W.W. Grainger, Inc.
Author: Joanne Simpson, Principal Advisor - Procurement and Contracts, Rio Tinto, Perth, Australia
In a perfect world, a contracts manager wants to find the best contractor to deliver the full scope of the project. But what do you do when the 'best' commercial and technical choice is not sustainable?
In almost any country in the world, principals (lead organizations) executing major projects are now expected to make supply and contracting opportunities available for local, regional or national enterprises (local content).1 Some of the work must go to smaller businesses operating around project sites.
Making room for local content in a major project is not easy. Local contractors often find it difficult to comply with the project's requirements. Principals and major contractors may be reluctant to engage them because they are perceived as high maintenance, more expensive and higher-risk.
The purpose of this article is to show that, with careful planning and management, you can not only to find and grow capable small and medium-sized enterprises (SMEs), but also give them real opportunities in major projects. And with smart planning and contract design at the right time in the project, you can successfully engage local contractors and create positive outcomes for the community.
SMEs may be hard to find
In many parts of the world, the right SMEs may be hard to find. And even if they can be found, it may be hard to make a place for them in a fast-moving, complex project environment. Principals tend to assume that SMEs cannot do much, and thus offer them only low-value, semi-skilled work with no growth or development potential.2
Why local content matters
Local content matters to principals - not only for compliance, but because it is in a principal's long-term interests. In any country, local content contributes to a project's Social License-to-Operate (SLO). SLO is a concept that originated in the mining industry but is now used more broadly.3
Achieving SLO means that communities around a project site are more likely to support the project. With the active participation of local SMEs they can expect to receive direct and positive benefit in the form of jobs, economic development and access to opportunities. They feel informed and involved. Not having a strong SLO can increase project risk or indeed cause it to fail entirely.4
A stronger local economy will also help the principal's future operating business. A stronger local supply base means the business will depend less on imports and may be able to source locally at lower cost.5 Local content is also important for the project's host country or region. It can create broader economic and social benefits for the region and the country.6 Local procurement by resource projects may well be underrated as a source of economic development.7
A bad experience can put SME support at risk
All of these benefits depend on SMEs having a positive experience with the project. If they experience financial distress, are put at risk, or do not get the benefits they expected, a push for local content can actually damage SLO. The secondary consequences of increased local content (e.g. in-migration, local inflation, environmental damage and changes in land use) can also be an issue.8 The challenge for the principal is to incorporate local content in a project so that both the principal and the SMEs benefit.
Who sets local content requirements?
Governments set the requirements, through general preferential procurement 9 or industry-specific legislation.10 Some activities may be restricted to nationally-registered companies, certain tax concessions tied to a minimum proportion of local content, or tariff protections applied to local industry. Project agreements between the principal, the landowners and the customary users of the land around the project site often include commitments to provide employment and contracting opportunities.11
Including SMEs can increase cost and risk
Basic business data can be hard to obtain without extensive research.12 Once contractors are identified, the principal must invest time and money to ensure they are capable. Without a pre-screening program, many under-qualified contractors may come forward expecting to be awarded work, creating both an administrative load and a challenge in managing expectations.
Specific challenges for SMEs include …
Increased risk to both parties results from several other factors:
Balancing risk with local content potential
We need to identify opportunities for potential SME involvement at an early stage, while the overall contracting strategy is being defined. But the most efficient strategy for the project may not optimize local content. Choices could include, for example, whether manufacturing and fabrication should be performed near the job site and then constructed by local contractors, or large, remotely assembled modules transported into the job site. 17
A detailed discussion of optimal contracting strategies is outside the scope of this article, but is clear that the principal needs to select a contracting strategy that balances project risk with local content potential.
How the strategy is applied is important …
Assuming a strategy has been chosen with good local content potential, two sets of tactics are available - one that creates and another that preserves opportunities and ensures a positive outcome for both parties. The principal has two main options for creating opportunities - scaling down the scope of work to fit SMEs (specialization and disaggregation), or encouraging SMEs to scale up (collaboration).
Creating opportunities: scaling down the work to fit
Local contractors may take part of a large, complex scope of work, if they are operating in a management framework provided by either the principal or a managing contractor. This provides essential project functions such as planning and cost control, that are beyond the capability of a small contractor.
Specialization means dividing an area of the project's scope into specialized packages that are of a manageable scale and complexity for local contractors, such as testing or maintenance services, and which do not impact the project's critical path.18
Disaggregation means taking a distinct area of the work, such as road freight or local roads construction, and dividing it into smaller packages with similar scope, with the principal or managing contractor planning and sequencing the works and managing issues and risk.
It is important to recognize that including local content adds cost and risk for a prime contractor. The principal should expect to adjust the contract risk allocation and compensation, to make including local content attractive to the prime.
Creating opportunities – encouraging SMEs to scale up
SMEs can scale up to meet project requirements in a number of ways, such as collaboration, licensing, technology transfer and joint venture.
Ensuring a contractor has the best chance of success
The story does not end with a pool of potential contractors waiting to be contacted. The principal must also do the following:
Outside any strict contractual responsibilities, when engaging local contractors a responsible principal should also ensure that the contractor...
Principals should also ensure they are will not be exposed to either significant delivery or reputational risk should the contractor fail.
Avoiding and managing financial distress
Even the most astute and observant contract manager will not catch every contractor in financial distress. More often than not, the trigger for such distress will have been external factors, not actions of the principal.
Small, local contractors may be particularly vulnerable due to their tendency to take on work with little or no financial buffer and may find it difficult to generate enough cash flow to meet the payments on debt and liabilities (e.g. payroll).24 Developing economies in particular may face difficulty in obtaining finance.25 They may also have limited understanding of the potential commercial risks they are accepting. Lack of liquidity or a tight credit market also increases the likelihood of contractor default.26
Principals can actively reduce a small contractor's exposure through a range of contractual measures. While shifting some risk back to the principal, the principal is generally able to bear or offset this risk at lower cost than the contractor, so it makes commercial sense. In certain circumstances the principal can do the following:
Regardless of the positive measures taken, the principal has a general duty to ensure the following:
Smart planning and contract design key to success
In summary, making room for local content in a major project is not easy, for all the reasons we have explored. But with smart planning and contract design at the right time in the project, you can successfully engage local contractors and create positive outcomes for the community.
So what do you need to do as a contract manager?
ABOUT THE AUTHOR
Joanne Simpson is Principal Advisor – Procurement and Contracts within Rio Tinto's Technology & Innovation group. As well, she is a senior commercial manager with 20+ years of procurement, contracts and commercial experience in major studies, projects and operations in the resources industry. Joanne has been involved with construction projects in at least 13 different countries, and is familiar with the challenges of contracting in developing economies. She holds Masters Degrees in Business Administration from the University of Western Australia and in Construction Law from the University of Melbourne in Australia.
The views expressed in this article are the author's only and do not necessarily reflect the views of Rio Tinto.