Whilst infrastructure investment is an attractive opportunity, investors should be prepared to mitigate the risk inherent in large construction projects.
Private investment in infrastructure, especially renewable energy projects, is surging across the globe. In fact, total new investment in renewable energy hit an all-time high during the first half of 2021. The resulting competition among investors has led funds to invest in riskier projects in the hopes of obtaining higher returns.
Risk on infrastructure projects comes in many forms. One of the more difficult risks to manage is the potential for cost overruns during construction and, the larger the project, the greater the risk for overruns. According to McKinsey & Company, 98% of megaprojects (projects with a total cost greater than US$1 billion) suffer cost overruns of more than 30%, and 77% of them are completed at least 40% behind schedule. Such cost overruns will significantly threaten an investor’s return, but this risk can be mitigated by ensuring that the owner of the project properly manages its relationship with its contractor. To that end, investors should be mindful of the following:
Make time for a robust front-end design. The more design work done before putting a project out to bid, the more defined the scope will be for the project. This will reduce the risk of unforeseen conditions and growth in quantities of material and equipment.
Shift the risk of cost overruns onto the contractor. A lump-sum or a guaranteed maximum price contract will provide the project with greater cost certainty than a cost-reimbursable contract. While a contractor will insist on a higher price to assume the risk of cost overruns, it may be better for investors to have that price negotiated upfront in exchange for greater cost certainty moving forward.
Insist on an engaged management team. Problems on construction projects tend to snowball if they are allowed to fester. During the project, the owner should employ an internal project management staff dedicated to monitoring costs, schedule and, most importantly, holding the contractor to the terms of its contract.
Understand international dispute resolution. In the event the owner and contractor cannot resolve their dispute on delays and cost overruns, they will be forced to have their claims adjudicated by a tribunal. International projects often utilise arbitration for disputes, with the International Chamber of Commerce being the most popular venue. The benefit of these proceedings is that they allow the parties to avoid the idiosyncrasies of a local court, the eventual award is typically kept confidential, and it is internationally enforceable.
The decision to invest in a capital project does not always account for the intricacies of the construction process, even though it can torpedo key cost assumptions. A bit of diligence and discipline during this phase can help ensure an investor’s targeted rate of return.