering design work to meet certain performance requirements, for the full range of procurement for the project, and for the construction work. EPC contracts are ‘turnkey’ contracts in that the contractor provides a complete package, so that the employer or project promoter has a structure ‘at the turn of a key’.

2.4 BOT-type projects

EPC contracts are often at the heart of a type of project structure called ‘Build- Operate-Transfer’ (BOT), or similar titles such as ‘Build-Own-Operate-Transfer’. These kinds of project typically involve the private sector designing some piece of infrastructure, financing its construction and then operating and maintaining it over a period of time, perhaps as long as 20 or 30 years. This period is called the ‘concession period’, because it is the period during which the private sector promoters will be able to operate the structure at a profit, before handing it over or legally transferring it to the government or official agency from whom the concession was obtained.

The essential idea behind a BOT-type project is that the government or an official agency in a country wishes to have a plant or other structure built and operating, but does not wish to or cannot finance such a project itself. It therefore agrees with private sector parties that, in return for being able to operate the plant, including the right to sell outputs from it (such as power) at a certain price and volume over a certain period, the private sector will build and render the plant operational. After the end of the period of operation, the government will finally obtain ownership or control of the plant. The government therefore has its plant at no direct cost to itself, while the private sector has had the profitable use of the plant for a sufficiently long period to justify the cost and risk of building and setting it up.

2.4.1 Parties to a BOT-type project

BOT is therefore a type of financing for heavy construction projects, parti­cularly infrastructure projects. The parties to such a project will normally include the following entities.

• A government or government agency. This party will grant the ­concession, or rights to construct, own and operate the plant or facility; it will grant the necessary lease or other right to occupy and use the land on which the plant is to be constructed; and often it will purchase all or some of the services or output provided by the plant, by entering into a separate ­agreement called an ‘offtake’ agreement. The government agency will be the party which usually invites tenders from interested parties for the ­project, and will then assess the tenders received against performance and other requirements. Since the government or official agency is to be a (­primary) party to the project it is essential that every other party to the project is certain that the agency or official body has the legal capacity to enter into the relevant contracts and other transactions involved in establishing the project. This will require specialist legal advice and guidance.
  
• The project company set up by the promoters (or ‘sponsors’) of the project as the vehicle for implementing the project, including entering into the offtake agreement and construction contract. The promoters will prepare the tender for the project detailing proposals for the design, construction, operation and financing of the project. They will typically be a consortium or grouping, consisting of a financing institution or syndicate of such institutions (typically a bank or syndicate of banks); an operator (to run the facility when it is built); a construction contractor (often a construction group); and sometimes various other interests.
  
• The construction contractor is the party responsible for designing, ­constructing and, often, commissioning the plant. It has to complete the project to budget, on time and to specification. The design provided by the construction contractor may be based upon a fairly general performance requirement and other requirements of the promoters; for example, the promoters may say that they require a coke calcination plant with a capacity of 500,000 MTPA to satisfy such-and-such specified requirements and national regulations and controls. There will therefore have to be effective communication between the promoters’ technical team and that of the construction contractor. Moreover, the contractor will need to price for the work to take into account the fact that it will be expected to keep within the lump sum fixed price that is nearly always expected. The promoters will be working to strict budgetary constraints and will expect near-absolute certainty as to cost and time, or programme.
  
• The operator will be a company or group which begins its work after the plant has been commissioned and is up and running. The operator bears relatively little risk, and will normally sign an operation contract to run and maintain the plant for a substantial period of time. Operators may themselves be investors in the project.⁴
  
• Financial institutions are a key party or parties to a typical BOT project. They will usually be groups of banks or lending institutions rather than individual banks or institutions, in order to spread the financial risk. The banks will have very considerable weight in the negotiations leading up to the project agreements and may be in a position to dictate many of the terms of the other contracts involved, including the construction contract. All aspects of the project will need to be acceptable to them before they will put up the necessary funds. The banks will typically secure their ­lending against the plant itself.
  
• Other parties could be investors in the project, putting up finance towards it in return for a share of the profits of the plant once it is operating; there will also be lawyers, insurers, suppliers, consultants and others involved in the project at various stages and in various ways, most usually advising or assisting one or other of the parties in the many complex issues that will inevitably arise.

2.4.2 Contracts involved in a BOT-type project

The various complicated arrangements that go to make up a BOT-type project are reflected in the no less complicated range of contracts involved.

The construction contract

Of particular interest to us is the construction contract between the project company and the construction contractor. There will typically be a detailed construction contract, such as the FIDIC Silver Book, setting out the responsibilities of each party, including the risks which each will be expected to bear.

One very important type of risk for the construction contractor is that of delay to the project and, in particular, delay resulting from matters over which he has no control. Because BOT projects typically involve complex heavy engineering construction work over a long period of time, a delay will almost always have a significant cost consequence. But unlike the more traditional contracts, the construction contractor in a BOT project will typically bear many of the risks for delay in construction even when he cannot control such risks. Some construction contracts, such as the FIDIC Silver Book, give the contractor a right to an extension of time for certain specified events, such as war or civil commotion, over which he has no control; but the range of these events is very limited.

