Risk allocation in NEC4 ECC – beyond compensation events

Key Points

•  NEC4 ECC compensation event process provides a clear risk-allocation mechanism for specified common events.
• There are many other risk-allocation provisions in the contract, which vary between main Options and can be included with secondary Options.
• Examples include cost overruns, delayed completion, inflation, foreign exchange, defects in construction, defects in design and aggregate liability. 

One of the key roles of any construction contract is to apportion risks between the parties. Most people who use and work with the NEC suite of contracts will be familiar with the compensation event concept, which provides a clear risk allocation mechanism for specified common events that can occur during construction works and services.

At its highest level, where a specified compensation event occurs, the contractor is given relief from the time and/or cost impact of the event. There is a plethora of useful guidance available on compensation events, detailing the events covered by the NEC standard list of compensation events, the process for assessing the cost and the time impact of compensation events, and other related issues.

Notwithstanding their importance, compensation events often overshadow the other risk allocation provisions in the NEC suite. These other risk allocation provisions (particularly those in the NEC4 Engineering and Construction Contract (ECC)) are the focus of this article, which outlines some of the other key risks and how they are apportioned between the client and the contractor.

Cost overruns

Under ECC Options C (target contract with activity schedule) and D (target contract with bill of quantities), even where a cost risk is allocated to the contractor, all else being equal the parties will still share the cost risk through the target sharing regime. The extent to which cost overruns are apportioned between the parties will depend on the stated contractor’s share of overspends as set out in the contract data.

Delayed completion

The cost risk associated with delayed completion may be partially or fully borne by the contractor through delay damages Option X7. The extent to which such cost risk is apportioned to the contractor will depend on the quantum of delay damages payable and whether they equate to the actual costs of delay as suffered by the client.

Inflation

Option X1 on price adjustment for inflation is a fluctuation provision which outlines the allocation of inflation risk between the client and the contractor. The specific application of Option X1 differs between the main payment options, however the impact is broadly that the prices are increased to reflect the change in the selected index or indices. 

In simple terms, use of Option X1 apportions inflation risk to the client. However, the extent to which the client holds inflation risk depends in practice on the specific index or basket of indices selected in the contract data. For example, the contractor will retain residual inflation risk where the change in the selected index or indices is less than the actual change in the contractor’s costs resulting from inflation.

Where option X1 is not used, inflation risk sits with the contractor, which may lead to a consequential risk premium in fixed or target price contracts.

Foreign exchange

Under clause 50.7 in ECC Options C and D and clause 50.8 in ECC Options E (cost reimbursable contract) and F (management contract), where the contractor makes a payment of defined cost in a currency other than the currency of the contract, these payments are included in the amount due as payments to be made to the contractor in the same currency.

The client therefore takes the risk on the applicable exchange rate at the time of the currency conversion calculation. However, the applicable fee is calculated in the currency of the contract using the exchange rates in the contract data, such that the contractor bears the exchange rate risk on the fee.

Option X3 on multiple currencies applies to ECC Options A (priced contract with activity schedule) and B (priced contract with bill of quantities) only. Under Options A and B, where option X3 is not used, the risk of currency fluctuation is borne by the contractor. Option X3 allows for the contractor to be paid in currencies other than the stated currency of the contract for specified items, with a maximum amount that may be paid in each currency.

The exchange rates stated in the contract data are used to convert the currency of the contract into the currency in which defined cost is to be paid. Accordingly, the exchange rate risk is held by the client for these items.

It should be noted that where the exchange rates are used, the degree to which currency fluctuation risk is apportioned will depend on the specific exchange rates entries in the contract data. For example, where a specific exchange rate (or an exchange rate on a specific date, such as the contract date) is stipulated between two currencies, the contractor will bear the risk (or the potential opportunity) of the actual exchange rate when carrying out the currency conversion being different to that stated in the contract data.

Defects in construction

During construction, under ECC Options C, D, E and F, the contractor recovers the cost of rectifying defects, except where defects are caused by the contractor not complying with a constraint on how it is to provide the works stated in the scope. This aims to create a culture of openness and transparency regarding the notification of defects.

After completion, the cost risk of defects correction is held by the contractor with the costs of rectifying defects constituting disallowed cost. Until the defects date, the contractor is required to rectify the defect itself.

Under the fixed-price contracts (ECC Options A and B), the cost risk of rectifying defects is owned by the contractor notwithstanding the point at which the defect is notified.

Defects in Design

Where Option X15 on contractor’s design is selected, the risk of defects in design is apportioned between the parties based on a skill and care standard. The contractor is liable for and bears the risk of any defects in design where it has failed to use the skill and care normally used by professionals designing works similar to the works in the preparation of its design.

Aggregate Limit of Liability

Even where a risk is allocated to the contractor, such risk can never be wholly transferred. This is often due to Option X18 on limitation of liability being used, which expressly limits the aggregate liability of the contractor under the contract.

However, even where Option X18 is not used, the contractor’s maximum aggregate liability for uninsured losses will in practice be limited by the economic and financial standing of the contractor. This applies equally to excluded matters, which are effectively unlimited liabilities of the contractor and include death and personal injury. While excluded risks are not contractually limited, they will be limited by the strength of the contractor’s balance sheet.