The Engineering and Construction Contract (NEC3): A Comparative Analysis – Part 2

by Reed Smith
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Introduction

In our last Alert, we assessed the philosophy of the NEC Engineering and Construction Contract (“NEC3”) against the FIDIC Conditions of Contract for EPC/Turnkey Projects (“FIDIC Silver”), with a view to assessing its suitability for high value, large-scale international projects. We considered the approach and structure of both, their “portability”, their approach to risk, and the role of third parties. There is a clear contrast between the two concepts:

  • FIDIC Silver: delivering a “turnkey” solution, where the employer expects the contractor to take full responsibility for delivery of the project.
  • NEC3: a more collaborative approach, with greater levels of contract administration as a consequence.

Now, we look in closer detail at three of the mechanisms which may be of particular relevance to large projects: pricing structure, programming, and testing.

Pricing: how much will it cost?

NEC3 contains six pricing options, which the employer is able to choose from. The six options are:

  1. Option A - Priced contract with activity schedule (lump sum contract)
  2. Option B - Priced contract with bill of quantities (re-measurement)
  3. Option C - Target contract with activity schedule (lump sum based target cost)
  4. Option D - Target contract with bill of quantities (bill of quantities based target cost)
  5. Option E - Cost reimbursable contract
  6. Option F - Management option 

NEC3 therefore instantly offers a selection of “off the shelf” clauses/mechanisms to fit a variety of requirements. It is generally considered that Option A will provide the greatest price certainty for the employer, with this certainty reducing gradually as you descend down through the options, with Options E and F providing the least price certainty. Indeed Option A is the most akin to the approach taken by FIDIC Silver.

The optional pricing provisions are drafted to fit the core clauses, and provide a comprehensive pricing mechanism: there is no need to revise other clauses in the contract in order to accommodate a particular approach to pricing.

FIDIC Silver does not contain any tailor-made pricing options, with pricing generally being calculated on a lump sum fixed price basis. If the parties want to provide for a more flexible pricing solution, FIDIC Silver may need substantial amendment. By using NEC3, the employer can select a pricing mechanism to reflect the project requirements. For example, if the employer wishes to incentivise the contractor to make savings, one of the NEC3 target cost contracts may present a more flexible mechanism than seeking to amend FIDIC Silver to make it resemble a target cost contract.

In practice, both the FIDIC Silver and NEC3 pricing provisions are likely to be the subject of substantial amendments when used for a large-scale project.

That said, NEC3 provides the flexibility of at least a framework for alternative pricing mechanisms, making the need for substantial amendments less likely. The target cost options contained within NEC3 at Options C and D, provide for the sharing of savings between the employer and the contractor. The relevant contractual provisions state that the contractor will share in any cost savings, in accordance with the share range, which will be as agreed between the parties and set out in percentage terms within the contract data. The provisions further provide that the contractor will correspondingly share in any cost excess, providing a gain/pain share mechanism.

It is of no surprise that FIDIC Silver provides no such option. Using FIDIC Silver on (for example) a target cost project would require bespoke amendments to a number of its clauses. Indeed, it is more common for FIDIC Silver to be amended in the other direction, from periodic valuations to milestone payments where only completed milestones are paid for and (in the absence of claims) an in-depth consideration of the extent of work done and the pricing of plant and materials is not required.

Although NEC3 is, through the options, flexible in its application, each of the NEC3 options comes with its own issues and considerations. For example, Option A is well suited to projects where the contractor has full design responsibility, whereas Option E is perhaps more appropriate for a project where maximum design flexibility and design development during the works is important. The “off the shelf” pricing mechanisms do, therefore, need some consideration before an option is selected. In the event that an employer is an inexperienced, or particularly “hands off” employer, the array of options may in fact be a drawback.

The early warning mechanism present in NEC3 places an emphasis on the contractor and the project manager giving notice of anything that may increase the costs under the contract. This should, on the face of it, encourage continuous monitoring of the costs being incurred and, one would expect, limit the scope for any nasty surprises at the end of the works. FIDIC Silver does not contain a similar early warning mechanism and users would not expect it to, on the basis of its general pricing philosophy. However, employers can introduce a shared savings mechanism or other incentives by way of the particular conditions, if this is something that is required on a project falling broadly within the scope of a turnkey project.

