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Sustainability: a global challenge

As with every major commercial sector, the construction sector faces significant challenges tackling the climate crisis, supporting the energy transition and delivering sustainable solutions. The issue is increasingly becoming a central feature of C-suite decision-making for both developers and contractors, as well as investors, funders and other stakeholders, not least because the process of construction itself is carbon-intensive. These challenges will undoubtedly become more pronounced as the global community strives towards carbon net zero in their strategic plans and further commitments are made at an international level.^[1]

The construction paradox

The global construction sector is one of the largest contributors to climate change and is therefore a key partner for governments intent on delivering the energy transition and achieving broader sustainability goals.

On the one hand, construction and operation of buildings alone are estimated to generate nearly 40 per cent of annual global CO2 emissions, and building stock is expected to double in area by 2060 (the equivalent of a New York City every month for 40 years).^[2] In this context, it is perhaps unsurprising that reports suggest that more than half of all materials extracted from the earth are transformed into construction materials and products, and excavation, demolition and construction activities account for anywhere between one to two thirds of waste generated annually.^[3]

On the other hand, the construction sector is under pressure to change. Perhaps the most obvious and pressing is the need to decarbonise and improve the energy efficiency of the built environment, both in terms of embodied carbon in the construction phase and operational carbon emissions over the lifespan of buildings and facilities (existing and new).

It is in this context that this article considers how the construction industry might facilitate the energy transition and a move towards more sustainable development by examining:

• the importance of the procurement model to innovative and sustainable development;

• the need to encourage and incentivise innovation beyond the design phase; and

• examples of how innovation works in practice by reference to ‘state-of-the-art’ technology and modern methods of construction.

The importance of the procurement model to innovative and sustainable development

A range of procurement models and techniques is available for securing the innovation necessary for the energy transition and delivering sustainable construction solutions. The optimal solution will depend on a range of inputs including the type of project, the client, the supply chain itself, the required levels of innovation and any funding constraints. This article explores a number of different considerations.

Defining and embedding requirements

It is key that environmental and broader sustainability requirements are made central to project planning at the outset.

Sustainability requirements may take into account a wide range of indicators including in relation to the selection of construction materials (eg, responsible sourcing and reductions in embodied carbon), waste management strategies (eg, as re-use, recycling or safe disposal of waste materials), efficiency and other aspects of operational performance (including emissions) and broader environmental and social sustainability indicators (eg, local resourcing, suitable labour and working conditions).

Specific requirements are likely to be determined by factors such as the nature and location of the project (including compulsory legal requirements), the identity and experience of the client and its funding strategy (eg, there are some prevalent requirements of multilateral development banks such as the IFC’s Performance Standards on Environmental and Social Sustainability and the 4th Equator Principles).

Where innovative solutions are required, clients may decide to engage with suppliers before tender to explore what is likely to be achievable and deliverable, by whom and when. Outcomes of early engagement can then be taken into account in project planning. For example, restrictions on budget may steer towards intermediate guaranteed outcomes, with competition, innovation and incentives used to encourage achievement of ‘stretch’ targets.

A key factor in achieving successful outcomes will be that requirements, once established, are embedded within the overall procurement process, from tender evaluation to delivery.

Integrating design, construction and potentially operation

A key challenge in many projects is ensuring that the constructed asset meets and sustains the relevant environmental and other performance standards set by the client’s initial brief. A division of responsibilities or a failure to cooperate between designers and contractors can exacerbate this.

In the authors’ experience, conventional models of contracting may not best facilitate a ‘whole life’ approach to optimising performance and other characteristics during operation as well as during construction. For example, traditional procurement with a separation of design and construction provides the employer with close control over design but potentially reduces opportunities for early buildability input from the construction team. Design and construction (including turnkey) contracts that place responsibility on a single contractor should enhance coordination between the design and construction teams, but the ability of the employer to influence the design process is likely to be reduced.

By contrast, a design, build and operate/maintain model may provide greater incentives to optimise sustainability as all project participants should directly benefit from greater operational efficiency. Features of contract models that wrap construction and building/facility operation could include longer-term incentives to help ensure that best available techniques and technologies are taken into account both in the initial design and at appropriate stages during the life of the asset.

Design competitions

Design competitions may be used to secure innovation in procurement. On major projects in some sectors, it is not uncommon for the employer to appoint two or more contractors at the front-end engineering and design (FEED) stage in order to secure alternative design solutions, maintain competition until the commercial proposal is settled with the successful contractor and mitigate against
re-procurement risks.

