The Importance of Understanding Volatility and Escalation
Lidiar Group’s Darren Cave has spent a large part of his career ensuring that key projects are delivered in line with expectations, budgets, and value for money. Across the resources, engineering, energy, civil, and industrial sectors, he has experienced the ups and downs of demand, and the challenges caused by booms and recessions and helped clients navigate the challenges caused by global supply chain disruptions, skills shortages, and more.
However, throughout Darren’s career, there hasn’t been a time more impacted by market and pricing volatility than what we have experienced and are experiencing in Australia. This raises challenges for developers and asset owners as they attempt to plan projects, gain budget certainty, and understand the challenging markets in which projects are designed, produced, and delivered.
In our latest blog, Darren breaks down the importance of understanding volatility and escalation.
Predicting The Future
There will always be challenges when planning and pricing major projects, and in some instances, there are factors way beyond the control of any professional unless they are equipped with a time machine. Any planning or procurement specialist developing a business case for a project in 2019 for delivery through 2020-2024 would never have predicted COVID-19, war in Ukraine, war in the Middle East, the collapse of major supply chains, lockdowns, stimulus packages, essential industry exemptions and more. Therefore, they could never have factored them into the project planning. They will have allowed for contingencies, potential time delays and more, but it was impossible to predict what happened and account for it in the initial business case.
Fellow QMCA Members, Civil Projects Partners tracked the changes in costs through the pandemic in their Construction Materials Shopping Guide, which is calculated by analysing the price of the industry’s most common materials weighted by proportion for a typical road project.
As can be seen in the graph, the changes to costs could not be predicted ahead of reality. Trends were shattered, prices fluctuated, and costs took almost two years to stabilise and regain some form of normality, but they didn’t drop back to levels seen pre-pandemic. However, thankfully, perfect storms of market conditions don’t strike too often, meaning there are ways to successfully manage and protect from market volatility driven by the usual drivers of supply, demand, and available resources.
Specification vs Expectation
When it comes to navigating market price volatility and cost escalation, project developers often find themselves in a tricky position. Recently, while consulting with a solar farm developer, I was asked a straightforward yet complex question: “How do we protect ourselves from market price volatility and rising costs?”
Following a competitive tender, the developer engaged their preferred EPC (Engineering, Procurement, and Construction) contractor under an early works agreement. The idea was to handle long-lead procurement and progress the design, with pricing updates at 30% and 80% design completion. At 80%, the contract price would be locked in as a lump sum, providing a clear cost structure moving forward.
This approach seems fair on paper, as it collaborates to manage risk while ensuring flexibility during the early works phase. However, the developer entered the process with the expectation that costs would decrease, influenced by the EPC contractor’s suggestion that opportunities for savings existed. As is often the case, the contractor was focused on protecting its own position, building in buffers to account for the risks typical of solar farm projects.
As the design progressed, the developer included every possible option, which naturally drove costs higher. This led to a situation where the design had to be scaled back to maintain a manageable budget. Friction arose, and the relationship between the developer and the contractor became strained:
- The cost increases surprised the developer
- The contractor assumed that the developer understood the impact of continuous design changes.
While individual changes might have seemed insignificant, when combined, they resulted in a significant cost difference, with strain caused by incorrect assumptions around the knowledge and understanding of both parties. We’ve previously looked at scope creep, and how to ensure teams are on the same page in The Importance of Project Scope
and at the early stage of any project; the advice stands as the foundations for success, but despite the best intentions of all parties, escalation can and does occur during project development.
Escalation
In my experience, the key factors that drive escalation during project development occur due to:
- Time—As project timelines stretch, costs naturally rise. It is crucial to build in allowances for escalation in the project budget.
- Scope Creep – Adding extra requirements along the way increases costs. An experienced Design Manager can help align the project with its original objectives.
- Market Conditions—Suppliers and subcontractors respond to market fluctuations. It is critical to timing your procurement to align with favourable market conditions wherever possible.
- Risk Allocation—Developers often want to pass all project risks to the EPC contractor, but this comes at a cost. A more balanced approach, such as pain-share/gain-share agreements, may be more cost-effective.
- Developer Approach – Treating contractors with respect and professionalism can have a significant impact. For example, a major mine in central Queensland struggled with contractor engagement because it failed to show that it valued the expertise it was hiring.
It is about effective communication, shared understanding, and a commitment to shared collaboration that rewards outcomes and doesn’t immediately default to an adversarial position, which is often seen in our industry to the benefit of lawyers and the detriment of projects, outcomes, and relationships. How do we overcome those challenges? In our next blog, The Importance of Escalation Safeguards, Darren will share Lidiar Group’s proven process for minimising volatility and escalation.