Why clients need carrots

Despite the Egan recommendations and a clear lead from the government’s procurement system, too few clients consider the potential benefits of the carrot of positive incentivisation as well as the stick of delay damages. To achieve Egan’s 20% increase in the number of projects completed on time, clients will have to expand their methods of enticing contractors.

This is particularly true now that the Construction Act has removed the client’s biggest stick – withholding all payment until practical completion. For contract periods of more than 45 days, contractors have a right to interim payments. However, there is nothing to stop clients in a strong position requiring contractors to agree to an initial payment of £1 and the balance on completion. More realistically, clients often link interim payments to milestone or staged completion dates, possibly combined with a right to claim damages if the contractor fails to meet a milestone.

Beyond this, clients still have the strong incentive of penalising contractors’ delay with general or (more commonly) liquidated damages. However, liquidated damages do not make a good stick for three reasons. First, because clients cannot arbitrarily set them at a financial level that forces the contractor to complete on time, but must pre-estimate their loss for the delay. This may be financially significant for commercial buildings with a high projected rental income, but a local authority client will have only nominal loss if a public library is delayed.

Contractors may choose to incur the liquidated liability where this is likely to be less than the additional expenditure required to meet the completion date

The second reason is that contractors may choose to incur the liquidated liability where this is less than the additional expenditure to meet the completion date. Finally, where pre-estimated losses produce large liquidated damages compared with contractors’ slim profit margins, contractors will spend considerable energy in claiming extensions of time to avoid cutting into these profits. Encouraging contractors to redirect these efforts into making up lost time or finishing early, albeit at the price of a financial incentive, has to benefit both parties.

The government is taking the lead in this as clients such as the Ministry of Defence and the Highways Agency introduce contracts that balance liquidated damages with positive incentives to complete on time and to budget. Some modern standard forms also include bonuses for early completion, which do not depend on the client and the contractor agreeing to accelerate. Both acceleration and bonuses often take the form of a liquidated savings share, which splits early completion savings between the client and the contractor with none of the legal limitations of liquidated damages clauses. If large liquidated damages represent a genuine pre-estimate of the client’s loss on, say, lease revenues, it may be financially worthwhile offering the same sums as liquidated bonuses for early completion.

The final incentive is the most radical – rewarding contractors for mitigating events that are at the client’s risk. For example, clients may find it worthwhile to offer contractors additional payment to complete on time following an event that would otherwise entitle the contractor to an extension. Significantly, the NEC, used in several “best practice” projects, allows contractors an extension on their accelerated completion date following a compensation event, even if the contractual completion date will be unaffected. If clients combine this with the optional bonus for early completion, contractors have a real incentive for mitigating compensation events.