Brazil: Project Finance Review 2016
Death, Taxes And Cost Overruns
By Júlio César Bueno of Pinheiro Neto Advogados
Cost Overruns: A Rule, Not An Exception
A construction project is usually considered successful if it is completed within its time, budget, and quality targets. In the past two decades, many articles have been written about construction cost worldwide but despite such amount of research within the field of construction planning, execution and management, limited progress has been made to prevent increase of cost overruns in larger infrastructure projects. Cost overruns raise the capital-output ratio and bring down the efficacy of any investments. Therefore, understanding why cost overruns happen and how to prevent and/or mitigate them is pivotal to the project finance industry.
Statistics reveal that the likelihood of actual costs being larger than estimated costs is 86 per cent; and that actual costs are on average 28 per cent higher than estimated costs. Being more project-specific, for rail projects, the average cost overrun is 45 per cent; for fixed links (bridges and tunnels), 34 per cent; and for roads, 20 per cent. As indicated by Professor Michael C Vorster, from the Virginia Polytechnic Institute and State University in Blacksburg, Virginia, “Construction costs are currently being boosted by up to 30 per cent as key personnel struggle with the claims-ridden nature of the modern construction industry.”
Cost estimates are made at different stages of the process: project planning; decision to build; tendering; contracting; and later renegotiations. Cost estimates at each successive stage typically progress toward a smaller number of options, greater detail of designs, greater accuracy of quantities, and better information about units prices. Thus, cost estimates become more accurate over time, and the cost estimate at the time of making the decision to execute is far from the final actual costs. Underestimation of costs at the appraisal phase is the rule rather than the exception for infrastructure projects. Cost overruns have than become an integral part of construction projects worldwide. The question is no longer whether there will be cost overruns, but how serious will they be. As one of my professors at the University of Cambridge used to say, “There are only three things certain in life: death, taxes and cost overruns.”
The Whys And Wherefores
A “cost overrun” may also be referred to as a budget increase, cost increase or cost growth. A cost overrun should, however, be distinguished from “cost escalation”, which is used to express an anticipated growth in budgeted cost due to factors such as inflation. Cost escalation is an anticipated upsurge in the cost of construction as a result of time and market forces and not due to project content changes.
Biases in forecasts may be explained by psychological tendencies among project promoters. The most common explanation is “appraisal optimism”: promoters and forecasters are held to be overly optimistic about project outcomes in the appraisal phase, when projects are planned and decided.
Some studies defend the idea of “inevitable tendency to forecasting errors” due to inherent problems in predicting the future and lack of experience on the part of forecasters. Notwithstanding this, a more objective approach may identify the following important contributing factors to cost overruns:
- poor project planning;
- poor definition of scope;
- incomplete design at the time of tender;
- unbalanced distribution of risk between owner and contractor;
- lack of proper trained management skills;
- unrealistic expectation in relation to the challenges of the project and/or complexity of works;
- inadequate and/or insufficient information on subsurface conditions;
- unexpected cash flow and financial difficulties faced by owners, contractors and subcontractors;
- poor site management and supervision;
- lack of skilled workforce;
- lack of synchronisation of individual responsibilities between the parties;
- poor communication between the parties;
- culture of conflicts and lack of trust; and
- fraud and/or corruption.
Among those factors, most certainly the ones related to subsurface conditions and poor communication play an important role. In that regard, a report from the UK National Contractors Group and Reading University Centre for Strategic Studies in Construction emphasises the importance of enhancing communication between parties as a major preventive factor to cost overrun: “Both in the UK and US construction sectors, adversity and disputes arise primarily due to lack of communication, distrust, misinterpretations of contracts, uncertainties of roles and responsibilities, and ‘us vs. them’ attitudes due to an imbalance of risks allocations.”
Two Basic Recommendations Against Cost Overrun
Drastically reducing geotechnical risks
Poor site investigations rank as one of the major contributors to inadequate and/or insufficient information on subsurface counditions. More realistic allocations of time and money should be made available to site investigation programmes. The prime purpose of any site investigation is to obtain the maximum amount of relevant engineering geology information on rock mass characteristics, faults, structural systems and groundwater conditions. This information is important in estimating the rock mass properties and assessing the stability of tunnels, slopes and foundations in the project. The information is also important to the contractor in that it should provide a basis for establishing the optimum construction method and the type of services that will be required in order to meet the construction schedules.
