Contract Risk Score for Customer, Contract, Price & Payment

As promised, we will now dig deeper into which questions – and why – are suited to set-up your own Contract Risk Scoring system. There are 20 basic questions so we will split this subject in 5 batches of 4 questions each.

As a reminder: Contract Risk Scoring is a methodology to score the risk of each relevant subject [from 0 (low) to 5 (high)] in your contract and to generate an overall score for the contract. The higher the score, the riskier the project. With the score, you will be able to make more rational decisions. This approach is specially suited for the (complex) Project business: infra, construction, turnkey equipment, oil & gas, power & renewable, etc. If you have questions, you may find the answers here. Otherwise, please don’t hesitate to contact us.

You can see all the questions on our free tool TRaCRs (Tender Risk and Contract Review system) available on our website (no registration requirement).

You can use this as the starting point for your own questionnaire. Typically, you should proceed as follows:

1. Perform an internal audit to identify the main contractual risks applicable to your business and your company
2. Select a useful number of representative questions. Too much questions will make the analysis time consuming. Fewer questions will leave out substantial risks.
3. Revise your process to base your decisions on the Contract Risk Score: Go-No Go decisions, margin levels, provisions etc.
4. Introduce a feed-back loop between your project execution and your Contract Risk Scoring system.
5. Improve your risk questionnaire based on your learning process and do some portfolio analysis.   

AfiTaC can support you with the above actions.

Question 1 – Type of Customer

The first question should always aim at understanding the type of Customer you are dealing with. Indeed, the behavior of your Customer will vary drastically between a state-owned company or a private Customer, with external financing or not.

Our experience is that state-owned companies represent a lower risk. They have a natural tendency (and a role model obligation) to treat their suppliers fairly. Historically, they have been less inclined to recover liquidated damages from their contractors.

When these state-owned companies are financed by multilateral development banks, these banks will introduce balanced contract conditions and payment guarantees and will bring some project oversight.  

On the other side of the scale are SPCs (Special Purpose Companies) and IPPs (Independent Power Producers) who rely on project finance. If the project fails, they go bankrupt. Because of this and the pressure from the Lenders (e.g. commercial banks), they are obliged to:

• Shift most risks to the Contractor, using mostly the EPC type of contracts.
• Recover LDs systematically in order to pay back the loan in case of project delay or performance shortfall.
• Generally, behave in a “contractual way”.

Large private companies (e.g. utilities and main contractors) are at the middle of the scale. They tend to be contractual but have repetitive business with some of their (sub-)contractors. This should stimulate win-win behavior and long-term relationships.

Question 2 – Type of Contract

No surprise that more balanced contracts bring less risks to Contractors.

Standard contracts are the result of considerable preparatory work. Revisions have benefitted from actual projects’ feedback. Therefore, FIDIC, NEC, World Bank conditions etc. are less risky for Contractors.

It is a very difficult exercise to write an “ad hoc” contract and fully incorporate balanced rights for both Employer and Contractor. Usually, “ad hoc” contracts are prepared by external legal counsel. They have a natural tendency to incorporate all possible protections for the Employer and wait for Contractor’s comments before moving to a more balanced version. These contracts require more effort and concentration from Contractors. Being riskier, this must be reflected in the Contract Risk Score.  

Question 3 – Are prices firm or adjusted for changes in costs (escalation)?

If prices are fixed and firm, all the risk leading to increase in costs are supported by the Contractor. Contractor may make a firm price provision in the tendered price. However, he will be under competitive pressure to keep this provision low. Furthermore, in case of substantial cost increase (e.g. due to unanticipated inflation), the Contractor’s margin will be affected. Contractor may sometimes benefit from decreasing costs but they should not bet on this happening. Generally, cost decrease happens in crisis periods when order intake will also suffer and fixed costs are less well covered.

A usual solution is to foresee a price escalation formula in the contract. Such a formula gives weights to cost components and links them to publicly available indexes. This allows to calculate the price adjustment, in an objective way, when the index values vary over time. Depending on the quality of the price escalation formula, the Contractor is more, or less, protected. The more the Contractor is free to influence the formula (adjusting the weights and indexes), the better he is protected. This justifies lower provisions and a lower margin.

The Contract Risk Score should favor price escalation over fixed & firm prices.

Question 4 – Impact of payment terms and payment security on the Contract Risk Score

A balanced contract is worth nothing if the payment terms expose the Contractor and the Employer doesn’t pay!

The Contractor is best protected when his payment terms are in line with his expenses. In that case, if the Contract is suspended or terminated at any point of time, Contractor will still have sufficient cash to pay all its suppliers, staff, materials, equipment etc. without relying on financing (including termination costs). We call this situation “exposure neutral”.

Often however, the payment terms are not “exposure neutral”. Sometimes, they are also not “cash neutral” (i.e. still able to pay invoices but no longer able to pay termination expenses). If the Employer stops paying for whatever reason, Contractor is far better off with a payment security (letter of credit, direct commitment by a multilateral development bank etc).   

In further posts, we will continue this discussion about Contract Risk Scoring. Please don’t hesitate to contribute with your comments.