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Making room for local content in construction projects

Published: 31 Mar 2015 Average Rating: 3.7 / 5 Print
 
This article appeared in Contracting Excellence magazine on 31 Mar 2015 view edition
 

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.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.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 …

  • higher capital and transaction costs than larger firms;13
  • greater need for more supervision and support to meet project standards;
  • limited quality control which makes it difficult to produce a consistent product or service; and14
  • lower productivity, due to lower skills, older or less efficient equipment and technology, and less effective business practices.

Increased risk to both parties results from several other factors:

  • Large enterprises and SMEs think differently, and their objectives may not always align. SMEs tend to be more innovative, opportunistic, cash-focused and oriented toward the short-term than large companies.15
  • Large enterprises have much greater power in a contractual relationship than SMEs. It is easy for a vulnerable small business to be damaged or even forced into insolvency if tested beyond its capacity, or left without its primary customer at the end of a project or in a downturn.16
  • SMEs are less resilient. They often have a narrow operating margin between viability and failure, and may not be able to ride out risks a larger firm could absorb.
  • Dividing the scope of work among smaller contractors means a greater number of interfaces to manage.
  • The timeframe to develop a SME to readiness may extend way beyond the deadline for project delivery. So SMEs may miss out on opportunities, or they may be rushed into work before they are ready.

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.

  • SMEs that may be too small on their own can combine specialized expertise or pool resources to collectively deliver.19
  • Major international contractors can enter into joint ventures with local contractors.20
  • The principal can provide co-investment to develop local facilities if it is strategically important to build local long-term capability.21
  • As an alternative to joint venture, international firms can enter into licensing and technology transfer arrangements, where the local firm acts as a distributor, agent or licensed manufacturer for the international firm.22

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:

  • Communicate opportunities proactively to community groups, ensuring SMEs have time to organize and respond.23
  • Ensure contractors can do the work, can cope with the scale and duration of the scope being offered and fully realize the commercial risk they are assuming.
  • Ensure the contractor both delivers the work and earns a reasonable return.

Outside any strict contractual responsibilities, when engaging local contractors a responsible principal should also ensure that the contractor...

  • has been tested and proved capable of doing the work;
  • is not excessively vulnerable and has a reasonable buffer against any unforeseen events;
  • fully understands its responsibilities, risks and liabilities, and has well-developed management plans in place in case things go wrong.

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:

  • Provide advance or pre-mobilization payments to support contractor cash flow that is recoverable at the end of the contract.27
  • Agree to pay for sub-orders when the order is placed (title transfer on payment mitigates some of the risk).
  • Provide direct-purchase and free-issue major items of equipment to minimize a contractor's up-front expenditure.28 Costs are often reduced because of the principal's greater buying power and the removal of contractor mark-up.
  • Structure packages to favor labor-intensive cost-reimbursable or unit-rate contractual arrangements rather than more capital-intensive fixed-price forms of contract.
  • Pay part of the contractor's remuneration as a fixed (but auditable) management fee.
  • Waive or limit withholding or deduction rights. Withholding of disputed amounts can be a significant source of financial distress to a contractor. The principal still has the right to receive a credit if the issue is later resolved in the principal's favor.

Regardless of the positive measures taken, the principal has a general duty to ensure the following:

  • Their own actions do not push an otherwise capable contractor into financial stress (e.g. by failing to pay on time).
  • They are aware of the contractor's commercial status and prepared to take appropriate action if the contractor is having this difficulty. (This may mean having to manage the contractor out of the contract if all reasonable measures have been exhausted and the contractor is genuinely unable to perform).

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?

  • Develop a clear local procurement policy as early as possible.
  • Ensure local content opportunities are identified in the planning stage.
  • Tailor procurement processes and terms to fit local capability.
  • Work with engineering and construction to structure scopes of work to local capability.
  • Look carefully at the commercial risk allocation of the contract and reserve excessive risks to the principal.
  • Ensure the tender and selection process provides transparent and equitable (or even favorable) access for local contractors.
  • Ensure contractors understand and are prepared for the risks they are taking on.
  • Provide appropriate post-award support.
  • Be prepared to be an advocate for your local contractor if they run into trouble.

END NOTES

  1. Local content: Some of this needs to come from small enterprises (SMEs) operating around the project site. Definitions of SME vary. The World Bank definition encompasses businesses with up to 300 employees and annual sales of USD15m.
  2. Ana Maria Esteves et al, 'Procuring from SMEs in Local Communities: A Good Practice Guide for the Australian Mining, Oil and Gas Sectors' 72.
  3. RG Boutilier, L Black and I Thomson, 'From Metaphor to Management Tool – How the Social License to Operate Can Stabilize the Socio-Political Environment for Business,' International Mine Management 2012 Proceedings (2012) 227.
  4. See e.g. the events that overtook the Malku Khota project in Bolivia http://rabble.ca/news/2012/07/bolivian-government-indigenous-communities-resolve-nationalize-canadian-mining-company.
  5. See e.g. the IFC publication 'Investing in People: Sustaining Communities through Improved Business Practice.' http://www.ifc.org/wps/wcm/connect/1dc2e10048865811b3fef36a6515bb18/CommunityGuide.pdf?MOD=AJPERES.
  6. Increasing Local Procurement by the Mining Industry in West Africa.
  7. Michael Warner, Local Content in Procurement: Creating Local Jobs and Competitive Domestic Industries in Procurement (Greanleaf Publishing Limited, 2011) 227.
  8. AM Esteves and MA Barclay, 'Enhancing the Benefits of Local Content: Integrating Social and Economic Impact Assessment into Procurement Strategies' [2011] Impact Assessment and Project...
  9. Increasing Local Procurement by the Mining Industry in West Africa.
  10. See e.g. the preferential procurement obligations of the Ghana Minerals and Mining Act (2006), and the Senegal Mining Code Law n°2003-36 of November 24, 2003 and Regulations (Decree) n°2004-647 of May 17, 2004, as cited in Ibid.
  11. See e.g. Aboriginal Participation Agreements in Canada - https://www.nrcan.gc.ca/mining-materials/aboriginal/14694.
  12. 'Developing a Transparent System for Local Contracting: A Manual for Practitioners Based on the eProcurement Experience in Chad Version 1.0' (2008) 91.
  13. Warner.
  14. Increasing Local Procurement by the Mining Industry in West Africa.
  15. Esteves et al.
  16. Esteves and Barclay.
  17. Warner.
  18. Increasing Local Procurement by the Mining Industry in West Africa; Esteves and Barclay.
  19. Esteves et al.
  20. Warner.
  21. Increasing Local Procurement by the Mining Industry in West Africa.
  22. See, e.g. Xiaolan Fu, Carlo Pietrobelli and Luc Soete, 'The Role of Foreign Technology and Indigenous Innovation in the Emerging Economies: Technological Change and Catching-Up' (2011) 39 World development 1204.
  23. Esteves et al.
  24. Ibid.
  25. Increasing Local Procurement by the Mining Industry in West Africa.
  26. Bode and Wagner.
  27. Increasing Local Procurement by the Mining Industry in West Africa.
  28. Ibid.

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.

 

 

 
 
 

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