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Allocation of Risk in Construction Contracts

Risk in construction contracts

'Risk', in a project delivery context, can be defined as 'an uncertain event or set of circumstances that, should it occur, will have an effect on the achievement of one or more of the project's objectives'.1 Risk exists as a consequence of uncertainty, and, in any project, the exposure to risk produced by uncertainty must be managed.2

Common risks prevalent in construction projects include weather, unexpected conditions, errors in cost estimating and/or scheduling, delays, financial difficulties, strikes, faulty materials, faulty workmanship, operational problems, inadequate plans and/or specifications, and natural disasters.3 Projects will also have additional specific risks, dependent on their nature and surrounding circumstances.

Although the volume and nature of contractual documentation for a construction project will vary as a consequence of the nature of the project, its scale and the procurement methodology adopted,4 a construction contract may be simply described as a contract between a contractor and an employer whereby one person (the contractor) agrees to construct an asset for another person (the employer) for agreed remuneration by an agreed time.5 A construction contract will include a compact of rights and obligations6 between the parties by which the parties allocate responsibilities between themselves in respect of risks that may transpire during the contract's execution. In doing so, the parties define the impact of the occurrence of risks on three key elements, namely: the asset that is to be constructed by the contractor, the time at which the asset must be completed by the contractor and the amount the employer is obliged to pay the contractor. The collective allocation of such risks in a construction contract represents its 'risk allocation'.

 

Pursuit of a 'fair and equitable' allocation of risk

Typically, in preparing the contract document bid package, the employer will be in a position to decide on its intended risk allocation. While there may be a temptation to allocate all or most major risks to the contractor, this must be tempered by an understanding of the potentially adverse consequences of allocating risk where doing so may preclude the submission of bids or result in an increase in cost such that the project is no longer financially viable.7 Improper risk allocation may also result in prolongation of construction completion times, wastage of resources and/or increased likelihood of disputes. As Shapiro states, 'proper risk identification and equitable distribution of risk is the essential ingredient to increasing the effective, timely and efficient design and construction of projects.'8

While it is of course possible for parties to negotiate all the terms of any construction contract, a number of standard form contracts have been developed and it is common for one of these standard forms to be used as the basis for the final construction contract.9 One of the features of standard form contracts is the intent to produce a 'fair and balanced' allocation of risk.10 The rationale for pursuing this is that doing so will provide the best chance of successful project delivery. Echoing Shapiro, Lane notes that, '[a] contract which balances the risks fairly between a contractor and an employer will generally, in the absence of bad faith, lead to a reasonable price, qualitative performance and the minimisation of disputes.'11 Abrahamson suggests that in order to achieve a fair and equitable allocation of the risks inherent in construction projects, a risk should be allocated to a party if:

  • the risk is within the party's control;
  • the party can transfer the risk, for example, through insurance, and it is most economically beneficial to deal with the risk in this fashion;
  • the preponderant economic benefit of controlling the risk lies with the party in question;
  • to place the risk upon the party in question is in the interests of efficiency, including planning, incentive and innovation; and/or
  • the risk eventuates, the loss falls on that party in the first instance and if it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by attempting to transfer the loss to another.12

While the principle of control of a risk is a powerful factor in the determination of risk allocation, it is not comprehensive and other principles should be utilised to address adequately the allocation of risk in a construction contract.13 For example, events of 'force majeure' by their nature cannot be controlled by either party but the consequences of such risks must be assessed and allocated. Bunni proposes that the following four principles are used for allocating risks in construction contracts:

  • Which party can best control the risk and/or its associated consequences?
  • Which party can best foresee the risk?
  • Which party can best bear that risk?
  • Which party ultimately most benefits or suffers when the risk eventuates?

The question of what is a 'fair and equitable' risk allocation is, ultimately, a subjective one albeit using objective tests mentioned above by way of assistance; in deciding how to procure a project and to allocate risks, an employer will need to weigh up the theoretical efficiency of the risk allocation with political and market dynamics and the needs of the particular project and its financiers (if any)...Click here to download the full 'Allocation of Risk in Construction Contracts' PDF »

 

See also: Introduction to the FIDIC Suite of Contracts

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1 Peter Simon, David Hillson and Ken Newland, Project Risk Analysis and Management Guide, Association for Project Management, p.17 (1997).
2 See Catriona Norris, John Perry and Peter Simon, Project Risk Analysis and Management Mini-Guide, Association for Project Management, p.4 (2018).
3 See Samuel Laryea and Will Hughes, The Price of Risk in Construction Projects, p.553 (2006).
4 See Julian Bailey, Construction Law, Volume 1, 2nd ed., p.49 (2016).
5 Peter Simon, David Hillson and Ken Newland (op.cit.), p.17 (1997).
6 Julian Bailey (op.cit.), p.1512.
7 Bryan Shapiro QC, 'Transferring Risks in Construction Contracts', p.5 (2010).
8 Ibid, p. 17.
9 See Graham Vinter, Project Finance, 4th ed., Sweet and Maxwell, p.1 (2013).
10 In relation to FIDIC, see Ellis Baker, Ben Mellors, Scott Chalmers and Anthony Lavers, FIDIC Contracts: Law and Practice, Informa, p.6 (2009).
11 Patrick Lane SC, 'The Apportionment of Risk in Construction Contracts', International Conference on Arbitration and ADR in the Construction Industry, Dubai (2005).
12 See article by Max Abrahamson, Journal of the British Tunnelling Society, Vols 5 and 6, November 1973 and March 1974; and CIRIA Report R 79 'Tunnelling – improved contract practices' (1978).
13 Nael Bunni, 'The Four Criteria of Risk Allocation in Construction Contracts', International Construction Law Review, Vol 20, Part 1, p.6 (2009).

 

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