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Chapter Two

Risk Allocation and Management

Risk allocation and management integrally affect the construction management process. Risks must be properly allocated to the team members who can best manage them. Contract clauses and construction management processes that create onerous risks for either the contractor or the agency will cause substantial project cost increases or even project failures. For proper alignment of team goals, risks must be allocated and managed with an open and equitable philosophy. Transportation agencies should strive to make project risks transparent to help ensure project success. Project team members should work together to mitigate or manage major risk items in a spirit of partnership and alignment toward customer needs.

The scan team explored risk allocation and risk management processes in the control of work on projects, including the relationships/responsibilities of the owner, consultants, testing services, prime contractor, and suppliers. Specifically, the international transportation organizations were asked how they identify and address risk in the construction process to ensure that legal and financial responsibilities are assigned to the appropriate party. The organizations were also asked how they manage high-risk issues (utility coordination, right-of-way procurement, environmental permitting, etc.) to eliminate or reduce their impacts.

The team found a variety of risk allocation and management strategies that directly related to the project delivery methods used in each country. As discussed in the project delivery section of this chapter, Germany and Ontario are the most similar to the United States in their delivery methods. Accordingly, they are also the most similar in their allocation of project risk to the contractor. England and Scotland allocate risks most aggressively to the private sector, but they also use project delivery methods such as ECI, design-build, consultant design and inspection, best-value procurement, and incentive contracts that allow contractors to best manage the risks. Table 6 provides a summary of the general risk allocation approach used in each country. Of course, unique project requirements may change the risk allocation strategy on any one project, but table 6 represents the overarching risk allocation philosophy of each country.

Table 6. General risk allocation by country and major delivery method.
Risk Issue Germany Ontario The Netherlands The Netherlands Finland Scotland England England
Design-
Bid-Build
Design-
Bid-Build
Design-
Bid-Build
Design-
Build
Design-
Build
Design-
Build
Early
Contractor
Involvement
Design-Build-
Finance-Operate
Traffic Control Design Owner Owner Contractor Contractor Contractor Contractor Contractor Contractor
Erosion Control Design, Permanent and Temporary Owner Owner Contractor Contractor Contractor Contractor Contractor Contractor
ROW Acquisition Owner Owner Owner Owner Owner Owner Owner Owner
Envioronmental Permits Owner Owner Owner Owner Owner Owner Shared Owner
Construction Operations Permits and Clearances Contractor Contractor Contractor Contractor Contractor Contractor Contractor Contractor
Hazardous Materials in ROW Owner Owner Owner Owner Owner Contactor Owner Contractor
Archeological Finds in ROW Owner Owner Owner Owner Owner Owner Shared Contractor
Utility Relocation in ROW Owner Owner Owner Owner Owner Shared Shared Shared
Change in Subsurface Soils and Conditions (Minor and Major) Owner Owner Owner Owner Owner Contractor Shared Contractor
Third-Party Incidents Before Interim or Final Acceptance Contractor Contractor Owner Owner Contractor Contractor Contractor Contractor
Third-Party Communications on Project Activities Shared16 Not Asked Owner Shared Owner Shared Contractor Contractor
Maintenance of Existing Facility, Pavement, etc. Shared Shared17 Owner Contractor Owner Contractor Shared Contractor
Maintenance During Winter, Nonwork Months Owner Owner Owner Contractor Owner Contractor Shared Contractor
Civil for Permanent Structures Owner Owner Owner Contractor Contractor Contractor Contractor Contractor
Civil for Temporary Structures Contractor Contractor Contractor Contractor Contractor Contractor Contractor Contractor
Inflation for Volatile Products Contractor18 Not Asked Owner Contractor Contractor Contractor19 Shared Contractor
Variances in Quantities Shared Not Asked Owner Contractor Contractor Contractor Shared Contractor
Major Subsurface Unknowns Owner Not Asked Not Asked Not Asked Not Asked Owner20 Owner21 Not Asked
Work Associated with RR Not Asked Not Asked Owner Contractor Contractor Shared22 Not Asked Not Asked
Variances in Insurance Cost Contractor Not Asked Contractor Contractor Contractor Contractor Shared Contractor
Repairs/Warranty Contractor Not Asked Owner Contractor Contractor Contractor Contractor Contractor
Latent Defects Contractor Not Asked Owner Contractor Contractor Not Asked Contractor Contractor

Risk allocation for design-bid-build contracts used in Germany, Ontario, and the Netherlands is similar to that found in traditional U.S. contracts. The agency retains the majority of risk involved with design, third-party coordination, and undiscovered work. The contractor is primarily responsible for risks encountered after design is complete and before maintenance begins. The contractor takes the risk for construction permits, civil for temporary structures, and variation in costs of bid unit prices.

