Catch 22: Construction Innovation and Procurement

 

Source: https://www.statista.com/statistics/270233/percentage-of-global-rundd-spending-by-industry/

Construction is in a catch-22 situation, where neither industry incumbents nor its clients can rationally commit to significant, expensive investments in innovation for the vast majority of construction projects. Procurement has a significant effect on technological opportunity and innovation because the effects of appropriability of intellectual property (IP), substitutability between suppliers, and risks associated with innovation for clients are mutually reinforcing factors that have worked against innovation in construction. 

 

The development of new technology and increasing productivity requires investment in R&D and IP. If firms cannot capture the benefits of innovation and IP for some reason, because of imitation, piracy or secure supply of materials for example, they will not invest in innovation. Because the traditional tender method does not allow capture of IP and knowledge externalities by contractors, there is a perverse disincentive to innovate. Tendering rules or codes have been developed to maintain the integrity of the bidding process, not to encourage innovation, and a successful tenderer’s scope to be innovative is limited. There is opportunity to maximise profits within the tender price by novel ways of organising work or driving down subcontract prices, but bidders are not asked to put forward design suggestions, there are no criteria for evaluation of novel proposals, and tenderers cannot be treated equally if one is preferred on an alternative tender, which is non-conforming in terms of the original invitation. 

 

The answer often proposed is that the best way to increase innovation lies in changing the methods and systems used to procure building and construction projects. If contractors can make novel proposals to owners, productivity can improve, and society benefits from innovation. With non-traditional procurement methods such as design and construct (D&C), build, own, operate (BOO) or build and maintain (B&M), this disincentive is reduced because contractors can appropriate benefits of innovation and R&D through improved performance. 

 

It may not be that simple. If all firms have access to the same technology, and compete through continual, but gradual, improvement, they are subject to a ‘ratchet effect’. First identified in the 1930s by sociologists studying workers subject to performance pay, they found workers choose to restrict their output because they rationally anticipate that employers will respond to higher output by raising output requirements by cutting piecework pay or worker incentives within firms. It was also an unintended consequence of Soviet planning. If a factory met or exceeded its planned target, the target for subsequent years was increased, thus reducing incentives and effort for the factory manager. 

 

In construction the ratchet effect can be seen in bidding for projects, where tenderers will typically not deviate far from a client’s expected cost for the project, and all tenderers have access to the same information. Because of the ratchet effect, a firm avoids revealing a significant cost advantage on one project that might jeopardise margins on future projects. Importantly, it allows for innovations that improve productivity and efficiency, that are neither disruptive nor expensive to contractors but will deliver a windfall gain if a project comes in well under budget, which will be hidden from the client and competitors as much as possible. This suggests that there will be cost-reducing innovations available to contractors if they decide to invest, but the pressure to find them will be affected by client demands, upfront costs, market conditions and a competitor’s likelihood of using them. [1]

 

Also, clients avoid risk associated with innovation on their projects and do not include it in their budgets. Clients can act as a significant barrier to innovation because they are concerned about both construction costs and operating costs, and do not think they individually will benefit significantly from a successful innovation. Further, clients carry a significant share of innovation risk and as a result do not take on the risks of budget and time overruns or poor building performance, and other costs associated with innovation. This risk minimisation objective also applies to financiers and insurers of construction projects.

 

While this argument might be generally true, exceptions prove the rule. An example is the Heathrow Terminal 5 (T5) project. This project demonstrates the effect a determined client with a clear strategy to encourage innovation in order to improve performance can have. In its role as the client BAA took on all the risk for the ₤4.3 billion project, under the unique T5 Agreement that the 60 first tier contractors signed. In total, 15,000 suppliers were involved. The overall project was divided into 147 sub-projects, with an integrated team led by BAA responsible for each one. Unlike the majority of megaprojects, T5 was delivered on time and on budget. 

 

The key relevant point about T5 was that innovations were actively sought out and rewarded. These included product innovations in offsite fabrication such as the roof structure, technological innovations such as the tunnelling process and equipment, process innovations such as the two logistics centres and management innovations in the industrial relations, insurance provisions and supplier incentives built into the T5 Agreement. 

 

The risk associated with large, complex projects can provide the motivation for clients to pursue and reward innovation by major contractors and suppliers, who on T5 demonstrated a capability for innovation that is left unused under traditional tendering and procurement methods. However, most construction projects are less complex, many are standardized and repetitive, and clients have no reason to support innovations that might marginally affect their project’s delivery or performance but increase the risk of cost overruns. Construction is in a catch-22 situation, where neither industry incumbents nor its clients can rationally commit to significant, expensive investments in innovation for the vast majority of construction projects. 

