[+] Share Risk, Help Industry Survive, Construction Urged

Flexible contracts could help to salvage Australia's weakened construction sector as price fluctuations and a labour-constrained market continue to curtail the nation's productivity. Perth-based Clough Group collapsed late last year with a $10-billion government project work book, including the Snowy Hydro 2.0 project, and about $248 million owing to creditors. Deloitte's report says the collapse was triggered due to the skyrocketing costs of raw material costs causing significant budget blowouts. But Australian Constructors Association chief executive Jon Davies is among a growing chorus in the sector calling for a dynamic shift in the way it is doing business. Davies is one of many calling for an arbitration mechanism, different equity structures and new contract types are among measures that need to be looked at as the roll call of failures grows, including Clough Group, Condev Construction, ProBuild Australia and more. Intel suggests it’s still straightened times for builders—data published by CreditorWatch from January shows that although only 3.7 per cent of businesses in the construction sector are at risk of default, 11.4 per cent are in payment arrears. That’s the highest percentage among the 19 industries the credit data firm studies for its Business Risk Index. Australian Constructors Association chief executive Jon Davies says large price rises for building materials as a result of supply-chain issues from Covid and the war in the Ukraine are contributing to difficult conditions in the construction sector. “Governments are investing all this money into infrastructure, but contractors are falling over because of the accumulation of risks they have taken on board they are unable to deal with,” Davies says. ▲ Deloitte’s Jason Tracy: Fixed-price contracts among the culprits. Deloitte-led Clough Group administrators Sal Algeri and Jason Tracy, who also led the ProBuild administration, say the trend for fixed-price contracts is one of the culprits. “Builders could operate profitably under fixed-price contracts during periods of economic and house price growth but Covid-facilitated cost escalations across materials and labour are outside builders’ control,” Tracy says. Lengthy builds are also to blame. With large projects, procurement processes can span many years, from scoping through to choosing contractors, financial due diligence and negotiation of engineering procurement construction contracts. Contractors are mostly expected to wear cost rises through construction periods that can span years, without having any real insight into price trends into the future. Also, large-scale price rises may be absorbed into a construction business for one or a small number of contracts. The challenge is builders have multiple jobs on at once, which all require materials with rising prices. This only compounds the problem. “That’s the crux of the issue. The stronger your balance sheet, the more you can weather the storm. The weaker you are, the more vulnerable you are,” says Tracy. Ways forward Contracts in construction are changing to try to address the risk-sharing and cost-escalation challenges facing builders. Players are also willing to take different approaches. For instance, Davies says, there’s growing recognition among developers that going for the cheapest bidder can have limitations. “Value for money is also about time certainty, reduced impact on the environment, improved diversity and inclusion outcomes and greater sovereign capability. So we need to look at the best contractual models for realising that extra value.” He says incentivising contractors to realise financial and non-financial value is important. “So if the developer is focused on the environment, then the contract has to remunerate the builder for driving environmental outcomes.” Tracy says there are other ways to fix the “broken” contracting model. “One option is to include flexibility within contracting arrangements to allow for a rise and fall of costs that fluctuate,” he says. “We’re seeing an increase in ‘pain and gain’ sharing arrangements, as well as hybrid contracts that include fixed costs and costs that are responsive to the market price.” Including chunkier buffers in large government projects is also vital. He notes equity investors have a role to play. “There’s a heightened need for equity in projects. ▲ Australian Constructors Association chief executive Jon Davies. “Cost increases can’t be the responsibility of debt providers because they don’t benefit from the risk upside; they’re only getting interest on the debt. “So project sponsors need more equity.” A mechanism that allows parties to arbitrate or mediate a situation in which a project’s costs blow out is another option. This may be as simple as the parties meeting once a month to review a progress report, with an independent assessment of the works completed prior to the meeting. “The mechanism would allow the parties to come together. There must be an open, transparent sharing of costs and project progress. This brings issues to the table earlier so they can be resolved,” Algeri says. Fiona Doherty, a board member of the Australian Institute of Quantity Surveyors, agrees future contracts must include novel ways of sharing of risk between the different parties. “We don’t think lump-sum contracts are a bad thing if the contract is set up correctly and the sharing of risk is there.” She says traditional tools such as guaranteed bills of quantities can also help, as well as certainty around design. “Two-stage tendering also helps to more fairly share risk,” she says. While many contracts do have associated insurance bonds, calling the bond in should the contractor default has limited effect—it won’t completely cover any shortfall and also means insurers view the Australian market as riskier, which only serves to raise the cost of any similar bonds issued in the future. A brighter outlook Davies says the reckoning the construction industry is undergoing could be positive long term. “There is huge demand for construction and construction services. We’re seeing a growing realisation among clients in the public and private sectors you cannot contract out risk because contractors are falling over. “When a contractor falls over, you’re the one that’s going to have to pick up the pieces, talk to the administrator and find another contractor to finish off the job for a significant premium and a significant delay to your project. “So clients realise things need to be done differently, because contractors are going to start to pick and choose contracts that are favourable to them.” You are currently experiencing The Urban Developer Plus (TUD+), our premium membership for property professionals. Click here to learn more.

[+] Share Risk, Help Industry Survive, Construction Urged

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