Risk allocation for design-build and design-build-finance-operate contracts is significantly different from traditional contracts. In these contracts, design-builders are allocated risks that occur during the course of design because they are directly in control of these risks as design is their responsibility. As shown in table 6, design of permanent civil structures is their responsibility, as is traffic control design. The agencies are also more willing to allocate or share third-party coordination responsibilities with design-builders because they have more control over when these elements need to be scheduled as a result of their design decisions. Because design-bid contracts typically use lump-sum pricing agreements, the contractor assumes the risk for overrun and underrun of anticipated material quantities.

The philosophy of the ECI contract is to promote team coordination early in the project development process. This philosophy is demonstrated through the large number of shared risk items. A shared risk implies that some portion of a risk is allocated to each party. For example, the Highways Agency assumes the major, or critical, risks involved with archeological finds, utility relocation, and changes in subsurface conditions. The risks for minor archeological finds, utility relocations, and changes in subsurface conditions are allocated to the contractor. Even the risk for cost overruns and underruns is shared in the ECI contract through the target pricing mechanism described previously in this chapter.

Some items vary by a country’s general risk philosophy rather than by delivery method. These items include hazardous materials in the right-of-way, changes in subsurface conditions, maintenance of existing facilities during construction, and warranty issues. Scotland is notably aggressive in assigning these risks. U.S. highway agencies have generally determined that maintaining these risks will result in the lowest cost over the long term. By maintaining these risks, contractors should provide lower bids. Scotland most notably assigns these risks to the contractor in the belief that the efficiency of incentivized management of the problem by the contractor is more significant in determining costs and delays than the emergence of the risk itself. Contractors must bid contingencies for these risks in their prices, but the owner is assured of a fixed cost. The allocation of inflation costs for volatile products (e.g., fuel, cement, asphalt, etc.) and variances in insurance costs differed from country to country, much as it varies among U.S. highway agencies.

The scan team discovered an awareness of risk management not present in all U.S. highway agencies. England and the Netherlands discussed systematic tools they have developed to identify, analyze, and allocate project risk appropriately. The Ministry of Transport, Public Works, and Water Management in the Netherlands has developed the Public Sector Comparator and the Public-Private Comparator to help it select delivery methods and allocate contract risk in the early stages of project development. The Highways Agency has developed the Highways Agency Risk Management (HARM) tool. Both of these agencies dedicate staff to assist project teams in identifying and quantifying project risk using probabilistic techniques. They apply the results to the selection of project delivery methods and appropriate allocation of project risks.

Risk Management:

  • The Netherlands has developed the Public Sector Comparator and the Public-Private Comparator.
  • The Highways Agency has developed the Highways Agency Risk Management (HARM) tool.

PPP Knowledge Centre in the Netherlands has developed a Public Sector Comparator and a Public-Private Comparator. The comparators are financial modeling tools that allow for a comparison of delivery systems and total project cost of the project life cycle. The objectives of the comparators are to 1) provide insight on the total costs, income, and risks over the project life, and 2) create a benchmark to make a comparison with the final public-private partnership proposals.

The Public Sector Comparator presents a structured format to project delivery selection and risk allocation, which involves five modules:

The system describes a process for the decisionmakers and gives insights from past application of the tool. The tool also provides sample checklists and guidance. One such checklist involves project risks. Table 7 is a list of project risks generated from the risk checklist and provided as an example in the comparator manual.

Table 7. Example of risk determination from Dutch Public Sector Comparator.
Risk Risk Description Example
Risk of unfavorable results of bidding process Risk of unfavorable results of bidding process Few bidders, therefore high prices
Design risk Probability of gaps in the design Inadequate lighting
Risk of unfavorable ground and soil conditions Probability of unfavorable ground and soil conditions Archaeological finding
Risk of extra costs during realization phase Probability of large accident Damage to works
Risk of extra costs during realization phase Probability of flooding Inundation of works
Risk of extra costs during realization phase Probability of protest demonstrations Environmental protests that interrupt the works
Technical risk Probability of problems with piling Ground conditions differ from trial results
Risk of extra costs during exploitation phase Probability of supplementary security requirements Law requiring additional safety measures
Risk of extra costs during exploitation phase Replacement investment sooner than planned Faster deterioration of asphalt road surfaces

