Risk Allocation in Construction Contracting - Oct 2009

Risk Allocation in Construction Contracting 1

Patrick Lamarre President & CEO SNC-Lavalin Nuclear Inc.

Sources of Construction Contract Risk

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Construction Contracts will generally need to identify and assign risks in the following areas: ¾Project Execution • Quality • Schedule • Cost

¾Financial Factors • Escalation • Foreign exchange • Cost of money

¾“Market” Factors • Supply – demand in local and global pricing as distinct from escalation

¾Regulatory Factors 2

Increased Contract Risk in the Nuclear Industry 3 The contract risks are compounded in the nuclear industry: ¾Extremely long project durations – typically 10 years • 3 year licensing period before substantial construction starts • 10 year exposure to escalation and foreign currency fluctuation

¾Limited number of qualified suppliers of critical commodities and equipment • Demand driven pricing out of step with inflation/escalation

¾Nuclear Regulatory Environment • Interpretation and application of EA, site license and CNSC requirements • Regulatory requirement for Owner/ Operator intervention in design process

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Contract Risk Allocation is Critical

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With the magnitude of Nuclear plant costs and potential steep cost escalation contract risk allocation must: ¾Allocate the risk factor to the party best able to manage the risk • Excessive contractor risk will result in un-economic levels of contingency and risk costs • Excessive owner risk may make the project un-financeable

¾Balance risk allocation to ensure alignment between the Owner and Contractor on project objectives ¾Reflect the reality of the regulatory environment and associated impact on project scope and schedule

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Different Contracting Methodologies Different Risk Allocation

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¾

EPC Reimbursable with a Mark-up on the total TIC

¾

Lump Sum(LS) for some aspects of E or P or both

¾

LS for full EPC

¾

LS from FEED estimate for the complete project or Converted Lump Sum (CLS) from FEED

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Who has the risk ?

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EPCM

Materials

LS Services

E

P

C

LS Services Equipment and Materials

E

P

C

Cost Reimbursable

LS and CLS

EPCM

Materials

Construction

Construction

RISK ALLOCATION OPTIONS 6

Owner Risk

Cost Reimbursable

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+ Advantages

-Disadvantages

Owner

Owner

•Maximum flexibility on project scope and schedule •Avoids excessive contingency and risk in contractor’s hands •Avoids confrontational change order environment

•Full risk exposure •Lack of cost certainty until late stages of project •Limits financing options

Contractor •Minimal risk exposure and certainty of cost recovery •Predictable revenues and earnings

Contractor •Low margin and low value-added work •Competitive bidding shaving margins further

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Lump Sum EPC

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+ Advantages

-Disadvantages

Owner

Owner

•Early cost certainty •Minimizes owner risk •Flexible financing options

•Premium cost due to contractor’s contingency and risk •Limited ability to make design changes without onerous change order process •Limited ability to intervene or influence the contractor’s project execution performance

Contractor •High margins commensurate with the risk •Reduced competition due to limited number of contractors who can assume the risk •Avoids Owner intervention in project execution

Contractor •Maximum risk strategy •Exposure to market demand and escalation which is difficult to predict and outside of the contractor’s control 8

Converted Lump Sum – CLS Model

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Open Book Estimate (OBE) MC

DBM

FEED

ENGINEERING PROCUREMENT CONSTRUCTION

Convert Cost Reimbursable into LSTK after Advantages over LSTK: • Design Freeze, P&ID’s complete and HAZOP’d • All Long Lead material are placed MTO’s bid for most cycle bulks defined • Schedule savings omitting EPC•LSLS cost consist of: • Cost reimbursable portion • Late changes can at minimal cost • LS mark-ups will bebe incorporated • Remaining engineering cost • Long Lead Material cost Cost negotiated and fixed • Remaining Procurement RFQ’s up-front based onmaterial • Conversion when quantities are known, lowering risk Reimbursable • Remaining Bulks known scope • Expediting, Inspection, Delivery of Equipment premium for material (escalation) andand Materialsfield costs • Construction Directs and Indirects Strategies and Awards • Potentially lower risk premiums•• Subcontract Mark-ups applied

~ 1212-15 months

Converted LS

60% Engineering

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Converted Lump Sum – Staged Contract Approach 10 The converted lump sum or staged contract approach is well suited to the nuclear industry: ¾Takes advantage of the 3 year licensing period to complete a majority of engineering so that material quantities are known and equipment pricing is firm ¾Allows the Owner flexibility during the licensing period to implement design changes necessitated by regulatory requirements ¾Shortens the forward window on construction to 5-6 years allowing more confidence in escalation forecasts and pricing ¾If some scopes are still undefined at conversion, leave them as T&M until adequate scoping is done 10

CONCLUSION

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•Successful “Fast Track” projects don’t exist •“ABC” of projects; ƒ FEED ƒ Engineering ƒ Procurement ƒ Construction DON’T CHANGE THE SEQUENCE OF THOSE ACTIVITIES!!!

•Planning •Alignment of interest

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Thank You

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