Allocation of Risk in Today’s Non-Residential Construction Marketplace
By K&L Gates attorneys John R. Dingess and Kari M. Horner
In December 2006, the Connecticut Department of Transportation (“ConnDOT”) was surprised by the lack of contractor response to its request for proposals for a $400-million plus, seven-year project to build a ten-lane bridge replacement for the Pearl Harbor Memorial Bridge on Interstate 95. Not a single contractor bid on the project.
Contractors were likely hesitant to build on the Pearl Harbor Memorial Bridge project because of uncertainties and difficulties in predicting labor and material costs for a seven-year project. One surety commented that the length of the project also contributed to the "risk profile" of the project. Another deterrent was the fact that the contract terms placed most of the risk on contractors, while also imposing high liquidated damages for failing to meet milestones. In response to the lack of bids, ConnDOT may break up the project or re-allocate the risk to lessen the risk burden on the contractors.
The lack of bids on the Pearl Harbor Memorial Bridge project reflects larger trends in certain sectors of the U.S. and international construction industry (such as heavy construction, infrastructure, transportation, industrial and telecommunications), including difficulties that contractors face in rising and unpredictable materials costs and a constrained labor market. However, the lack of contractor response also shows a new market in which an increasingly smaller number of contractors are being presented with a multitude of large construction projects, allowing the contractors to select their preferred projects and reject those that they deem too risky.
Booming Markets Are Allowing Contractors to Pick and Choose Projects
Currently, the construction market for large scale infrastructure and industrial projects in the U.S. is continuing a boom period that has lasted several years, and the market will likely remain hot for the immediate future. Contractors are adjusting their business plans accordingly. They are limiting their bidding to projects in which they specialize, and may choose not to bid on a project in which the contractor does not expect a good rate of return. Generally, profit margins are rising, and fewer contractors are willing to compete for a project on a low-bid, hard money basis. As exemplified by the Pearl Harbor Memorial Bridge project, the number of available projects and the strength of the market now afford contractors the opportunity to walk away from projects or contracts containing unfavorable conditions. For example, when the tower portion of the Bay Bridge project in California was originally bid in 2004, Caltrans received one bid that was nearly double its estimate. After being re-estimated by Caltrans, the project received two bids, close to the engineer’s estimate. Nationwide, state transportation departments are reporting decreases in the number of bids for projects.
Despite the continued slump in U.S. residential markets, non-residential markets continue to explode. The U.S. Census Bureau predicts that in 2007, private nonresidential construction spending will increase 9 percent to $343 billion and public construction spending will increase 6 percent to $285 billion. For January through July of 2007, $156 billion was spent on public works projects, 11 percent more than for the same period in 2006. In March 2007, the California Transportation Commission pledged $4.5 billion in transportation infrastructure funds. Hotel and motel construction has increased by 60 percent; private office, educational, communication, and power projects have increased by more than 20 percent; and health-care construction is up 12 percent from last year.
Data centers are another area of strong growth. Revenue in this sector increased by more than 30 percent in the last year as companies in the telecommunications market pushed to meet customer demand and government regulation. Data centers built in the last five to ten years are having difficulty meeting technical and power demands, forcing a building boom that will also include large expenditures on maintenance and energy usage. It is also anticipated that billions of dollars will be spent on data centers in the immediate future and that there will be a push for the “greening” of these types of buildings.
The market for new power plants and wind farms also remains very strong, with high levels of activity and backlog, despite concerns about potential future carbon legislation and rising coal-plant construction costs. Huge growth is also anticipated for refinery construction in the United States. From 2002 to 2005, about $30 billion was spent annually in the U.S. on refinery expansions. This number is expected to double to $60 billion in the next five years.
Manufacturing plants are another source of booming construction in the U.S. Minnesota Steel Industries LLC is building a $1.6-billion mine-mouth steel plant in Nashwauk, Minnesota. Shin-Etsu Chemical Co. Ltd is building a $1-billion PVC/VCM complex in Houston. Toyota is planning to build a $1.3-assembly plant near Tupelo, Mississippi in 2008.
Rebuilding the Gulf Coast after Hurricane Katrina will also be a huge source of new construction. New Orleans Mayor C. Ray Nagin predicts $100 billion of construction over the next ten years in New Orleans alone.
