Future-proofing the energy transition: strategies for mitigating project disputes

Emerging trends, future disputes: strategies to safeguard project delivery 14 min read

While disputes risk is inherent in the delivery of any major project, this has been exacerbated by current market forces. In our recent Insights we explored how that risk can be both mitigated and managed. ¹

In this Insight, we explore the major trends that we believe will prove the most fertile ground for future projects disputes (particularly with the increase of mega energy projects), being:

• new contracting models, which might be used to minimise disputes, if parties adopt a collaborative approach in practice as well as in principle
• the pace and complexity of the energy transition
• the ongoing risk of contractor insolvency.

We also consider how the management and mitigation strategies we previously outlined can be adopted as these trends evolve.

Key takeaways

• The number of insolvency appointments in the construction sector are the highest in over a decade.
• The current infrastructure boom, coupled with an increase in collapses of Australian builders, has caused parties to revisit their traditional approach to risk allocation.
• Against that backdrop, the energy transition is happening at pace.
• In an evolving market, the disputes risk is amplified. But strategies can be implemented early to ensure parties are well placed to understand and manage that risk.

Future trends

Mitigating risk through alternate contracting models

Over the last few decades, major infrastructure projects have been let on the basis of contracts with a predictable and often principal-friendly 'tried and tested' approach to risk allocation, with a fixed price and fixed program.

However, this approach is no longer fit for purpose for at least two reasons:

1. a contractor's market: with the current infrastructure boom and energy transition, the contractor market is in a much stronger bargaining position than it has been historically—to put it at its lowest, the infrastructure industry is extremely busy and, as a result, contractors can be more selective about the projects they choose and risk profiles they're willing to accept, and this is even with more second- and third-tier international contractors entering the Australian market;
2. market volatility: as previously discussed in our Insight: 'Construction project risk-management strategies in a challenging market', despite this general level of busyness, the long-term health and viability of the industry has come into sharp focus in view of recent unpredictable external factors like COVID-19 and associated supply chain constraints, extreme weather events, hyperinflation and geopolitical instability, which we have seen manifested in the high-profile collapses of Australian builders.

Combined, these factors have compelled parties to revisit their traditional approach to risk allocation. This shift is seeing the increased adoption of contracting models across the collaborative spectrum, from bespoke risk-sharing regimes tacked onto traditional D&C or EPC contracts, to incentivised target cost and other forms of collaborative contracting.

The principles of collaborative contracting seek to reshape how risk is shared between the principal and the contractor, and encourage more open and constructive cooperation. A key driver behind this collaboration is to short-circuit the seemingly inevitable risk of exaggerated, ambit claims and accompanying protracted dispute resolution processes that can sometimes attach to incorrect, inappropriate or uncollaborative risk allocation.

We've seen a market move to more collaborative approaches at all stages of projects—in procurement, where principals are recognising the need to demonstrate a willingness to engage in risk-sharing from the outset in order to attract market participants—to delivery, where projects in distress have seen parties agree to a 'contractual reset' of traditional D&C and EPC contracts already on foot.

In relation to dispute resolution in particular, collaborative principles have driven:

• new mechanisms in procurement contracts, including:
  • the requirement for a project board or project committee comprising representatives of all parties to make unanimous decisions on the project
  • bespoke risk sharing mechanisms for risks that are particularly difficult to determine, such as contamination or utilities
  • a limitation on legal claims to only wilful default or fraud
  • an emphasis on dispute avoidance prior to dispute resolution, eg by requiring any dispute to first go through a project committee before being referred to a contractually established dispute resolution board
  • obligations to cooperate and collaborate in good faith; and
• the resolution and 'reset' of disputes on projects already on foot and subject to traditional contracts, which has seen the introduction of:
  • incentives linked to KPIs to motivate completion or preferred behaviour
  • bonus payments linked to new milestones or preferred behaviour
  • new dispute resolution committees to ensure future disputes are dealt with early and efficiently
  • reporting requirements to increase visibility on the project.

