Identifying Risks

Certain inherent risks are controllable and should be assigned to the participants who are best able to exercise control over the situation. Other inherent risks are beyond the control of any participant. The following lists some of the major areas where inherent risks are found:

• Codes and regulations.

• Construction.

Site conditions.

• Labor. Operations. Casualties.

Allocating risks to participants who are best able to control events is illustrated in Figure 1-4.

Figure 1-4. Allocate Risks to Participant Best Able to Control Events

Responsible Party

Risk Element

Engineering, construction related: Process technology selection

"2, Owner Cn Engreer

Preproject analysis

Design of system involving new technology

S

P

Contingency allowance

Design errors and omissions

P

Insurance

Design chances

P S

P

Contingency allowance

Ambiguous specifications and plans

P

S s

Contingency allowance

Mechanical completion

S

P s

Contingency allowance

Completion by date certain

s s

P s

Contingency allowance

Unknown site conditions

P s

s

Preproject analysis and contingency

Unilateral owner-directed changes

p

Contingency allowance

Natural disasters

p

S Insurance

Court injunction, war, or civil disturbances

p

Contingency allowance

Patent infringement

s

S P

Contingency allowance

Coordination of subcontractors and suppliers

P s

Contingency, related project experience

Labor d isputes

s

P s

Contingency, related project experience

Labor productivity

p

Contingency, related project experience

Changes of law

P s

s s

S Preproject analysis and contingency

Inability to meet performancespecifications

S

S P

Contingency allowance

Operations related: Selection of O&M contractor

p

Preproject analysis

Higher than expected O&M cost

s

s

P Contingency and contractual incentives

Changes in supply and character of fuel

P

S Preproject analysis

TABLE 14 (continued)

Risk Element

Process performance

Responsible Party

Responsible Party

Change in price of utilities

S Contractual incentives

Chanaes in environmental, health, safety regulations_

S Contingency allowance and preproject analysis

Availability of plant

P Insurance, contractual Incentives

Natural disasters

Insu ra nee

Increases in taxes

P Contingency allowance

Increases in insurance premiums

P Contingency allowance

Poor management and operations

P Contractual incentives

Financial related: Changes in tax laws

Contingency allowance opinion of tax counsel

Financing availability, cost, arbitrage

Preproject analysis

Inaccurate cash-flow projections

Contingency allowance

Changes in interest rates

Contingency allowance

Adverse IRS determination

Preproject analysis

Revenue shortfalls from general economic factors_

Contractual incentives

^P3 Primary responsibility 2S = Secondary responsibility

Engineering. The engineer is responsible for exercising the skill and diligence that is normally rendered by a reputable professional engineering firm under the circumstances. Mistakes resulting from a failure to perform to this standard are commonly termed "errors and omissions." These can result in costly change orders, damage to equipment, or injury to persons.

Engineering errors and omissions are controllable by the engineer, who should assume responsibility for this risk. However, the potential financial exposure arising out of this risk is much greater than the revenue normally available from the engineer's work. The engineer's fees will usually not exceed 5-8% of the total cost of the project, while the damages resulting from an engineering error may well exceed the total project cost. This exposure is reflected in the high premiums for professional-malpractice insurance, and it is included in the rates charged for engineering services.

Mistakes can occur even though the engineer is not negligent. Historically, this has been the owner's risk because the engineer is obligated only to perform with ordinary engineering skill and diligence. Therefore, the owner should determine whether the engineer will be willing to guarantee the work. If so, the remedy to the owner is clear. In most cases, however, engineers will limit responsibility to reperforming the defective engineering only. They will not assume liability for any resulting loss or damage. Furthermore, engineering guarantees are not insurable-professional liability insurance will cover only actual negligence.

To enable the engineer and other project participants to work at the lowest reasonable price, the owner should require that each participant indemnify the others from exposure to lawsuits arising from his work. Whenever something goes wrong on a project, all participants are named in the resulting lawsuits, regardless of any actual participation in, or responsibility for, the claimed wrong. This arrangement, called "cross indemnity," causes the participant who is at fault (or who has contractual responsibility in the matter) to bear the burden of defending the other participants and of paying any resulting damages. An owner should not contract with any participant refusing to agree to such an indemnity.

