Construction Workers

Construction Industry Economics and Policy

A BLOG ABOUT THE STRUCTURE AND PERFORMANCE OF THE BUILDING AND CONSTRUCTION INDUSTRY

Why Modern Methods of Construction Don't Work

Offsite manufacturing, modular and prefabricated building have been transforming construction like nuclear fusion has been transforming energy: they have both been twenty years away from working at scale for the last 60 years. These ‘modern methods of construction’ have a dismal track record. The brutal economies of scale and scope in a project-based, geographically dispersed industry subject to extreme swings in demand have always bought previous periods of their growth and development to an end.

While the history of prefabrication features major projects like the Great Exhibition in 1855 and more recently the Oresund Bridge in 2000, the reality is that prefabrication has only been successful in specific niche markets such as institutional buildings, or house manufacturers like the Japanese and Scandinavian firms Sekisui and Ikea. Failures like Katerra in mid-2021 and the mail order houses sold by Sears Roebuck a hundred years ago in the US are common. In the UK 2017 Industrial Strategy Construction was one of the four Sector Deals along with AI, the car industry and life sciences, with the aim to change the way buildings are created with a manufacturing hub for offsite and modular construction. By 2021 the focus had moved on, to the energy efficiency of buildings and new design standards.

The up-front capital requirements of prefabrication make it a capital-intensive form of production, which brings high fixed costs in a cyclic industry characterised by demand volatility over the cycle. This means macroeconomic events often determine the success or failure of the underpinning business model and the success or the eventual failure of the investment. A batch of new US prefab housing firms failed during the GFC after 2007, for example, demonstrating the importance of the relationship between economic and business conditions and the viability of the business model for industrialised building.

Manufactured housing in the US also provides an insight into the institutional barriers to industrialisation in construction that exist in many countries and cities. Although the Department of Housing and Urban Development hasa national code, US cities discriminate against manufactured housing as local and county governments use a variety of land use planning devices to restrict or ban their use, and often place them in locations far from amenities such as schools, transportation, doctors and jobs. Despite these barriers, in 2021 there were 33 firms with 136 factories that produced nearly 95,000 homes.

An ambitious attempt at offsite manufacturing (OSM) and industrialized building was made by Katerra, a US firm that was reinventing construction but has now gone into receivership. The manufacture of building elements and components somewhere other than the construction site has been variously called prefabrication, pre-cast and pre-assembly construction. Types of offsite construction are panelised systems erected onsite, volumetric systems that involve partial assembly of units or pods offsite, and factory built modular components or pods. The degree of OSM and preassembly varies from basic sub-assemblies to entire modules. Katerra manufactured prefabricated cross laminated timber (CLT) structures.

Katerra

Katerra was a Californian start-up, founded in 2015. In 2017 it reached a $1 billion valuation, The company’s goal was complete vertical integration of design and construction, from concept sketches of a building to installing CLT panels and the bolting it together. On their projects the company wanted to be architect, offsite manufacturer and onsite contractor. This led to issues with the developers and contractors the company dealt with most of whom, it turned out, didn’t want the complete end-to-end service Katerra offered.

The company started by developing software to manage an extensive supply chain for fixtures and fittings from around the world, but particularly China, and then added a US factory making roof trusses, cabinets, wall panels, and other elements. In 2016 the business model changed because architects weren’t specifying Katerra’s products. Katerra would design its own buildings and specify its own products. In 2017 it built a CLT factory that increased US output by 50 percent. The factory shut in 2019. Dissatisfied with design software that didn’t meet its needs, it developed a custom suite called Apollo. This was to be a platform for project development and delivery, well beyond the document control and communication of then available software from Oracle Aconex, Trimble Connect, Procore and SAP Connect. Apollo integrated six functions:

1. Report: use an address to find site information, zoning, and crime rates etc.;

2. Insight: design with the two building platforms;

3. Direct: a library of components used in the building;

4. Compose: for coordination between the different groups working on a project;

5. Construct: for construction management (similar to Procore and Bluebeam):

6. Connect: for managing the workforce on a project, with a database of subcontractors.

One of the company’s three founders was a property developer, and his projects provided the initial pipeline of work that made the company viable. Initially, buildings were designed by outside architects, but in 2016 the company started a design division. A second founder had a tech venture capital fund, the third and CEO did a stint at Tesla. Their ambition was to leverage new technologies to transform building by linking design and production through software, designing buildings in Revit and converting the files to a different format for machines in the factory.