Although risk allocation in any contract is a matter for individual ­negotiation, and it is always possible for the parties to negotiate their own particular allocation of risk, the huge constraints of time and budget that apply in a BOT project will usually severely limit the extent to which the construction contractor will be able to obtain more time and/or money for delays.

Another type of risk is that of underperformance of the plant or other ­facility. This will nearly always have serious costs consequences.

In any negotiation, whether over risk allocation or otherwise, it will be essential for the terms of the construction contract to be related to the terms of the contract between the government agency and the project company. The promoters will normally try to ensure that the construction contract is, as far as possible, ‘back-to-back’ with the offtake contract so that if, for example, certain construction risks are to be borne by the project company under the construction contract then those risks will also be borne by the government agency under the offtake agreement.

Another feature of BOT construction contracts is that the contractor’s ­liability may be limited: for otherwise the contractor could find itself liable for sums exceeding by many times the value of the contract itself. In the FIDIC Silver Book, the contractor’s liability is, subject to certain exceptions, limited to 100% of the contract price.⁵ Such a limitation seems in principle to be sensible, since otherwise prudent contractors would be heavily discouraged from tendering for BOT projects.

The following are other important features of the construction contract in a BOT-type project:

• There will need to be detailed provision for what is to happen if, for any specified reason, the contractor’s employment under the contract is terminated or the contractor becomes insolvent and incapable of continuing; or if for any other reason the contractor is required to be replaced. Such ­provision will often include procedures for another contractor to ‘step into’ the project, and the terms of the offtake and operation agreements will need to allow for this accordingly.
  
• Changes or variations to the work or the scope of the work will normally be provided for specifically in the construction contract. These will normally originate in the government or official agency, whose requirements might change: for example, the agency might wish to increase the output capacity of a particular part of the plant, so necessitating additional and varied design work.

The offtake agreement

The other contract of particular interest to us in a BOT project is the offtake agreement between the government or official agency and the project company by which the government agency agrees to purchase the outputs or services of the plant or structure at a certain price and volume over a certain period.

This agreement will contain performance obligations; the company will warrant, or undertake, that the outputs will be of a specified quantity and quality and be delivered at certain required intervals. There will normally be penalties for failure to comply with the warranted performance, which might include a fixed financial penalty; this could be in addition to other rights to seek compensation.

2.5 The FIDIC Silver Book

Although we have mentioned it mainly in connection with BOT-type ­projects, the FIDIC Silver Book is a free-standing EPC/tumkey contract which can be used in other situations as well. In whatever type of project it is used, however, its terms will need to be adjusted to take into account the terms of the other contracts involved in the project; just as we saw how the EPC contract in a BOT project had to be made back-to-back with the project company’s obligations to the government agency under the offtake agreement.

The following are important features of the Silver Book:

• As with other EPC contracts, there is no engineer in the Silver Book, although the employer can (and often does) appoint a representative in order to facilitate communications with the contractor. All claims, whether contractor’s or employer’s claims, are submitted to the employer, not to the engineer, for agreement or determination in accordance with the terms of the contract. If the contractor is dissatisfied with the employer’s decision he can challenge it by referring it to the Dispute Adjudication Board ­constituted under the contract.⁶ In practice, the employer will appoint an engineer to consider any claims and advise the employer, although he is answerable to the employer only.
  
• The contractor has full responsibility for all features of the work. The employer will state its requirements for the completed project in terms of expected performance and prepare a document (the ‘Employer’s Requirements’) against which the contractor will tender.⁷ Although the Employer’s Requirements may contain detailed technical information and data, these will (with certain very limited exceptions⁸) be a matter for the contractor to verify as part of its design responsibilities. In a BOT project, the Employer’s Requirements will usually include any technical requirements contained in the contract between the employer and the ­government agency.
  
• The FIDIC guidance advises that the Silver Book should not be used where there is insufficient time or insufficient information for the contractor to examine thoroughly the Employer’s Requirements or for it to carry out its design, risk assessment studies and estimating. Further, if the project will involve substantial underground works or works where the contractor is unable to inspect or assess the ground conditions then the risks of encountering unforeseen conditions (borne by the contractor) might be so great that the contractor should consider using another form of contract. However, in a BOT project the issue may at least to some extent be resolved by ensuring that there are suitable back-to-back arrangements with the government agency. The agency may be willing to negotiate some relief in certain cases if to do so seems necessary in order to ensure that the best qualified contractor is engaged on the project.
  
• As with the Red and Yellow Books, the contractor’s risks under the Silver Book are limited in that the contractor will not be liable to compensate the employer for any loss of use resulting from a defect in the works, even if that defect arises during the defects liability period under the contract; moreover, the defects liability period may not be extended for more than two years. The contractor’s liability is also limited to 100% of the contract price, subject to certain exceptions (see clause 17.6).
  
