Risk Allocation in Construction Contracts

The Importance of Risk Allocation 

Risks are inherent in all construction projects. As stated by Barnes, ‘from the moment that the decision to begin design is taken until the new facility is in use, the client is uncertain about the outcome of the project’. Risks can almost never be eliminated, merely managed, transferred or shared between parties. In allocating rights and obligations, construction contracts are the primary method in which employers and contractors are able to allocate these risks. Ensuring this risk allocation is correctly formalised in the contract, as well successful completion of construction and engineering works, are the two essential aspects required to avoid project disputes.  Negotiation of the risks which each party is to bear prior to entry into the contract and confirmation of these risks in the contract then sets each party’s expectations of the project and may help to prevent misunderstandings as to which party bears a specified risk, which frequently results in disputes. 

Indeed, ensuring a balanced allocation of risk between the contractor and the employer is vital for delivering a construction project efficiently while reducing costs. For example, allocating too much risk to a contractor may discourage tenderers from submitting bids, increasing the cost of bids and increasing the possibility of prolonged construction times and disputes. 

As summarised by Lam et al: 

‘The cost of improper risk allocation could be seen from the response from contractors such as adding a high contingency (premium) to the bid price or delivering low quality work. During the project, the owner might spend more management resources for the increased work disputes. Upon completion of the works, litigation of contractual claims might come after.’

This is especially the case for risks resulting from the behaviour of third parties or arising through the fault of no party as disputes arising from these risks tend to be more difficult and costlier to resolve.

The exact allocation of risk for each contract will vary according to the scale, nature and circumstances of the project and should be decided by parties themselves through negotiation. 

Stages of Risk Management

The five stages of risk management are risk identification, risk analysis, risk allocation, selection of risk management techniques and monitoring of the management of risk consequences.

Types of Risks

Risk can be defined as ‘the chance of something happening that will have an impact on objectives’. Broadly, there are three general types of risks which the parties must allocate between themselves:

• ‘Quality’: the specifications and performance of the asset to be constructed
• ‘Time’: the dates of completion for the whole project and for specific stages of the project 
• ‘Cost’: the payment for the whole project and for specific stages of the project 

Some specific risks that arise in construction projects and which should be allocated between the parties include quantities i.e. the volumes of resources, errors with information provided by the employer to the contractor, unforeseen ground conditions, force majeure, and changes in the law. 

Identifying and Analysing Risks 

It is clearly impossible to consider and account for all possible risks that could arise during construction before both parties agree to a construction contract. Barnes notes the persuasive argument that the parties should focus on and consider purposefully the few sources of risk which supply the vast majority of the uncertainty while a very large number of minor risks can be allocated to the contractor without substantially increasing the amount of risk they bear.

Analysis of the risks depends ultimately on the probability of the risk eventuating and the effect on the project if the risk eventuates. Risks that are have a high probability of occurring, and those that will cause the most significant loss, should be those that demand the most attention.

Allocating Risks: Abrahamson Principles

The efficient allocation of risk requires consideration of the nature and consequences of the risk. Whether the risk is within one party’s control is the first consideration.  

First elaborated by Max Abrahamson, the so-called ‘Abrahamson Principles’ state that where a risk is within a party’s control, the risk should be borne by that party if: 

• It comes about due to the party’s wilful misconduct or lack of reasonable efficiency or care; 
• The party can transfer the risk by insurance and allow for the premium in pricing of the tender, and it is most economically beneficial and practical for the risk to be dealt with in that way; 
• The preponderant economic benefit of running the risk accrues to the party; 
• To place the risk on the party is in the interests of efficiency (including planning, incentive and innovation) and the long-term health of the construction industry on which that depends; or
• If the risk eventuates, the loss falls on the party in the first instance, and it is not practicable or there is no reason under the above four principles to cause expense and uncertainty, and possibly make mistakes, in trying to transfer the loss to another.

These principles have garnered widespread support. Lord Diplock of the House of Lords referred to the principles in Photo Production Ltd v Securicor Transport Ltd [1980] AC 827, stating that ‘it is generally more economical for the person by whom the loss will be directly sustained to do so rather than that it should be covered by the other party by liability insurance’.

On the other hand, where the risk is outside the control of all parties, the task of risk allocation is more evaluative. The ‘Bunni criteria’ suggests possible relevant factors to consider when allocating risk:

• The party which can best control the risk and/or its associated consequences; 
• The party which can best foresee the risk; 
• The party which can best bear the risk; or
• The party which ultimately accrues most benefits and incurs the least detriments when the risk eventuates. 

Applying these principles, all major risks associated with the construction project can be efficiently allocated to each party. Where the contractor bears risk, the contractor acts as a ‘quasi-insurer’ by valuing the risk into their tender price through a risk price premium. 