In 2018, after raising $865 million in venture capital led by SoftBank’s Vision Fund, Katerra acquired Michael Green Architecture, a leading advocate of CLT, and over a dozen other architects and contractors. In 2020 the business model changed again, by taking equity stakes in developments to boost demand. Katerra struggled to complete the projects. Accumulating losses and cost overruns during the Covid pandemic overwhelmed the company and in June 2021 Katerra Construction filed for Chapter 11 bankruptcy.

In six years Katerra had grown to a 7,500 person company. That growth cost both money and focus, of the total US$2.2bn raised, SoftBank invested $2bn between 2018 and 2020. Without a clear focus, Katerra didn’t have a target customer base and got distracted by software and developing internet-of-things technology. The executive team was dominated by industry outsiders, but Katerra hired architects and engineers from traditional firms. Tension was inevitable. The fatal problem was execution, Katerra didn’t vertically integrate acquisitions into a company that did everything. It was fragmented and didn’t have a product platform or Apollo ready in time.

With Apollo, Katerra was actually behind other companies developing platforms that manage design and construction in various ways. These platforms are at the technological frontier, a fourth industrial revolution technology for OSM with automated production of components. Other firms have developed different approaches to digital manufacturing and restructuring of firm boundaries to Katerra, integrating design and construction through development of digital platforms that provide design, component specification and manufacturing, delivery and on-site assembly.

For example, in 2018 Project Frog released KitConnect, bringing together a decade of development into prefabrication and component design, and integrating BIM with DfMa and logistics. US start-ups in the wake of Katerra like Junoand Generate also don’t build factories but outsource assembly. Outfit offers homeowners a DIY renovation from its website, then orders and ships the materials and provides step-by-step instructions for completing the work (the Sears model again). Also in 2021, the IPO for PM software company Procore raised $635 at a valuation near $10bn, a record for construction tech. Rival Aconex was bought by Oracle in 2017 for $1.2bn. Platforms are in the process of becoming a basic part of construction tech. In the UK Pagabo launched a procurement platform in 2021, mainly for the public sector, using framework agreements for building work valued between £250k to £10m. Australian 2021 procurement IPO Felix had local start-ups Buildxact, SiteMate, Mastt, Portt and VenderPanel with competing platforms.

Conclusion

The idea of construction as production was based on OSM, but after decades of development has yet to become a viable business model. There have been successes in manufactured housing, but often macroeconomic factors undermined their viability. Niche markets exist in institutional building, or wherever it is the most effective or efficient piece of technology available. This manufacturing-centric view of progress in construction, endorsed by numerous government and industry reports, is the end point of the development trajectory from the first to the third industrial revolutions.

The technological base of OSM is a mix of those from the first industrial revolution, like concrete, with second and third revolution technologies like factories and lean production. Despite all efforts this has not become a system of production because OSM does not deliver a decisive advantage over onsite production for the great majority of projects. Instead, construction has a deep, diverse and specialised value chain that resists integration because it is flexible and adapted to economic variability. Policy makers may neither like nor appreciate this brute fact, but economies of scale are the economic equivalent of gravity and OSM has not delivered.