 

The traditional procurement method does not allow capture of IP and knowledge externalities by tenderers. Therefore, many believe the best way to increase innovation lies in changing the methods and systems used to procure building and construction projects, but while there will be cost-reducing innovations available to contractors if they decide to invest, the pressure to find them will be affected by client demands, upfront costs, market conditions and a competitor’s likelihood of using them. As a result, innovation is difficult, though not absent. 

 

 

[1] Given a variety of locations with different relative prices, there will be a best location for supply of the most productive factor. Therefore, firms can raise productivity by moving to a site with a larger supply and lower relative price of the most productive factor, so for any one location there will be a better technology in use somewhere else (but with different relative prices). However, firms face search and switching costs when looking for new technology, and sunk costs in adopting one.  

 

 

More Data on Australian Contractors

 Grattan Institute Transport Infrastructure Report

 

 

The Grattan Institute, a Melbourne based think tank for public policy, released an important report into procurement of Australian transport infrastructure projects. Their Megabucks for Megaprojects report has four chapters and makes 12 recommendations. The chapters contain a lot of carefully compiled and useful information, while the recommendations are all worthy and, despite their careful phrasing, make a strong case for greater client involvement in the design, documentation and management of large public sector projects. 

 

Chapter 3 of the report is ‘Competition is fundamental’, addressing the issue of the dominance of tier one contractors. The chapter collects data on projects and contractors that is not readily available, with the sources and methodology detailed in the appendices. Their key point is the increase in size of projects since 2014, as shown in Figure 3.3 below.

For the last few years the quarterly value of work done on these large transport projects has been over $5 billion. In 2020 Australian governments spent a record $120 billion on road and rail transport projects. 

The argument is that it is increasingly difficult for mid-tier contractors to win work on these very large projects, of the 11 projects above $3 billion 8 were ‘contracts involving multiple tier one firms’. These firms are ‘few and well-known’ in Australia and their Figure 3.10 shows how few, and how they consolidated their position through M&A over the last couple of decades. 

The two sources of potential competition for the three tier one contractors are domestic rivals that might scale up sufficiently or new international entrants to the Australian market. In chapter 4 the report argues strongly for breaking up large contracts to allow greater participation from domestic firms, Recommendation 10 is: State governments should develop and use a systematic approach to determining an optimal bundling of work packages for large projects, including when to disaggregate bundles that include both complex and straightforward activities. While not a new idea it is still important because public clients do not generally do this, and often do not have the resources required to manage multiple contracts. 

 

That leaves international entrants, which the report argues have been playing an important role since 2005: ‘International entrants add to local competition, and it’s very helpful to governments if there are a variety of market players willing and able to take on work. In particular, when tier one firms form a joint venture to bid on a large contract, the only source of genuine competition may be from international firms’. Their Figure 3.5 shows the distribution of contracts between new international entrants and firms that were already here in 2006. Of those firms, Bouygues won 4 contracts, Lang O’Rourke and Acciona 5 each. 

There are barriers to entry when bidding for these contracts, on top of the high bid costs. These are the lack of transparency in the weighting given to selection criteria and the emphasis on local experience. The report’s Recommendation 8: In selecting a successful bidder, governments should not weight local experience any more heavily than is justified to provide infrastructure at the lowest long-term cost. Governments should publish weightings of the criteria used to select the winning bid for a contract. The Grattan Institute is strongly opposed to ‘market-led proposals’ from contractors, and strongly in favour of open tendering. The state with the highest transparency rating is NSW, also the state with the most contracts with new international entrants. 

The report collects data on 51 projects over $1 billion in Australia since 2006. Their dataset of transport infrastructure projects includes 177 contracts worth more than $180 billion (in December 2020 dollars). That data makes this an important contribution to the debate about construction industry policy in Australia, to the limited extent that there is such a debate. A couple of decades ago this data would have been published by the Commonwealth, by the Department of Industry or similar organization, and incorporated into the procurement guides being developed by the Australian Procurement and Construction Council and related State agencies. The report concludes “these guidelines leave a great deal of room for subjectivity in the choice of contract type. Although some of the state guidelines and decision-support documents are quite detailed, none go so far as to prescribe a rigorous and systematic methodology for procurement strategy selection.”

 

This raises the awkward question of who the report is addressing. The fundamental problem is the politicization of the project selection process not the cost of delivery, Australian construction is not expensive by international standards. The recommendations address the problem obliquely by highlighting improvements in procedures and processes, all of which have merit, but not considering alternatives such as the role an independent authority could play or national coordination of procurement and other regulatory systems. In this it was something of a missed opportunity

 

 State and Federal budgets have billions in unallocated funds for projects at all levels (community sports grants, local and regional infrastructure) and for major projects the Commonwealth has Snowy Hydro, the NAIF, the Murray-Darling Basin Plan etc etc. These projects, large and small, shovel money out the door with little or no accountability and there is no evidence that politicians are interested in change at this time.  