The Continuing Relevance of Risk Allocation and the Abrahamson Principles

There has been a divergence between the theoretical optimal allocation of risk and practice in the construction industry. While the efficient allocation of risk requires risks to be allocated to the party best able to manage or bear it, most, if not all, of the risk tends to be allocated to the contractor in reality. Ward, Chapman and Curtis argue this is because clients tend to be unwilling to take on risk, with lawyers inexperienced in the construction industry tending to draft contracts which reduce the risk taken on by their clients. This effect is more pronounced in single-instance participants, such as those undertaking renovations or redevelopments of their homes, because there is no need to maintain relationships with contractors after completion of the project.

This divergence may be a primary reason for anxiety in the construction industry. In a study by the University of Melbourne, surveys of participants in the industry were conducted which found that ‘contractual risk allocation’ was considered the biggest issue confronting the industry.

The same study also found that:

• Many contractors in the industry do not understand or are unable to assess risk properly;
• The current attitude to risk allocation places too much pressure on those in the industry, such that the current attitude is unsustainable for the industry; 
• While contractors are able to take on additional risk, it is clear that most do not price risk properly and merely hope that the risk will not occur or that they can adjust during the construction phase so that there are additional funds if the risk eventuates;
• Risk allocation is often determined by lawyers drafting contracts, sometimes to the exclusion of those with an understanding of the project and the risks associated with it;
• ‘Tough’ risk allocation in a contract may lead to increases in project costs of 15-50%; and
• ‘Tough’ risk allocation increases the number of disputes, increasing project costs by 10-50%. 

Rahman and Kumaraswamy also conducted surveys on the efficient allocation of risk and compared that to what presently occurs in the construction industry. The results also support the proposition that risk is usually inefficiently allocated between parties, as below: 

		% Risk Lies with Presently		% Risk Should be Allocated to Manage
No.	Type of Risk	C	O	C	O	J
1	Site access	38	62	34	53	13
2	Unforeseen site conditions	31	69	15	59	26
3	Quantity variations	35	65	19	63	18
4	Weather	74	26	63	22	15
5	Acts of God	13	87	10	59	31
6	Financial failure of client (owner)	29	71	15	82	3
7	Financial failure of contractor	74	26	63	22	15
8	Subcontractor failure	93	7	90	3	7
9	Accidents at site	91	9	85	8	7
10	Defective construction work	94	6	94	3	3
11	Inflation	41	59	28	53	19
12	Economic disaster	39	61	24	51	25
13	Labour, materials, and equipment availability	80	20	74	12	14
14	Labour problems and disputes	83	17	82	10	8
15	Material and equipment quality	88	12	85	8	7
16	Owner-furnished equipment	10	90	5	85	10
17	Environmental hazards (project area only)	67	33	55	15	30
18	Environmental control (as impacting on the project)	64	36	47	21	32
19	Existing codes and regulations	77	23	65	16	19
20	Changes in codes and regulations	36	64	17	68	15
21	Safety at site	89	11	78	7	15
22	Public disorder	37	63	20	48	32
23	Union strike	78	22	64	13	23
24	Errors and omissions	31	69	24	62	14
25	Conflicts in documents	25	75	13	63	24
26	Defective design	11	89	4	83	13
27	Change in scope of work	12	88	6	81	13
28	Design change	13	87	5	82	13
29	Change order evaluation and negotiation	38	62	24	48	28
30	Contractor competence	78	22	78	14	8
31	Cost of legal processes	54	46	38	22	40
32	Delayed payments on contracts	38	62	13	69	18
33	Delays in resolving contractual issues	59	41	31	30	39
34	Delays in resolving disputes	56	44	33	32	35
35	Labour and equipment productivity	92	8	90	3	7
36	Quality of work	88	12	89	4	7
37	Third-party delays	49	51	32	44	24
38	Legal impossibility	24	76	12	69	19
39	Physical impossibility	21	79	8	65	27
40	Buildability and constructability	50	50	27	43	30
41	Construction method	94	6	90	3	7

Key: C = Contractor, O = Owner, J = Joint 

It is clear that the Abrahamson principles remain relevant and an ideal to strive towards despite competing interests in risk allocation in practice. However, Ward, Chapman and Curtis argue the principles are not intended to be completely prescriptive and merely a useful first step in determining the allocation of risks, and there are other relevant considerations: 

• While it is uncontentious for a party to bear risk if the risk is within their control, each party must recognise each risk and the effects on either party;  
• While insurance costs are usually borne by the employer, both parties should aim to obtain insurance and the party who is able to obtain the cheapest policy should obtain insurance; 
• There are no guidelines on how to match economic risks and benefits or to determine the reward for taking on a particular risk, the willingness to take risk and the ability to take risk; 
• The notion of ‘efficiency’ changes depending on the perspective from which party it is assessed and the underlying objective to be advanced with the project; and
• Considering where the loss falls and whether the loss can be transferred is in essence a ‘catch-all’ which may not resolve any of the aforementioned issues. 