The constraints of OSM have outweighed the drivers and benefits. At this stage the market share of OSM remains small and niche, estimates are low single digits of total construction work in the UK, US and Australia. Success elsewhere is restricted to a few specific markets and project types. The problem is not the technology, which can be made to work, but the expected economies of scale are difficult to achieve because of a range of factors. Some of these factors are internal to construction, but others are external. In particular, macroeconomic events like financial crises or energy and commodity price changes can quickly undermine a business model.


Norman Foster said in an interview ‘A building is only as good as its client’. With industrialized building the client is the producer, which is not necessarily a bad thing, however this has restricted its use to niche markets. How to apply the technologies of the fourth industrial revolution so they work with the economies of scale for onsite production in construction, beyond the OSM paradigm that has been followed for years without success, is the challenge


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The contribution of the built environment industries to output and employment are a significant component in macroeconomic stability, directly through household incomes and indirectly through aggregate demand. Recognising this, policies to increase building and construction work are a common response to slowdowns in growth during the contraction phase of the business cycle, and increased infrastructure spending is seen as an effective policy to support demand in the short run while developing assets for the future. The Australian experience managing the global financial crisis after 2007 and the end of the mining boom in 2014 are two examples of the importance of the Built Environment Sector to macroeconomic policy outcomes.


Taking a broad view of an industrial sector provides evidence of its role and significance in economic and technological development. The Industry Value Added of the sixteen built environment industries contributed 14.2 percent to Australian GDP in 2018-19, within their long-run range between 14 and 15 percent of GDP since 2006-07. The BES share of total employment fluctuated between 16.5 and 17.5 percent of total employment, reaching a high in 2011 after a major fiscal stimulus during a period of exceptionally high mining investment expenditure.


Australian Built Environment Sector: Summary Statistics.

2018-19 Employment IVA $bn

Total Australian Built Environment Sector 2,126,000 270

Total Australia Employment and GDP 12,867,000 1,801

BES Percent of Australia total 16.5% 14.2%

Sources: ABS 8155, ABS 5206, ABS 6202.


Australia built environment
Economic Role

Fiscal Policy and the Global Financial Crisis


The economic stimulus used by governments during the global financial crisis that started in 2007 followed the Keynesian macroeconomic fiscal policy framework of increased government expenditure. The Australian Government’s response to the crisis included a major school building program and a home insulation scheme, as well as large and small infrastructure projects. As the following Figures show, the counter-cyclical timing and impact of the Rudd Government’s fiscal stimulus and building program is an example of the effectiveness of policies that engage the entire BES network of firms and organizations.


The figures below show how the increase in Commonwealth Government spending in 2009-10 on schools, buildings and infrastructure flowed through to the wider economy over the following years. The big increase in public sector building work was in the 2009-10 and 2010-11 budgets. With the increase in public building there was a very large increase in the IVA of the built environment industries. The BES IVA increased by 12 percent over 2009-10, at a time when nominal GDP growth was under 2 percent.


global financial crisis and Australian construction
Government expenditure on building
Australia construction GFC
Annual percentage change in output
Australia construction GFC
Annual percentage change in employment

Australia was the only G20 country to avoid a recession during the global financial crisis, and one reason was the increase in Commonwealth construction expenditure. After starting to increase in 2008, in 2009-10 Public sector building work done more than doubled to over 1.5 percent of GDP. Australian Government net debt had previously peaked in 1996 at 18 percent of GDP, then fell to zero by 2006, and was back to 12.5 percent of GDP in 2013-14 after the GFC and years of large budget deficits[i].



Monetary Policy and the Transition


Rebalancing the economy after the mining boom ended in 2014 was another major macroeconomic challenge. To support aggregate demand the Reserve Bank of Australia lowered interest rates and encouraged banks to lend for mortgages and property development. During the subsequent residential boom in apartment building from 2013-18, the BES supported output across the economy as the mining boom ended and engineering construction and business investment fell from 18 percent of GDP to 8 percent. Over that period residential building rose from around 120,000 to over 200,000 commencements a year, due to an increase in high density apartment developments. In 2017-18 BES employment growth peaked around 6 percent, at the top of the residential cycle.


