Australian transmission projects using incentivised target cost contracts must weigh up risks

The ITC model is a hybrid of the design and construct (D&C) and Alliance contract models. It was developed in response to increased pricing volatility in the infrastructure sector and seeks to encourage owners and contractors to act in a collaborative manner and jointly manage risks. The model provides incentives for contractors who meet their deadlines and stay within budget, by sharing cost savings and cost overruns between the contract parties. But use of the ITC model does carry risks. 

The transmission sector has seen an increase in the use of ITC contracts in recent years and this is expected to continue. Given its increasing popularity on major transmission projects – including HumeLink, the largest energy infrastructure project in New South Wales – owners and contractors should be aware of the benefits and risks of the ITC model.

Features of the incentivised target cost model

Cost

Under the ITC model, the owner reimburses the costs incurred by the contractor during the project – subject to some limited exceptions –  plus a fixed margin covering profit, preliminaries and other overheads.

The actual cost to perform the work is then assessed against a target cost for the work which was agreed during tender. Where the actual cost is less than the target cost, the contractor shares in the benefit of the savings in what is known as ‘gainshare’ - usually on a 50/50 basis. The reverse, known as ‘painshare’, also applies, where the contractor shares in the ‘pain’ of cost overruns.

In the transmission sector, the traditional ITC model has been modified to acknowledge the unique features of that sector. Instead of a 100% cost reimbursable approach, limited fixed price components for certain scopes of works are often agreed, along with pre-agreed variations, provisional sums and adjustment mechanisms for commodities, which allow for greater pricing flexibility by adjusting the target cost. Additional mechanisms such as the provision for owner supplied materials further alters the ITC model. 

Time

While ITC models in other sectors have seen an Alliance contract approach to time, where there is only a ‘best endeavours’ obligation to achieve completion by a specific date, the transmission sector has to date preferred a more traditional completion regime, with a fixed date for completion and delayed liquidated damages for late completion. Even so, an incentive regime is still usually provided, where the contractor is entitled to additional payments for achieving completion ahead of the agreed target date.

Performance

The obligations in relation to the performance of the work and, in particular, the obligations in relation to quality, defect rectification and warranties, remain largely the same in the ITC models used for transmission projects as for a traditional D&C contract. While some ITC models do not have hard obligations in relation to performance, and often pay contractors for defects rectification, this approach has not been typical in the transmission space.

As with obligations in relation to time, an incentive regime is usually included where the contractor can become entitled to additional payments for achieving certain performance targets.

The various incentives available to contractors may, however, be put at risk where there has been a serious safety incident on site, or other pre-conditions to payment have not been met.

The ITC model is still evolving and is nearly always heavily adapted from project to project, and jurisdiction to jurisdiction. While this means there is no ‘standard approach’ it does allow parties to adapt and accommodate requirements and expectations of the specific project and stakeholders. This also means that, when considering this model, close attention needs to be given to the way it varies from previous projects.

Pros and cons of the incentivised target cost model for contractors

The main benefit for contractors of the ITC model is that it allows for more flexible pricing arrangements that should significantly reduce a contractor’s exposure to cost overruns. It also generally allows for a more collaborative approach.

Due to the risk sharing nature of this model – with all parties sharing the risk and taking part in potential losses or gains – it requires all parties to be transparent with, and aware of, project risks and timelines. Contractors are incentivised to be efficient and timely in their work, and to remain within their budget. At the same time, they benefit from the general sharing of risk and the protection from cost overruns.

Even so, this model does carry a few potential downsides for contractors, including more complexity, an increased risk of disputes, and instances where the model mismatches with subcontracts further down the supply chain.

Complexity

ITC contracts are generally more complicated to get off the ground than a traditional lump sum D&C contract. The target cost, painshare and gainshare regimes, incentive regimes and risk sharing need to be negotiated and agreed up front.

Management of an ITC contract can also be more complex given the risk sharing nature of the model which requires the parties to negotiate and agree outcomes in many instances. In addition, the payment processes themselves can become more complex with the ‘open book’ nature of an ITC contract adding significant administrative time to the assessment of any payment claims.

Risk of disputes

The collaborative nature of ITC contracts requires a significant change in how the parties conduct themselves and requires a level of transparency, information sharing and joint decision making which is not commonly found in traditional D&C arrangements.

If parties are not familiar with this collaborative approach, and are subsequently not able to effectively make this cultural change within their organisations, the risk of disputes could increase. In addition, determining the appropriate risk allocation between parties can be challenging and, if not balanced correctly, could also lead to increased disputes.

Mismatch with subcontracts

There may be instances in which the ITC contract cannot be passed down the supply chain, with subcontractors instead engaged on a more traditional, lump sum basis. This can create the risk of a mismatch in rights and liabilities up and down the supply chain.

Passing the incentivised target cost model down to subcontractors

Passing down the ITC model to subcontractors has the benefit of incentivising subcontractors in a consistent way and helping to achieve deadlines early or on time, within the allocated budget. Due to the risk sharing nature of the model, risks might also be better managed throughout the supply chain. In addition, the model has the benefit of payments and incentives contractually operating on a ‘back-to-back’ basis.

There are, however, risks in passing down an ITC model to subcontractors. These risks largely stem from the inherent risk of a mismatch between the management and outcome of the ITC model upstream and using a separate ITC model downstream. This risk increases where the upstream arrangements do not take into account the arrangements extending down the supply chain.

Managing two collaborative models separately can become difficult for all parties, particularly where those parties have different approaches to collaboration. The downstream ITC model could, for example, inadvertently incentivise subcontractors to prioritise completion of the works early and under budget while sacrificing overall quality of the subcontract works.

Management of a downstream ITC model is also more time and cost intensive than managing a traditional fixed priced subcontract. One benefit of a fixed model is that there is no reason to dispute any incentive or bonuses for completing works early or within deadline. Subcontractors are paid a contract sum agreed upon prior to commencement of work, upon the completion of work. This is less resource intensive for the head contractor as they are not required to closely monitor the time and budget of a project, or assess complex payment claims downstream while simultaneously making equally complex claims upstream.

Contractors using the ITC model therefore need to ensure they have additional administrative and management personnel available to keep the collaborative model operating effectively. This is particularly important in situations where multiple ITC subcontracts are adopted, or where there is a mix of ITC and non-ITC subcontract arrangements.

Whether it is appropriate to pass down an ITC model to subcontractors will need to be carefully considered on a case-by-case basis. While there are benefits to signing up subcontractors on an ITC basis, parties will need to ensure that they are able to act in a truly collaborative manner up and down the supply chain in order to reap those benefits.

Co-written by EJ Yeoh of Pinsent Masons.