Internationally, spending on oil and gas projects, transportation infrastructure (such as rail systems and airports), skyscrapers and other large non-residential projects is expected to remain high. Worldwide, national oil companies are making huge investments in oil and gas energy projects and multibillion dollar projects for refineries, liquefied-natural-gas (LNG) plants, gas-to-liquids (GTL) plants, pipelines and underwater facilities abound. Markets in the Middle East and China are showing significant growth in all market sectors, including general construction. Notably, China is planning twenty new bridges within its Chongqing region. It has been reported that a new coal-fired power plant comes on line each week in China. China also has large projects related to its water supply, such as the recently-built $25 billion Three Gorges Dam Project and the $58 billion South-to-North Water Diversion Project. The market is booming in India in all areas of engineering and construction. Recently, India opened its domestic real estate market to direct foreign investment and hundreds of millions of dollars are pouring into the country to develop shopping malls, office complexes, data centers, manufacturing facilities and so on. In the Middle East, a Dubai-based developer just issued a notice to proceed to an American contractor to build a 23 mile suspension bridge from Yemen to Djibouti. Initial costs of the project are estimated at $10 to $20 billion. In Queensland, Australia, a $2.4 billion dollar project to design and build an advanced water-treatment plant is planned for the Western Corridor Recycled Water Project.
Generally, the Current Market is a “Seller’s Market” for Contractors
Large contractors are currently enjoying a “seller’s market,” in which a large backlog of billions of dollars of projects is developing. As already described, projects are proliferating in multiple markets, both in the U.S. and internationally. The healthy markets and general indicators that these markets will continue to grow are allowing contractors to engage in business practices that will increase their profit margins and minimize risk.
In this market, contractors have the ability to focus on projects in which they have certain expertise, and choose to work with owners that they feel are reliable. The large volume of available projects is also allowing contractors to refuse onerous contract clauses such as clauses unduly shifting risk to contractors, providing for high amounts of liquidated damages, requiring onerous indemnity obligations and imposing liability for consequential damages. As a consequence, margins are increasing.
Engineering News-Record (“ENR”)’s Top 400 Contractors increased their revenue to $262.76 billion in revenue in 2006, an 11.5 percent increase over their 2005 revenues. However, due to some reporting changes, this increase may actually be closer to 18.15 percent.
Specialty contractors are also benefiting from the current market place. ENR’s “Top 600 Specialty Contractors” generated $65.47 billion in revenue in 2006, a 14 percent increase over their 2005 revenue of $57.44 billion. The market forecast looks promising for these contractors, with many potential projects in the future. In fact, the market looks so promising that investors have showed renewed interest in specialty contractors. Increased investment will continue to expand the growth of these specialty contractors.
Money to fund the expansion of growth in infrastructure projects is also coming from other sources. In September 2007, the California Public Employees’ Retirement System (“CalPERS”), decided to shift up to $2.5 billion of its assets into infrastructure investing. In certain markets, the use of public-private partnerships as a source of funding for infrastructure projects is increasing.
There are not enough contractors to complete all available highway construction projects. As a result, contractors are picking and choosing projects they want to bid on. Nationwide, the number of bidders for highway projects is decreasing.
There are some signs that the market may be cooling, at least in the U.S., due to some concerns about the credit crunch caused by the melt-down of the sub-prime mortgage market. However, the two biggest challenges that international contractors face in the non-residential markets are (1) materials costs and (2) labor shortages.
The traditional local and regional construction markets are becoming increasingly global. In this increasingly global market, many large contractors have expanded into various international markets and may also team with local contractors to obtain and execute a project. The increased globalization of construction means that no market sector is immune to material price escalations and labor shortages. However, consistent with the experience of contractors working primarily in the United States, the hot global construction market has allowed these international contractors to select projects with less risk and higher stability and profit margins.
International construction, as a whole, continues to expand. For ENR’s Top 225 International Contractors, combined revenue for projects from outside of the home country of these contractors was $224.42 billion, up 18.5 percent from 2005 revenues of $189.41 billion. The increase follows a 13.1 percent increase in revenue for projects outside a contractor’s home county from 2004 ($167.49 billion) to 2005 ($189.41 billion). At the same time, revenue for these firms also increased in their home countries, rising 14.2 percent from $373.42 billion in revenues in 2005 to $426.26 billion in revenue in 2006. This increases follows an 11.5 percent increase in revenues from the firms’ home countries from 2004 ($334.79 billion) to 2005 ($373.43 billion). Due to the vast world-wide backlog of available projects, some international contractors are opting to stay within their own home markets rather than expand into new ones.
International contractors face the same two major obstacles that any contractor working on a large non-residential project faces – a shortage of qualified workers and unpredictable escalating materials costs. However, international contractors face an additional challenge as the drop of the U.S. dollar, the “primary currency of international construction contracts,” has dropped against other major currencies.
Recently, large contractors have undergone a number of acquisitions and consolidations. Large companies use these acquisitions and consolidations to establish themselves in the international heavy construction market. Some recent acquisitions or mergers include:
• URS Corporations’ acquisition of Washington Group International
• Leighton Holdings Ltd.’s purchase of 45 percent stake in Al Habtoor Engineering
• Jacobs’ acquisition of Edwards and Kelcey and Carter & Burgess
• Perini PCR’s acquisition of Rudolph and Sletten
• in January 2007, Stantec Inc. announced a letter of intent to acquire Vollmer Associates LLP
• AECOM added Hayes, Seay, Mattern and Mattern
• Terracon acquired H.C. Nutting Co.
