Risk Assessment and Allocation for Highway Construction Management

6. Risk Allocation

6.1. Objectives of Risk Allocation

The contract is the vehicle for risk allocation. Whether the contract is for construction, construction engineering and inspection, design, design-build, or some other aspect of highway construction management, it defines the roles and responsibilities for risks. Risk allocation in any contract affects cost, time, quality, and the potential for disputes, delays, and claims. In fact, contractual misallocation of risk has been found to be a leading cause of construction disputes in the United States.⁽¹⁷⁾

In a 1990 study, the Construction Industry Institute® (CII), a group of construction industry owners, contractors, and academics who study the industry and create best practices, states the following:

The goal of an optimal allocation of risk is to minimize the total cost of risk on a project, not necessarily the costs to each party separately. Thus, it might sometimes seem as if one party is bearing more of the risk costs than the other party. However, if both owners and contractors take a long-term view and take into consideration the benefit of consistently applying an optimal method to themselves and to the rest of their industry, they will realize that over time optimizing risk allocation reduces everyone's cost and increases the competitiveness of all parties involved.

Highway agencies have arrived at a somewhat standard set of risk allocation principles for highway projects in the traditional design-bid-build process. Most highway agencies follow the risk allocation principles suggested in the AASHTO Guide Specifications for Highway Construction. For example, highway agencies have discovered over time that maintaining the risk of differing site conditions (Guide Specifications for Highway Construction, Section 104.02) with the agency will result in lower bid prices and lower costs to the public in the long term. While this practice for the allocation of differing site conditions in the industry has undoubtedly resulted in an optimal risk allocation strategy, other traditional risk allocation principles have resulted in adversarial relationships between agencies and the contracting community.

The risk allocation principles embedded in the industry's guide specifications are tested and well established in case law. However, their use can promote a one-size-fits-all process of risk allocation. The rigorous process of risk identification, assessment, analysis, and mitigation described in this document allows for a more transparent and informed understanding of project risk. When risks are understood and their consequences are measured, decisions can be made to allocate risks in a manner that minimizes costs, promotes project goals, and ultimately aligns the construction team (agency, contractor, and consultants) with the needs and objectives of the traveling public.

The objectives of risk allocation can vary depending on unique project goals, but four fundamental tenets of sound risk allocation should always be followed:

1. Allocate risks to the party best able manage them.
2. Allocate the risk in alignment with project goals.
3. Share risk when appropriate to accomplish project goals.
4. Ultimately seek to allocate risks to promote team alignment with customer-oriented performance goals.

6.1.1. Allocate Risks to Party Best Able to Manage Them

A fundamental tenet of risk management is to allocate the risks to the party best able to manage them. The party assuming the risk should be able to best evaluate, control, bear the cost of, and benefit from its assumption.⁽¹⁸⁾ For example, the risk of an inadequate labor force, a breakdown in equipment, or a specific construction technique is best borne by the contractor, while a risk of securing of project funds or project site availability is best borne by the agency.

Following this principle of allocating the risks to the party best able to manage them will ultimately result in the lowest overall price because contractors will not be forced to include contingencies for possible financial losses or take gambles in an extremely competitive bidding environment. Inappropriate risk shifting from the owner to the contractor can result in misaligned incentives, mistrust, and an increase in disputes.

A second CII study discusses the concept of allocating risks to the party best able to accept them:⁽²⁰⁾

Because of the advantages and disadvantages associated with efficient and equitable allocation of risk, each project should be assessed individually and to determine for each risk what allocation consideration will reduce the overall cost to the project's total cost of risk.

6.1.2. Risk Allocation in Alignment with Project Objectives

Risks should be allocated in a manner that maximizes the probability of project success. The definition of a clear and concise set of project objectives is essential to project success and these objectives must be understood to properly allocate project risks. For instance, if the public needs a project completed sooner than would be achievable under traditional contracting and risk allocation methods, the agency may be forced to ask the contractor to assume more risk for timely or expedited completion and it must be willing to compensate the contractor for assuming this risk.

Allocating risks in alignment with project objectives begins with a clear understanding of the project objectives by the agency and a clear communication of these objectives to the contracting, consulting, or design community. While this idea seems simple, in practice it is often difficult to identify and prioritize concise objectives because of the complex nature of highway construction projects. A sample of project objectives is listed in table 9.

The project objectives in table 9 vary in style and emphasis because of unique project needs, but they all help define the agencies' requirements in terms of schedule, cost, quality, aesthetics, and end-user requirements. Ranking of the project objectives is important. Every project has tradeoffs among schedule, cost, and quality. It is to the project's benefit if both the agency and industry are in alignment with these project objectives.

The importance of clearly understanding and defining project objectives cannot be overemphasized. Project objectives directly determine optimum risk allocation strategies, or when project risk allocation is justified in deviating from traditional industry standards. In addition, project objectives can affect the procurement methods and contracting strategies. The objectives should be understood early in the project process and referred to for any important design, procurement, contracting, or construction management decision.