An exception to the above approach occurs when the owner agrees to furnish a "wrap-up" program, which insures all participants. Such a program can result in significant cost savings. Wrap-up programs usually do not include professional-malpractice insurance for the engineer or other participants rendering professional services. If a wrap-up program is used, the owner should avoid assigning risks to participants who are covered under the program. Otherwise, the desired cost savings will not be realized; in fact, project cost will be greater because of duplication of insurance coverage.

Codes and regulations. The engineer is responsible for the application of the proper technical codes and for facility-safety and environmental regulations. To identify applicable regulatory requirements, the engineer will probably consult with an industrial underwriter during the development phase of the project. Additional consultation with environmental, health and safety, and building officials at the local, state, and federal levels is essential. The engineer must also rely heavily on working experience with similar projects, as well as on research and sound judgment, to define the applicability of codes to the project. Overkill through the application of inappropriate codes and regulations increases project costs without adding value.

Construction bid prices are directly dependent on the contractor's perceived abilities to forecast, assess, and manage those elements of exposure that are directly under its control. Normally, construction cost overruns are attributable to inaccurate estimation of construction requirements. Inaccurate estimates result from inadequate or premature scoping of the project. For example, design or specifications may be inadequate; vendors and contractors may not be committed to fixed-price contracts; or contingency allowances, engineering changes, or site conditions may not have been adequately foreseen.

Fixed-price construction affords the owner and financier some protection against cost overruns by placing responsibility for construction, as specified in the engineer's design, on the construction contractor. However, the contractors bidding on fixed-price jobs normally assess the risks and add a contingency factor to their bids. For risks that are within the contractor's control, contingency amounts will be at a minimum. For risks that are beyond the contractor's control, contingency amounts can approach the full cost of occurrence of the risk. The owner pays for the risk whether it occurs or not. If the risks no not occur, the contractor realizes more profit.

In the reality of the marketplace, however, a contractor who prices each and every risk into a bid will not win the job, since other contractors may be willing to accept some risks in order to secure the work. In today's highly competitive construction market, owners are able, therefore, to shift substantial uncontrollable risk to contractors with virtually no price impact. If a contractor does not have the financial wherewithal to overcome the occurrence of a substantial risk event, the owner may have to assume the resulting additional cost. To prevent this strategy from backfiring, an owner should assign to the contractor only those risks that are within the latter's control. This includes taking the time to ensure that construction bidding documents are complete and unambiguous.

If the owner desires to minimize the duration of the project by "fast tracking '—starting construction before design is complete—

a form of cost-reimbursible construction contract should be used, and should include bonus/penalty incentives to motivate the contractor's performance. A hybrid form of contract may also be used, where the contractor fixes the price of those elements that can be estimated while the balance of the work is performed at unit rates or cost reimbursible subject to performance incentives.

Schedule. Delays in the completion of a project result in increased interest and overhead expenses, a general escalation of construction costs, and lost revenue from lack of production. Delays can result from such conditions as poor design or construction management, inadequate scheduling estimates, labor strikes or slowdowns, unanticipated site conditions, delays in delivery of equipment, or defective equipment. Completion of project milestones on schedule is essential, since meeting debt-service requirements usually depends upon the generation of revenues on a predictable and timely basis.

The project schedule must be realistic. If construction is broken up into packages in an attempt to maximize competition and the use of local resources, the schedule must be sufficiently detailed to promote the proper coordination and interfacing of the various contractors. This often requires the services of a construction manager who understands the construction process and how to manage and coordinate contractors.

Site conditions. The risk of unknown site conditions can be minimized by making a thorough geotechnical evaluation of the site during the project-development phase. Engineers and constructors must protect themselves against exposure to risk resulting from subsidence, dewatering problems, compaction, archaeological finds, nonrecorded obstructions, and other unknown conditions, by prequalifying the site with assumed site conditions.

If the owner allocates the risk of site conditions to the construction contractor without furnishing sufficient information on surface and subsurface conditions, or if information furnished is disavowed by the owner, contractor contingencies will be at a maximum. This is a risk that is uncontrollable, and thus is best assumed by the project owners as a part of the speculative risks of the venture. Contingency amounts will i:hefl be within the control of the owner, thereby avoiding any cost increases for the risk of conditions that may not arise.

