Time for construction derivatives?

Downtown Burj Dubai

• Increase image
• View all images

The projects industry needs to think more creatively about how to reduce risk and still deliver great buildings in a $2 trillion market.

According to MEED Projects, $2 trillion of major construction schemes are in development in the GCC. But the construction industry is already struggling to deliver the fraction of this $2 trillion that has been turned into contracts so far.

Capacity shortages along the project supply chain are intensifying with consequences that could be damaging.

The chief executive of one of the UAE's largest building firms says recruiters from other companies are going to extremes to hire skilled people. In one instance, they were seen on a competitor's site offering workers significantly higher wages.

This approach will not, ultimately, help anyone. Strategic action, not competitive attrition, is needed to increase the industry's total capacity.

Pressure

The balance of power has swung in favour of the suppliers of project services. Shortages have resulted in clients being forced to pay more, but this is raising questions about the viability of planned investments.

Some construction companies are insisting on working for just a small group of select clients. This may make their lives easier, but it will not relieve the pressure on the region's infrastructure and housing stock.

And despite the boom, much of the value being created by the construction industry is being lost to speculators. Real estate agents that sell buildings often make more money than the firms that built them.

It is time for the projects industry to think more creatively about how to deliver great buildings. One option which seems to be finding favour is to reduce vertical disintegration of the supply chain by clients, architects, engineers, construction firms, subcontractors and materials suppliers working together more closely, through partnership, alliance or even merger.

Risk

But vertical integration does nothing to address the biggest challenge of all: how to deal with the risks associated with GCC project delivery, a task as large as any attempted in construction history. As the new joint ventures will soon discover, vertical integration may lead to risks being multiplied rather than reduced.

In other industries, the challenge of delivering a product in the future when prices are unpredictable has been addressed by forwards and futures contracts. This methodology could be adapted to Gulf projects.

It might work like this. A construction company promises to deliver a project for $100m in three years for a fixed price. It protects itself against unforeseen changes to the proiect cost by reaching an agreement with the client so that it will be paid an additional amount, which represents a proportion of the difference between the fixed price and the market value of the finished building.

This arrangement provides an incentive for the builder to do the best possible job on the building, thereby maximising its final value. It also provides an incentive to get the job done on time: the sooner the job is done, the sooner the company receives its profit windfall.

Edmund O'Sullivan

• Increase image
• View all images

Bookmark & Share

Favorites	Digg
Del.icio.us	Google
MySpace	Facebook
Reddit	Newsvine
Live	More ...

To:
From:
Note:

But what if the supplier wants to get that additional money earlier? The answer might be a discount market for construction contracts. Say the agreement is for the contractor to get 25 per cent of the extra, final value of the building. If that is $100m, then the contractor might be prepared to sell the contract for $12.5m now rather than $25m later.

Equity schemes

In short, what will be created is a derivatives market in construction contracts. Sceptics say that derivatives have been the source of the banking industry's recent problems. That may be true. But it is also true that the financial derivatives market has mobilised trillions of dollars for a growing number of industries.

There are three major potential benefits in developing a GCC construction contracts derivatives market. It will:

• Encourage buyers and sellers to concentrate on quantifying the true level of risks involved in projects.

• Allow them to manage those risks more scientifically.

• Provide an additional means of mobilising the billions of dollars that the GCC projects market needs.

There are other benefits:

• Building service suppliers will be able to focus on their core skills rather than worrying about potentially ruinous risks.

• Money will be mobilised to pay for the skills that the GCC projects require.

• A way would be created for banking expertise to be used constructively in the region's building industry.

There is a further compelling element to this proposal. It would allow companies creating Gulf projects to establish equity schemes for their key employees based on the quality of the work they do, not the transient windfall gains from capacity shortages that will eventually end.