A Megaproject Incentive Contract
Heathrow Airport’s Terminal 5 is one of the most extensively documented megaprojects. Built by British Airport Authority (BAA) and completed in 2007 there is a book, a volume of ICE Proceedings, numerous academic journal and conference papers, and many more newspaper and magazine articles. Apart from its size, cost, and enormous numbers, the distinguishing feature of T5 is that it came in on time and on budget, one of the few megaprojects to do so. How that was achieved is, I think, an interesting story.
The foundation was the T5 Agreement, a sophisticated incentive contract between BAA and its suppliers, a large and diverse group of traditionally competitive engineers, architects and design consultants, specialised subcontractors, general contractors, fabricators and manufacturers. The supplier network had 80 first-tier, 500 second-tier, 5,000 third and 15,000 fourth-tier suppliers. Over 50,000 people worked on the site at some point during construction. This was an unusually collaborative approach, with BAA taking responsibility for project management using the complex incentive contract to minimize risk.
The purpose of a procurement strategy is finding the most appropriate contract and payment mechanism. An effective procurement strategy enables an ability to manage projects while dealing with changes in schedule, scale and scope during design and delivery. This is the trinity of time, cost and quality in building and construction. The bigger the project, the harder it gets. For BAA the investment in T5 was around the same as the then value of the company, and the government imposed significant penalties on late completion and underperformance.
Two commonly used categories of explanation for cost overruns and benefit shortfalls in major projects are technical and psychological, Technical explanations revolve around imperfect forecasting techniques, such as inadequate data, honest mistakes and lack of experience of forecasters. Psychological explanations focus on decisions based on unrealistic optimism, rather than a rational scaling of gains, losses and probabilities.
T5 is on the left side if the picture. It included the main terminal building and two satellites, 62 aircraft stands, an 87m air traffic control tower, car parking for 5000 vehicles and a hotel, road and underground rail and services infrastructure. There were 1,500 work packages in 147 subprojects, clustered into 18 projects led by 4 project heads for civil engineering, rail and tunnels, buildings, and systems.
Two rivers were diverted around a site of 260 hectares, and the T5 building itself is 40m high, 400m long and 160m wide.
Before work started on T5, BAA studied a group of similar projects and the problems they had encountered, known as a reference class. It is a process based on pooling relevant past projects to identify risks and get a probability range for outcomes. For example, the reference class based forecast for fatalities on a project the size of T5 was six, with the safety program the actual outcome was two.
Using this reference class to forecast time and cost performance by estimating probability ranges for T5, BAA designed a procurement strategy. BAA was a very experienced client and they dealt with these issues in a systematic way. Under Sir John Egan they had started a program called CIPPS, which produced the first iteration of the T5 Handbook in 1996. This was revised as test projects completed, and by 2002 a budget of £4.3bn and schedule of 5 years was in place.
The procurement strategy for T5 centered on managing innovation, risk and uncertainty. BAA’s management team recognized the size, scale and complexity of the project required a new approach if the project was to succeed. The contractual framework was envisioned as a mechanism to permit innovation and problem solving, to address the inherent risks in the project.
BAA used in house project management teams to create relationship-based contractual arrangements with consultants and suppliers. Traditional boundaries and relationships were broken down and replaced by colocation, so people from different firms worked in integrated teams in BAA offices under BAA management. The focus was on solving problems before they caused delays.
An example of a T5 innovation in design management was the Last Responsible Moment technique, borrowed from the lean production philosophy developed by Ouichi Ono for Toyota. LRM identifies the latest date that a design decision on a project must be finalised. The method implies design flexibility, which is logically an approach used when there is unforeseeable risk and uncertainty, but once the decision is made the team takes responsibility and the task is to make it work.
The contractual agreement developed was a form of cost-plus incentive contract. However, unlike other forms of cost-incentive contracts where the risks are shared between the client and contractors, under the T5 Agreement BAA assumed full responsibility for the risk. The client explicitly bearing project risk was a key innovation that differentiates T5 from many other megaprojects.
Because BAA held all the risk, suppliers could not price risk in their estimates, which meant that they had to maximize their profit through managing performance. BAA used an incentive based approach with target costs to encourage performance and proactive problem solving from suppliers. Although there is a risk with over-runs, the risk is hedged on the basis contractors will strive to achieve cost under-runs in order to increase their profit.