Upon completion of the risk analysis, any supplemental financial considerations are made and a sensitivity analysis is conducted. The sensitivity analysis is based on the modeling of cost and uncertainty in the risks and can be generated several ways, depending on the time and cost the agency wishes to invest. The Public-Private Comparator offers a more detailed discussion of the risk quantification and sensitivity analysis process. The following steps are offered in the Public-Private Comparator section on risk valuation:

  1. Develop a list of the risks.
  2. Categorize the risks.
  3. Determine the global risk allocation and make a selection of the most important risks.
  4. Estimate the size, impact, and probability of the risks.
  5. Assess the interrelationships (and correlations) of the risks you have defined.
  6. Develop a risk matrix.
  7. Determine the probability distribution.
  8. Study any possible correlations.
  9. Calculate the value of the risks.
  10. Present the results.

The Highways Agency in England also takes a risk-based approach to project delivery and contracting. In recent years, it has developed HARM, which involves dedicated staff to assist project teams in identifying, quantifying, mitigating, and allocating risks appropriately early in the project life cycle. The team assesses risk in much the same manner as described above. Although the Highways Agency did not share a manual for HARM, it has a clear statement of fair risk allocation in its Highways Agency Procurement Strategy (Highways Agency, 2001a):

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 consequences of only those risks that actually occur.

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.

The Highways Agency's statement on fair allocation of risks mirrors the philosophy of the majority of countries. The value-for-money HARM process is an attempt to operationalize this philosophy. Although the other countries share the philosophy of appropriate risk allocation, they do not all have resources such as dedicated staff, scientific risk assessment processes and tools, and delivery mechanisms that allow for the implementation of this philosophy. The Netherlands and England understand the need for the integrated approach to risk management and, although they are not completely standardized in their practices, they have a greater awareness and more strategic approach than typically found in the United States.

U.S. Parallel - Design-Build Risk Allocation

As design-build project delivery continues to increase in the United States, so too does the awareness of appropriate risk allocation on these projects. The AASHTO Joint Task Force on Design-Build views this as a critical element of success for design-build projects. More information is available at Web site of the AASHTO Joint Task Force on Design-Build. See Section 10 - Risk Allocation in the Report on Current Design-Build Practices for Transportation Projects. The Design-Build Contracting Final Rule also discusses the importance of risk allocation and management. See HWA DB Final Rule 23 CFR 636.114 and 115 at Final Rule.

U.S. Parallel - Washington State DOT Cost Estimate Validation Process

To provide the public with better cost estimates and transportation engineers with more accurate predictions of project uncertainty, the Washington State DOT has developed a Cost Estimate Validation Process (CEVP®). CEVP is an intense workshop in which a team of top engineers and risk managers from local and national private firms and public agencies examine a transportation project and review project details with WSDOT engineers. Many participants have had extensive first-hand experience in large project programming and delivery.

The CEVP workshop team uses systematic project review and risk assessment methods to identify and describe cost and schedule risks, and evaluate the quality of the information at hand. The process examines, from the very beginning, how risks can be lowered and cost vulnerabilities can be managed or reduced. A dividend of CEVP is the promotion of activities that will improve final cost and schedule results. For more information on the CEVP process, Click Here.

Conclusions

This chapter stresses the importance of the preconstruction aspect of construction management in project success. The scan team found that the international organizations involved in this scan rely on the private sector for many construction management functions traditionally performed by U.S. highway agencies. Project delivery is applied strategically and supports appropriate construction management methods. Procurement turned out to be a major topic with all countries. The scan team found that international transportation organizations use many factors in addition to price when selecting contractors. Finally, the team found sophisticated risk management strategies that tied all of the preconstruction aspects of construction management together. The scan team's summary observation is that the application of construction management methods begins before construction, and this is the time to begin aligning team goals with the customer's needs and requirements.

Third-party communications responsibility varies slightly with project type and project location. Minor maintenance is performed by the contractor and major unplanned maintenance is performed by the ministry. Germany allows for variation in the price of cement and steel on large-scale projects. In that circumstance, risk is shared. Unless term contract of 5 or more years where inflation index is used. Major subsurface unknowns (e.g., those that render the original proposals physically impossible such as the discovery an abandoned mine) are bid on a unit-price basis once they are discovered. Archeological risks are shared with DBFO responsible for minor discoveries and HA responsible for major discoveries. Advance work by owner and coordination by contractor.

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Page last modified on November 7, 2014
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