As use of the NEC4 contracts becomes increasingly common in Ireland, this article considers the pricing model of the construction contract that is used on some of the world’s largest construction and infrastructure projects: the NEC4 Engineering and Construction Contract, Option C. By Alexander de Búrca, Arthur Cox LLP

The New Engineering Contract (“NEC”) was first published by the UK-based Institution of Civil Engineers in 1993. The goal of the NEC was to promote greater collaboration between the client and the contractor and better overall management of construction projects. From the original NEC, a suite of contracts has been developed, with the fourth and most recent versions of the suite (“NEC4”) being published in 2017.

The contracts of the NEC suite are structured to have both core clauses and optional clauses. Within NEC4, the “main option” is which of the six potential pricing models to choose. This article is focused on Option C, the pricing model involving a target price with an activity schedule, as this is one of the more common choices when the NEC contracts are used on larger projects. Option C can be used whether or not the contractor has any design responsibility.

Under Option C, there is a pain/gain share mechanism whereby the final price paid to the contractor will depend on the difference between the expected cost of the works and the outturn cost of the works.

At the outset of a project, the contractor prepares an “Activity Schedule” setting out the various activities (i.e. the various elements of works and design) that the contractor expects to carry out to complete the scope of the expected works. The entire scope of the works should be included in the Activity Schedule. The contractor, as part of its tender, includes a lump sum price in the Activity Schedule for the completion of each activity. These prices are referred to as the “Prices” and together represent the expected cost of the works at the outset of the project.

In addition, the contractor is required to prepare forecasts of the total “Defined Cost” for the whole of the works in consultation with the project manager (i.e. the person appointed by the client to administer the contract) and to submit these forecasts to the project manager. The Defined Cost is “the cost of components in the Schedule of Cost Components less Disallowed Costs”. The Schedule of Cost Components sets out various heads of costs that the contractor will incur in carrying out the works, such as staff costs, equipment purchase and hire, plant and materials, sub-contractor costs and design. Disallowed Costs include costs that are not justified by the contractor’s accounts and records, were incorrectly paid to a sub-contractor or supplier, were incurred because the contractor did not properly follow procedures in the contract or were incurred in correcting defects.

The forecasts of the total Defined Cost are required to be updated as the works progress.

At regular assessment dates during the course of the work, the contractor can submit applications for payment for the total Defined Cost forecast to be paid by the contractor before the next assessment date, plus an additional percentage of the Defined Cost as a fee. Together, the Defined Cost and the fee is the “Price for the Works Done to Date”, which is the basis for the contractor’s payment entitlement.

The project manager certifies payment based on this submitted payment application. Unsurprisingly, significant client and contractor resources are required to monitor ongoing expenditure during the execution phase of a project, but this approach offers advantages in terms of increased transparency and collaboration.

When an element of the Defined Cost has been finalised, the contractor notifies the project manager of this and provides the necessary information to demonstrate that the cost has been correctly assessed. If any amount was previously incorrectly assessed, it is corrected in a later payment certificate.

Following completion of the works, the project manager assesses the contractor’s share of any applicable pain or gain. The contractor’s share is based on the difference between the total of the Prices estimated at the beginning of the project that is set out in the Activity Schedule, and the total of the Price for the Works Done to Date at the completion of the project, which could be higher or lower than the total of the Prices. This difference is then divided into increments that fall within certain agreed share ranges, and the contractor is responsible for an agreed percentage of each range. If the price of the work done is less than the total of the Prices, the contractor is paid its share of the saving. If the Price for the Works Done to Date is greater than the total Prices, the contractor pays its share of the excess. It is open to the parties to agree the applicable share between client and contractor for each of the share ranges (i.e. whether it is 50/50 split or otherwise), but the share will invariably be calibrated to incentivise completion of the works below the total Prices.

The NEC4 Option C is therefore quite different from other standard forms of construction contract more commonly used in Ireland such as RIAI, FIDIC and the public works contract. As both the client and contractor share in any cost overruns or savings, Option C is intended to encourage the efficient completion of the works and co-operation between the parties. The successful implementation of an NEC4 Option C contract requires all the parties involved to move to a more collaborative and transparent approach to contracting as envisaged by the NEC. This approach is typified by the clause found at the beginning of the NEC forms of contract that requires the parties to “act in a spirit of mutual trust and co-operation”.

The successful use of NEC Option C will also require realistic target costs being set at the outset of a project. As with any target cost pricing model, the credibility of the target cost depends heavily on the maturity of the project information available when determining the target cost. If, for example, the design is insufficiently advanced, the target can become little more than an educated guess, increasing the risk of early divergence between forecast and actual cost. To set a realistic target, the design should be substantially developed, particularly for high value or technically complex elements. Likewise, the main sub-contract packages should ideally have been tendered or at least robustly market-tested, allowing the parties to base the target on real pricing rather than assumptions. If this pre-contract work is not carried out, the target cost mechanism can generate misaligned expectations, entitlement disputes, and an erosion of the collaborative approach that Option C is intended to promote.

While the use of the NEC suite of contracts in Ireland is still quite limited, it is becoming more popular. For example, Transport Infrastructure Ireland has stipulated that NEC4 Option C will be the contract used for each of the civils works packages that are to be tendered in respect of the MetroLink project. In addition to the MetroLink, NEC has noted that NEC4 is being or will be used on a number of substantial infrastructure projects in Ireland such as the Adare Bypass, which is due to complete in time for the 2027 Ryder Cup, projects at Dublin Airport as part of the daa’s capital investment programme and Irish Rail’s anticipated DART+ expansion programme. With the use of the NEC suite of contracts in Ireland only likely to increase, MetroLink’s significant procurement programme is an excellent opportunity for the Irish construction industry to become better acquainted with these forms of contracts.

The Arthur Cox Construction and Engineering team has considerable experience in advising both employer-side and contractor-side clients on target cost pricing as well as on collaborative contracting including the nuances of the NEC suite of contracts. If you require any assistance or have any thoughts on target cost pricing and the future of the NEC suite of contracts in Ireland, we would be delighted to hear from you.

Author: Alexander de Búrca, Associate, Arthur Cox  www.arthurcox.com

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