Over the next two years £60bn of construction spend is due to be procured by regulated utilities. Getting the procurement strategy right is critical. Simon Rawlinson of EC Harris looks at the options
01 / INTRODUCTION
The commencement of procurement of capital works programmes for gas and electricity distribution under a new regulatory framework, RIIO, has signalled the start of a comprehensive re-procurement of construction and maintenance spend by the UK’s utility companies.
These programmes of work present opportunities for contractors to secure long-term workload. The supply chain will be required to raise its game in responding to complex procurement need and aligning delivery and route to profit. For utility companies to get supply chains to contribute to their success, packaging of work, programme management and the setting of incentives are critical.
The acronym RIIO (Revenue = Incentives + Innovation + Outputs) summarises the priorities of the new regulatory landscape - attracting investment and management skill into utility supply at a reduced cost to the consumer: revenue will be used to drive incentives, innovation and outputs.
Between now and 2020, the UK’s water, electricity and gas transmission and distribution industries, are likely to spend £60bn on maintaining and improving their networks. Transport spending on rail, roads and airports is expected to total at least £70bn over the same period. The volume of re-procurement is unprecedented, involving over 30 separate utilities competing for programme delivery expertise as well as conventional delivery capacity.
The challenges set out in RIIO, will also affect the water industry in their future settlement. They focus on the measurement of utility company performance through outcomes: rewarding outperformance with the opportunity to earn higher returns, and penalising under-performance with a reduced income. Outcomes against which performance is measured include customer satisfaction, reliability and availability rather than outputs such as the delivery of an investment programme. These outcomes have to be delivered against a cost reduction target. In addition to improved revenue, it is anticipated that a high (frontier) regulatory score will be received well by funders, leading to reductions in the cost of a utility’s capital, creating further opportunities to increase profitability. Poor performance will have the opposite effect.
Shortfalls in the delivery of either construction or asset maintenance could expose the client to revenue and reputational penalties. As a result, with contractor performance having a greater potential impact on the client’s regulated return, then the design of the strategy and selection of key partners has become more business critical. Current arrangements are unlikely to drive these new behaviours, so new solutions are needed.
02 / COST EFFICIENCY AND WIDER PERFORMANCE CHALLENGE
Challenges around improved efficiency and cost reduction are a key feature of current regulatory settlements, many of which were negotiated in 2008 at the height of the last boom. Cost reduction and efficiency targets in excess of 15% were common in the AMP5 final determination. The effects of construction deflation and higher than expected operating cost inflation have blunted the regulators’ efficiency drive. Regulators will continue to apply pressure on price levels into the next control period - with significant consequences for the supply chain, which will need to deliver at the lowest cost possible to meet these targets.
Utility companies face other challenges too - the ageing of their specialist workforce could, for example, result in skills shortages, while the growing importance of asset maintenance will require investment in data, new joined-up ways of working and new technical capabilities.
Early price determinations - for gas distribution for example - provide clear evidence of the future cost challenge, requiring an average reduction in cost allowances of 17% compared to company business plans. Given that market prices are at rock bottom, managing future cost escalation will be a priority.
In addition to cost challenges, suppliers under the new frameworks need to respond to three further changes in the client’s business environment:
- Regulatory focus on outcomes, not outputs Company performance will be measured on aggregate outcomes such as improved water quality rather than the completion of a capital investment. Output thinking is expected to help optimise spend across programmes by moving thinking away from a project-by-project mindset. Contractor incentives must align with this approach.
- Capital maintenance A growing proportion of total capital spend will focus on maintenance of existing assets, totalling £30bn in the period to 2020. Integration of asset management with project delivery should be a key aspect of clients’ performance improvement planning, together with the development of management regimes to risk-assure ongoing serviceability. Planned inspection regimes should aim, for example, to enable assets to be run at the lowest cost consistent with acceptable and predictable performance levels.
- Customer satisfaction Customer satisfaction key performance indicators are now an important element of the regulatory incentive. Procurement strategy will need to align the contractor’s performance with the regulator’s performance model, rewarding more than just good project delivery.
Taken collectively, investment into utilities will remain high, but costs will be under even greater pressure. Workload will often be fragmented, so will benefit from being delivered as a programme. The outcomes of the investment will also be measured collectively, mainly through metrics such as availability and customer satisfaction. Success will depend not simply on the volume of work done, but the selection of work to optimise impact and to minimise waste.
For utility companies, developing and implementing the right procurement strategy needs to be a business priority. This means understanding the market, devising a solution that aligns with the business and sector, and creating interest through market engagement. For the supply chain, an appreciation of new priorities and a positive response has the potential to open up opportunities to share in the continuing success of clients in the utilities sector.
03 / EFFECTIVE DELIVERY OF KEY BUSINESS OUTCOMES
Looking forward to future settlements, the main objective of a utility company’s procurement strategy should be to align as effectively as possible the delivery of future capital expenditure with business need and the priorities set by the regulator. Business need describes the full range of outcomes that need to be delivered, in terms of customer requirements, availability, business performance, risk transfer and regulatory outcomes.