The level of interaction between the employer and contractor on pricing and payment required by NEC3 often raises an important general point in connection with its use on large fixed price projects. How do you reconcile this level of pro-active project management with the turnkey “just tell me when it’s complete and ready for operation please” approach to EPC projects, and on large process and power plants? In truth, very few large projects respect this contracting philosophy in its purest sense; every employer will manage and monitor the performance of a contractor. But nevertheless there is a real need for an employer and contractor to reflect on whether NEC3, and its level of interaction, will suit their EPC, turnkey project, in the same way that FIDIC Silver might do.

As mentioned above, FIDIC Silver is often amended on large-scale projects, including those for wind and/or power plants, to incorporate a payment by milestone mechanism. This allows the parties to break the contract price down into smaller sums, with payment triggered by, for example, the completion of certain types of work, delivery/incorporation of certain equipment, or the passing of certain tests. For employers wishing to utilise a milestone approach, NEC3 presents its own similar solution. Although it does not use the term “milestones”, Option A works on the basis that the price for work done up to a certain date is the total of the prices for particular ‘completed activities’ as set out in the corresponding activity schedule. NEC3 may therefore be an equally useful starting point for an employer wanting to utilise a pricing mechanism that ties in with a pre-agreed set of activities/milestones.

Programme: how long will it take?

The programme is an important tool for any large construction project: this is what will set out the contractor’s intended route to project completion. Both FIDIC Silver and NEC3 require the contractor to produce a programme for the project. However, it is fair to say that NEC3 places greater importance on the programme as a “fluid” day-to-day management tool.

FIDIC Silver requires the contractor to provide a programme within 28 days of the commencement date, and to revise this programme if it becomes inconsistent with actual progress. There is also a mechanism for the employer to require the contractor to submit and follow revised proposals if the employer thinks that progress has fallen behind the programme.

NEC3 introduces a concept of the “Accepted Programme”, which is intended to be detailed, fully integrated and comprehensive, produced by the contractor and approved by the project manager. NEC3 allows for the agreed programme to be identified in the contract data, or submitted by the contractor to the project manager for approval.

So far, so similar. In NEC3, however, the importance of the programme is emphasised in several ways throughout the contractual provisions; indeed, if there is not an accepted programme in place, it can become difficult to operate many of the related provisions. The programme is intended to be utilised on a day to day basis and is hence very detailed. The contract prescribes an extensive list of information which must be shown on the programme – including provision for “float” and “time risk allowances” which might not typically be included on a programme prepared under FIDIC Silver. The contractor is also required to submit revised programmes at regular intervals. Although FIDIC Silver does set out a reasonably detailed list of what needs to be included in a programme, employers will often amend these provisions to place more prescriptive programming obligations on the contractor, so that the programme shows a live critical path for the project.

In NEC3, the importance of the programme is underlined by the fact that the employer can withhold 25% from all payments due to the contractor until the first programme is submitted. There is no equivalent provision in FIDIC Silver.

The programme is also of importance in relation to the compensation event provisions in NEC3. Indeed, a failure by the employer to comply with the accepted programme gives rise to a compensation event itself. The accepted programme is used as the baseline against which any claims by the contractor are assessed. It is therefore essential to keep the programme updated so that these assessments are not made on the basis of out of date information. When providing quotations for compensation events which affect the programme, the contractor is required to submit a revised programme. If he does not, or if there is no accepted programme yet in place, the compensation event will be assessed by the project manager rather than on the basis of the contractor’s quotation.

Programming is vital to the good management of any large project. This will be true regardless of whether a project is carried out under NEC3 or FIDIC Silver. NEC3’s dedication to the accepted programme can be helpful in this regard, but it requires the contractor and project manager to fully enter into the spirit of the provisions and to make sure that the programme is agreed, used and updated as required. The NEC3 approach might also need a change of mind set in terms of the investment in resources needed to keep the programme “alive”, as well as to overcome many employers’ reluctance to buy into and accept a contractor’s programme, for fear of how that might increase its obligations to do things by a particular date, and more generally, make it easier for the contractor to establish entitlements to extension of time.

Testing: how will I find out if it works?

