By Meg Utterback  Holly Blackwell  King & Wood Mallesons’ Dispute Resolution Group

The risks faced by investors, owners and contractors on large infrastructure projects in Asia, South America, Africa and other developing nations are varied. Large scale projects to build infrastructure such as power plants, hydroelectric dams, highways, railways, and airports can range from US$100 million to billions of dollars in value. These projects often impact local populations, industries, and the environment. Because local resources are often limited, foreign contractors are called in to undertake the work. Project structures can create a wide web of contracts, contractors, and subcontractors subject to domestic and foreign regulations, codes, and procedures. Project owners and contractors often fail to consider project risks (or are too late in addressing them) resulting in additional costs and delay, diminished profit, and possible litigation. Risk cannot be eliminated but it can be managed.

I. Project Risks

Risks encountered on global infrastructure projects can generally be broken into four categories: host country risks, social and environmental risks, economic and financial risks, and technical risks.

Host country risks are associated with the local political, governmental, and regulatory environment. They include risks of expropriation of assets, government instability, political violence, hostility aimed at foreign contractors, and terrorist activity. Additional host country risks include local government corruption and solvency of local government owners and assurance of payment. While these risks are widely documented and often easy to uncover, they are often under-estimated.

The Dabhol India power project remains a classic example of a project derailed by host country risk. After a change in government, tensions manifested between project owners and local government authorities during the second phase of the project. A heated dispute arose when the state electricity board, the sole offtake customer, defaulted on payment. The dispute took nearly four years of litigation, including 40 court and arbitration cases and more than 100 court appearances, US$ 5 million in legal fees, and extensive negotiations with the local government to finally settle. More recently, Chinese contractors fell victim to host country risk in Libya. In March 2011, a wave of Chinese contractors were forced to evacuate workers and abandon projects, equipment, and supplies due to the escalating conflict in Libya. News reports estimate losses to PRC contractors are in excess of US$1 billion. Under PRC law, contractors are encouraged to procure export credit insurance, but not all policies cover all host country risks. Careful assessment of host country risk is critical before commencing or proceeding to the next phase of a project.

Social and environmental risks relate to the interaction between the project and local conditions. Social and environmental risks include destruction of ecosystems, displacement of towns and people, adverse impact on local industries, loss of livelihood and jobs, pollution of air, water, and land, availability of skilled local labor, and the impact of importing foreign labor. Failure to account for social and environmental risks can lead to protests or disturbances by the local population, create pressure for public owners, and inevitably lead to project delay. For example, a foreign contractor undertook the transmission and distribution phase of a power plant in South America. The project assumed an 18 month schedule for completion. When the contractor was unable to obtain visas for workers, it was forced to hire local laborers which lacked engineering and welding skills. Moreover, the contractor failed to account for host country holidays in the schedule. During the course of performance, the laborers went on strike three times, protesting for overtime pay, holidays, and better salaries. The project finished 15 months after scheduled completion.

Economic and financial risks are those which directly affect the bottom line. They include risks associated with owner default, repatriation of proceeds, ability to procure and costs of project insurance (e.g., performance bond, letter of credit, or bank guarantee), increased costs of local commodities when “buy local” requirements are imposed, and payment in foreign currencies. Currency fluctuation is a material risk on international projects which can significantly impact return on investment, especially when a project is delayed. For example, in June 2005, a Chinese contractor was awarded a US$ 100 million project. At that time, the exchange rate was RMB 8.3 to US$ 1.00. The contractor anticipated a project value of RMB 830,000,000 and planned a low margin of 8% or US $8 million. The project was delayed until January 2009, when the exchange rate was RMB 6.83 to US$1.00. The project value was reduced to RMB 683,000,000, resulting in a negative delta of RMB 146,800,000 (US$ 21,522,694) and a substantial loss to the contractor.

Technical risks are associated with the physical construction, operation, maintenance of facilities. They are often amplified by lack of country experience and lead to substantial increases in costs and delay. Technical risks include lack of knowledge of local safety and quality procedures and project procurement systems, lack of skilled labor and building materials, and failure to anticipate issues such as customs delays for imported equipment and materials. Technical risks also include delays and disruption due to design changes and non-performance of subcontractors or suppliers. For example, a foreign contractor entered a bid for a US$100 million project to upgrade two airport air traffic control systems in Asia. To save money, during tender, the owner cut portions of the works and awarded those portions to local subcontractors. The foreign contractor reduced its bid accordingly, but did not change its time for completion. Its work was contingent on the completion of civil works by local subcontractors. The local contractors were slow to mobilize and produced sub-standard work (e.g., leaking buildings, crumbling cement walls, bad wiring, and no climate controls). The project was delayed 30 months, leading to substantial cost overruns, heated arbitration, and US$ 3.5 million in legal fees.

II. Managing Risks to Avoid Disputes

These risks foster disputes and can lead to battles between contractors and owners over claims for variations, additional costs, schedule relief, and liquidated damages. Basic steps to manage risk such as those discussed below can help avoid litigation and boost project success.