The workload required by utility companies inevitably varies in accordance with the condition of the network and growth in demand for new capacity. Typically the key elements of a programme will relate to the following outcomes:
- Asset maintenance Work required to keep the network operating at an agreed level of performance, managing workload effectively so that only necessary work is undertaken at appropriate frequencies.
- Performance enhancement Work required to improve network performance. In water this might involve investment in plant or network capacity to address water quality or flooding risk issues identified in the business plan.
- Supply demand Installation of new capacity in response to new sources of demand and requirements for connections related to new development.
- Customer service Improvements to customer services including right first time delivery and faster response times.
Services delivered by contractors may also cover emergency response, although these services are often managed in-house.
Different elements of workload such as asset maintenance or the construction of new capacity typically need different approaches to delivery.
A high proportion of asset maintenance work is well defined and predictable, potentially leaving plenty of opportunity for efficiency gains through volume purchasing and scheduling.
However, with major plant also requiring upgrades or equipment replacement, there remains potential for high complexity and risk in maintenance works. By contrast, works associated with enhanced network performance or new capacity potentially have a much more varied scope - particularly as delivery teams will be encouraged to identify different ways of achieving the desired outcome.
This diversity in workload underlines the clients’ need to access a varied supply chain, and points towards the growing importance of programme management as a means of optimising the end-to-end capital spend process.
It is widely recognised that the separate delivery of individual projects, however large and complex, is likely to result in sub-optimal business outcomes. Programme-wide management approaches, ideally aligned with business need, are a far more effective way of ensuring desired outcomes are achieved, particularly with the many hundreds of individual contracts that a utility client will let over a regulatory period.
The key elements of programme management function - whether in-house or delivered externally - are as follows:
- clear management accountabilities for the end-to-end delivery of the programme, taking into account links and dependencies with other parts of the business, particularly in connection with asset management and customer facing functions
- integration of programme-critical business functions into the delivery process, such as stakeholder engagement in the option development or approvals processes
- investment selection on the basis of the best combination of outcomes - performance, safety, risk and profitability
- programme-wide change and risk management - reducing overall risk allowances and managing the impact of change across the portfolio
- programme-wide supply chain strategy - supplier engagement, project allocation, aggregation of spend, optimised scheduling of work and application of the incentive mechanism
- progress reporting based on KPIs related to business need and incentivisation.
An increasing number of utilities clients are securing benefits from the adoption of a programme-based approach to delivery. Programme management does involve an extra layer of management which is necessary to align project delivery with wider business needs, but which will be offset by downstream benefits.
The challenge is to achieve the optimum allocation of roles below the programme level - giving the supply chain the flexibility that it will need to bring innovation and efficiency to the delivery of the capital programme.
04 / KEY COMPONENTS OF THE PROCUREMENT STRATEGY
The development of a client’s procurement strategy will be affected by a number of constraints including public procurement procedures, available time, the client’s organisational capacity and capability, and the amount of effort required in business planning to establish the agreed investment programme. The timing of procurement relative to the regulatory price review will determine the extent to which the supply chain can contribute to, and buy into the business plan.
In previous cycles, the main objective of the procurement strategy has typically been to meet public procurement statutes, to secure resources and to access delivery partners through framework arrangements. Plenty of benefits have been secured. However commercial incentives have not always been successful in motivating a shared focus on cost reduction and other positive outcomes. Root causes include fluctuating workload and under-utilisation of capacity. Similarly, the inconsistent application of price competition has affected contractor alignment.
A key issue in connection with cost reimbursable contracts is that pain/gain share mechanisms can create perverse incentives - focusing the supply chain’s attention on the margin associated with delivery of the target price rather than the gain share associated with outperformance.
As clients approach their new frameworks, they will want to secure enhanced governance and control, greater collaboration across the supply chain and more effective incentivisation. Further opportunities to drive down cost and increase efficiency will also need to be pursued, including “delayering” on-costs within the supply chain or by avoiding duplicate work by consultants and specialists.
Based on lessons learned from current frameworks, there are key areas where improvements in performance can be made.
Determining the client’s role The regulatory model is encouraging a joined up response from client and supply chain. In determining the procurement strategy, the client must determine how involved it needs to be to ensure that business needs are met and the regulatory incentive is not compromised. There are a number of models of client engagement, including the “intelligent client”, the “thin client” and the engaged alliance partner. Clients also have different levels of direct involvement in delivery via Direct Labour Organisations (DLOs).
The key elements that the client should ideally own include:
- Owning and articulating the critical success factors for the programme
- Designing and managing the performance system
- Owning the relationship with the regulator and end user clients
- Managing the programme.
An important lesson learned is that clients also need to get out of the way to enable the supply chain to maximise their contribution to performance improvement. Standards or approval processes that interfere with the operation of the delivery team are counter productive - and should ideally be removed.