6.1.3. Risk Sharing

The concepts of risk sharing and risk allocation are often used synonymously. The American Society of Civil Engineers has gone as far as to define risk allocation as "the process of identifying risks and determining how-to what extent-they should be shared."⁽¹⁸⁾

However, the term "risk sharing" can be somewhat misleading. In reality, no risk is truly shared; instead, exposure to the risk is split among the parties. Risk sharing is clearly defining the point at which the risk is transferred from one party to the other. These transfer points should be scrutinized for appropriateness and then explicitly and clearly addressed in the contract. For example, a risk that is commonly shared is unusually severe weather. A contract provision for unusually severe weather may grant the contractor a right to a time extension while not providing for additional compensation of costs. In this situation, the agency is allocated the risk of delay while the contractor is allocated the risk of additional costs.

Another example of risk allocation comes from WSDOT. Traditionally, the agency maintained the risk for differing site conditions on drilled shafts for bridge piers. On a number of projects, it experienced substantial cost growth for differing site condition claims from contractors using equipment that was insufficient to remove small boulders in the drilled shafts. The agency determined it had two choices:

1. Specify the equipment and method for drilling the shaft so that these small boulders could be removed when encountered.
2. Allocate the risk for removing these boulders to the contractor in hopes that it would choose the appropriate method for removing the rocks.

Unfortunately, neither option was aligned with standard agency policy. Because the agency foresaw too much risk in prescribing the means and methods of construction, it chose the second solution of allocating the risk of the differing site conditions to the contractor.

Communication among parties is a key to any sharing of risk allocation. Risk-sharing provisions should be written with the principle of risk management and alignment of project objectives as described above. All nontraditional allocation of risk should be clearly pointed out to the contractors.

6.1.4. Risk Allocation in Alignment with Customer-Oriented Performance Goals

The ultimate goal of risk allocation should be to help align the project team with customer-oriented performance goals. A primary finding of the 2005 construction management scan was that the European highway community allocates more risk to the private sector, which has resulted in better alignment of team goals with customer goals.⁽¹⁰⁾ For example, the Highways Agency in England has key performance indicators that deal with client satisfaction with the product, client satisfaction with the service, predictability of time, predictability of cost, safety, and process improvement. The agency has found that traditional risk allocation practices do not always align teams with these customer-oriented performance goals.

While the concept of allocating risks in alignment with customer-oriented performance goals may seem to be a significant departure from traditional practices in the United States, highway agencies are already doing this through the use of alternative contracting techniques. For example, A+B (time plus cost) procurement is used on selected projects in the majority of highway agencies in the United States. In essence, A+B procurement passes the risk for early completion to the contractor to achieve a customer goal of satisfaction with the service. In an extreme example, the use of public-private partnership techniques is shifting the risk for customer satisfaction almost entirely to the private sector. Agencies and the industry should strive to innovate and develop new risk allocation techniques that align all team members with customer goals.

6.1.5. Risk Allocation Matrix

Perhaps the most widely used tool for risk allocation is a simple risk allocation table or matrix. Agencies and consultants often find it useful to compile the list of project risks (see Chapters 2, 3, and 4) in the form of a project risk allocation matrix. The matrix is intended to be a template for risk allocation in the contract provisions and a communication tool for all team members throughout the design and construction management process. The matrix can be a great benefit in keeping all team members aligned as they write individual provisions in the contract documents or sections of relevant procedural manuals. It provides clear direction when determining how far to carry design or when writing contract provisions. Table 10 provides a simple example of a risk allocation matrix as presented by the American Consulting Engineers Council and the Associated General Contractors of America in their 1992 Owner's Guide to Saving Money by Risk Allocation.⁽¹⁹⁾

Although table 10 is an example of a simple risk allocation table, the concepts can be expanded to cover all significant risks on the project. It intentionally does not contain a category for shared risks, but every attempt should be made to clearly assign the responsibility to one party.

Allocation matrices are a fundamental tool in the development of design-build contracts. Appendix C provides an example design-build risk allocation matrix adapted from WSDOT's "Design-Build Responsibility/Risk Allocation Matrix" and Colorado DOT's "Southeast Multi-Modal Corridor Project's Contractual Responsibility Allocation Charts." It provides a detailed framework to make risk allocation decisions for each design-build project. The matrix is also applicable to traditional design-bid-build projects or projects that employ some type of innovative contracting.

6.2. Innovative Contracting Tools and Techniques

The contract is the vehicle for risk allocation. The contract provisions determine risk allocation, which in turn affects cost, time, quality, and the potential for disputes, delays, and claims. Most highway agencies follow the risk allocation principles suggested in the AASHTO Guide Specifications for Highway Construction. In December 1991, however, the Transportation Research Board published the final recommendations of Task Force A2T51 in a benchmark document titled Transportation Research Circular Number 386: Innovative Contracting Practices. In 1990, FHWA implemented Special Experimental Projects 14 (SEP 14) to provide a means for evaluating some of the task force's more project-specific recommendations. While SEP 14 is still in use today to monitor innovative contracting methods, many innovative methods- such as A+B (time plus cost) bidding, lane rental, and warranties-have become mainstream and do not require SEP 14 approval on projects with Federal-aid financing.