The incentive was paid as an agreed lump sum based on the estimate for a particular sub-project (the target cost). If suppliers delivered under budget than that extra amount of profit would be split three ways between the suppliers and BAA, with a third held as contingency until the project completed. Conversely, if the suppliers took longer than expected or more funds were needed to finish a project, it would affect their profit margin.
Through the T5 agreement, and the planning that went into developing it, BAA was able to set performance standards and cost targets. The integrated teams focused on solving problems and, with the alignment of goals and the gainshare/painshare financial incentives in the Agreement, suppliers were able to increase their profits.
The T5 Agreement’s financial incentives rewarded teams for beating deadlines for deliveries, and was project team based, as opposed to supplier based, to encourage suppliers to support each other. BAA paid for costs plus materials, plus an agreed profit percentage which varied from 5 to 15% depending on the particular trade. With full cost transparency, BAA could verify costs had been properly incurred. BAA was able to audit any of their suppliers’ books at any time including payroll, ledgers and cash flow systems.
Megaprojects have a terrible track record of cost overruns, which is why the reporting on T5 is so positive. It was an exceptional project in every respect and, like many megaprojects, became a demonstration project for introducing new ideas into the industry. Once construction started, the delivery of T5 on time and on budget, with a remarkable safety record, was due to the three inter-related factors of risk management, integrated teams, and the alliance contract. BAA held all the risk and the incentive contract meant suppliers could gain through performance. Instead of risks and blame being transferred among suppliers, followed by arbitration and litigation, BAA managed and exposed risks, and the suppliers and contractors were motivated to find solutions and opportunities.
The T5 Agreement highlights the fact that procurement as a strategy is primarily about finding an appropriate mix of governance, relationships, resources and innovation. There were three iterations of the Agreement, as it developed in stages through trial and error. The values written into the T5 Agreement stated ‘teamwork, commitment and trust’ as the principles that BAA as the client and project manager wanted from suppliers and contractors. This was achieved through a partnering or alliance approach, driven down through the supply chain by the 80 firms in Tier 1 to Tier 2 and Tier 3 suppliers. The procurement strategy and T5 Agreement helped popularize the framework agreements in use today, where major clients find long-term industry partners for building and construction work.
The success of T5 was also a successful translation of the Toyota lean management paradigm, bringing co-location, integrated teams, LRM design management and other lean techniques, and cooperative relationships into a megaproject environment. BAA invested so heavily in preparing for T5 because of the risk the project presented, effectively they were betting the company on the outcome. They built two logistics centres on-site, and a rebar workshop, to minimize delays in the supply chain.
Not many projects have the unique combination of scale, circumstances and complexity found in T5. Nor associated stories like decades of planning inquiries or the failure of the baggage handling system on opening day. As a highly visible and controversial project, and at the time the largest construction project in Europe, it was also unusually well documented.
This is the third in a series of procurement case studies. The previous ones were on the building of the British parliament house at Westminister in 1837 and the Scottish parliament's Holyrood Building in 1997.
Some T5 Publications Brady, T. and Davies, A. 2010. From hero to hubris – Reconsidering the project management of Heathrow’s Terminal 5, International Journal of project Management, 28; 151-157. Caldwell, N D, Roehrich, J K, Davies, A C, 2009. Procuring complex performance in construction: London Heathrow Terminal 5 and a Private Finance Initiative Hospital, Journal of Purchasing & Supply Management, Vol. 15. Davies, A., Gann, D., Douglas, T. 2009. Innovation in Megaprojects: Systems Integration at Heathrow Terminal 5, California Management Review, Vol. 51. Deakin, S. and Koukiadaki, A. 2009. Governance processes, labour-management partnership and employee voice in the construction of Heathrow T5, Industrial Law Journal, 38 (4): 365-389. Gil, N. 2009. Developing Cooperative project client-supplier relationships: How much to expect from relational contracts, California Management Review, Winter. 144-169. Potts, K. 2009. From Heathrow Express to Heathrow Terminal 5: BAA’s development of Supply Chain Management, in Pryke, S. (Ed.) Construction Supply Chain Management, Oxford: Blackwell. Potts, K. 2006. Project management and the changing nature of the quantity surveying profession – Heathrow Terminal 5 case study, COBRA Conference. Winch, G. 2006. Towards a theory of construction as production by projects, Building Research and Information, 34(2), 164-74. Wolstenholme, A., Fugeman, I. and Hammond, F. 2008. Heathrow Terminal 5: delivery strategy. Proceedings of the ICE - Civil Engineering, Volume 161, Issue 5. All the papers in this Issue were on T5.