Perform host country due diligence: Host country due diligence is the most valuable investment a foreign contractor can make to mitigate risk and avoid disputes. At the onset, a contractor should consider host country risks such as volatile political environments and fluctuating regulatory regimes. A contractor will want to carefully analyze the country’s track record in similar projects or whether a pending local policy could impact the project. To avoid disputes over rejected claims for additional costs, the costs of local input materials (and the fluctuation thereof) should be considered and reflected in bids and agreements.

Host country due diligence can also mitigate social and environmental risks. A contractor should anticipate the ability of foreign workers to obtain visas, local protest of imported laborers, and availability of a local workforce. Owner solvency, history of payment in prior projects, and source of project financing should be considered to mollify financial risk. Local regulations can also impact performance security. A contractor will want to ensure its performance bond may be reduced pro rata with areas taken over by the owner. To reduce technical risks, due diligence to understand site conditions, local safety and quality procedures, quality of local materials and workforce can help avert disputes over responsibility for defective or delayed works.

Consider impact of project risks on project structure: Project structure should reflect project risks. For example, when host country due diligence reveals a project will be subject to considerable social and environmental risk, a project delivery method with greater owner involvement in the design phase may be appropriate. An owner or in-country partner will be more sensitive to these issues and in a better position to address them before they become a problem for the project as a whole. When an owner has limited technical knowledge or local resources, technical risks can be avoided by selecting a project structure with less owner involvement such as Design-Build or EPC.

Economic and financial risks also impact project structure. Currency fluctuation can play an important role in determining what portion of the project can be contracted for off-shore. In the power sector, PPA’s are frequently in the currency of the host country while financing is through international bodies utilizing foreign currency. Currency fluctuation will impact the contractor’s return and project financing will vary depending upon the amount of risk the investor deems acceptable. Though an in-country owner may prefer DBFO, an inbound contractor may later find financing is too risky or too difficult to obtain.

Engage strong local partners: Strong local partners can substantially mitigate risks attributed to undertaking a project in a foreign country. Local partners can provide local skilled laborers when local conditions make it difficult or impossible to employ imported laborers. Local partners can also negotiate with the local workforce when relations go awry. In many countries, security can be an issue for foreign contractors. Local partners help arrange security to protect foreign workers, equipment, and the project site. Strong local partners can also assist with government relations and obtaining project permitting. Naturally, it is important to know your local partner. A local partner which boasts an elaborate network of government connections may create more risk that it is worth.

Account for risks in the contract: It goes without saying that identification and allocation of project risks should be reflected in project agreements. For example, when payment will be made in a foreign currency, the parties may agree to renegotiate payment terms if the currency fluctuates more than five percent. In such case, if a settlement can not be reached, the parties may further agree to deem the event force majeure to later avoid a lengthy battle on payment terms. Similar provisions should account for escalating costs of local supplies and materials, including fuel prices, when local sourcing is required or local conditions make imports impractical. Both parties will also want to ensure bond terms and other forms of payment security comply with local law.

In multi-stage projects, to avoid later disputes over design responsibility, owners should clearly delineate the scope of works and the start and end of design responsibility for each project stage. Contractors will want to seek reassurances from owners regarding the accuracy of project specifications and basic engineering information. As with most international agreements, foreign contractors should pay special attention to dispute resolution and applicable law provisions. Negotiate for foreign arbitration and governing laws, as local laws and courts may be protectionist, particularly where the owner is a government entity or public undertaking.

Communicate and maintain proper documentation: Project success or failure largely depends on the ability to communicate with the other side. When communication fails, participants lose trust, look for negatives, and stop trying to help each other succeed. Regular and productive project communication is critical. Conduct regular site, internal, and owner-engineer meetings. Document with meeting minutes and distribute to all involved parties. Maintain complete and accurate coordinated drawings at the site that reflect the most recent variations to the contract and scope of works. Actively monitor project progress and welcome feedback from project participants.

Failure to address variations when they arise also drives disputes. In China, owners and contractors are accustomed to settling claims at the end of the project. Internationally, owners and contractors want firm and predictable costs. Surprises end in litigation because the owner will reject a claimed variation on the basis of lack of notice or delinquent notice. Contractors should adopt a system for submitting, monitoring, and negotiating variation requests. Clearly identify who has approval authority and avoid on-site oral approvals. Upon approval of a change order, the owner or owner’s representative should give clear instructions and identify the result (e.g., increase in time or reduction in scope).

Disputes can and will occur, but good documentation never results in litigation. Poor documentation leads to litigation because the parties lack enough information on the record to negotiate a settlement of claims and variations. Communicating about time and cost issues in a well documented non-confrontational manner will result in a professional atmosphere and project success.

III. Conclusion

Unsettled disputes on large scale infrastructure projects are a frequent source of international litigation and arbitration. They arise and go unsettled because of local naiveté, lack of information, and insufficient planning. They drain valuable resources, substantially delay projects, generate substandard works, obliterate budgets, and can result in doomed projects. Though some risks are unavoidable, time and money spent on early planning, local due diligence, and strategy to address and distribute identifiable project risks is well worth the investment.