Innovative contracting techniques provide a means to allocate risks in alignment with project and customer goals. A+B bidding provides a means to allocate the risk for early completion to the contractor to achieve a customer goal of satisfaction with the service. Lane rental provides a means to allocate the risk for creating congestion during construction to the contractor. Likewise, warranties provide a means for passing long-term performance of the facility to the contractor. All of these techniques provide a means for aligning the construction partner's goals with the customer goals, and they can be effective when used on the right project.

Figure 21 provides a list of innovative project delivery, procurement, and contracting methods that can be used for risk allocation. Agencies can develop these nontraditional techniques and consider them on a project-by-project basis. As these techniques are considered, agencies should follow the fundamental tenets of sound risk allocation, including allocating risks to the party that is best able manage them, allocating the risk in alignment with project goals, sharing risk when appropriate to accomplish project goals, and ultimately seeking to allocate risks to promote team alignment with customer-oriented performance goals.

Figure 21: Innovative contracting approaches for risk allocation

6.3. Contingency Considerations

Any party assuming a risk must be prepared for the financial burden associated with that risk. Prudent contractors and agencies use the quantitative risk assessment techniques described in Chapters 3 and 4 to estimate the contingency necessary to complete a project. Proper risk allocation will allow for the minimization of this contingency for both parties.

When an agency requires a contractor to assume a risk in a lump-sum contract, that contractor must include a contingency. This will obviously cost the owner money, but it may achieve a required project goal. An option that is not often exercised in the public highway industry but that has been successful in the private sector is establishment of a shared contingency pool, a sum of money set aside by the agency for an uncertainty in the project. The contractor can spend the contingency pool at its standard unit rates, but if the contractor can avoid spending the contingency pool, it can receive an incentive payment of 50 percent of the remaining money in the contingency pool. In the WSDOT example, the agency could have set $500,000 aside for removal of boulders encountered in drilled shafts. If the contractor used appropriate construction methods and requested only $300,000 of the pool to complete the work, it could receive a $100,000 incentive (50 percent of the money remaining in the pool). This incentive would be more profit than if the contractor had used the entire contingency pool at its standard unit rates. In this fashion, the agency and the contractor truly share the risk and rewards for managing the project uncertainty in construction.

6.4. Conclusions

The rigorous process of risk identification, assessment, analysis, and mitigation described in this document allows for a more transparent and informed allocation of project risk. When risks are understood and their consequences are measured, decisions can be made to allocate risks in a manner that minimizes costs, promotes project goals, and ultimately aligns the construction team (agency, contractor, and consultants) with the needs and objectives of the traveling public.

The 2005 construction management scan found that the European highway agencies have a more mature risk culture than found in the United States. The following statement of fair risk allocation is from England's Highway Agency Procurement Strategy).⁽²¹⁾

Fair Allocation of Risks

The HA has sought to improve the certainty of final construction project costs on certain contracts by the transfer of most risks to the contractor. This has been successful in improving cost and time certainty but it may not necessarily deliver best value as it comes at the price of a risk premium. A fair allocation of risks requires that risks are identified prior to the establishment of a contract. In addition, offerors need to be able to assess the potential consequence of a risk and to be able to include an appropriate risk allowance in the price bid. It is unlikely that a client will get best value if offerors have had to rely on guesswork if they have had inadequate information or if they will not be in a position to manage the risk. The outcome will be that the offerors will either guess too high or too low, neither of which scenarios will result in best value. The client will either pay too much or the quality of the product or service may be threatened by commercial pressure.

In theory, best value is achieved by the owner paying for appropriate risk management measures together with the costs of dealing with the consequences of only those risks that actually occur. However, the contractor and the supply chain are more likely to contribute to the effective and efficient management of risks if they have fair and reasonable incentives. The judgment required by a client is how much to pay for the transfer of a risk, and at what level it is judged better value to retain the risk and to pay any consequential costs. The HA will accept risks where suppliers are prepared to work in partnership to manage the risks and control the consequences.

6.5. Illustration: Risk Allocation

The following is an example risk allocation for the US 555-SH 111 interchange project. As described below, the executive management and the project team decided to pursue a design-build delivery for the project because of time and staffing constraints.

US 555-SH 111 Interchange Risk Allocation

One of the risks that the project team described in the risk charter in the Chapter 5 illustration was "too many projects in the region for the QDOT staff." During the course of preliminary engineering, full funding for design and construction was allocated to the project earlier than expected and political pressure was put on the project team from the State level to complete the project early. Given the staffing issues and the need for early completion, the regional executive management and the project team determined that the project should be delivered using a design-build delivery method.

The team created a design-build risk allocation matrix to be certain that it was allocating the project risks equitably and in line with the project goals. A sample of the design-build risk allocation matrix is shown below. Note that the allocation for the right-of-way risk concerning landowners at the US 555-SH 111 junction has been subdivided. QDOT has retained the risk for securing right-of-way within the basic configuration in the request for proposals, but left the door open for the designbuilder to procure right-of-way outside the basic configuration at its own risk. Likewise, the team allocated the risk for a successful project information plan to the design-builder. In this manner, the State has retained some risk, but left the project open for design-builder innovation.