However, design competitions can create challenges for employers and suppliers. For example, designers and suppliers will want their intellectual property rights protected. As a result, intellectual property rights protection and appropriate non-disclosure arrangements need to be in place from the outset. There can also be tensions in sharing ideas during competitive processes unless the unsuccessful bidder receives a genuine commercial share in the value of its innovative ideas. Where ideas developed by the unsuccessful bidder will be used by the employer, consideration needs to be given on both sides to any ongoing responsibilities or liabilities and the terms of ownership or licensing of newly created intellectual property rights.

Another important challenge is the balance between upfront investment in innovation and longer-term financial savings. There may be a reluctance from suppliers to produce fully developed and innovative ideas unless development costs are going to be fully reimbursed. By contrast, less developed ideas might save upfront costs but increase risk during construction and may also result in missed opportunities for whole life cost benefits. These are issues employers need to consider carefully at the outset of the project.

Early contractor involvement

Early contractor involvement (ECI) contracting is frequently adopted in a number of sectors in order to bring in appropriate expertise and to encourage collaboration and innovation within the supply chain as early as possible.

ECI should enable the supply chain to understand the employer’s requirements more clearly, identify optimum design solutions and, where applicable, innovative or more sustainable alternatives, while avoiding unnecessary abortive work or contractor-retained contingencies. Because suppliers can engage with the employer’s engineering team at an early stage, design development can be integrated with buildability and operability. Suppliers can gain a proper understanding of any approvals requirements and processes, and prepare a robust construction programme.

Important considerations for an employer will be to secure innovation where necessary, but also to avoid over-engineering to ensure that requirements are satisfied and targets are achieved while keeping within the agreed budget and programme. This may be managed in a number of ways, including structured fee or incentive arrangements and gateways for advancement or exit. It is usually critical for the employer to be sufficiently resourced and capable of monitoring work during ECI so that it can identify any unnecessary scope and risks, as well as any potential missed opportunities for improvement.

In the authors’ experience, some employers have been reluctant to adopt ECI due to concerns over losing negotiating leverage with contractors and losing the benefit of outside competition and innovation too early in the project. As a result, variants and alternative approaches to ECI have developed. For example, in an optimised contractor involvement (OCI), contractors may be brought in at a stage in design that is late enough for a competitively tendered target price to be obtained, but early enough for them to be able to influence buildability and value engineering.

Value engineering after contract award

A relatively simple and common arrangement to incentivise innovation in sustainable design and technologies might be to allow the selected contractor to share in reductions of development costs or savings in whole life costs stemming from any value engineering proposals accepted by the client and instructed as a change order (see, eg, the JCT and NEC contract suites).

Building information modelling

Building Information Modelling (BIM) is a collaborative process for producing, managing and sharing whole life asset information through common data standards and protocols underpinned by cloud-based technologies and systems. In simple terms, a person can upload information to a common data environment where it can be consolidated with information supplied by others.

From a construction and operation perspective, BIM should facilitate suppliers working together from an early stage to improve efficiencies in the design and construction process, achieve cost and programme savings and facilitate optimum whole of life asset management and performance. From a legal perspective, as an interactive multi-party process, BIM presents some potentially complicated challenges relating to: design liability and duties to warn in relation to consolidated models; professional indemnity insurance cover relating to consolidated models; protection of sensitive know-how stored in the cloud and integrity of data stored in the cloud; as well as software and accessibility risks relating to the cloud itself.

While the use of BIM is mandated for UK centrally secured projects and adopted by various clients in the private sector, in the authors’ experience, there is some distance to go before widespread interactive coordinated models are achieved. There are greater levels of electronic exchange and cloud-based information management, but BIM is still used primarily for data collection and detection of design clashes. It has not replaced conventional contractual processes relating to design coordination requirements and design review and acceptance procedures.

Supplier participation in the equity

One way to align interests and find efficiencies and savings in whole life costing of potentially capital-intensive innovation projects could be to invite key suppliers to have an equity stake in the project.

In theory, the interests of a supplier taking an equity stake should be more structurally aligned with the interests of the other investors and sponsors. The supplier should be encouraged to take actions beneficial to the project, including finding efficiencies and savings in whole life costing. The supplier might be willing to bear a higher proportion of its costs of tendering and development, and to provide stronger certainty and visibility at an early stage on capital expenditure. This would also apply to operating expenses if the contractor is also the operator.

However, there is also potential for conflicts of interest. First, suppliers may prefer a lower but earlier and potentially more certain cash return over a short period than a bigger but hypothetical return over a longer period. Second, as the sponsors are likely to be required to accept exclusivity on the letting of the relevant supply contract, it is unlikely there will be a competitive tender process. Third, some suppliers may not be willing to accept project risk in the long run and could add contingencies into their prices to cover the risk of equity loss. This is sometimes regarded as a reason for limiting suppliers taking equity to a relatively minor interest.

