Construction is now 12 months into its recovery and project procurement has become much more challenging - even in the regions. SImon Rawlinson of EC Harris takes soundings from projects and considers the best options in a fast-moving market
If there is one UK industry that is currently riding the crest of the recovery, then it is construction. With output up by 4.8% year-on-year, the industry is growing far faster than the wider economy, albeit while recovering from a much deeper contraction. Forward indicators of activity point to continued expansion of workload, with the widely read Markit construction purchasing manager’s index (PMI) pointing to much better growth prospects for construction than either manufacturing or services. With the PMI index standing at levels not seen since autumn 2007, some worrying parallels to the previous boom are emerging - particularly with respect to resource availability and the viability of projects. It is increasingly clear that the market is entering a period of high volatility - just as a raft of complex, high-quality schemes are coming to the market both in London and the regions. Resolving the interests of suppliers who need to secure profitable work, and clients who are focusing on achieving certainty on their projects is never easy but, at this point in the cycle, good execution of procurement strategy is playing a crucial role in setting up projects for success.
For once, construction has not been the last sector of the UK economy to come out of recession. The recovery, now into its fifth quarter, could not have come a moment too soon, evidenced by weak financial performance across the sector. However, the damage inflicted by six years of downturn - in terms of workload, employment, insolvency and profitability will be long-lasting. What might have been a steady recovery has been ignited by the housing boom which has seen extremely rapid rates of growth during 2013/14, even if actual workload remain 35% below the peak seen in 2007. The housing boom itself has had three key impacts which will help to determine the shape of the recovery: Firstly, growth has occurred in a sector which is less price sensitive than others, such as retail or the utilities, due to rapid house-price inflation; secondly, the scale of projects in central London has absorbed a great deal of contractor and materials capacity; and thirdly, the legacy of residential projects delivered at rock-bottom prices during the downturn is a highly risk-averse approach on both sides of the contract. These factors are combining to make project delivery even more challenging as the recovery gains pace.
How market conditions evolved during the downturn
The UK construction industry entered the 2008 crash after a sustained period of expansion in activity. However, project profitability had been eroded for both clients and contractors by general inflation, the global commodity boom and the collapse in the value of the pound. When the downturn came, goodwill in the industry was in short supply and many clients relied on taking full benefit of changes in market conditions to ensure that their projects remained viable.
From the peak of the market in the first quarter of 2008, volumes of work fell by 20% in a year. Construction prices initially fell by 10% by the end of 2008 and eventually stabilised at around 25% below peak price levels. Taking into account background inflation in wage agreements etc, by the time the recovery took hold prices were at a discount of around 35% to 2008 levels. Employment fell by at least 15% - involving the loss of at least 430,000 jobs, and over 20,000 business failures occurred between 2008 and 2013, which is twice the long-term rate of failure.
Many clients shifted quickly to procurement models based on variants of single stage, lump-sum design and build contracts. Initially, these projects were relatively easy to procure, with main contractors being able to secure deep discounts from throughout the supply chain. However, as the downturn continued projects became progressively more difficult to resource and deliver. A round of main contractor profit warnings and restructurings in 2012 demonstrated how deep the problems had become, with some contractors submitting sub-economic bids to maintain turnover. As the market started to recover in mid-2013, the degree of competitive pressure on projects began to fall. However, it will still take at least another 9-12 months for contractors to work through the discounted jobs on their books.
In anticipation of a recovery in the market and in recognition of the limited capacity for bidding in the supply chain, clients began to change procurement strategies in 2012 and 2013. In the infrastructure and utilities markets, employers have been able to leverage their large long-term programmes to put in place performance-driven alliances and frameworks that align the commercial interests of the supply chain with that of the client. In commercial markets where one-off appointments are more common, a gradual shift to two-stage tendering has taken place - initially with elements of competition in the second stage, but more recently with a single main contractor and a competitively tendered second tier of specialist sub-contractors. Even based on the two-stage procurement model - which increases the visibility of specialist sub-contractors and which reduces abortive bid costs - projects in some markets are increasingly difficult to procure successfully. As a result, the effective promotion of projects by clients into their marketplace and the management of the design and procurement process by their advisors have taken a crucial role in securing bidder interest and certainty of outcome.
