26 August, 2015
A guaranteed maximum price contract is a hybrid of a cost reimbursable contract and a fixed lump sum. A contractor is reimbursed the costs that it actually incurs when they are incurred, which assists with cashflow. However, unlike an alliance, those costs are capped at the Guaranteed Maximum Price or the GMP. The contractor must, therefore, ensure that its GMP reflects an accurate scope of work because beyond the GMP, the contractor bears the risk.
There are many variations on GMP contracts and they can be used in a variety of contracts in the mining industry, ranging from services contracts to complex engineer, procure, construct contracts.
While guaranteed maximum price contracts certainly are not new, they have not traditionally been used in the mining context. However, with the increased focus on reducing costs and maximising efficiencies, project owners could consider this pricing mechanism to achieve budget certainty and potentially savings by only paying for work that is actually performed to deliver the scope of work.
We have set out below a high level checklist for project owners when engaging contractors under a guaranteed maximum price contract.
What should be capped?
Anything that the contractor can accurately price or if there is the potential for savings. The cap that is the GMP can apply to the whole of the contract price or just a component. For example, in a contract for services in which the only reimbursement to the contractor is for labour at set rates with a small proportion for materials, it makes sense to cap everything that the contractor is being paid. However, for an EPC contract, it may make more sense to pay particular components on a lump sum (eg the engineering component) and then have a GMP apply to the remainder of the costs. GMPs work really well where there is a real opportunity for the contractor to make savings through innovation. If savings can only ever arise due to compromising quality, a GMP may not be appropriate.
Do you know how has the GMP been calculated?
Usually, a GMP will be proposed by the contractor and then negotiated. The benefit of a GMP is that it allows the owner to examine the “build-up” of the GMP – theoretically, it should consist of an estimate of the costs which are to be capped with a percentage allowance for risk. Asking a contractor for that build up or requiring a tenderer to include that build up in its tender can mean that the owner can identify areas where the GMP may need further explanation. For example, if the contractor has included a large percentage for risk because it is concerned about latent conditions, then it may be more appropriate for the project owner to take on the risk of latent conditions and reduce down the risk component of the GMP.
Alternatively, if the contractor has not made an allowance for risk, this should be a cause for concern for a project owner. Not including a sufficient allowance for risk can lead to a contractor sacrificing quality or making claims throughout the delivery of the project in an attempt to recoup some of its losses.
Have you included appropriate mechanisms for the GMP to be adjusted?
Despite the name, a guaranteed maximum price is not an absolute guarantee on the price. It needs to be adjusted in the same manner that a lump sum is adjusted, for example, for costs arising out of variations or risks that the contract assigns to the owner. If the contract does not allow for the GMP to be adjusted for specified risks, a contractor will include a large allowance for risk in the GMP and it will be much higher than it needs to be. In allowing for adjustments to the GMP, the same principles as when adjusting a lump sum apply; place the risk with the party best placed to manage it. If that party is the owner, allow for an adjustment to the GMP.
Do you have sufficient rights to audit and to correct payments?
As with any cost reimbursable contract, it is important that the contractor keeps records that can be easily audited by the owner, given that it would be virtually impossible to do a thorough check of costs each time a payment claim is made. It is equally important that those records are readily available to the owner on short notice and easy access. In order for the audit rights to be of any use, it is necessary to include a right to correct previous payment certificates and claw back payments if costs are found to be paid incorrectly.
Does the contract work for all parties?
As with all contracts, it is important that the payment mechanism is workable and that the contractor receives fair value for the work performed. Passing too much risk to the contractor through an inflexible GMP will not incentivise the contractor to work with the owner to deliver a best for project outcome. Similarly, a GMP with unrealistically high risk allowances built in may have the same result. Instead, a realistic price, with sensible adjustment mechanisms will ensure that the parties continue to talk to each other and that both achieve a value for money outcome.
There are many considerations to be taken into account when deciding to engage a contractor under guaranteed maximum price contract. Often, for a project owner, the first of these contracts can take some time to refine and negotiate and requires a reasonable amount of work up front. However, once that first contract has been negotiated and is in the delivery phase, the implementation of guaranteed maximum price contracts for further projects is significantly easier and, in our experience, project owners rarely look back and choose to implement a large proportion of projects on a guaranteed maximum price basis.
For further information, please contact:
Melanie Cave, Partner, Herbert Smith Freehills
melanie.cave@hsf.com