Encouraging innovation beyond design

The identification and application of innovative solutions does not need to end once any applicable technology is selected or design is finalised. Construction contracts can be, and often are, prepared in a way that incentivises suppliers to go beyond initial design or minimum targets.

Key performance indicators and incentives

Provided they are achievable, key performance indicators (KPIs) with incentives can be a powerful motivator for achieving successful outcomes, including innovation necessary to achieve a step change in performance.

Incentive arrangements are often used to encourage cost efficiency, programme milestones, safety levels, quality (by reference to rates of occurrence of defects) and, where applicable, improved levels of performance and efficiency in operation. Incentives will be more attractive to employers, and more likely to be acceptable to funders, if they are self-funding, effectively financed out of the employer’s unspent contingency budget.

Collaborative contracting models

Projects requiring a higher degree of innovation may need alternatives to fixed price lump sum contracts. A fixed price may not be economically efficient where innovation is required or work is less defined. Fixed price risk transfer is also often associated with adversarial behaviours underpinning a culture of claims for increased costs and extensions of time. A target cost or cost reimbursement model (with risk/reward) may produce better value for money and behaviours.

A target cost contract is a cost reimbursement arrangement (plus contractor’s overheads and profit) which aims to incentivise a contractor to complete work within time and budget. If the contractor fails to do so, it will bear a proportion or the ‘pain’ of any excess outturn cost but, if it succeeds in completing the project under budget, it will share the ‘gain’ of any savings with the developer. This should offer advantages to an employer as there will be less risk to price in the contract while incentivising the contractor to find ways of making construction processes efficient, keeping costs down. The absence of price certainty, however, may be less satisfactory to projects looking for limited recourse project finance.

More incentivised contracts go further than target cost contracts in seeking to align the interests of the employer and supply chain. Under a target cost contract, a contractor may still look to make claims (to secure relief from liability for delay and increases to the target cost to avoid pain share), and view additional returns on cost savings only as a secondary consideration. If there is a cap on the contractor’s pain share, a target cost contract becomes cost reimbursable above the cap.

While there is no ‘one-size-fits-all’ model, contractors engaged under incentive contracts are typically reimbursed actual costs under a transparent payment model. However, rewards (profit and corporate overhead) are earned mainly or wholly through achieving successful outcomes against various indicators rather than simply as a function of increasing cost. Rewards are maximised by a higher rate of return on incentives rather than by compensation events giving rise to additional permitted construction costs plus margin. Incentives could be set up to reward achievement of stretch targets in operation, as well as to find productivity and other efficiencies to drive down outturn cost and reduce programme costs.

Some employers on major projects will look at ways of encouraging innovation and collaboration across contract or programme lines in order to achieve overall project requirements. One option is to use a strategic alliance framework between the employer and its individual key contractors, under which participating contractors are entitled to additional incentive payments if overall KPIs are achieved. Incentives might be funded from the employer’s unspent project-level contingency, plus the employer’s share of savings against any unspent contract-level contingencies.

Another model is a pure alliancing structure. Pure alliances are quite different to other contract models, with a collective approach to risk ownership, management and delivery, and exposure to collective performance. They represent a holistic approach to procurement where the team comes together under a single contract to deliver a project jointly, with common goals and shared risks and rewards on a mostly ‘no claim, no blame’ basis. Crucially in an alliance, achievement of successful outcomes may take into account the effect on all participants, including the client.

An example of innovation in practice: ‘state-of-the-art’ technology

Technology continues to evolve and has been identified as key to supporting the energy transition and driving innovation and improvements in sustainable construction. New technology can come in all shapes and sizes. For example, in the offshore wind sector it may range from new gearbox components to larger turbines or floating foundations.

Using ‘state-of-the-art’ technology

For employers, there are a number of issues associated with using new technology. For example, new technology often needs to be certified by an independent third party (eg, DNV-GL) as conforming to international standards. This will usually be a requirement of insurers and any lenders. Third-party certification may take time and has the potential to delay the commencement of construction. There may need to be closer definition and control over interim milestone payments so that the employer and other stakeholders can be satisfied that progress towards a successful outcome is being made.

As well as using new technology, employers may be looking to secure the benefits of product improvements and may want a right to be informed of advances in technology. Furthermore, proprietary or ‘black box’ know-how, including source codes and spares, may need to be protected by escrow arrangements so that it can be accessed in the case of insolvency of the supplier or withdrawal from the market.