• In the Silver Book, the employer is required to make decisions or determinations on various matters if they cannot be agreed with the contractor. If the contractor is dissatisfied with any such decision or determination then he can give a notice to the employer stating his dissatisfaction within 14 days of receiving it. If he does so, the contractor need not comply with the determination, but either party can then refer their dispute about it to the Dispute Adjudication Board under clause 20.4 of the contract conditions.⁹
  
• The Silver Book, as with the other FIDIC Books, goes some way to mitigating the financial risks of the project by requiring the contractor to provide a performance security¹⁰ and the employer an indemnity in respect of any claim under the performance security which the employer was not entitled to make. There are detailed provisions relating to the provision of such security. All the FIDIC Books provide drafts of a range of securities. For his part, the employer under all the FIDIC forms is required to provide, on request, evidence to the contractor that he has in place appropriate financial arrangements to enable him to discharge his payment obligations under the contract (clause 2.4).
  
• The FIDIC Books all provide for a regime of testing at key stages of the works and for a more general right (clause 7) to inspect and test as the works proceed. The principal provision in the Red, Yellow and Silver Books is clause 9, which sets out a scheme of testing on substantial completion of the works and prior to the employer taking over; the contract will normally contain more detailed and specific test requirements in the particular conditions.
  
• Payment of the contractor under the Silver Book is based upon the ­submission by the contractor of a monthly or other periodic statement, with supporting documents, including a progress report as required under clause 4.21. Payments are normally made according to a schedule of ­payments based on certain milestones being achieved.
  
• Other clauses of the contract cover termination by employer or contractor (clauses 15 and 16); specific risks and responsibilities, in particular obligations to indemnify one party by the other in respect of claims for personal injury or damage to property and in relation to care of the works (clause 17); intellectual property and industrial rights (clause 17); and the parties’ obligations to insure (clause 18).

2.6 Particular risks: The unforeseen and design

We can illustrate the contrast in risk allocation between the Silver and the other FIDIC Books by looking in more detail at some specific and important risk areas: unforeseeable physical (often ground) conditions, and design responsibility, including errors or deficiencies in details and data.

2.6.1 Unforeseeable physical conditions

In the Silver Book, the contractor bears the risk of unforeseen difficulties unless this is otherwise stated in the contract. By clause 4.12, unless the contract states otherwise:

• the contractor is to be taken to have obtained all necessary information as to risks, contingencies and other circumstances which may influence or affect the works;
  
• by signing the contract the contractor accepts total responsibility for ­having foreseen all difficulties and costs of successfully completing the works; and
  
• the contract price is not to be adjusted to take account of any unforeseen difficulties or costs.

The risk borne by the contractor here is therefore total, unless the contract (by the particular conditions) expressly permits an additional payment. Equally, the contractor is not permitted an extension to the contract completion date if he encounters physical difficulties (clause 8.4). By ­contrast, under clause 4.12 of the Yellow and Red Books, the contractor could obtain an ­extension of time and additional payment (cost but not profit) if he encounters physical conditions which were unforeseeable in the sense that no ­experienced contractor at the date of tender could reasonably be expected to have foreseen them. He is also permitted an extension of time by clause 8.4.

2.6.2 Design responsibility

The design-build forms impose on the Contractor the obligation to ‘design, ­execute and complete the works in accordance with the Contract’ so that, when complete, the Works will be ‘fit for the purposes for which [they] are intended as defined in the Contract’ (clause 4.1). We will look in more detail at what is meant by ‘fit for purpose’, and some of the difficulties that can arise in practice, in Part II.

The contractor gives the same undertaking as to compliance with the ­contract documents (and applicable laws – clause 5.3).

Under the Silver Book, however, the contractor is responsible even where the Employer’s Requirements contain errors and even where the contractor could not reasonably have been expected to detect them, with certain very limited exceptions.

We see this from clause 5.1 of the Silver Book, by which the contractor is deemed to have scrutinised, prior to the Base Date,¹¹ the Employer’s Require­ments and to be responsible for the design of the works and for the accuracy of the Employer’s Requirements (including design criteria and ­calculations) with certain limited exceptions.

Clause 5.1 provides that the employer:

• is not to be responsible for any error, inaccuracy or omission of any kind in the Employer’s Requirements (as originally included in the contract); and
  
• is not to be taken to have given any representation of accuracy or completeness of any data or information,
  
• except as stated in four specific situations listed in clause 5.1 (which we will look at very shortly).

Further, any data or information received by the contractor, from the employer or otherwise, will not relieve the contractor of his responsibility for the design and execution of the works.

Thus, even if the employer provides the contractor with data or other ­information, and the contractor reasonably relies on it in designing the works, the contractor remains responsible for any error or inaccuracy in that information or those data.

The exceptions to the contractor’s otherwise comprehensive responsibility are stated in clause 5.1 sub-paragraphs (a) to (d). They are: