| | RISK MANAGEMENT - A VALUE ADDED PROPOSITION
By: Reza Nikain, PE, PMP, MIEAust, PSP, CFCC
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Introduction
The Business Development group identifies the Project, bids or negotiates the contract terms and then lands the project. Then comes execution, the Project is handed to the Project Management team and off they go. Will the project be a success? Are the Owner's and Contractor's definition of success aligned? What can be done to enhance the probability of success? What can go wrong?
Project conflicts are disruptive and pose business loss exposures to Developers, Owners and Financiers. To control the adverse consequences of these conflicts, participants often embark upon developing plans to manage their respective risks. If these risk management plans are executed and periodically updated in an effective manner, controlling, reducing or altogether eliminating the adverse impact of risk elements is possible. Fundamental to the success of the process is the recognition of the manner in which the parties approach risk allocation and management.
Successful implementation of construction projects requires establishing a framework for all project participants to understand their respective roles and to understand the potential impact of their failure to fulfill the expectations. Often, conflicts arise due to differing expectations caused by project scope and contract interpretations, estimate and schedule assumptions, misunderstood responsibility allocation, poorly defined project objectives or inability by one party to execute to the level expected of them. Simply having an effective and comprehensive management program will not ensure a worry free project execution. An efficient execution aided by proactively identifying and managing risks and executing mitigation approaches will enhance the probability of success. Basic Characteristics
The characteristics of a successful and effective risk management process that will add value to the execution of the project and meet each parties' expectations include: - A system that is transparent, understandable, repeatable and capable of incorporating the risks resulting from project specific circumstances;
- Recognition that the process is influenced by "people" - relying solely on policies and procedures manuals is not sufficient; and
- A system that is integrated with the Project Control tools and is monitored will best contribute to the Project Success Objectives.
These concepts provide the basic framework for an effective program development and execution. The basic premise of risk management is governed by the types of risks and methods of control. The two fundamental risk types are: - Business Risk: Those risks where there is a probability for profit or loss.
- Pure or Insurable Risk: Those risks where there is only chance for loss.
The Owner's initial decisions during contract formation and project development stages are often driven by a series of conceptual estimates and a developing approach for managing uncertainties. Risk, by definition, is an event that can influence the successful achievement of important project objectives ("Project Success Goals"), and most commonly carries a negative connotation. Generally, the approach to fair and efficient risk allocation is to assign the risk to the contracting party that is best positioned to assess and manage the risk elements. However, the more likely that a risk will affect the outcome of a party’s Project Success Goal, the more important is for that party to have controls in place to know with great precision the incremental performance of activities that must be performed to achieve the Project Success Goal. Simply put, the best method to attract bidders and to minimize cost to the Owner is to evaluate risks that the Owner is best positioned to control and assume, assign risks to the contractor that the contractor is well-positioned to control, provide a clear mechanism to measure the impact that a risk may have on a Project Success Goal and provide a mechanism to share and/or assign the remaining risks which neither party can control. Risk Management approaches generally fall into three categories: - Pass the Risk along through the contract delivery method and / or language and provide a vehicle to know if the risk emanates, its impact and what is being done about it
- Insurance and Surety process
- Keep the risk and manage it through a Risk Management process
The common denominator is that owners, engineers, contractors, financiers, etc. all rely on an estimate of their business risk, and from their estimates develop expectations of the outcome which typically form the basis of the risk management program. The Value Proposition is integral in this process. The efficiency of the analysis would be significantly enhanced if prior claim patterns and sources of conflict / loss that are rooted in execution problems are more accurately identified and their potential influence is more readily quantified. This approach allows for a more rapid identification and development of response plans and is by far more efficient to execute. Risks are characterized by three factors: - Risk event or identification of what may happen to negatively impact the Project
- The probability and likelihood of the event occurring
- The potential impact or the amount at stake if the risk event were to occur
Once Risks are identified and categorized, the Risk Management process provides the means to monitor the progress and the effectiveness of the program. To be efficient, in the context of the Value Proposition, the system utilized must be integrated with the Project Control system. This will facilitate the utilization of information that forms the basis of all management decisions and is an integral part of implementing the mitigation measures. Dynamics of an Effective Program
To appreciate the elements of an effective risk management program and execution of it, the following concepts should be well understood: - Project Lifecycle: The Risk Management process during various stages of the project life cycle must be adapted to the critical elements within each phase.
- Project Types: The scale, complexity and contracting approach will have a significant influence on the risk elements and approach in monitoring and management.
- Sources of Conflict During Contract Execution: Understanding the source of conflict will facilitate for better monitoring practices and the integration of those practices in the overall Project Management process.
- Risk Management Monitoring Process: Adapting of the monitoring process to the major factors that contribute to the level of exposure and the potential mitigation approaches can facilitate a more successful outcome.
A. Project Lifecycle
Project requirements vary during the development cycle. The development cycle or phases can be divided into the following phases: - Conceptual
- Development
- Execution and Implementation
- Finishing, Termination and Recording of Lessons Learned
The Project Success Goals first must be defined and aligned between project stakeholders before development and further stages in the Project Life Cycle can be completed. While the overall Project Success Goals are the basis for approving the project and going to the next stage in the Project Life Cycle, no doubt each project phase has a different set of information and criteria to achieve. For example, during the conceptual phase, parties concentrate on establishing the standards for the basic economics, feasibility, product / performance guidelines and potential team members and Project Stakeholders. These are the building blocks to allow the parties to determine the characteristics of the project design, execution and risk allocation. The level of resources expended is often much less than is required for the execution phase, the opportunity to address risks in a more cost effective manner is much greater.
The initial conceptual analysis and decision making often focus on the return on investment ("ROI") that a project will generate for the company. Often projects will only be approved to proceed on to Development if they meet specific ROI requirements. For Contractors, ROI is simply an anticipated margin on the project. On occasion projects are required to meet regulatory requirements. In either case, a key exercise is to minimize the capital expenditure while still meeting the then understood Project Success Goals of each Project Stakeholder. The assumptions and estimates used to make decisions and establish protocols during this stage are critical factors in the ultimate success of the program. These estimates and assumptions are based on preliminary data and feasibility studies which are sometimes based on forecasts of costs and profits many years into the future. Assumptions used in this process must be tracked and validated as true or otherwise treated as risks.
During the development stage, the scope is further defined based on the performance metrics (life of use, production output, downturn capability, on-stream time, etc.) quality standards, resource requirements and activities; the master budget and schedule is then better refined and established. Each of these criteria must be certain to be within the boundaries of what the Project Stakeholder finds acceptable. The desired Project Delivery Method (How the Scope of Work is to be released - Design / Build, Design / Bid / Build etc.) and the Contract Type (reimbursable, lump sum, Unit Price, etc.) are also evaluated and established during this period.
The execution and implementation phase that follows includes establishing the contracts, procurement and construction, as well as ensuring that the scope, performance, quality, budget and time goals stated by the Project Objectives are met. The number of opportunities to influence the project characteristics in a cost efficient manner decreases as time elapses from the conceptual to finishing phases. B. Project Types
Within the project phase's framework, the project type will have an influence in time required and the resources required to achieve the proper level of planning and control. Risk Management Systems often have preliminary screening tools to determine if a project should undergo more careful scrutiny-perhaps by a third party or executive management. However, the rules used to determine if the project triggers this higher level of scrutiny should be uniformly applied and transparent so that decisions can be quickly understood by executive management and third parties (auditors) reviewing the project risk screening process. The primary factors typically influencing the project management process are scale and complexity. Scale is often measured by the level of resources, such as funding requirements, labor hours, and influence area. Larger and unique projects typically have higher levels of risk, thus requiring more resources to implement a comprehensive Risk Management System. Project Complexity is influenced by a variety of factors such as the type of contracting approach, technology and regulatory requirements, sourcing of the funding requirements, and scope / delivery schedule sensitivity. For example, a revamp / addition which requires tie-in to an operating facility is typically more complex to manage and execute than a Greenfield project. Therefore, the management process / control must be tailored to the project needs and must draw on the need to meet variables such as: - Project / process technology and / or state of the art undertakings.