While suppliers will usually be expected to provide a commitment to use good industry practice, they may be reluctant to accept strict fitness for purpose obligations and may require additional exclusions from liability (including regarding performance guarantees) or, possibly, lower-than-usual caps on liability. A provider of new technology may be able to rely on ‘state-of-the-art’ defences in defence of liability for negligent design or product liability. In the UK, the standard of care in relation to design depends on what was expected of a competent designer at the date of the design. However even pioneering designers have to be prudent. In Independent Broadcasting Authority v EMI Electronics Ltd and BICC Construction Ltd,^[4] the court held that even though the design and construction of a cylindrical communications mast was ‘both at and beyond the frontiers of professional knowledge at that time it was still incumbent on [the designer] to exercise a very high degree of care’.

Providing a ‘wrap’ of technology and design

Various issues can arise where an employer requests a ‘wrap’ providing single point responsibility for design, construction and performance. A main contractor asked to ‘wrap’ third-party design or technology will need to consider factors such as whether technology is ‘black box’ or open access, if there is any relationship or track record between the designer or technology provider (either positive or negative), and whether the employer will provide the main contractor with direct recourse to the designer or technology provider, for example, by way of novation or warranty.

In some cases, a main contractor may only be willing to accept a partial risk transfer, particularly where design or technology is not proven or if there are extensive exclusions or limitations of liability in the relevant FEED agreement or technology licence. A partial wrap may involve the main contractor being liable for performance guarantees, liquidated damages and defects attributable to proprietary technology failures only to the extent that it can recover from the technology licensor, that is, on a ‘back-to-back’ basis. However, employers may look to give the main contractor the burden of proof that failures stem from the technology. They may also look for a full risk transfer in respect of any open-access information and in relation to the structural integrity of physical works.

An example of innovation in practice: offsite and modular construction

‘The Farmer Review of the UK Construction Labour Model: Modernise or Die’,^[5] published in October 2016, concluded that the UK construction industry would face ‘inexorable decline’ unless it embraced modern methods of construction (MMC). MMC is a significant component of the UK government’s recently published ‘Analysis of the National Infrastructure and Construction Pipeline 2021.’

One area that has been embraced is offsite and modular construction, for example, assembly of turbines for offshore wind farms and production of units of modular construction for buildings. Offsite processes differ from traditional construction, which focuses on design followed by works onsite. Perceived benefits include improved efficiency and productivity (with significant potential for replication), reduced margin for error, reduced environmental impact (including carbon emissions and waste) and, as a result, savings in programme and cost.

There are various contractual and risk matters to take into account with this method of construction. For example, the proximity of the offsite facility to the development site will have a bearing on project cost and environmental impact, and not all projects will be compatible with the use of ‘off-the-shelf’ rather than bespoke products. As demand increases, capacity may also be an issue.

Because more work takes place off-site, suppliers are likely to need greater levels of payment before delivery of plant and materials to site. This can raise issues as regards security of payment as well as ownership of plant and materials. If the construction site has the ability to house a logistics centre or temporary factory, some of the risks of early payment can be substantially mitigated.

Depending on the approach taken, some elements of work may be procured separately from the modular components (eg, foundations in a wind farm project). In these circumstances, it will be necessary to ensure that design and programme are coordinated effectively and interface risk is properly managed. Generally, design decisions need to be settled at the outset of the project, and quality management and testing procedures (including during manufacture) are crucial to ironing out interface issues, improving structural integrity, durability, future maintenance planning and the safety of the finished build. Interface issues can drill right down to the smallest of component parts in order to mitigate the risk that, at worst, defects only come to light when the relevant unit arrives on site.

Robust quality management and assurance procedures are likely to be key to satisfying insurers and any lenders or purchasers. While there is significant scope of improvements in quality and construction processes, insurers in particular may perceive greater risks with offsite and modular construction, such as greater risks of serial defects and/or the need to remove modular units giving rise to more expensive costs of reinstatement relative to traditional builds.

Concluding remarks

It is apparent that a shift in the practices adopted by the construction industry is required to support the energy transition and a move towards more sustainable development.

There is increasing focus on embedding appropriate sustainability indicators in procurement processes in order to drive and unlock potential environmental and economic advantages.

Opportunities for improvements will be maximised by challenging or disrupting traditional or established practices and rewarding innovation.

Economic stimulus packages can encourage investment, but there are inevitably constrained budgets for capital investments as well as operating and maintenance expenditure. There is, therefore, a challenge to find the right balance between potentially substantial upfront investments in delivering innovative and sustainable development and the financial savings and wider benefits that could be achieved from those investments.

Based on our experience, employers and contractors alike are increasingly engaging in the climate change debate and developing new ways of thinking. Ultimately only time will tell whether the construction industry is willing to adopt the strategies necessary to achieve the overall goals.

James Doe is a partner at Herbert Smith Freehills in London and can be contacted at james.doe@hsf.com. Tim Healey is a partner at Herbert Smith Freehills in London and can be contacted at tim.healey@hsf.com.