In addition, risk allocation under these principles requires trust between the parties and a mutual appreciation of all risks and their effects. An absence of this leads to risk allocation being sidelined in favour of a narrow focus on the contract and its clauses. 

Risk Allocation Tables

After the parties have agreed on a suitable allocation of the major risks in a construction project, the allocation of these risks can be expressed in a risk allocation table in the tender documents, usually in an appendix. An example of a risk allocation table can be seen below:

	Types of Risks	Client (Owner) Retains Risks	Contractor Retains Risks
General
1	Specific law changes	Yes	No
2	General changes in law	No	Yes
3	Force majeure events e.g. extreme weather	Shared	Shared
4	Uninsurable risks	Shared	Shared
5	Insurance costs: construction and operation	Shared	Shared
6	Protest action	Shared	Shared
7	Labour relations	No	Yes
Financial Risk
8	Interest rate movement risk: fluctuation in the base rate for loan interest	Yes	No
9	Interest rate movement risk: fluctuation in interest rate margin	No	Yes
10	Indexation risk: maintenance and operational phase	Yes	No
11	Exchange rate movements	No	Yes
Site Risk
12	Land acquisition delay	Yes	No
13	Ground conditions	No	Yes
14	Unforeseen contamination	Shared	Shared
15	Planning approvals	No	Yes
16	Third-party site access e.g. utility owners, land owners	No	Yes
17	Archaeological artefacts	Yes	No
Design
18	Design specification and fitness for purpose	No	Yes
19	Compliance with legislative design standards	No	Yes
20	Design for road safety performance	No	Yes
21	Design for road-specified travel volumes	No	Yes
22	Planning approvals: impact of designation conditions on design prior to contractual close	No	Yes
23	Cost and responsibility of obtaining outline planning consent approvals	No	Yes
24	Additional design works required by operator	No	Yes
25	Design delays	No	Yes
Construction
26	Site safety	No	Yes
27	Construction cost and programme risk	No	Yes
28	Design fault	No	Yes
29	Construction traffic management	No	Yes
30	Adverse weather events other than force majeure	No	Yes
31	Planning approvals: impact of designation conditions on construction	No	Yes
32	Construction cost increases including fuel and material supply costs	No	Yes
33	Construction errors and defects	No	Yes

This can assist in the pricing of a tender option and can allow both parties to clearly understand who has borne each specific risk. 

Allocation of Events

While risks themselves can be allocated amongst the parties, the allocation of risk could alternatively be set out through ‘events’ rather than specific ‘risks’. This approach has been said by some to be the preferred method because there could be many different events resulting from the eventuation of the same risk. For example, the finding of a latent site condition could lead to four different events:

• Frustration of the contract;
• Variation to the works as specified;
• Variation to the contractor’s proposed method for the works; or
• Extension of time for the works but there being no variation to the works. 

Risk Management

After the allocation of risks and pricing for the risk in the tender price, the parties must manage the risks which they have agreed to bear, which aims to either reduce the likelihood of the risk eventuating and/or reducing the possible negative consequences occurring from the risk eventuating. The types of strategies for risk management can be divided into categories:

• Risk elimination (e.g. proceeding on a different basis and/or preventative measures);
• Risk reduction (e.g. by undertaking further investigations or due diligence such as by conducting further analysis of ground conditions);
• Risk transference (e.g. by legal, contractual and insurance measures); and
• Risk retention (e.g. self-insurance, bearing a large deductible, internal risk management). 

Standard Form Contracts and Risk Allocation

These principles of balanced risk allocation, especially the Abrahamson principles, usually form the basis of the risk allocation used in standard form contracts. For example, the Abrahamson principles have been incorporated into the Australian Standard contracts based on the AS4000 General Conditions of Contract. These standard form contracts focus on reducing the number of disputes and therefore usually result in fewer disputes compared with bespoke contracts, which usually contain terms which are weighted highly in favour of one party.

How We Can Help

If you require any advice on building claims, including if you have a potential claim or have a claim made against you, please do not hesitate to us at admin@valorumlaw.com.au or voregan@valorumlaw.com.au. Our expert construction lawyers will be on hand to assist you.

The information contained in this article is general information only and not legal advice. The currency, accuracy and completeness of this article (and its contents) should be checked by obtaining independent legal advice before you take any action or otherwise rely upon its contents in any way.

Contributors: Harry Chen, Valentina O’Regan