However, because of their relatively new nature, the majority of projects containing these mechanisms remain in delivery, so time will tell as to whether they can effectively mitigate the risks of disputes, and relevantly, the risk of a contractor walking away from a project either because they have the power to do so or because it is the only remaining option.

While such a highly collaborative process, with bespoke risk-sharing mechanisms, includes a significant investment of time and money and is not without disputes risk, it can enable parties to mitigate costs overruns, delays and other risks on an ongoing basis, therefore reducing the likelihood of significant, protracted and disruptive disputes during the course of delivery. This is further explored in our Insight: 'Three ways to avoid construction project disputes'.

The energy transition

The energy transition is firmly underway. With the sheer volume of renewables projects and network infrastructure required to be completed, at pace, the risks giving rise to disputes are multiplied.

For the energy transition, not only does the rate of change and corresponding pressure on resources exacerbate the existing disputes risks inherent throughout the construction industry, but these projects also face unique, additional challenges.

The first step for industry participants to mitigate the costs, delay and inconvenience associated with the potential for major litigation, or a costly and significant project reset, is to be aware of the key risks and make allowance for them at the outset.

This falls broadly into the following categories:

Connection and regulatory risk

The challenges associated with registration, commissioning and connection to the grid, as well as regulatory intervention and oversight, have already played out in the renewables sector across Australia. For numerous projects, this has been a driving cause of delay, cost overruns and lost generating revenue.  

While significant work is being done to increase certainty for investors, ² it is critical that all parties to a construction contract account for connection complications in programming, budgeting and risk allocation at the outset. ³

This will be particularly pronounced in the offshore wind sector. With a new regulatory framework and licensing regime in play, ⁴ it will be critical for contracting parties to have a proper understanding of all of the timeframes, permit requirements and approval mechanisms in effect.

Evolving technology

In onshore wind, we have already seen how evolving technology can make contractual requirements redundant after only a few years, rendering the scope and bargaining position between construction parties unworkable. As explored in our recent Insight, such issues are likely to amplify on technically novel and complex projects such as offshore wind and hydrogen. The construction environment, weather risk and geology will also continue to create hurdles for pumped hydro and offshore wind, as seen already in Australia and elsewhere.

Heightened risk factors

While challenging market issues play out in the construction industry more broadly, the energy transition brings another layer of complication. Long before COVID-19, delays on renewable projects arising from connection risk had been cited as the cause of the RCR Tomlinson administration. ⁵ Others remained afloat, but abandoned their foray into the sector. ⁶ Some argued that collaborative approaches to contracting were needed to balance this risk, long before the broader market begun revisiting this. ⁷

Since then, the challenge of hiring and retaining individuals with the requisite expert technical knowledge has only worsened, with grid and connection skills in hot demand around the world amidst existing, industry-wide labour shortages. The extensive demand for network upgrades and ancillary infrastructure to facilitate the transition are only increasing the pressure on stretched supply chains and labour markets.

Increasing use of split and disaggregated contracting

Against the backdrop of escalating costs, ever-increasing scale⁸ and a proliferation of hybrid projects (comprising combinations of wind, solar and battery storage), we increasingly see project sponsors explore (and financiers begin to accept) the use of split and disaggregated contract packages (ie multiple contractors and suppliers delivering different packages).

Like collaborative contracting, this also tends to lead to a higher level of cooperation by contracting parties, which in turn can mitigate the risk of major disputes or resets. However, these contracting models also bring new challenges, notably increased interface risk, potential warranty or liability gaps between contractors, and heightened due diligence by financiers and any incoming investors. We have already seen in the offshore wind sector overseas how this can lead to significant disputes.

Contractor insolvency risks

Notwithstanding the increased appetite to adopt more collaborative contracting principles, construction industry participants are grappling with the consequences of a significant increase in insolvency appointments facing the sector. In many instances, these insolvencies are occurring downstream, at the subcontractor level.