Australia construction interest rates
Private Sector Construction and Interest Rates

Australia’s mining boom started in the early 2000s, and between 2006-07 and 2013-14 Engineering construction more than doubled its share of Construction IVA, increasing from 12 to 24 percent. Over that period the share of Construction services fell from 67 to 55 percent of total Construction IVA, while Building was around 20 percent. By 2016-17 Engineering had fallen to 16 percent of Construction IVA, Building had increased to 25 percent, and Construction services were 59 percent. The shift from Engineering to Building meant BES IVA was growing around twice as much as GDP between 2003 and 2017, and the strong backward linkages between industries meant the effect on the economy was stronger compared to the mining boom because of the large amounts of imported plant, machinery and equipment included in the Engineering work statistics (included are oil and gas platforms for example).


The BES clearly has a significant role in the economy, as the examples of the effects on BES output and employment of fiscal policy in the global financial crisis and monetary policy in the transition after the mining boom show. In the first case, a very large increase in 2009-10 on Public sector building work saw an increase in BES IVA of 12 percent and employment of 6 percent. In the second case, after 2013 as engineering construction work fell from the highs of the mining boom, interest rates were lowered and the increase in residential building work supported the economy during a difficult macroeconomic transition.


Within Construction, internal dynamics saw significant changes as the IVA shares of the three component industries rose and fell with changes in the composition of Construction output: Construction services between 67 and 53 percent; Building between 20 and 27 percent; and Engineering between 12 and 24 percent of Construction IVA. While those fluctuations in output were occurring there was a shift in employment away from Construction services as Engineering increased, which was reversed after 2014 as Building work increased and Engineering fell.


Industry shares of Construction employment
Industry shares of Construction employment

Conclusion


Between 2007 and 2019 the Australian BES accounted for 14-15 percent of GDP and 16-17 percent of total employment. It has a significant macroeconomic role in the economy, as these examples of the effects on BES output and employment of fiscal policy in the global financial crisis and monetary policy in the transition after the mining boom show. In 2009-10 expenditure on Public sector building work led to an increase in BES IVA of 12 percent and employment of 6 percent. In 2013-14, as engineering construction work fell from the highs of the mining boom, interest rates were lowered and increasing residential building work supported the economy during a difficult macroeconomic transition over the next three years.


In the same way as Tourism, Defence and Manufacturing are not themselves an industry but collections of related industries that make up an industrial sector of the economy where firms have similarities in products and processes, industries that contribute to the construction and maintenance of the built environment can also be collected and their contribution to output and employment measured. The economic role of the BES is important and better data can contribute to economic policy decisions that, through the BES and its dense network of linkages between industries, significantly affect macroeconomic outcomes.


[i] See the Commonwealth Government’s Budget Paper No. 1, Budget Strategy and Outlook for the years 2006-07 to 2013-14 for details. The fiscal stimulus totalled over 5 percent of GDP over 2009-12.



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Grattan Institute Transport Infrastructure Report




The Grattan Institute, a Melbourne based think tank for public policy, released an important report into procurement of Australian transport infrastructure projects. Their Megabucks for Megaprojects report has four chapters and makes 12 recommendations. The chapters contain a lot of carefully compiled and useful information, while the recommendations are all worthy and, despite their careful phrasing, make a strong case for greater client involvement in the design, documentation and management of large public sector projects.


Chapter 3 of the report is ‘Competition is fundamental’, addressing the issue of the dominance of tier one contractors. The chapter collects data on projects and contractors that is not readily available, with the sources and methodology detailed in the appendices. Their key point is the increase in size of projects since 2014, as shown in Figure 3.3 below.


For the last few years the quarterly value of work done on these large transport projects has been over $5 billion. In 2020 Australian governments spent a record $120 billion on road and rail transport projects.



