Contingency Management for Megaprojects by the trimountaine group llc
The global infrastructure community is faced with daunting challenges. Various reports from the OECD, the World Bank, and various consultancies suggest that between $50 and $80 trillion will need to be spent by 2025 on major infrastructure projects in order to meet demand. Not only will the global community be challenged in financing those costs, but the individual projects will be larger and more complex than anything done in the past.
China, for instance, has plans to develop a $36B underground rail link between two major ports that will run twice the length of the English Channel. In addition, the country has development designs on water projects that could exceed $80B as well as the world's longest gas pipeline, the world's largest airport and a new deep water port in Shanghai estimated at over $18B.
Gone are the days when Megaprojects (those costing more than $1B) seemed complex. Today's challenges are on a "Gigaproject" scale.
Managing the complexity of these gargantuan projects is the critical challenge facing sponsors and contractors. And controlling risk will be a crucial part of any success.
Risk mitigation comes at a cost, though. Due to the size and scale of these projects, it is not enough to simply focus on reducing the risk. Projects must simultaneously reduce the cost of controlling that risk.
This effort is called Contingency Management, and reflects the needs of the project to simultaneously reduce exposure to uncertain events while not overpaying for such risk measures.
To be clear, we refer here to the total contingency in the project, and not merely the amount formally set aside for uncertainties. Total contingency consists of a number of different risk measures, including:
- Project contingency
- EPC risk premiums
- Estimation rounding
- Managerial reserves
- Internal risk resources
- Project controls
- Escalation factors
- Increased project financing costs
Trimountaine research suggests that the total contingency amount included in a project estimate may be as high as 30-40% of the total cost of the project.
Contingency management consists of two primary functions:
- Normalize the total project contingency
- Reduce the financing cost of the contingency
In normalizing the project contingency, managers have the dual responsibility to both establish that the individual contingency components are properly developed while ensuring that there is no overlap in risk coverage between contingency elements.
A step-by-step process is needed to adequately identify and quantify the different contingency components. This often begins with a holistic evaluation of needed project contingency (thru the use of such tools as Reference Class Forecasting or Monte Carlo Simulations) before getting very specific into the friction points and risk premiums embedded in project contracts, engineering take-off lists, and financing documents.
Note, it is important for projects to look at the overall risk, and not merely the risk held by any one entity. Often, substantial savings may be found by reallocating risk to parties that can finance that risk more efficiently.
Once the contingency analysis has been completed, projects are then able to determine the most efficient way of financing the needed risk controls. There are five primary parties that can hold or manage some part of the total contingency. Determining which party should hold what risk is an evaluation that depends on both the entity's capability to control the risk as well as their ability to finance the excess exposure.
For instance, a contractor may be best suited to manage the procurement of steel for a megaproject. And it may be tempting to assign cost overruns due to steel to the contractor. However, if the cost overrun is due to a spike in steel prices on the global market, then the contractor is in no better position to manage that risk than anyone else. Rather, that risk may be better suited for a third party (such as an insurer) to manage.
Each of these parties not only has a different tolerance for risk but has different risk financing vehicles available to use. For instance, equity participants may elect to establish a capital reserve or a contingent capital fund instead of forcing the contractor to hold certain contingencies on their balance sheet. How the debt market would react to such a reserve would help to quantify the potential benefits of that risk allocation.
Similarly, governments engaging in Public Private Partnerships (PPP) may elect to provide certain overrun guarantees to solicit private financing participation in the project. This would be an instance where certain risks have been pushed back onto a customer.
Recognizing the available vehicles to finance the risk control is equally important. In addition to contractual guarantees, projects have access to capital market derivatives, overrun insurance, contingency captives, capital reserves, contingent capital, and a host of other options. And newer solutions to manage these risks are being developed quickly to address project needs.
The Trimountaine Group has found that efficiently financing contingent risk can lead to tangible cost savings of 12 - 18% of the project budget.
Contingency Management is a critical step in any project's efforts. For today's mega (and giga) projects, though, these efforts are doubly important. Inefficient risk financing can end up costing the project hundreds of millions of dollars.
For more information on The Trimountaine Group and our methodologies and capabilities, please feel free to reach us at
66 Essex Street, Suite #2, Salem, MA 01970
(617) 899 1299