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.
*
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.