Developments in the past six months have shown that a set of commercial skills needed to deal with the uncertainty and ambiguity of two-stage bidding are being re-learned by a new generation of clients, consultants and contractors. For businesses that have grown accustomed to the apparent certainty provided by lump-sum tenders, the learning curve is proving to be steep. In particular, the second bid stage on some projects is being used by some bidders as an opportunity to test the commercial resolve of clients and their teams - their access to current, quality market data, ability to analyse complex submissions and willingness to challenge the supply chain’s proposals. Working through this stage effectively is essential so that projects remain viable and are established on a fair financial footing.
How market conditions have evolved during 2014
Most forecasters anticipated that the construction recovery would become firmly established during 2014, but, in reality, the change in market sentiment occurred far faster than many clients and their advisors expected. Specialist contractors in particular are increasingly confident about the strength of the recovery and the implications for their ability to secure favourable commercial terms on the projects which they selectively target. Key aspects of the evolution of the market over the past six to 12 months include:
- Speed of change in the marketplace. Clients have needed to adapt their procurement strategies rapidly in response to changed sentiment. Bid tactics that were acceptable 12 months ago such as two-stage tenders with competition between main contractors in the second stage are no longer acceptable to most bidders. Similarly, main contractors are finding lower levels of interest from their trade contractors. Early engagement with the supply chain so that there is time to tune the procurement strategy in response to feedback on commercial terms, timescale and the bid list is now essential.
- Increasing number of projects in procurement: The combination of a buoyant housing market and the sudden rush to deliver office projects for occupation in 2017-18 has created a level of demand for bidding resources that hasn’t been seen for many years. Long-standing projects that appeared to be well advanced in procurement are being overtaken by projects being brought forward at breakneck speed by clients who are absolutely focused on meeting a narrow window of opportunity. The range of capabilities beyond estimating that are required to complete bids means that contractors have to recruit multiple roles in order to expand their bid-team capability.
- Changes in client priorities: With the balance of power shifting decisively in favour of the supply chain, clients have started to change their priorities which is in turn having an effect on procurement tactics. Assurance of the certainty of project outcomes, particularly in connection with programme and the quality of finished work, has become crucial - especially in residential development, where successful delivery of the project to expected standards of finish is vital to assure the completion of forward sales. Clients’ increasing reliance on alternative sources of project finance involving joint ventures and private equity rather than bank finance has also introduced a range of project participants with a much greater interest in the assurance of project outcomes.
- Ability to resource design and procurement: Consultant teams have come under high levels of pressure to complete design to meet procurement programmes and are also facing challenges in resourcing their increased workload - particularly given a rapid expansion in front-end work on new commissions. Consultants’ ability to resource design is not always helped by a continuing tendency to default to complex, one-off solutions that are challenging to procure or construct in a resource-constrained market. Design management has become a critical discipline required to ensure that design programmes are realistic and are met - and that an appropriate level of design information is provided to bid teams. Incomplete or uncoordinated design and the reissue of information during the bid period can massively affect the confidence and level of interest of bidders on a project. With BIM becoming more widely adopted, the availability of experienced designers with appropriate BIM skills has the potential to be an additional constraint.
- Reduced levels of competition in the supply chain: Many clients have responded to the changed market dynamic by reducing the size of their bid lists, particularly for main contractors at the first stage bid. Reducing the list to three or four candidates that are known to have a strategic interest in the project and client relationship has helped to maintain commercial tension among main contractors. However, many clients have standing orders that require demonstrable competition in the second stage and this is proving increasingly difficult to secure - trade contractors are more selective in their bid targeting. Furthermore, with a number of main contractors having their own integrated supply chain, independent sub-contractors want assurance that their bids will be considered on a like-for-like basis before committing resources to a submission.