Alignment of work content and business need
Optimising programme content and costs from the perspective of the full range of stakeholders is typically a client activity. It will only be effective if the client has a clear understanding of the asset base, cost base, cost drivers and opportunities for improvement.
Packaging the workload
“Chunking” a programme of work into the right streams to attract supplier interest is an important competitive enabler. Workload can be split by geography, by asset type or by the nature of the contractor selection process. “Chunking” may result in the identification of opportunities for specialist second or third tier supply contracts to be placed in advance to secure volume savings. Once contracts are let “feeding the machine”, or maintaining a steady flow of work, is a vital client role.
Securing capability and capacity
Capacity is less of a concern than it was when frameworks and alliances were last procured in 2008/9. However, with major infrastructure investment in transport and energy coming on stream, management capability is expected to command a premium. Programme management, outcome assurance and delivery innovation are likely to become supply chain differentiators. Investment by clients in market research, supply chain awareness and capacity building will be a critical activity - particularly with over 30 utility companies competing for high level contractor support and input.
Setting price levels and/or price targets
Given efficiency targets set by the regulators, the determination of price levels will be a critical aspect of the procurement. With cost reimbursable contracts likely to remain the preferred commercial mechanism, the client’s ability to set realistic and challenging target costs will be critical, relying on a thorough knowledge of cost drivers, together with opportunities for greater efficiencies such as offsite manufacture, and asset data capture through BIM.
Setting the incentive model
Appropriate incentives are at the heart of the procurement challenge, as current mechanisms have been found to be wanting. As an alternative, high level performance measures related to client KPIs have been found to be too remote and as a result could be ignored in the contractors pricing model.
In the next review period, incentive mechanisms that establish back to back links between the client’s performance rewards and contractors are likely be very common, but will need to be proportional to secure contractor interest, meeting key criteria around cash generation and consistent workload for example, as well as levels of profit. The zero profit model for example, where all margin is linked to performance rather than output is new and realistic but will need to be applied very carefully. Crucially, incentive schemes have to be believable, as the worst outcome for a client would be for unstated margins to be built into the supply chain’s project pricing model.
05 / TYPICAL PROCUREMENT OPTIONS
This section sets out three typical models that are often considered as the basis for a performance-driven programme delivery strategy. Individual contracts and selection processes will still be required to allocate and manage specific projects.
Alliances are fully integrated project teams, under direct client control. Roles within the alliance may be undertaken by the client’s employees or by members of the supply chain. As inputs are difficult to disentangle, work delivered by an alliance is typically contracted on a cost-reimbursable basis, with a pain/gain share. Construction risk is usually retained by the client.
The key benefit of the alliance approach is the client’s direct involvement in project development and delivery, and the encouragement of collaborative working.
Other benefits of an effective alliance include the ability to collectively develop a complex project scope, easy incorporation of client direct contracts and ready integration with operational teams. Alliances typically require a high level of client involvement, in staffing, management and provision of facilities such as office space and IT. Alliances have a successful track record in highly complex transport and oil and gas projects and have been adopted by some utility clients.
On outcome based projects, the key challenge is an effective incentive mechanism, as the client’s close involvement in management will make it difficult to pass performance risk into the supply chain.
Frameworks are pre-qualified contracts for design, delivery and maintenance services. Frameworks can facilitate integrated solutions or single appointments. The main purpose of frameworks is to secure capacity and to simplify procurement, enabling contracts to let on a call-off basis. Work undertaken on frameworks can be priced either on a cost-reimbursable basis, or can be competitively tendered. The contract and the risk transfer can be chosen to suit the needs of the project. Frameworks are well established across the public sector and are increasingly associated with collaborative ways of working. With appropriate incentive mechanisms, frameworks could be used to deliver outcome based projects. The key issues associated with the use of frameworks include assurance of workload and the definition of the client’s role in managing a programme of works. Frameworks could complement the activities of an independent programme manager.
3. System integrators
A system integrator is a contractor employed to integrate design and construction works, taking a high level requirement and delivering completed projects which meet the client need. The system integrator is responsible for project management, design, procurement and management of construction. Contractual arrangements and payment mechanisms can be varied to suit the desired risk transfer. The key benefit of the system integrator approach is the allocation of key management roles to the supply chain - encouraging integrated solutions to complex project requirements, leaving the client to focus on defining business need. System integrators could readily be tasked with responding to outcome based requirements, with appropriate incentive mechanisms being put in place. However, a client will need to establish a programme management capability to integrate the activities of a number of system integrator roles.
06 / SUMMARY
A utility’s capital programme delivery strategy has become a more business critical arrangement under new regulatory settlements, and current procurement options and incentive structures are unlikely to deliver the performance required.
Given the peak of activity associated with the regulatory review and fixed timescales associated with procurement regulation, utility companies could find themselves in a race against the clock if an early start on planning and business change is not made.
Utility clients also need to manage their transition to new frameworks, services and roles. Planning for handover and closedown of existing contracts must also be a key element of the strategic plan.
Thanks to Greg Bradley, Steve Bromhead, Dennis Geary and Terry Povall for their contributions to this article