Chapter 3 - Project Risk

Summary:

A global methodology for evaluating project risks is described in this Chapter, as well as insurance and the risks the parties may be willing to absorb. Various risk profiles of various types of owners and contractors are reviewed, as well as projects that are most risk prone. Building types, which tend to generate major claims are identified, along with their specific risks. The author points out a series of proven mitigation steps that can reduce or eliminate a variety of project risks.

§ 3.1 Evaluating Project Risk

Project risk management is a simple and effective methodology that is — unfortunately — very rarely employed. Although many global contractors, especially in petrochemical and nuclear construction, have been using these techniques for years, public agencies often initiate vast projects without any formal study of project risks or mitigation steps.

It is a lot like going for a skydiving lesson without anyone checking your parachute.

A useful risk management study starts with an understanding of the typical losses and failures that occur with regular frequency in the construction industry. A large number of governmental agencies, sureties and professional liability carriers keep a virtual warehouse of statistics on failures and disputes in public contracting. The prediction and evaluation of such risks lies at the heart of actuarial science. The purpose of a risk management study is applying those industry lessons to a specific project concept, and then creating a winning strategy for the avoidance of risk and/or the mitigation of catastrophic damage or irrecoverable economic losses.

§ 3.2 Risk Identification

The following is a list of major risks that should be evaluated in a Project Risk Study, as more fully described in Section 3.3.

§ 3.2.1 Ownership

The type of owner is the most important risk factor. In general, well-funded, stable, locally-oriented public agencies with long-term relationships with the project participants are known and stable risks. Homeowner associations, small government entities, joint powers authorities, non-profit organizations, school districts, churches, individuals and community groups are the most risk prone.

§ 3.2.2 Building Type

There are a few building types that are recognized as exceptionally risky to design, build and operate.

Obviously, private facilities such as refineries, industrial plants and oil and gas pipelines pose natural risks of explosion and fire. Public airports and fuel farms can pose similar risks. But the industry competence and established quality standards for such facilities are extremely high. Furthermore, these types of project risks are generally insurable by the owner and contractor.

Generally, any structure open to the public is risky due to the possibility of personal injury claims by individual members of the public. Airports, sports and entertainment complexes, retail and other similar facilities and complex highways generate a disproportionate number of such claims. They often remain open to the public during construction. In addition to the construction phase, they present long-term risks of slip and fall, public liability and related claims.

Condominium associations are often described as pre-fabricated class actions. They are personal homes that by their nature are meant to be economical, often meaning cheaply constructed and often lacking in high quality amenities. These are the worst type of residential projects from a risk standpoint. In many California markets, participation in such projects is nearly uninsurable. When public agencies take on such mixed use retail and public residential projects, the risks apply to largely the same degree.

Certain public projects may appear innocuous, but can be extremely risky. While the design and construction of water pipelines in the desert would appear to be a low risk venture, such a project led to a $146 million claim in Arizona. Not only was the desert environment particularly corrosive to the pipeline system, the loss of water flow to Phoenix and the threat of major flash floods was a risk the owner did not wish to accept. Loss of water supply, or other critical needs, during critical agricultural or manufacturing periods arguably could have generated incredible consequential damages.

§ 3.2.3 Location of Project

There are other risks for remote jobs. For example, the availability of materials and labor productivity in such areas as the Eastern Sierras or the California deserts may be a significant risk on large jobs.

Urban, suburban and rural projects have inherent and peculiar risks. A major risk issue is whether the responsible designer and contractor have the experience, familiarity and professional exposure in the region to fairly evaluate and effectively mitigate those local risks.

The author has seen an inordinate number of claims where a public agency has chosen: 1) local designers with limited experience with the type of project (e.g. their first major hospital) or 2) highly experienced project architects from another state with limited local experience in the region (e.g. Southern California architects designing ski condos in the Sierras).

§ 3.2.4 Contract Provisions

The contracts themselves can create large project risks. It is tempting to grade the fairness of project contracts on a one-to-ten scale. There are numerous agencies in California that regularly issue unfair and unconscionable contracts. On the other hand, some publicly issued contracts are too lenient and sloppy. In one case, a public agency contract, written by their architects, contained seven different definitions of “completion.” They conflicted with each other and what were commonly accepted industry standards.

