While investors in capital projects have always grappled with achieving value while managing risk, the current market presents unique challenges and opportunities. As the major projects pipeline expands, particularly driven by regional renewable energy projects, investors must navigate a landscape marked by project delays, labour and material shortages, increased prices, contractor insolvencies, and growing concerns about sustainability and climate change.
We consider how these market conditions are impacting risk allocation, what this means for equity and debt investors, and outline three approaches to manage project risk.
Current market conditions and implications for projects
Energy transition driving increased competition
While the last decade in the infrastructure sector has been dominated by urban transport projects, the next 10-15 years is set to be focused on energy transition, driven by decarbonisation and sustainability goals. This involves significant regulatory and policy reform, technology advances, private capital investment, and an overhaul of existing network infrastructure.
This transition contains significant challenges, particularly for investors in long-standing sectors like mining and resources. With contractors increasingly drawn to renewable energy and major public infrastructure projects, mining projects face competition for skilled labour and resources. In particular, with just under half of Australia's infrastructure spending allocated to projects in regional and remote areas, worker shortages risk delays and budget blowouts for mining and renewable energy developments which are predominantly focused in these areas.
Supply chain issues and rising costs
While cost certainty is still fundamentally important for both government and privately financed construction, the past few years have brought about unprecedented challenges to cost control. The COVID-19 pandemic disrupted global supply chains, including for construction contractors and sub-contractors who have faced significant issues in obtaining visibility and managing the procurement of parts and equipment (particularly critical parts with long-lead items) from overseas suppliers and manufacturers. These factors have led to a raft of issues for construction and infrastructure projects, including delays, critical program changes and cost escalation. Many lump sum contracts have been converted to incentive target pricing to avoid disputes and insolvencies.
Non-COVID global issues such as the conflict in Ukraine and the resulting energy and resource demands, as well as action on climate change, have also contributed to a higher inflationary environment not experienced in decades. With costs likely to remain high, principals are looking to sustainable cost reduction measures such as switching to renewable energy sources (e.g. fleet electrification) and creating strategic joint ventures to optimise economies of scale.
Evolving ESG expectations in project strategy
Now integral to strategy, the scope and importance of Environmental, Social, and Governance (ESG) is broadening, driving enhanced transparency and accountability. Mining and resources projects face the hurdle of establishing social licence to operate, including managing environmental impacts. This involves meeting evolving expectations around diversity, equity and inclusion, mine closure and rehabilitation, as well as contributing to liveability and protecting cultural heritage. In addition to these long-standing ESG areas, water stewardship and biodiversity are fast becoming urgent priorities for projects. With investors increasingly concerned about the long-term viability of their projects and reputational risks associated with unsustainable practices, principals that prioritise ESG principles can get an edge over their competitors — from accessing capital to securing licence to operate and attracting talent.
Approaches to manage project risk
The implications outlined above reinforce the need to tailor the contracting approach to the market conditions in which the project is being developed.
Three approaches to consider, adapted as required for the nature of the project, include collaborative contracting, adjustments to the tendering process, and embedding climate-aligned contracting.
Consider collaborative contracting / processes
In a highly competitive market, principals may need to consider accepting more risk to secure a contractor with a proven track record and achieve value for money. This might involve adopting non-lump sum pricing models, such as cost-plus or target cost contracts, which can provide greater flexibility in managing project uncertainties. While these pricing models transfer some risk back to principals, they also allow for more collaborative risk-sharing arrangements, which can incentivise contractors to control costs and manage risks effectively. However, like all contracts, to succeed they must be well managed, and attracting the best talent to manage contracts is key to success.
Adjust the tendering process to manage supply chain risk
Supply escalation and disruption are influencing risk allocation in project procurement, with shorter tender periods and tender validity periods as well as an increased willingness to consider novel pricing mechanisms to manage risk, such as rise and fall mechanisms, open book pass through costs, and material specific regimes. Additionally, with a less stable contractor and subcontractor market, principals have increasingly focused on tender evaluation beyond contractor capacity to deliver to understand supply chain resilience / weaknesses, and have sought to include mechanisms to check the health and solvency of contractors during the delivery phase.
Embed climate-aligned contracting
Embedding climate objectives into procurement and counterparty arrangements has transitioned from a ‘sleeper issue’ to a key lever in the transition to a net zero economy. Amid an increased demand for 'green' investments by debt and equity investors, organisations are facing elevated expectations to set and meet ambitious emission reductions targets. In this context, climate-aligned contracting is emerging as a practical tool to allocate the accelerating and dynamic risks associated with climate change, including physical risks such as increases in the frequency and intensity of extreme weather events, and economic transition risks such as the responses of governments, capital markets and consumers in the transition toward net zero emissions.
To learn more about proactively managing project risks or discuss how project stakeholders are responding to current market conditions, please contact us.
