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Construction Management and Economics (February 2007) 25, 111–112

Letter to the Editor

Performance-Based Contracting: an Under a new proposal, Performance-Based

alternative approach to transacting in Contracting (PBC), if financial issues and discussions
construction were dealt with separately from delivery, it would be
possible for the transactors to focus on quality issues
Dear Sir, such as the performance of buildings and the require-
ments of the client. Once these issues were agreed and
Criticism of the Private Finance Initiative (PFI) and built, payments from the public sector would only be
Public Private Partnerships (PPP) continues in aca- forthcoming after completion, when the performance of
demic journals, the press and even current affairs a building could be measured against its specified
programmes on television and radio. Yet the PFI requirements. Moreover, payments for the use of the
survives. While governments have always used and in building or structure would be spread over a long
the foreseeable future will use private firms to carry out period or even indefinitely.
building work on their behalf, a new approach to This would release the teams negotiating contracts
engaging contractors (which could be extended to from a large number of complications and possibly
private sector clients) might be worth considering, reduce the costs of procurement and tendering.
based on the performance of buildings rather than their Naturally risks would still need to be identified and
construction materials and labour. measured by both parties but these would be assessed
PFI places responsibility for costs throughout by the purchaser quite separately from the supplier.
the building life cycle with contractors and funders, The emphasis becomes one of building performance
partly in order to limit the escalation in price, which rather than the components and materials used in
often occurs in public sector projects. As a result construction and the methods of financing.
contractors and funders have little option but to If public sector clients could approach building
internalize both the costs of contracting and the on- suppliers with specifications concerned with the per-
going costs of inappropriate building methods or formance and use of buildings and structures, contrac-
building design. tors or developers would then have an incentive to
However, the transaction costs associated with PFI provide quality in their built solutions to ensure
are high for all parties and it is generally accepted that payments in the long run. Contractors would be
the cost of finance of private firms is higher compared completely responsible for the construction phase.
to public sector borrowing. These increased costs may Finance for projects would be based on arrangements
be compensated for by possible efficiency gains due to between contractors and their banks quite separate
the incentivisation created by PFI. It is by no means from the clients of the contractors, in the same way
clear that any improvements in efficiency compensate production is financed in other industries. Contractors
for both the increase in risk premium the public sector and developers would be able to use their size and
must pay in order to enable PFI projects to proceed and reputation and the security of their public sector orders
the public sector’s loss of direct control over the to negotiate with their banks competitive terms needed
finished building. to finance construction until completion of buildings.
The contractual complexities of PFI mean that the The costs of finance to contractors or developers would
private sector has a dual role. It is engaged to supply the be higher than public sector borrowing rates; the
public sector with buildings and structures and it is also interest rates paid would be built into the pricing of
expected to finance the project. This dual role of the projects.
private sector under the PFI invariably involves costly The basis of the funding would be the income stream
and often lengthy negotiations. The cost of procure- generated by the completed building or structure. As
ment alone has become prohibitively high, especially this income stream is derived from the public sector
for contractors, to the point where contractors have there is no issue regarding the ability of the client to
begun to show increasing reluctance to bid for projects pay. The contractor would still have to demonstrate a
under PFI. track record of successful delivery of similar projects in
Construction Management and Economics
ISSN 0144-6193 print/ISSN 1466-433X online # 2007 Taylor & Francis
DOI: 10.1080/01446190601043119
112 Letter to the Editor

the past and a competent management of the contrac- It might be argued that contractors do not have the
tor’s business to gain the confidence of the lender. capital to undertake PBC. However, although some
This arrangement can be seen as an example of collateral would be expected the lender’s security
Performance-Based Contracting because in PBC pay- would be based on the future guaranteed income
ments are not made during the construction phase. The stream rather than the accumulated assets of a
client only pays suppliers once buildings are in use and contractor. As in other production processes, there is
payments are based on meeting performance require- no inherent reason why the producer should not be
ments and providing a service. responsible for securing finance. Using PBC the
PBC may be seen as a logical extension of PFI or contractor/developer would be able to use the contract
Public Private Partnerships (PPP). Both PFI and PPP and the promise of a future cash flow as collateral to
adopt a whole life cycle approach in so far as post finance the construction phase.
construction use of buildings and structures are built It might also be argued that the risks of PBC are too
into the contract. In PFI and PPP the finance for both great and too long term for contractors, who are not
the construction and post-construction phases are liable beyond the retention period following comple-
sourced in the private sector. If the public sector were tion. However, it does not follow that contractors could
only required to pay for a project over an agreed period not build up the expertise and resources in-house in
of use, once its construction is completed and the order to undertake the life cycle commitments neces-
building is in operation, then suppliers, such as sary for PBC, given the corporate will and the necessary
developers and contractors, would concentrate on the incentives.
service of ensuring the performance of buildings and Like so much innovation in the construction industry
structures was satisfactory. the change may well have to be initiated by the client
Using the PBC model, contractors would need to be side. Although PBC may be relevant to private sector
able to demonstrate to clients how to improve the value clients, the public sector client, acting as a good client,
of their projects. There are distinct possibilities for is in a strong position to create the conditions and
efficiency gains. terms necessary for contractors to respond with PBC.
PBC potentially offers an opportunity to present a Specifying performance levels and desirable outcomes,
new model of contracting that would provide incentives and measuring and monitoring them form the core of
for building and construction improvements and the contract. As with any contract, both sides must be
innovation, restructuring of the construction market able to agree on their expectations for payments based
and improvements in productivity. on performance to be met.
The key to improving performance is giving firms Private sector firms would then compete to provide
incentives both positive and negative through the the building, and quality would be driven by contrac-
market mechanism. The first firms to adopt PBC tors’ needs to protect their reputation and maintain
would gain a competitive advantage and expand while good relations with their clients. They would have the
those that were slower would lose market share. incentive of being considered for repeat PBC business.
Positive incentives would need to motivate firms and Market principles would also shape their behaviour as
demonstrate to their competitors in the construction firms compete for market share and pursue company-
industry that firms, which adopted PBC for at least growth policies.
some of their work, found such projects profitable. This What makes PBC so timely in the UK is that it takes
would encourage others to follow. Negative incentives
advantage of the cultural changes in the construction
would be provided by performance penalties.
industry brought about by PFI, namely the increased
It cannot be claimed that PBC is revolutionary in
awareness of post-construction considerations. It could
itself. Like most developments in construction, the
be used to combine this change in public sector
concept of PBC is already widely in use in other
construction procurement with traditional methods of
industrial sectors. It is merely the next logical step
financing projects in the public sector, without return-
in construction and service procurement based on PFI
ing to the days of passing additional costs back on to
principles but without the private finance discussion
the public sector client.
necessary in PFI. This new mode of working is not even
new to construction. For example, similar arrange- Yours faithfully,
ments are in use in the German construction
industry, and in the UK many firms already undertake STEPHEN GRUNEBERG
PBC-type work when installing and servicing building University of Reading, UK