Labor. Because the financial impact of a labor dispute can be so serious, it is essential that the constructor and construction manager have a thorough understanding of site labor conditions, local work rules, and craft jurisdictional policies. Labor risks can be minimized by negotiating a project work agreement with local craft and by coordinating labor jurisdictional areas among the various crafts prior to the start of work.

Work stoppages and labor disputes are frequently attributable to the actions of the construction contractor. The construction contract should specify no relief for labor actions that could have been avoided or that do not actually impact the contractor's ability to complete the work as scheduled. Likewise, stoppages that are beyond the contractor's control should be shouldered by the project owner.

The project owner should determine when the contractor's labor agreements will expire. He should also decide whether to assign the risk of wage increases to the contractor, or assume it himself in order to minimize contingency pricing.

Operations. After construction and acceptance testing, operational risks-the possibility that the facility will fail to provide expected levels or revenue-become the area of major concern. Events and conditions that can affect the flow of revenue during operation include improper operation, poor maintenance, disruption or changes in the character of the fuel supply, employee work stoppages, natural disasters, condemnation by a public authority, or changes in health, safety, and environmental regulations.

For a state-of-the-art facility, performance is the most pertinent concern. The facility may fail to perform as specified despite proper design or workmanship, because the process itself is not viable or cannot be scaled up as anticipated. This is the entrepreneurial risk that is usually assumed by the owner of the technology.

Casualties. The construction or operation of the facility can be disrupted by casualty occurrences or force majeure events: fire, flood, tornado, earthquake, or accident. These are the nonspeculative risks that are usually covered by liability or property-damage insurance. The owners must coordinate the insurance coverage of each participant and specify detailed insurance requirements so that there will be no unintended gaps. In addition to property-damage insurance, the owner should consider procuring business-interruption coverage for the loss of revenue or increased costs resulting from loss or damage to equipment and structures.

Financing. The financing entities must be assured of the timely repayment of project debt, both interest and principal. The cost of financing the project will vary in proportion to the financier's perception of such assurances, as well as financial market conditions. For proven technology, a nonrecourse debt (not backed by guarantee) may be available at near prime rates. Anything less than a full feeling of assurance will raise the financing rate or require some form of independent guarantee or collateral. Additional areas of major financing risk include adverse IRS determination of tax benefits, revenue shortfalls resulting from the general condition of the economy (such as double-digit inflation or reduced product demand), lack of credit-worthiness or experience history of project participants, and availability of insurance.

Other project risks can be artificial and unnecessary. Such risks may be introduced into the project through ambiguous contract language, poor communication among project participants, failure on the part of some participants to meet contractual obligations, poor contract administration, or improper coordination of contractual obligations such that essential work is not performed. Artificial, or contractual, risk is also introduced through the use of onerous contract terms which require a participant to accept an unmanageable risk, or it may arise because there are too many parties to the contract, or the parties are incompatible. In addition, a participant may assume certain risks contrary to intent or without realizing it. Statutory or common-law assignment of liability may be unanticipated or improperly addressed, or the party who has accepted the risk may lack sufficient assets to make good on its obligations.

Managing risks. The first step in risk management is to reduce or mitigate it to the greatest degree possible. Start by segregating the speculative risks from the nonspeculative risks. Recall that nonspecu-lative risks are those that threaten loss and offer no potential for gain-such as natural disasters or other casualty loss-and are generally insurable. Speculative risks offer the risktaker economic gain in return for effective performance and proper risk management. Good management and prudence are the risktaker's insurance against loss.

To minimize the impact of uncertainties, project participants must recognize risk elements, understand risk accountability, know how to manage risk effectively, and be able to share risk equitably through the contractual process.

A clear definition of each participant's role and responsibilities is essential when assigning risks. This is especially true in situations where one party may assume multiple roles, as in the case of an or where financing agreements dictate who assumes the various responsibilities. All too often the task of role definition is overlooked in the initial enthusiasm and accelerating momentum of the project. Role definition is a complex task that requires much thought and the input of all potential participants. It can serve to identify many of the project risks and provide a basis for risk allocation that has the support and acceptance of all project participants. Figure 1-4 broadly outlines each participant's responsibilities.