Mergers are expected to reach a record level in 2007, as the stock value of companies rises and firms look for additional sources of funding. Also, concerns about an increase in the capital gains tax in the United States are fueling acquisition and merger activity.
Material Markets May Check Contractors’ Ability to Compete
Although contractors may now have more ability to pick and choose projects, they must still complete projects within budget to realize a profit. One potential pitfall to a project is the rapidly changing and rising materials market. Contractors who have entered into a lump-sum contract may face huge losses if materials prices suddenly spike. U.S. courts have generally been unforgiving if a contractor has tried to impose increased materials prices on an owner if there is not a contract provision allowing the contractor to do so. See, e.g., Chainworks, Inc. v. Webco Indus., Inc., No. 1:05-cv-135, 2006 WL 1521946 (W.D. Mich. May 31, 2006). The materials market not only makes it potentially difficult to complete a project within budget, but to bid on the project as well. Suppliers are unable to provide bids for terms as long as they could in previous markets, instead limiting quotes to 30- or 60-days. These fluctuations in material market prices have also increased the difficulty of bidding on a project.
Prices for important materials such as iron, steel, asphalt, brick, structural tile clay, ready-mix concrete, gypsum, poly-vinyl chloride (“pvc”) products, copper and diesel fuel have all seen dramatic increases in prices at some point in the last few years. Speculation in commodities markets has made it difficult for contractors to control or predict prices of these commodities.
Another factor associated with rising material costs is the rising cost of shipping due to a shortage of bulk ships. Some of the shortage is due to the increased demands from China, India and other developing countries to meet their shipping needs. As the costs of shipping increases, sometimes shipping costs will exceed the costs of the cargo. Eventually, these costs will be passed on in the price of the goods.
The volume of industrial and infrastructure projects in Asian countries such as China, India, South Korea and Japan is also contributing to the increase of materials prices. China exemplifies the growth of large construction projects in Asia, witness the $25 billion Three Gorges Dam and the $58 billion South-to-North Water Diversion Project. In a short period of time, China went from being a large exporter of ore and other raw materials to being the world’s largest importer. China’s large amount of infrastructure and construction and preparation for the 2008 Summer Olympics has caused it to consume approximately 25 percent of the world’s steel supply and 40 percent of the world’s cement supply in 2005. The willingness of these countries to pay for materials needed for their construction projects has contributed to a world-wide increase in materials costs. Similarly, the increased demand for certain kinds of heavy equipment for use in Asian projects is increasing prices for that equipment.
Some challenges of the rising costs of certain materials, such as copper, may be offset by using design changes that incorporate alternative materials. However, the cost of so many materials have risen so much that in some cases, such as copper, potential substitutes, such as stainless steel piping and PEX (cross-linked polyethylene), are now also vulnerable to price increases.
The increased costs of key materials have contributed to some delay in commencement of some projects. For example, the Florida Department of Transportation has delayed at least $1 billion of highway construction projects because of the increased costs of key materials such as asphalt, concrete, steel and earthwork. In Washington D.C., officials decided to delay a waste water project until market conditions improve after the total cost of the project budget rose from $148 million in 2000 to $350 million in 2006 to $600 million in 2007. Materials prices and labor costs were factors in the only bid for Phase II of the Huey P. Long Bridge project in Louisiana coming in at $452.6 million as opposed to the anticipated $299 million. The single bid for the bridge project was accepted because of fears that any delay would only increase future bids and may, in fact, result in no bids.
Labor Market May Also Affect Current Project Capabilities
and the Future of Major Contractors
Regional and international contractors also face challenges in the shortage of qualified labor, which has resulted in current increased labor costs and short- and long-term staffing problems. Work volume is steadily growing, but the number of new hires is not equal to the number of retiring workers, which will continue to increase in the next five to ten years as the “baby boomer” generation retires. One survey of international and regional engineering contractors estimated that over 50 percent of the current workforce will have retired by 2015. New employees will enter the workforce at a rate of 2 percent to 5 percent annually; however, that is not enough to offset the 6 percent reduction in the workforce due to these retirements. Also affecting the increased demand for labor is the large number of personnel required to rebuild hurricane-damaged areas and meet refinery-building project demands along the Gulf Coast.
With respect to managers, 23 percent of respondents to a survey conducted by FMI Corp. estimated that between 20 percent and 39 percent of their management team will be replaced in the next five years, and 21 percent said that 40 percent to 59 percent will be gone in five years. At the same time, the average respondent to this survey estimated that work volume will increase by 79 percent during the same time period.