Procurement, Contracts and Information

Procurement case study: Heathrow Terminal 5 2007

A Megaproject Incentive Contract

Heathrow Airport’s Terminal 5 is one of the most extensively documented megaprojects. Built by British Airport Authority (BAA) and completed in 2007 there is a book, a volume of ICE Proceedings, numerous academic journal and conference papers, and many more newspaper and magazine articles. Apart from its size, cost, and enormous numbers, the distinguishing feature of T5 is that it came in on time and on budget, one of the few megaprojects to do so. How that was achieved is, I think, an interesting story.

The foundation was the T5 Agreement, a sophisticated incentive contract between BAA and its suppliers, a large and diverse group of traditionally competitive engineers, architects and design consultants, specialised subcontractors, general contractors, fabricators and manufacturers. The supplier network had 80 first-tier, 500 second-tier, 5,000 third and 15,000 fourth-tier suppliers. Over 50,000 people worked on the site at some point during construction. This was an unusually collaborative approach, with BAA taking responsibility for project management using the complex incentive contract to minimize risk.

The purpose of a procurement strategy is finding the most appropriate contract and payment mechanism. An effective procurement strategy enables an ability to manage projects while dealing with changes in schedule, scale and scope during design and delivery. This is the trinity of time, cost and quality in building and construction. The bigger the project, the harder it gets. For BAA the investment in T5 was around the same as the then value of the company, and the government imposed significant penalties on late completion and underperformance.

Two commonly used categories of explanation for cost overruns and benefit shortfalls in major projects are technical and psychological, Technical explanations revolve around imperfect forecasting techniques, such as inadequate data, honest mistakes and lack of experience of forecasters. Psychological explanations focus on decisions based on unrealistic optimism, rather than a rational scaling of gains, losses and probabilities. 

 

T5 is on the left side if the picture. It included the main terminal building and two satellites, 62 aircraft stands, an 87m air traffic control tower, car parking for 5000 vehicles and a hotel, road and underground rail and services infrastructure. There were 1,500 work packages in 147 subprojects, clustered into 18 projects led by 4 project heads for civil engineering, rail and tunnels, buildings, and systems.Two rivers were diverted around a site of 260 hectares, and the T5 building itself is 40m high, 400m long and 160m wide.

Before work started on T5, BAA studied a group of similar projects and the problems they had encountered, known as a reference class. It is a process based on pooling relevant past projects to identify risks and get a probability range for outcomes. For example, the reference class based forecast for fatalities on a project the size of T5 was six, with the safety program the actual outcome was two.

Using this reference class to forecast time and cost performance by estimating probability ranges for T5, BAA designed a procurement strategy. BAA was a very experienced client and they dealt with these issues in a systematic way. Under Sir John Egan they had started a program called CIPPS, which produced the first iteration of the T5 Handbook in 1996. This was revised as test projects completed, and by 2002 a budget of £4.3bn and schedule of 5 years was in place.

The procurement strategy for T5 centered on managing innovation, risk and uncertainty. BAA’s management team recognized the size, scale and complexity of the project required a new approach if the project was to succeed. The contractual framework was envisioned as a mechanism to permit innovation and problem solving, to address the inherent risks in the project.

BAA used in house project management teams to create relationship-based contractual arrangements with consultants and suppliers. Traditional boundaries and relationships were broken down and replaced by colocation, so people from different firms worked in integrated teams in BAA offices under BAA management. The focus was on solving problems before they caused delays.

An example of a T5 innovation in design management was the Last Responsible Moment technique, borrowed from the lean production philosophy developed by Ouichi Ono for Toyota. LRM identifies the latest date that a design decision on a project must be finalised. The method implies design flexibility, which is logically an approach used when there is unforeseeable risk and uncertainty, but once the decision is made the team takes responsibility and the task is to make it work.

The contractual agreement developed was a form of cost-plus incentive contract. However, unlike other forms of cost-incentive contracts where the risks are shared between the client and contractors, under the T5 Agreement BAA assumed full responsibility for the risk. The client explicitly bearing project risk was a key innovation that differentiates T5 from many other megaprojects.

Because BAA held all the risk, suppliers could not price risk in their estimates, which meant that they had to maximize their profit through managing performance. BAA used an incentive based approach with target costs to encourage performance and proactive problem solving from suppliers. Although there is a risk with over-runs, the risk is hedged on the basis contractors will strive to achieve cost under-runs in order to increase their profit.

