How to incentivise good performance in an alliance contract

In traditional contracting there is usually a relatively clearly defined scope which the contractor is required to deliver for a set price. In tendering a price, the contractor will take into consideration all of the potential risks associated with the work (i.e., all the things that could go wrong which might impact on the cost of doing the work or the time it takes to complete it).

It therefore follows that where a project is more complicated and there are a greater number of risks and/or where it is difficult to assess the impact of those risks, a contractor is likely to include an allowance for those risks materialising in its tendered price. This usually leads to higher prices to reflect the risks that are allocated to the contractor (even though those risks might never materialise) . In many cases, the customer is willing to pay that price premium in return for shifting that risk to the contractor (preferring price certainty over a lower price but with risk attached to it) but even then, where a risk materialises which results in additional cost to the contractor, the contractor may be less likely to prioritise the delivery of that project as it sees its profit margin gradually being eroded.

Alliance contracts take a difficult approach to risk. They rely on sharing risks amongst the alliance and relying on the collective strength of the alliance to respond to challenges that arise during the lifetime of the project. Rather than one party being entirely responsible for a particular risk, which it might not be best placed to manage, the alliance is collectively incentivised to find the best solution to the impact of such risks regardless of how that risk arose or which party might have been behind that risk occurring. The parties are willing to do this because the commercial model will (hopefully) be set up in such a way that successfully doing so will increase the financial gain they will receive under the contract.   The alliance parties therefore have an aligned financial interest in driving a project towards success.

Rather than paying a fixed price to a contractor for the delivery of a defined scope, an alliance contract will usually operate such that each contractor is reimbursed for all of their direct costs in undertaking the work. This ensures that the alliance partners are properly paid for the work done and are not out-of-pocket for investing time and resource in doing things which will ultimately lead to the successful delivery of the project.

However, all of these costs must be shared on an ‘open-book’ basis so that there is full transparency and no incentive for alliance partners to over-engineer the work or cut corners to try and make a little bit more profit.

It is also common for alliance partners to be paid a contribution towards their corporate overheads. Again, this is all done on a transparent basis to ensure that the alliance partners are kept whole.

It is vital that the payment model prescribes a meaningful reward for alliance members. In traditional contracting doing this is much more straightforward – usually a contractor can rely on getting paid a percentage of its costs as a ‘profit margin’ for delivering the works, with this profit potentially being subject to an additional uplift for good performance or a small reduction for poor performance.

However, under an alliance model reward needs to be linked to overall performance so the starting point is to agree what that ‘good’ alliance performance needs to look like. This involves setting key performance indicators, which are often agreed outcomes based on, for example, the delivery of certain works by a certain date, or to certain standards. The better the performance by reference to these agreed outcomes, the more reward the alliance partners will receive.

If the performance of the alliance is poor, then the amount of the reward will be lower. If the pre-agreed outcomes are not achieved, then the financial burden of failing to do so will be shared between the alliance. The aim will always be to calibrate this model in such a way as to incentivise the alliance to deliver the project goals and drive the right behaviours in doing so.