The drain of qualified personnel presents the possibility that despite the large number of available projects, contractors will not be able to find enough qualified people to complete the work. In one recent survey conducted at the Construction Users Roundtable (“CURT”), 86 percent of respondents reported current trade labor shortages on projects. This is a particular problem for projects that require specialized technological experience such as deep water or severe climate projects. In some instances, contractors from one industry can afford to pay higher wages in order to lure managers or estimators away from a different industry or their competitors. Certain trades, such as electricians, may receive extra incentive to move from commercial to industrial projects. The CURT survey reported that 85 percent of respondents believed that the shortage and mobility of qualified personnel is driving costs up. In the international context, contractors who are able to pay higher wages may be able to recruit qualified personnel from other countries. As a result, some construction contractors have been hiring less skilled people.
The increased demand for skilled trade labor has led to a high increase in wage and benefits. In 2006, average increases in the first year of labor agreements rose 4.5 percent. The highest demand is on skilled trades, including pipefitters, boilermakers, welders, electricians, millwrights and structural ironworkers. However, demand for these trades is only expected to increase, considering the backlog of large infrastructure projects and the volume of workers needed for reconstruction of large areas of the Gulf Coast.
Finding and retaining top managers has become a key goal for many contractors. While finding and retaining workers is one way to insure the contractor’s ability to meet project demands, it is also a potential factor in an owner’s selection of the contractor for a project. In addition to raising salaries, improving benefit packages and adding compensation in the form of stock options, some companies are increasingly focused on recruiting college and high school students through internships or other work programs to find and retain top talent. Companies also have to address workplace culture differences between younger and older workers and knowledge management issues in order to prepare for the anticipated labor shortage.
Contractors are not the only group to respond to this labor shortage. In response to the anticipated demand of both trade workers and materials workers, local trade groups and universities and colleges are responding. For example, the International Brotherhood of Electrical Workers started the “Florida Initiative” to help form relationships between experienced nonunion electricians and union contractors. Universities are expanding construction management programs. However, even with these increased educational opportunities, there may not be enough time to supply the market with experienced managers to meet demand in the face of increasing rate of retirement for experienced construction managers. Many contractors and engineering firms are expanding their succession programs and increasing investment in the training and retention of their employees.
What is a Reasonable Allocation of Risk in the Current Market?
In this “sellers market” for U.S. and international contractors, contractors have been able to use the market in their favor to influence owners to move away from contract risk allocation that has traditionally favored the owner and placed more risk on the contractor, to a risk allocation that is more favorable to the contractor. For example, owners have typically required lump-sum contracts, which brought major risks to the contractor if prices of materials or labor fluctuated or if there was a delay in the project. Now, contractors are moving away from lump-sum turnkey contracts towards contracts like cost-plus fee plus incentives, open-book estimates, reimbursable engineering-procurement-construction (“EPC”) management and conversion from lump-sum to reimbursable pricing structures. One hybrid structure allows a turnkey contractor for an EPC contract to bid lump sum for the portions of the contract that is within its control while also allowing the contractor to bid on a reimbursable basis for those aspects subject to price fluctuations outside of its control. Of course, a contractor can still offer a hard money bid, but include a large contingency to offset risk and market fluctuations.
This shift has allowed contractors to have increased protection from recent rising and unpredictable labor and market costs, including in the form of favorable escalation clauses. Certain U.S. government agencies have also taken steps to accommodate contractor risk concerns. The Federal Acquisition Regulations now allow price escalation provisions in all fixed-price agreements. In 2004, the Virginia Department of Transportation began using a special monthly price adjustment for steel on specific projects. The Florida Department of Transportation also implemented a program to account for price escalation with respect to fuel and bituminous material used in particular highway projects. As a result of these shifts in risk allocation, the amount of fixed-price work in the backlog of projects has declined.
This trend towards shifting some of the risk away from the contractor has added to the stability and profitability of these large non-residential projects, which may help sustain this hot “seller’s market.”
The Holy Grail – “True Partnering”
The concept of “partnering” among all project participants has been around now for some 20 years. It has met with various levels of failure and success. How many times have we all chuckled or outright laughed at this seemingly unreachable goal? It is suggested that in view of today’s marketplace, the time may be right for the industry, as a whole, to revisit the concept of partnering. It is further suggested that the industry’s goal should be to level the playing field for all industry participants so that all may benefit from a successful project. The first step towards this objective is to re-evaluate risk allocation and to place particular risks with the participant best able to control them.
On a final note, “public private partnerships” or “P3s” have recently washed upon the shores of the United States. They hold the promise of financing in a responsible manner the vast infrastructure projects needed to keep America competitive in today’s global marketplace. Yet, short-sighted politics and a misguided approach to risk allocation have stalled the development of P3s in the United States. They deserve a fresh look if we as a country wish to furnish our citizens with the amenities of life that we have all become accustomed to everyday whether traveling our highways or commuting on our light rail systems or departing for points around the world from our airports.
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