Allocating Risk at the Contract Level

Abstract

This chapter introduces a structured approach to project contracts. Contracts are characterized based on three complementary perspectives; formal, trust and commercial. The formal-trust axis is subdivided into market contracts, relational contracts and partnering contracts. Further, contract commercial conditions can be cost-based or price-based with financial incentives. The type of contract selected for the supply of materials and services is important from a risk perspective as it is the contract type that defines how project risks are divided between the contractual parties. In a price-based contractual environment, the supplier bears all the risk in manufacturing equipment and providing services provided the owner refrains from making changes. In a cost-based environment, the execution risks are born solely by the owner but the supplier can impact the risk level. In a partnering environment, an ad hoc alliance contract identifies the execution risks and determines how these risks are shared by the parties. Contractual incentives in the contractual agreements can be used to encourage all parties to trade risks for opportunities.