How to incentivise good performance in an alliance contract

A fundamental principle of alliance contracting is the idea that all alliance partners should work together to deliver the project as a whole. It follows, therefore, that the financial “gain” or financial “pain” attributable to each alliance partner should be directly linked with the performance of the overall alliance (whether good or bad) and not to the performance of individual alliance members. 

For an alliance to work effectively, getting this commercial/financial model right is absolutely key. If the alliance partners are not appropriately incentivised to work together in this way, the alliance will not operate effectively. It is therefore vital to invest time and effort into getting the commercial model right from the outset, to ensure that the alliance structure drives the right behaviours and fairly rewards the partners for adopting that solutions-driven mindset. If risk and reward is not appropriately balanced, then it will be difficult to encourage parties to sign up to this collaborative alliancing structure.

How is this achieved?

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.

What are the potential barriers to alliance contracts?

An obvious benefit for project partners is that the risks are shared between the alliance parties. This decreased level of risk makes alliance contracts an attractive proposition for delivery partners, which should help reduce overall costs and increase the likelihood of successful project delivery. It might also encourage a wider range of interested parties giving the project developer a greater choice of parties (with a wider pool of expertise) to form an alliance with.

However, despite the clear advantages and obvious attractiveness of the idea of alliancing, alliance models are not without their challenges when it comes to implementation. Where there is one dominant or more influential alliance partner, this may impact upon the impartiality of important decisions and cut across the intention to have 'one voice'. The management of an alliance contract can also become difficult in situations where a large number of parties are involved.

Furthermore, the 'painshare' aspect of an alliance contract and reliance on other alliance partners to help mitigate and resolve issues that arise may discourage parties from wanting to commit to this sort of model. Although in traditional contracting a party might be exposed to the full extent of the risk, it is equally entirely within its control to act upon and manage that risk. However, in an alliance contract, the consequences of a poor result will be shared amongst the parties to the alliance which may result in alliance partners choosing to allocate their strongest resources to contracts that it has over the alliance contract, where there might be a higher risk exposure.

It is therefore critical that these issues are considered and factored into any payment model so that the contract drives the right behaviours and incentivises the alliance partners to collectively deliver the project successfully in order to share in the fair and just reward.  

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