Constrained budgets bring cost into focus for NEC users in Australia

With Covid-19 stimulus projects a fading buzz in the Australian infrastructure sector, Infrastructure Australia (2024) reports that the major five-year public infrastructure spending pipeline of AU$213 billion (£107 billion) is down 8% down in the 2023–2024 financial year from an all-time peak in 2022–2023. 

But while the public infrastructure sector is expected to continue to shrink, the renewable energy and defence sectors are both in growth mode. Spurred on by the AUKUS treaty between Australia, the UK and USA, defence spending in particular is expected to balloon, exceeding AU$100 billion (£50 billion) in the 2030s. This year, Australia will spend a record AU$56 billion (£28 billion) on defence, up 6% year on year. 

However, the new political leadership in the USA and UK, and forthcoming 2025 federal election in Australia, could point to a reset of priorities as well as new pressure on project budgets. The expected result will be an increased focus on cost control and delivery efficiency to meet the expectations of a still ambitious project pipeline. 

Effect on NEC projects 

With new pressures on the horizon, how are those projects using the NEC contract suite in Australia positioned to respond? 

NEC contracts are designed to ensure that effort, risk and costs is fairly shared between client and service provider. The collaborative core of each contract is designed to promote schedule and cost transparency with built-in incentives through the early warning process to identify and mitigate cost pressures and continue with work. 

While cost management and control is central to the NEC contract approach, there are four key aspects to consider in the current conditions: choosing the right main option, understanding market conditions, being clear on defined costs and ensuring transparency. 

Choosing the right main options 

The first step to managing cost effectively is to recognise that cost and risk are two sides of one coin. Risk transfer, just like cost transfer, cannot take the place of effective management. Without clarity of risk and effective management, contractors must price for a probability the risk will materialise and therefore increase their costs. 

While cutting corners to rush projects to market with insufficient planning often occurs, the cost of these shortcuts upfront can often lead to long-term cost pressures. For instance, inadequate geotechnical data resulted in a 9% increase in Australia’s total capital spend in the 2023–2024 financial year. 

For NEC users it is critical to start with the right main option payment mechanism to ensure risks are allocated to those best able to manage them. Option C (target contract with activity schedule) contracts have been growing in Australia under those settings, with an increased share of risk held by the client when compared to the traditional fixed-price contracts that have dominated the market. Highly complex projects, and projects with imperfect information, are well suited to this approach. 

Understanding market conditions 

Cost escalation has been a defining characteristic of the Australian infrastructure environment following Covid-19, driven by government stimulus investment, a housing construction boom and constrained supply of materials and skills. 

The cooling of some markets, the progress of the investment peak through design and into construction as well as the rise of investment in alternative sectors has increased labour availability in some markets. Understanding these dynamics and the likely future environment helps to understand the optimal future risk allocation. 

Infrastructure Australia (2024) provides an annual insight into the performance of the sector and emerging constraints over a five-year horizon. The latest study gives a baseline perspective of more than 50 resource and labour inputs, providing a foundational understanding that can be complemented with deep dives into critical materials for a project or organisation. 

Being clear on defined costs 

NEC4 defined costs are predefined costs for performing an activity or provide an outcome that is used to assess payments, compensation events or amounts due in termination. If a cost is not defined, then it is assumed to be included in the fee. 

Defined cost is the main basis for assessing the financial impacts of compensation events and, under Options C, D (target contract with bill of quantities) and E (cost-reimbursable contract), as the basis for reimbursing contractors for work done to date. 

In some circumstances clients may want to establish greater certainty on key elements of a project. Eight cost components are included in NEC4: people, equipment, plant and materials, charges, manufacture and fabrication, design, and insurance. 

Clause 52.1 draws the delineation between defined cost and fee. It can require defined costs not set in the contract data to be ‘at open market or competitively tendered prices with deductions for discounts, rebates and recoverable taxes.’

Ensuring transparency

A fair model of risk sharing requires transparency to determine actual costs. However, in an environment of escalating costs, trust can be under stress. To deliver clarity, inspections are a key tool to draw a better understanding of project realities. Project or service managers are permitted under clauses 50.9 and 52.4 in Options C and E to inspect accounts and records of the defined-cost items claimed.

The cost of staff working on the project can often be a source of uncertainty, however these costs form part of ‘people’ costs detailed in the schedule of cost components. To determine these costs, assurance inspection needs to focus on payroll departments and associated payslips, employment contracts, payroll reports and timesheets.

Transparency on costs of labour is often at risk of being overlooked, or met with uncertainty, in planning and therefore sometimes left as a source of future conflict.

Industry collaborations

NEC has recently strengthened its partnerships with some of the pre-eminent Australian infrastructure industry groups to improve commercial skills and awareness and to promote contracting reform. NEC has established a partnership with Consult Australia, as well as collaborations with the Royal Institution of Chartered Surveyors in Sydney and the Institute of Collaborative Working Australia.

Reference

Infrastructure Australia (2024) Infrastructure Market Capacity Report 2024. https://www.infrastructureaustralia.gov.au/2024-infrastructuremarket-capacity-report.