- Regional / cultural contracting practices, domestic vs. international and multinational arrangements.
- Contracting approaches, new and / or innovative contracting arrangements, repeat relationship – active vs. passive Owner involvement.
- Project type relative to the organizational history. One of a kind undertakings vs. routine programs.
- Project scale - typically projects with larger budgets carry more risk.
- Duration sensitivity and / or absolute completion-needed dates. A project with an aggressive completion schedule typically carries higher risks.
- Market, environmental, regulatory and other regional factors.
One area that can affect the overall risk model and risk allocation is the contracting method. Contracting methods have significant bearing on sources of conflict and the resolution process. Contracting methods include traditional general contracting with a fixed, unit price or cost reimbursable contract, multi-prime contracts or design-build contracts. The popularity of design-build contracting approach has increased due to its potential for reduced project costs, improved delivery schedules, enhanced accountability for project quality, and simpler risk allocation mechanism. Variations of design-build contracting practice include: - Teaming and Partnering
- At-Risk Construction Manager GC / CM (General Contractor / Construction Manager)
- EPC (Engineer / Procure / Construct )
- DBO (Design / Build / Operate)
Regardless of the contract type, conflicts may arise from efforts to allocate and mitigate risk through contract language. Thus, the initial effort must focus on developing effective contracting language, premised on a sound execution strategy, complemented by appropriate risk allocation to meet the Project Success Goals. Various contracting strategies such as integrated project delivery systems or multi-point contracting methods each have a different risk distribution model. The management requirements for the stakeholders and execution will thus be different as well. Execution requirements within a design-build contract are different given the project dynamics, the relationship between the internal design and construction entities, and the influence of one contracting party on another's performance. The contract scope must be evaluated with the backdrop of the risk inherent in the development process, and proper risk mitigation measures must be in place well in advance of the execution schedule. Therefore, given the particulars of each contracting approach, the management and mitigation effort will have to be tailored to meet the risk profile of the contract and each party's appetite for risk taking. The degree of Owner's involvement in the project development and execution will have a significant bearing on risk allocation, monitoring and execution. From an Owner's perspective, with an ongoing facility management and operating program, project management is further influenced by the contracting formality and approach. If work is being performed by the "in-house" resources, the management challenges are remarkably different than if a formal contract is formed with an independent contractor. Notwithstanding the contract type, if the Owner is to perform work, make key decisions during the execution, or meet a particular equipment delivery date, the risks associated with the completion schedule are more dependent on the Owner's actions than if the scope and the associated coordination responsibilities were shifted to the contractor. In either case, it is important for the Owner to know when events can affect its Project Success Goals and require proper coordination through utilization of appropriate risk reporting and monitoring tools. Employment of an effective risk identification process is important in all Project Phases. The choice for the Project Delivery and Contract Forms must be made in a way to optimize achievement of the most important Project Success Goals. Therefore, Project Success Goals must be prioritized as to which is the most important so that the various Project Delivery Methods and Contract Forms can be assessed. A simple matrix can be used to qualitatively identify the optimum Project Delivery Method and / or Contract Form that will achieve the most important Project Success Goals. Compliance with the Risk Management System is a critical step toward ensuring that the most important Project Success Goals are attained and mitigating the potential adverse impacts of risks on these Project Success Goals. C. Sources of Conflict during the Execution Stage
The success of any project is impacted, positively or negatively, by the performance of parties involved, particularly actions of: - Owner
- Architect / Engineer
- Contractor / Subcontractor
- OEM / Vendor
- Others - financial institution, insurers / surety, consultants, lawyers, accountants, etc.