A concept that is worthy of consideration is the Geotechnical Baseline Report, which aims to establish a contractual understanding of the subsurface site conditions, referred to as a baseline. Risks associated with conditions consistent with, or less adverse than, the baseline are allocated to the contractor; those significantly more adverse than the baseline are accepted by the owner. The more clearly defined the anticipated conditions, the more easily the encountered conditions can be evaluated.
Therefore, the baseline statements are best described using quantitative terms that can be measured and verified during construction. Where the baseline has been set determines risk allocation and has a great influence on risk acceptance, bid prices, quantity of change orders and the final cost of the project. The interpretations and statements contained in the Geotechnical Baseline Report should reflect the risk allocation attitudes and preferences of the owner.
The following measures are recommended by the American Society of Civil Engineers (ASCE 2007) to reduce geotechnical risks:
- provide an adequate budget to explore subsurface conditions;
- retain suitably qualified and experienced design consultants to investigate, evaluate potential risks;
- prepare drawings, specifications and a Geotechnical Baseline Report consistent with the risks;
- allocate sufficient time and financial resources to prepare a clear Geotechnical Baseline Report that is consistent with other design documents;
- develop unit price payment provisions that can be adjusted to the conditions encountered;
- review and discuss the baselines with the bidders before the bids are submitted; and
- maintain an appropriate reserve fund, depending upon the perceived risks on the project.
Enhancing Communication Through Dispute Boards
Dispute boards can play an important role to regroup the parties and lead them to a joint approach towards what is “best for the project”.
A dispute board is a “jobsite” dispute avoidance and adjudication process, typically comprising three independent and impartial persons selected by the contracting parties. The significant difference between dispute boards and most other ADR techniques is that many dispute boards are established at the commencement of a project and by undertaking regular visits to site, are actively involved throughout the construction process.
The idea behind such a standing dispute board is that it may be called upon at an early stage to help the parties resolve their differences before they become polarised in their views. The dispute board encourages the parties to solve their own problems, creating an atmosphere where the parties communicate and recourse to the advisory role of the board. Resolving conflicts at an early stage, or even before they arise, is an obvious benefit that greatly minimises costs such as legal fees, and reduces loss of productive time and goodwill between the parties.
With the clear support of the World Bank and other multilateral agencies, a number of institutions have rules specifically designed to regulate the conduct and outcome of proceedings before dispute boards. These institutions include Cartered Institution of Arbitratores (CIArb), the Federation of International Consulting Engineers (FIDIC), the American Arbitration Association (AAA-ICDR), the International Chamber of Commerce (ICC), the London Court of International Arbitration (LCIA), the Royal Institution of Chartered Surveyors (RICS) and the Hong Kong International Arbitration Centre (HKIAC). There is now a growing interest in dispute boards at these institutions, and an emerging willingness to use dispute boards as well in a Project Finance context, considering the complexity of its relationships and many contracts involved.
There are three types of dispute board:
- dispute review board (DRB): the DRB reviews the matters in dispute and makes a non-binding recommendation to the parties. DRBs are common in the United States, and contracts of the FIDIC series also provide for a DRB option, as do the dispute board rules (DB rules) of the ICC;
- dispute adjudication board (DAB): the DAB adjudicates and makes a binding interim determination in respect of the matters in dispute. The ICC DB rules provide a DAB option as an alternative to the DRB option discussed above. Contracts of the FIDIC series also contain a DAB option; and
- combined dispute board (CDB): the CDB reviews the matters in dispute and makes a non-binding recommendation to the parties, but if either party requests (and no party objects) the CDB acquires the power to make a binding interim determination. The CDB is a hybrid option available under the ICC DR rules.
Dispute board panels of three are usual, but this composition is not mandatory. Typically, each party selects one member of the dispute board, with the third member, who acts as chairman, being appointed either by the parties or by the first two members. Despite the first two appointed members being party selections, each dispute board member is entirely independent. Appointment is not as party representative. The members are to serve both parties with total impartiality.
According to the Dispute Resolution Board Foundation (DRBF), dispute boards have been employed in over 1,200 projects. Of these, all but a handful have been adopted by the parties, thereby avoiding costly and time-consuming arbitration and litigation. Dispute boards costs range from 0.05 per cent of the final construction contract cost, for relatively dispute-free projects, to a maximum of 0.25 per cent for difficult projects with disputes. Considering only projects that refer disputes to the dispute boards or that had difficult problems, the cost ranges from 0.04 per cent to 0.26 per cent with an average of 0.15 per cent of the final construction contract cost, including an average of four dispute recommendations. For more information on the use of dispute boards visit www.drb.org, the official website of the DRBF, a charitable organisation based in Seattle, USA, whose function is to promote the development of dispute boards throughout the world.