If FIDIC Silver has one clear advantage over NEC3, it is that it contains express provisions relating to commissioning and testing, both at and following completion. FIDIC Silver sets out a comprehensive testing procedure to ensure that, when the contractor hands over works to the employer, these demonstrably comply with the employer’s requirements. Contractors used to operating under the FIDIC Silver regime will be familiar with these concepts and will be adept at providing for this when considering things like programming and milestones for payment.

NEC3 does not, as a base draft, incorporate any detailed testing mechanisms, with clauses 40 to 45 broadly covering “tests” and defects. This should not, however, be seen as a clear deficiency of NEC3 as it was not drafted in an attempt to match the detailed provisions that can already be found in the FIDIC Silver and other forms. Rather, NEC3 leaves these details to be addressed on a project-by-project basis and recorded in the works information. There is, of course, nothing to stop the parties from amending the base contact to include such a mechanism, nor from developing the pricing option selected to introduce a testing criteria. Of course, if such changes are made to NEC3, the remainder of the clauses will need to be revisited to take into account the testing regime. A key advantage of FIDIC Silver is that the entire contract has been prepared to accommodate the testing regime and any resulting considerations are already incorporated into relevant corresponding clauses.

FIDIC Silver also deals with the particulars of performance testing to be carried out by the employer, generally after completion: namely testing which is carried out by the employer, in something of a role reversal from the testing ordinarily carried out by the contractor prior to completion. That said, it is quite common (in the event that tests after completion are required) for the FIDIC Silver standard provisions to be significantly amended.

Determining whether testing is fundamental may hinge on the specifics of the particular project. For example, when acting on projects for power or other process plant, we invariably encounter very detailed and important testing mechanisms. In relation to wind projects in particular, this regime can be complex where the contract needs to allow for testing of turbines either individually or as strings/sections. The advantage of using the FIDIC Silver over NEC3 here is that the structure of the testing mechanism is already in place, albeit that some amendment may be required.

However, employers should not necessarily be put off by NEC3’s apparent lack of a standard testing/commissioning structure. NEC3 has been utilised on some large-scale projects, for example it was used by BAA to deliver the £4.2 billion Heathrow Terminal 5 project. It can be assumed that detailed, bespoke, testing provisions will be included on large-scale projects of this nature. However, this demonstrates that the NEC3 testing regime does not, of itself, need to be a bar to its use on complex, high-value, integrated projects.

Conclusion

To recap, we have looked at a number of criteria in assessing NEC3 against the more traditional FIDIC Silver book. Here is a brief comparative summary of the points we have looked at in Part 2 of this client alert series: 

Criteria

 

FIDIC Silver

 

NEC3

 

Pricing Structure

 

Lump sum price basis

 

Flexible – 6 different prices options with no amendments required

 

Programme

 

Reasonably extensive provisions

 

Extensive provisions including ability to withhold payment if programme is not submitted

 

 

Testing (Generally)

 

 

Reasonably extensive testing provisions included

 

Limited testing provisions, with detail to be included in works information

 

Testing (Performance Testing)

 

Provisions included to deal with this

 

Provisions do not deal with performance testing to be carried out by employer; if any kind of testing is to be carried out, detail must be included in works information 

 

Our two alerts have demonstrated that there is no obvious, one-size-fits-all, answer to the question of which contract is more suitable for a project. Inevitably this will depend on the requirements of the project and the approach of the employer. It is also important to bear in mind that there will be no true “off the shelf” solution for any project as any standard form is likely to be adapted and tailored to the particularities of the project.

What is important is to select a standard form that matches the philosophy of the project, and to be sure that the parties intend to operate the contract in a manner that reflects the drafters’ intentions.

For large international projects, FIDIC is, at present, still seen as being in the driving seat. However, as mentioned above, NEC3 is becoming more common and certain players in the market seem to be embracing its philosophy. Whatever the parties’ particular preference, there is no reason why NEC3 cannot be used as the basis for any given large-scale project. That said, years of use, understanding and familiarity give FIDIC a substantial advantage, particularly outside the UK; whether NEC3 can overtake FIDIC as the “go-to” form of contract for large international projects is open to debate. Watch this space…

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Reed Smith | Attorney Advertising

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