Any exposure to risk must be commensurate with the benefits to be derived from participation in the project. The role-analysis process should result in a careful and rational determination of which participants are best suited to assume each specific risk. It is essential that the participant who can best control the outcome of an event or task be assigned responsibility for any associated risks. Even so, there is a trend among owners to shift risk indiscriminately to other participants. Yet if any risks are assigned without regard to a participant's ability to control them, the project may be needlessly jeopardized.

Naturally, each participant will want to protect his own interests. A governmental owner does not want to obligate the tax base and wants the project to be totally self-sufficient; the engineer and constructor want to receive reasonable compensation for their services; the financiers want to be assured of timely payment of principal and interest. However, risk mitigation is a give-and-take situation. If the project is to have optimum chance of success, all parties must see a potential financial gain equal to their risk exposure.

Use the following guidelines and Figure 14 to assist in making a rational allocation of project risks among the project participants:

(1) Allocate sufficient risk to participants to motivate them to perform properly.

(2) Consider the degree of control over the risk to be allocated when assigning risk responsibility.

(3) Consider the participants' abilities to control risks allocated to them.

(4) In general, allocate risks of a national or international character (such as a currency devaluation or an oil embargo) primarily to the project owner.

(5) Share mutually dependent risks on a preselected, rational basis, rather than overlapping. This will prevent conflict and inadvertent assumptions of loss because of inability to determine fault.

Once risks are at their minimum, the next step is management. Each participant should approach each risk situation aggressively and in a manner that will reduce the probability of its occurrence and/or minimize its impact should it happen. Techniques for risk management include:

• Obtain firm price quotations from vendors and contractors for all major engineered items.

• Perform sufficient preliminary engineering during project development to clearly define scope and identify inherent risks.

• Assign risks prudently by means of appropriate contractual formats. Various formats range from fixed-price- through full-cost-reimbursible- to incentive-type contracts.

• Dedicate specific contingency budgets and reserve margins to each risk area.

• Use outside consultants to evaluate risk, identify potential cost impacts, and develop contingency plans.

• Investigate the reputation and financial stability of all project participants.

• Conceptualize the project thoroughly so that all objectives and restraints are understood by all participants.

• Make certain that no risk, unless purposely shared, is included in more than one participant's scope of responsibility.

• Re-evaluate potential risk situations as the project progresses.

Commercial insurance is available to protect project participants from the economic consequences associated with nonspeculative risks. Insurance policies vary in terms of coverage, and should be closely scrutinized to see just what is being insured, both in terms of the actual property or persons protected and the events being insured against. Figure 1-5 outlines insurable risks and applicable coverages.

Warning: Do not overinsure. Insurance is intended solely to protect project participants from catastrophic financial losses. De-ductible~a nd limited cost sharing with the underwriters will keep premiums low while providing needed protection. Contingency allowances should include insurance deductibles. Overuse of insurance as a mechanism to reduce risk increases project costs without benefit.

Project insurance requirements must be coordinated with experienced financial advisors, and must be consistent with the overall exposure of the project participants.

Figure 1-5. Insurance Covers Losses from Nonspeculative Risks

Exposure Insurance coverage

Repair or replace damaged equipment

Property damage/Builder's risk/Transit

Pay for continuing expenses and lost

Business interruption

revenue while repairs are being made

Pay for continuing expenses if procured

Contingent business

equipment is delayed by an insured peril

Interruption/Extra expense

Protect against legal costs and judgments

Comprehensive general liabilitv

to third parties

Provide funds if a contractor or vendor fails to

Performance and payment bonds

perform within the scope of this responsibility

Pay for project expenses resulting from

Cost overrun/Delayed opening

uncontrollable circumstances

Pay project equity participants if tax credits

Investment-tax-credit recapture

are recaptured by IRS because facility is

destroyed

Modify the plant to meet specified

Efficacy*

performance guarantees

Pay debt service while plant operates below

Efficacy*

specified performance levels

Pay for damages caused by engineering

Professional liability

errors or omissions

Injuries to employees

Workers' compensation

*Efficacy insurance market is limited, with large deductions and high premiums

*Efficacy insurance market is limited, with large deductions and high premiums

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