The argument is that it is increasingly difficult for mid-tier contractors to win work on these very large projects, of the 11 projects above $3 billion 8 were ‘contracts involving multiple tier one firms’. These firms are ‘few and well-known’ in Australia and their Figure 3.10 shows how few, and how they consolidated their position through M&A over the last couple of decades.



The two sources of potential competition for the three tier one contractors are domestic rivals that might scale up sufficiently or new international entrants to the Australian market. In chapter 4 the report argues strongly for breaking up large contracts to allow greater participation from domestic firms, Recommendation 10 is: State governments should develop and use a systematic approach to determining an optimal bundling of work packages for large projects, including when to disaggregate bundles that include both complex and straightforward activities. While not a new idea it is still important because public clients do not generally do this, and often do not have the resources required to manage multiple contracts.

That leaves international entrants, which the report argues have been playing an important role since 2005: ‘International entrants add to local competition, and it’s very helpful to governments if there are a variety of market players willing and able to take on work. In particular, when tier one firms form a joint venture to bid on a large contract, the only source of genuine competition may be from international firms’. Their Figure 3.5 shows the distribution of contracts between new international entrants and firms that were already here in 2006. Of those firms, Bouygues won 4 contracts, Lang O’Rourke and Acciona 5 each.



There are barriers to entry when bidding for these contracts, on top of the high bid costs. These are the lack of transparency in the weighting given to selection criteria and the emphasis on local experience. The report’s Recommendation 8: In selecting a successful bidder, governments should not weight local experience any more heavily than is justified to provide infrastructure at the lowest long-term cost. Governments should publish weightings of the criteria used to select the winning bid for a contract. The Grattan Institute is strongly opposed to ‘market-led proposals’ from contractors, and strongly in favour of open tendering. The state with the highest transparency rating is NSW, also the state with the most contracts with new international entrants.




The report collects data on 51 projects over $1 billion in Australia since 2006. Their dataset of transport infrastructure projects includes 177 contracts worth more than $180 billion (in December 2020 dollars). That data makes this an important contribution to the debate about construction industry policy in Australia, to the limited extent that there is such a debate. A couple of decades ago this data would have been published by the Commonwealth, by the Department of Industry or similar organization, and incorporated into the procurement guides being developed by the Australian Procurement and Construction Council and related State agencies. The report concludes “these guidelines leave a great deal of room for subjectivity in the choice of contract type. Although some of the state guidelines and decision-support documents are quite detailed, none go so far as to prescribe a rigorous and systematic methodology for procurement strategy selection.”


This raises the awkward question of who the report is addressing. The fundamental problem is the politicization of the project selection process not the cost of delivery, Australian construction is not expensive by international standards. The recommendations address the problem obliquely by highlighting improvements in procedures and processes, all of which have merit, but not considering alternatives such as the role an independent authority could play or national coordination of procurement and other regulatory systems. In this it was something of a missed opportunity


State and Federal budgets have billions in unallocated funds for projects at all levels (community sports grants, local and regional infrastructure) and for major projects the Commonwealth has Snowy Hydro, the NAIF, the Murray-Darling Basin Plan etc etc. These projects, large and small, shovel money out the door with little or no accountability and there is no evidence that politicians are interested in change at this time.


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About the Blog

This blog is interested in the organisation of the building and construction industry and its role in the creation and maintenance of the built environment.

Like other industries, it is being reshaped by rapid and widespread advances in materials, technology and capability. How those advances might affect an industry changes slowly over time is, I think, an interesting question.The blog collects data and discusses these trends and their effect on industry structure and performance.

 

The economic perspective focuses on firms and industries rather than individual projects.

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Gerard de Valence

I studied politics, philosophy and economics at Sydney University and worked in the private sector for a decade before becoming an academic in the School of the Built Environment at the University of Technology Sydney and UCL’s Bartlett School of Construction and Project Management in London. The ABOUT page has my bio.