The presence of lengthy disclaimer statements, indemnities, or outrageous insurance provisions may be a tip-off towards the type of attitude and approach to contracts administration that the public agency intends for the project as well. Often, such clauses are met by a flurry of inquiries and comments during the bidding period, or a dearth of bids on the appointed day of bidding itself.

A solitary and stratospheric bid on a major civic project can be both an embarrassment and an economic hardship for a public agency.

It is critical for the parties to carefully review every unfamiliar style of contract (e.g. a highway contract that does not follow either CalTrans Standard Specifications or the Southern California Greenbook.) Parties are especially warned to beware of typewritten contracts that sound like they follow Standard AIA, Engineers Joint Contract Documents Committee (EJCDC) or Consensus Document forms, but are substantially re-written and may contain incredibly oppressive terms.

It is a better practice to use the industry printed forms (e.g. AIA) or for highway or bridge projects, the CalTrans/Greenbook documents, and issue a set of Special Provisions or Contract Addendum that tailor those documents to the specific project. It is much easier for public entity participants and the contracting community to review specific additions, deletions, and modifications of those lengthy contract forms, rather than hunt through the haystack for the “Golden Screws.”

It should be obvious, but standard national construction forms do not contain the required provisions for public works jobs in the State of California. So, those standard provisions should also be included as a matter of course, as set forth in Chapter 9.

The printed industry forms should be annotated and included in the bidding package to fully reflect and notify the parties of the additions, deletions and modifications by way of editorial hash marks, carrots and references to the Special Provisions and Addenda.

§ 3.2.5 Investigate the Parties

The most direct methods of checking out a potential party to a public works contract include: 1) checking their references, 2) reviewing their bidding materials carefully and 3) talking to agencies and firms familiar with their project management performance.

With the advent of the internet, there is very little information about a public entity, contractor, or individual that is not in the public record, private research databases or blogosphere commentaries. The issues to investigate include current and past projects, litigation history, licensing status, disciplinary record, bankruptcy, tax liens, credit history, and numerous other factors are available immediately over the Internet.

The parties’ Dunn and Bradstreet, Standard and Poor’s and other financial ratings can be obtained. These are generally available through a preliminary title search, a public records search and news clipping services, at little cost. In addition, ENR.com, Construction.com, Lexis/Nexis, and Google.com are excellent sources on firms and individuals in the construction industry.

§ 3.2.6 Public Financing Method

If there is a significant risk that up-front investment in a project may not be repaid, the reward for participation should be substantial. The famous Orange County bankruptcy (as well as the bankruptcy of the Cities of Vallejo and Stockton) are reminders that Chapter 9 Federal Bankruptcy is a real threat and risk associated with public entity creditworthiness.

While public agencies have traditionally been cautious about budgeting and financial matters, the size of large projects can swamp their traditional budgeting and revenue cushions. Speculative projects, which count on pie-in-the-sky revenue projections, should be avoided. There are numerous economics firms in California that can provide reasonable and valid projections of future growth and financial viability.

But even the most conservative projections rely upon key assumptions that need to be carefully examined. What happens if the price of gasoline doubles, or fuel oil triples? Or if interest rates or commodity prices escalate out of control? What is the sensitivity of the project’s economics to those fluctuations (a so-called “sensitivity analysis”)?

Public agencies often describe projects using just the “construction cost”. It is a very deceptive way of portraying the actual project costs. The so called “soft” expenses which include such very real expenditures as agency administration, project management, design and engineering, inspection and testing, software installation and maintenance, startup and performance testing and related expenses can meet or exceed construction costs.

It is lamentably rare for a public agency to realistically disclose to the public the long term finance costs of a project (although that type of disclosure is imposed by law on every car dealership in California). It seems appropriate in an era of an apparent lack of transparency and openness in government and the public markets (e.g. Enron, the California budget crisis and TARP) that the public be given a realistic estimate of the overall costs of major public decisions. Such public disclosure is vital when comparing the various types of project delivery systems described in the last chapter.

The general principles of public accounting and overall standards of civic integrity require public entities to carefully arrange financing to pay for the original bid amounts and soft costs (or at least the engineer’s estimate). Contractors should always verify the source and reliability of the funds (e.g. federal grants). A common failing with underground or complex urban projects is an unrealistically low contingency amount — which typically should be at least 10-15 percent of overall project cost and far larger amounts for particularly risky projects (e.g. the Oakland-San Francisco Bay Bridge Signature Span).