The incentive was paid as an agreed lump sum based on the estimate for a particular sub-project (the target cost). If suppliers delivered under budget than that extra amount of profit would be split three ways between the suppliers and BAA, with a third held as contingency until the project completed. Conversely, if the suppliers took longer than expected or more funds were needed to finish a project, it would affect their profit margin.

Through the T5 agreement, and the planning that went into developing it, BAA was able to set performance standards and cost targets. The integrated teams focused on solving problems and, with the alignment of goals and the gainshare/painshare financial incentives in the Agreement, suppliers were able to increase their profits.

The T5 Agreement’s financial incentives rewarded teams for beating deadlines for deliveries, and was project team based, as opposed to supplier based, to encourage suppliers to support each other. BAA paid for costs plus materials, plus an agreed profit percentage which varied from 5 to 15% depending on the particular trade. With full cost transparency, BAA could verify costs had been properly incurred. BAA was able to audit any of their suppliers’ books at any time including payroll, ledgers and cash flow systems.

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Megaprojects have a terrible track record of cost overruns, which is why the reporting on T5 is so positive. It was an exceptional project in every respect and, like many megaprojects, became a demonstration project for introducing new ideas into the industry. Once construction started, the delivery of T5 on time and on budget, with a remarkable safety record, was due to the three inter-related factors of risk management, integrated teams, and the alliance contract. BAA held all the risk and the incentive contract meant suppliers could gain through performance. Instead of risks and blame being transferred among suppliers, followed by arbitration and litigation, BAA managed and exposed risks, and the suppliers and contractors were motivated to find solutions and opportunities.

The T5 Agreement highlights the fact that procurement as a strategy is primarily about finding an appropriate mix of governance, relationships, resources and innovation. There were three iterations of the Agreement, as it developed in stages through trial and error. The values written into the T5 Agreement stated ‘teamwork, commitment and trust’ as the principles that BAA as the client and project manager wanted from suppliers and contractors. This was achieved through a partnering or alliance approach, driven down through the supply chain by the 80 firms in Tier 1 to Tier 2 and Tier 3 suppliers. The procurement strategy and T5 Agreement helped popularize the framework agreements in use today, where major clients find long-term industry partners for building and construction work.

The success of T5 was also a successful translation of the Toyota lean management paradigm, bringing co-location, integrated teams, LRM design management and other lean techniques, and cooperative relationships into a megaproject environment. BAA invested so heavily in preparing for T5 because of the risk the project presented, effectively they were betting the company on the outcome. They built two logistics centres on-site, and a rebar workshop, to minimize delays in the supply chain.

Not many projects have the unique combination of scale, circumstances and complexity found in T5. Nor associated stories like decades of planning inquiries or the failure of the baggage handling system on opening day. As a highly visible and controversial project, and at the time the largest construction project in Europe, it was also unusually well documented.

This is the third in a series of procurement case studies. The previous ones were on the building of the British parliament house at Westminister in 1837 and the Scottish parliament's Holyrood Building in 1997.

Some T5 Publications

Brady, T. and Davies, A. 2010. From hero to hubris – Reconsidering the project management of Heathrow’s Terminal 5, International Journal of project Management, 28; 151-157.

Caldwell, N D, Roehrich, J K, Davies, A C, 2009. Procuring complex performance in construction: London Heathrow Terminal 5 and a Private Finance Initiative Hospital, Journal of Purchasing & Supply Management, Vol. 15.

Davies, A., Gann, D., Douglas, T. 2009. Innovation in Megaprojects: Systems Integration at Heathrow Terminal 5, California Management Review, Vol. 51.

Deakin, S. and Koukiadaki, A. 2009. Governance processes, labour-management partnership and employee voice in the construction of Heathrow T5, Industrial Law Journal, 38 (4): 365-389.

Gil, N. 2009. Developing Cooperative project client-supplier relationships: How much to expect from relational contracts, California Management Review, Winter. 144-169.

Potts, K. 2009. From Heathrow Express to Heathrow Terminal 5: BAA’s development of Supply Chain Management, in Pryke, S. (Ed.) Construction Supply Chain Management, Oxford: Blackwell.

Potts, K. 2006. Project management and the changing nature of the quantity surveying profession – Heathrow Terminal 5 case study, COBRA Conference.

Winch, G. 2006. Towards a theory of construction as production by projects, Building Research and Information, 34(2), 164-74.

Wolstenholme, A., Fugeman, I. and Hammond, F. 2008. Heathrow Terminal 5: delivery strategy. Proceedings of the ICE - Civil Engineering, Volume 161, Issue 5. All the papers in this Issue were on T5.