The construction sector has always featured prominently in Australian insolvency statistics. There are several structural features that make the construction sector particularly vulnerable to liquidity issues, including fixed price contracting, imbalanced risk allocation, strong industry competition driving lower tender bids and narrow profit margins, and historically poor payment practices.

The most recent ASIC data on insolvency appointments shows a worsening of this trend. In the financial year ended 30 June 2023, 2,211 companies in the construction sector entered into external administration or had a controller appointed for the first time, representing around 28% of all insolvency appointments. This is the highest number of construction sector insolvencies in over a decade, and reflects a trend of increasing numbers of insolvency appointments in the sector in recent years.

Figure 1: Construction sector insolvencies as a percentage of all insolvency appointments—historical data

Source: https://asic.gov.au/regulatory-resources/find-a-document/statistics/insolvency-statistics/

Construction insolvencies are expected to continue to increase in the short to medium term as inflation, strained supply chains, the rising cost of inputs and labour, and increased interest rates continue to exert pressure on the sector. Accordingly, industry participants face an increased risk of being exposed to counterparty insolvency risk (both upstream and downstream).

Practical strategies to manage insolvency risk

Ideally, insolvency risk would be mitigated at the procurement stage. In the current economic environment, this may include exploring price escalation mechanisms (such as price benchmarking and periodic indexation) to manage cost increases and price volatility resulting from supply chain disruptions, rising inflation, geopolitical instability and extreme weather events.

A principal can also manage insolvency risk:

• at the contracting stage, by undertaking extensive counterparty due diligence and negotiating robust rights in relation to performance security, indemnity and termination rights
• over the life of the project, by continuing to monitor the performance and financial position of the contracting counterparty.

The principal's due diligence should be sufficient to identify any concerns regarding the financial and operational credentials of both the counterparty and the security provider. It is important to obtain a detailed understanding of the contractor's corporate structure and past delivery record, and the financial capacity of any security provider to satisfy the performance security securing the obligations of the contractor.

It is also important to continue to monitor the financial health of the contractor during the life of the project. Late payments to subcontractors and suppliers, poor performance, building defects, variations and time overruns may indicate solvency (rather than performance) issues. Notices under Security of Payment legislation, supplier and trade creditor demands (including statutory demands), and the sudden loss of key staff are often the proverbial canaries in the coal mine.

Ideally the construction contract will provide for adequate performance security and contain broadly expressed indemnity, step-in and termination rights, which would include clear rights to call on the performance security, give the principal direct recourse to subcontractors and any security they have provided and, ideally, improve the principal's potential leverage in an insolvency scenario. Upstream and downstream contracts should include a right of novation or assignment to minimise the impact of an insolvency on the continuation of a project.

Performance security should be sufficient to meet the obligations of any indemnity and ideally be:

• unconditional and payable on demand
• capable of covering future, contingent and unascertained claims (not just liquidated claims)
• subject to a non-injunction undertaking from the contractor
• capable of being called without notice.

Practical tips if faced with an insolvent contractor

If a principal is faced with an insolvent contractor, it should consider whether it is entitled to call on the performance security.

Calling on bank guarantees may mitigate against the financial consequences of a contractor's insolvency. However, a principal should carefully consider its contractual rights before making demands under a guarantee to avoid or mitigate any subsequent legal challenge. If a principal decides to call on a guarantee, it should be mindful of the following practical matters when making the demand to minimise the risk of an injunction by the contractor or its external administrator:

• ensuring that all of the principal's representatives executing demand letters have the authority to do so
• considering whether the guarantee instrument incorporates the International Chamber of Commerce Uniform Rules for Demand Guarantees (which include various procedural requirements for demands)
• if guarantees are provided by several different financial institutions, making demands on those guarantees simultaneously to minimise the scope for an application for injunctive relief.

Next steps

It is a challenging time for the projects industry, but also one of opportunity. By understanding the unique problems currently faced, and implementing appropriate strategies, parties will be far better placed to manage and minimise their impact.