The alignment of the overall project objectives with the plan developed for execution is an essential requirement. Failure to have this alignment before the execution stage and failure to manage the alignment during the execution stage can significantly affect achievement of the Project Success Goals. The level of effort and resources at risk during the execution stage are higher than at any other time during the project. Any impact due to conflict will have a larger effect on the project than in any other stage. To better appreciate the complexities associated with resolution of the problems and conflicts, sources of conflict need to be better understood. The typical sources of conflict include: - Perception (including contract interpretation)
- Communication and / or miscommunication
- Role and responsibility incompatibility
- For example, Contractors’ abilities - financially and / or technically
- Bid / Tender Assumption - concepts such as:
- Buying the Project at all cost
- Inadequate bid analysis
- Execution-performance period inadequate
- Scope definition and management
Each project participant develops its execution plan based on estimates and assumptions. If all parties achieve their plans, the project would likely be successful and free of conflicts. As the project is perceived to be performing in accordance with the plan, the expectations that each party's objectives will be met is heightened. The likelihood of conflicts is tied to the accuracy of assumptions and developed expectations. Assumptions made during project development can affect the overall direction and development of the project plan. Conflicts that arise late in the project are often more difficult to resolve. The impacts of late developing conflicts are typically greater and less likely to be resolved by negotiation as they conflict with the heightened expectations of the parties and on occasion lead to disputes. Analysis of project performance in the context of contractual requirements is a critical element in early recognition of potential conflict. While, in theory, any contract clause may become the basis of a conflict, the clauses that form the foundation of a majority of conflicts include: - Changed Conditions: This clause may also be referred to as "differing site conditions." While there is no universal approach in dealing with this clause, the likely approach is to test the actual condition with those contemplated given the contractual requirements. Claims typically arise from differences in clause interpretation and risk allocation expectation.
- Variation in Quantity: On occasion, estimated quantities form portions of contract price. Where quantities are not accurately estimated or cannot be estimated, this clause typically allocates the risk for unit prices to the contractor and the risk for the quantities to the Owner. The claims likely arise when the change in quantities are such that the initial assumptions that formed the unit prices are no longer valid, or there are indications of indirect costs disproportionately being assigned to the unit prices.
- Time Extension, Delay, Liquidated Damages: These clauses provide the protocol for requesting an extension of time to the project completion and / or establishing the charge against the contractor for failure to complete the work within the specified time allocated in the contract. Often, there is specific language as to what would be necessary to demonstrate the entitlement to the additional time, sometimes even specifying the methodology to be applied.
- Changes and Extra Work: The Owner typically has the right to order extra work; the contractor's protection is that it would be paid for the related costs. Typical claims arise as to the determination of what constitutes true extra work, the extent of the ripple effect and time extensions associated with the added and / or changed work scope.
- Payment Clauses: The failure of an Owner to make timely payments may become an obstacle to the contractor's performance. Yet, the failure of the contractor to comply with the requirements for payment, may become the basis for untimely payments. Disputes arise when either party does not meet the payment requirements.
- Quality Standards: The standards employed by an Owner may allow the Contractor to make choices in design, procurement and even construction techniques which are not acceptable to the Owner. When Owners do not require a specific quality plan to be submitted at the bid stage so that the Owner can close important gaps, a claim or unexpected Change will result.
- Completion Status: These definitions often relate to a milestone payment, or transfer of risk between the parties. Often the value of the bond security changes (example: the bond value may drop after Acceptance of the project to ensure performance of only the warranty obligation.) The coverage of certain liabilities and policies are defined by the status of the project at the time of the loss event.
These are only a sampling of the various clauses that often are the basis for construction claims. The common element is that once there is a conflict in interpretation, pricing, etc. the cost of conflict is time and resources, efficiency, profitability and, on occasion, survival of the organization. As such, a Risk Management System that identifies and evaluates risk created by the structure and language of the project contract is very important. A critical review of risk with the planned contract and the negotiated contract before execution is important. After the contract is executed and the project has begun implementation, risks should be identified and evaluated in the context of the Project Contract. D. Risk Management Monitoring Process
Project phase, type, and sources of conflict are some of the major variables often considered in designing a Risk Management and Monitoring process. The designed process for the monitoring and proper management would have to be premised on an approach that is fully integrated and is systematic, simple, and usable for the entire duration of the project. Major program objectives are developed based on a result-oriented system / process which: - Minimizes the financial risk to the Project - the system should allow for timely identification and management of the emerging risk elements.