- Availability of market intelligence. As volumes of bids have grown, the ability of trade contractors and main contractors to provide well-considered market testing feedback has also reduced. This pressure is increasingly affecting the setting of first-stage budget prices by main contractors. Clients with established relationships with the supply chain are in a better position to secure this input - potentially through direct procurement of some sub-contract packages. However, few clients have a pipeline that is sufficiently large to guarantee a continuous stream of work to specialists. The knock-on effects of limited market intelligence include less certainty in cost planning, reduced levels of feedback to designers and less buy-in by main contractors into the client’s cost plan. In a rapidly evolving market, where competitive pressure is falling and where pricing levels are becoming harder to predict, direct intelligence from the supply chain has increasing value.
The combined effect of these developments has been to exaggerate some of the feverish aspects of market conditions even while workload levels remain significantly below pre-crash levels. This is not a universal state of affairs, and in some circumstances, it is possible still to let a project using single-stage D&B. These projects are very much in the minority though - even in the regions.
Clients and their teams have been used to working in a market weighted in favour of the employer and in some cases did not recognise the potential for the balance of power to shift quickly enough. At the same time, some bidders may be taking an overly-optimistic view of the strength of the recovery, which has resulted in a highly volatile tender market. Should some projects be delayed or cancelled due to funding or affordability challenges, then the market dynamic could see another dramatic shift.
Critical success factors for procurement in an upturn
Market forecasts currently indicate that construction activity will increase at around 5% per annum for the next three to four years. Although the volume of workload is not expected to reach pre-crash levels before 2017, a combination of large, complex high-risk residential and regeneration projects can be expected to sustain activity levels in all of the UK’s major construction markets. The implication is that, for the foreseeable future, clients need to be particularly proactive in the procurement of their projects. There are a number of steps that clients and their project teams can take to increase the likelihood of a successful outcome on their projects, including:
- Effective engagement by the client: The ability of the client and their advisors to understand and respond to the commercial drivers and motivations of their supply chain is essential - clients need to be firm and fair in their dealings with suppliers, recognising that sensitive issues will need to be resolved directly during the bid process if problems are not to be carried through to the construction phase. Clients increasingly have a critical role as an ambassador for their own projects: articulating their own needs, engaging directly with the specialist supply chain and setting the performance culture of the team.
- Assurance of design quality and completeness: The quality of a design and the effectiveness of its delivery during project procurement can have a critical impact on the attraction of a project and the commitment of the supply chain to the bid. The second stage provides an opportunity for a contractor team to assess the performance of a consultant team and to make any necessary allowances for risk around design complexity and delivery. With design responsibility being passed to contractors on many projects, the delivery of design to an agreed level of completeness is also a critical aspect of risk transfer. Furthermore, delivery to programme is vital for procurement timescales to be met, and for bidders to be held to their prices. In the current market, clients should anticipate having to take positive steps to assure both the design programme and design deliverables.
- Resourcing the procurement process: As the bidding market has become more challenging, the procurement process needs better resourcing - particularly if clients are required to demonstrate commercial tension in the second stage of bidding. This requires a proactive and fully resourced response from the successful first-stage main contractor, working closely with the client’s team in the preparation of bid documents and the assessment of returns. It is difficult for clients to precisely describe the inputs that will be required from the contractor to secure the desired second-stage outcome, but the need for a shared, open approach to package procurement - and buy-in to the client’s commercial targets are a vital foundation to the process.
- Disciplined change management: Two-stage procurement brings forward the involvement of the contractor team in design development and refinement, meaning that design changes introduced during the bidding process have the potential to delay financial close or to undermine the degree of risk transfer achieved through a fixed-price contract. Scope changes driven by incremental improvements to design should be discouraged as part of a wider, client-led project performance culture. In addition, where value engineering is required to deliver projects on budget, it should be applied consistently - so that there are no mixed messages to the supply chain with respect to either the project budget or the commercial discipline of the project.