§ 3.3 Risk Mitigation Strategies

While there are numerous methodologies for risk avoidance, the simplest and most widely used is a risk management spreadsheet. It is populated with a listing of the universe of typical construction industry risks as well as those posed by the specific project.

The risks are further evaluated with estimates of their probability of occurrence, the minimum and maximum adverse outcomes, the expected values of those outcomes (frequency x severity), the availability and cost of insurance for the specific risk for various durations, a list of reasonable mitigation steps and their costs, and an evaluation of the party most likely to prevent, absorb or insure the adverse result, if it occurs.

After an overall survey and in-depth project evaluation, a risk management plan is developed and implemented.

During the course of certain projects, it may be appropriate to evaluate the potential gains that might be generated from certain activities versus their expenses and financial risks.

For example, a company may wish to design and build certain types of water treatment facilities but refrain from operating them due to the different set of risks and insurance programs associated with such ventures.

As another example, a company may be willing to take on a design-build-operate water treatment project over thirty years, but not be willing to absorb the risk of the fluctuating cost of electricity, changes in environmental laws, or union labor rate changes. It may, on the other hand, be willing to accept the risk of variable interest rates on borrowed funds.

Obviously, any situation or risk involving personal injury or death raises the most serious concerns. Those concerns go beyond a management or monetary analysis and encompass our basic moral obligations to each other and broad issues of ethical responsibility.

Some risks, unfortunately, cannot be insured or avoided. Sometimes the magnitude of those risks makes it inappropriate to proceed with the project. Those risks may be financial, technical or inherent physical dangers.

§ 3.4 Project Risk Checklist

The following is a checklist of risks for large projects:

Site Risks

• Floods, Earthquakes, Fires & Windstorms

• Differing Geotechnical Conditions

• Expansive or Corrosive Soils

• Unexpected Utilities

• Sinkholes and Springs

• Boring and Tunneling Equipment Failures

• Archeological Finds

• Stray Electrical Currents

• Sight-line Conflicts

• View Impairment

• Ownership, Easement or other Title Issues

• Squatters or Hold-Over Tenants

Economic Risks

• Project Financing

• Grant Conditions

• Market Demand

• Commodity Prices

• Labor Agreements

• Economic Fluctuations

• “Unexpected Events”

• Cost Overruns & Construction Claims

• Bankruptcy of Contractors and Consultants

• Tax Law Changes

• Disruptions in Payment Process

• Economic Obsolescence of Plant, Process and Products

• Competing Projects

• Embargoes

• Energy & Materials Shortages

Political Risks

• Lack of Interagency Cooperation

• Change of Leadership

• Environmental Opposition

• Public Utilities Commission

• Federal Transit Administration

• U.S. Congress Appropriations

• Social Legislation

• Workplace Rule Changes

• Fluctuating Taxes & Duties

• Value of Government “Guarantees”

• War, Insurrection & Other Hostilities

• Sabotage/Terrorism

Design and Construction

• Design Errors

• Coordination of Drawings

• System Integration

• Excessive Changes

• Site Safety Issues

• False Claims

• Substitution of Materials

• Damage in Shipment

• Sabotage

• Interruption of Service

• Major Accidents

• Start up and Commissioning

Environmental Risks

• Site Contamination

• Perceived Environmental Impact

• Long-term Degradation of Environment (air, water & soil)

• Endangered Species & Ecosystems

• Toxic Spills

• Environmental Legislation

• Remediation Risks

• Toxic Materials Handling & Disposal

• Environmental Terrorism

Human Frailties

• Corruption or Bribery

• Theft and Embezzlement

• Computer Hacking

• Theft of Data

• Health Problems

• Physical or Mental Disability

• Community Tragedies

Long-Term Risks

• Corrosion

• Subsidence

• Welding Failures

• Stress Failures

• Concrete Failure

• Derailment

• Railroad Crossings

• Intersection Collisions

• Technical & Economic Obsolescence

• Structural Collapse

• Foundation and Masonry Failures

• Site Contamination & Mold

• Chemical Release

• Explosion