- Can be applied without significant effort and overly cumbersome approaches - techniques that are too complex are seldom followed.
- Is implemented as early in the life of a project as possible and followed through project close-out to achieve the greatest benefits. Changes in the scope and assumptions must be incorporated dynamically to achieve maximum benefit.
- Fully integrated into the business practices and methods. The project controls outputs are commonly the basis of progress monitoring and reporting. The system must be developed to utilize these outputs as the basis for a decision making process which manages risk elements. For Project Owners, risks occurring to one project can affect the business plan and planning / execution of other projects.
A comprehensive Risk Management System not only defines the risk identification and evaluation methodology, and the roles and responsibilities of its participants, it also characterizes the risk tolerance for the project by identifying the allowed cost, schedule and performance / quality contingencies, identifies the approach to interpreting risk type, defines the timing of the plan, and describes the reporting and tracking approaches. The most effective risk response strategy includes actions for primary response as well as a backup approach. Response planning has four potential solutions: - Elimination / Avoidance: This approach eliminates and / or avoids the potential risk element by changing project plans. For example, avoiding an innovative contracting approach on a time sensitive project would eliminate the contracting risk from the project.
- Shifting / Transferring: This approach gives the management responsibility of the risk element to another party, often at an added premium. Securing various types of insurance policies is a form of risk shifting. While in concept, many risks and liabilities are best shared, caution is necessary where in some situations, Owners shift the Risk to Contractors, who in turn shift the Risk to the Subcontractor / Vendors. This type of approach may result in an inefficient risk allocation.
- Mitigation: This approach entails reducing the likelihood and / or the cost of a risk event’s impact to a level that would be within an acceptable tolerance. The likely approaches are through performing some additional work, such as additional engineering effort or allowing additional time / schedule to meet the project objectives.
- Acceptance: This concept entails proactively developing contingencies to accept the consequences of the risk events. Establishing and defining risk triggers are critical elements in managing accepted Risks. Effective monitoring, control and communication of the Project Management information are at the root of risk acceptance.
Based on the risk identification and response planning program, once the risk event signs are observed, the likelihood and impact of the risk event can then be readily identified. A systematic approach can then integrate other major factors and parameters such as: - Project Management Structure - this is determined and influenced by the delivery method chosen.
- Contract form chosen - the mechanism for how and when the executing parties are granted payment and completion status.
- Integrating risk trigger mechanisms in the Project Management program.
- Execution plan Risks - the risks that emerge due to the inability of a party to execute correctly whether due to their own fault or for reasons beyond their control.
Conclusion
It is well recognized that project conflicts are disruptive and present business risk to owners and developers. To proactively manage these risks, each project should be evaluated not only in the context of the scope and ultimate performance requirements, but also in light of the risks associated with the execution issues, including technology, project management / execution and parties' tolerance to the assumptions that provide the basis of the risks identified. All these factors should then be integrated in the risk management planning and execution program. Most current models rely on past practices as the principle indicator of the future performance. If each project were identical (same structure, management team, scope, location, contract, schedule, etc.) this would be a very reliable model. In reality, projects are a unique collection of risks associated with varying project structures and team, contract forms, scopes and execution strategies. Project Risk Management can be performed in a systematic manner to identify, evaluate and manage risks associated with assumptions made in the early stages of a project and expectations developed by the parties before and during execution. Business practice audits, particularly the benchmarking of the Risk Management program and assessing the effectiveness of the monitoring and control against the industry standards will provide for either developing a new collaborative program or transforming the program so the likelihood of meeting the project success goals are enhanced.
Risk Management Services are provided through Nielsen-Wurster's subsidiary company, Pegasus Global Holdings, Inc. For more information on Pegasus Global Holdings, Inc, please go to our website located at www.pegasus-global.com.
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