What buyers need to know about the 'risk pendulum'

posted by Clive Muir
26 July 2021

The UK Court of Appeal’s recent ruling in Clin v Walter Lilly & Co highlights the importance of clear risk allocation in contracts, an issue that is becoming more critical as a result of the pandemic.

So, what should contractors and clients consider when entering into contracts and how can they adopt an approach to risk allocation that spans the whole supply chain?

Clin v Walter Lilly & Co highlights the need to get risk identification and allocation in contracts right. The ruling confirmed that property owner Jean-François Clin was liable for a delay to demolition works, resulting from his failure to secure the required planning permission. This risk was not clearly defined and allocated in his contract with contractor Walter Lilly & Co, and ultimately entitled the contractor to an extension of time and additional costs.

As a result of supply chain shocks linked to the pandemic and exacerbated by factors such as climate change legislation, the Suez Canal blockage, and semiconductor and rare earth shortages, the relative bargaining positions of those involved in contracts may deviate from the previous balance. This often pushes the “risk pendulum” towards a weakened party and in order to win work, they may accept risks in the contract they would not normally, or they may fail to price risks adequately.

Furthermore, without careful consideration and understanding of what risks could occur and where risks lie, parties to contracts may overlook pandemic-related emergent risks. For example, supply shortages affecting critical materials or labour could make it more challenging to deliver projects according to contractually-agreed cost, timescale and quality targets. This can potentially result in the breach of a contract which has not been designed for such eventualities.

Risk rarely disappears but can be shunted around and often down the supply chain to smaller, potentially financially-weaker suppliers. Supply chain risks may therefore be transferred to parties that may appear best able to manage them technically, but may be less able to bear them financially.

To ensure the parties to the contract understand the extent of their risks, and make tender pricing and risk mitigation decisions accordingly, the need for early risk identification and analysis cannot be overstated. This is especially important for specialist or highly-complex projects with significant time, cost or quality implications.

The mantra is “risk should be allocated to the party best able to manage it”. However, it is also important to consider risk culture, the parties’ relative bargaining powers, the need or even desperation to win work and the ability to bear the risk should it arise.

The client’s commercial objectives for a project, which generally focus around cost, schedule and quality (the “golden triangle” of project management) also influence how to allocate risk and the most appropriate type of contract. For example, a fixed-price contract may be more appropriate if the client’s focus is mainly on cost certainty, whereas a cost-plus type contract may be more applicable for a complex or uncertain project with other objectives. Liquidated damages and other contractual incentives may be applied if time or quality are the drivers.

Depending on the client’s objectives and the value, risk and duration of the project, three areas to consider are:

1. The contract type. For example, fixed price, target cost or cost plus. i.e. “the risk pendulum”.

2. The pricing arrangement. For example, single source, a partnering arrangement or competitive.

3. The service type. For example, design, build, design & build or a longer-term DBFO-type relationship.

These areas define the level and control of risk between the parties and consequently influence risk allocation decisions.

The allocation of risk in the contract, if not adequately considered, may affect tender prices or lead to unpleasant surprises. For example, a fixed price may have high cost certainty but may have a risk contingency added by the tenderer and furthermore may attract limited interest from tenderers. This can lead to less competitive prices and later on may expose the successful tenderer to a greater likelihood of business and consequent project failure.

On the contrary, cost-plus contracts come with low cost certainty and may incentivise the contractor to spend too freely. This may be mitigated by more a competitive tendering environment, open book accounting and an ability to carry out more complex projects or alter the scope and pace as work progresses.

The pandemic and other current supply chain shocks have highlighted the importance of the role of risk in understanding, identifying and managing contractual relationships. While clients may choose to push the risk pendulum around, they should first take steps to understand the potential implications for project outcomes.

☛ Clive Muir is a risk manager at risk management consultancy Equib.

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