- Balanced allocation of risk: An intelligent approach to risk allocation will make a major contribution to the attraction of a project. Particular areas where the balance can be modulated include levels of damages and the allocation of delay risk associated with third parties including statutory authorities. The separate procurement of enabling works contracts such as demolition, and basement construction provides further opportunities to reduce the main contractor’s risk exposure, while also creating a programme window for more detailed design and procurement work.
Procurement solutions for a rising market
- Many procurement options remain open to clients including negotiation with a single provider or options such as construction management, which give clients greater access and control over their supply chain. However, these options require clients to accept a higher level of commercial and pricing risk than what is acceptable to their funding partners or is permissible under standing orders. The commercial requirements of the contract, such as the administration of construction management may also be beyond the capability of the client. On the basis that two-stage tenders will continue to be the most common means of procuring large-scale projects, clients do need to consider the specific steps that they can take in order to present their projects to the market effectively. These actions will help to ensure that their bid process delivers an acceptable outcome by securing the right team, establishing a high performing project culture and meeting commercial targets. The key steps that clients need to take to ensure these outcomes include:
- Early engagement with potential bidders - ensuring a good level of interest and that their scheme is included in the bid pipelines of targeted contractors. Clients will need to trade on the attraction of the current project and the quality and visibility of their future pipeline to be able to secure their preferred bid teams.
- Using behavioural assessment techniques as part of the selection of key contractor partners. This approach was pioneered on the Olympics and has been adopted widely by utilities companies. The assessment enables clients to understand how well the contractor team will work in support of project objectives.
- Minimising the costs of early bidder engagement, to make the project as attractive as possible - for example, by reducing requirements for pre-qualification information which is likely to be already available from previous bid submissions.
- Providing assurance that the project will proceed - this may require assurances in connection with funding arrangements or critical target cost levels.
- Clearly articulating the bid process, client performance expectations and the required balance between cost, quality, programme and certainty of outcome.
- Demonstrating that bidders have a reasonable chance of securing the work at both main contract and sub-contract level. This involves not only keeping bid lists short, but also ensuring that they are “symmetrical” - so that all competing contractors will access a comparable supply chain and will have a similar level of overhead. Unbalanced bid lists reduce the level of competition within the supply chain rather than increase it.
- Investing in a high level of engagement in the contractor’s bid process. This typically involves the detailed definition of the contractor’s second stage bid activities as well as the encouragement of a proactive engagement by client-side advisors.
- Accelerating the procurement programme through the direct pre-procurement of enabling works packages, as well as the consideration of pre-purchase of materials with a long lead-in period.
- Increasing the level of client engagement with second-tier specialist sub-contractors through direct procurement. Reverse two-stage procurement involves the novation of separately appointed sub-contractors to the successful main contractor. Direct engagement is particularly suitable for sub-contracts which require a high level of design input that may need to be funded through a pre-contract services agreement.
- Assuring the quality of second-stage design deliverables - which requires the performance management of design, based on a clear definition of output requirements and roles and accountabilities - as well as the formal review of design completeness prior to issue.
- Amending commercial arrangements to make the project attractive to specialist sub-contractors. Measures including advanced lump-sum payments or accelerated payment during the contract have acted as a strong incentive to the supply chain, albeit backed up with bonds to provide the client and funders with appropriate security.
- Assuring the financial stability of the second tier supply chain - through thorough financial vetting and also through the assurance of prompt payment on projects.
Changed market conditions require clients to alter their own approach to procurement to assure that projects continue to deliver certainty and value. At the root of effective procurement is a good quality, robust and buildable design that provides an attractive risk profile to the supply chain. Close alignment of design deliverables with the execution of the procurement strategy and construction methodology is essential to de-risk a project and to present it as an attractive proposition to potential contractors. Effective procurement in a market upturn relies upon close attention to the basics of design management and change management as well as a more flexible approach to the allocation of risk. Clients depend on their teams to deliver this discipline and will need to play a part through their own commitment and engagement with the project. Team building starts during the bidding process and procurement provides a key opportunity for clients to establish the right performance culture.