Review of Scottish public sector procurement in construction

6. Approach to market

6.1 Overview

6.1.1 How a procurement exercise is carried out - the approach to market, the contract terms and conditions, and the management of the project - has a direct link to the quality of the end product.

6.1.2 In this chapter, we examine some commonplace practices. Our recommendations in this area are designed to ensure that the importance of the way in which a project is procured is recognised both in terms of its impact on project delivery and on the economic wellbeing and sustainability of the marketplace.

6.1.3 Our vision is for a fair and transparent approach to contracting and to the allocation of risk.

6.1.4 There are many different ways in which a project can come to market. These each have their own advantages and disadvantages. We deliberately do not attempt to say that there is one 'right' way to take a project to market. There are however, some very wrong ways.

6.1.5 What needs to improve is the understanding of the risks and opportunities associated with different approaches, and the consideration which underpins a decision to follow any particular path.

6.1.6 Successful implementation of the recommendations in this chapter will depend to a very large degree on the capability and capacity of the people and systems (such as for pre-qualification) which are used. These elements are dealt with in detail in chapter 7.

6.2 The importance of design

Defining the project

6.2.1 At the risk of being accused of stating the obvious, it is important that before buying something, you should know what it is you want to buy - or perhaps more accurately, what purpose you want it to serve. In practical terms for construction, that means getting the business plan and design brief right.

6.2.2 And yet, however obvious it may be, we are certainly not the first to have felt the need to say it in relation to public sector procurement of construction. As recently as June 2013, the Scottish Government's architecture policy articulated this very point:

"Design should be considered at the very outset of public procurement projects. It is an essential part of achieving value for money, by ensuring capital costs are competitive and that savings can be achieved on running costs without compromising the quality of the design. Getting the brief right up front can deliver long-term value." ^[15]

6.2.3 We have also received a striking number of comments throughout this process indicating that not enough time or attention is being given to this pre-market stage. As one stakeholder told us:

"The most common failure of construction projects occurs right at the start of the project. For public sector clients, the briefing stage is generally not fully understood and, without detailed advice and support from construction professionals, projects are doomed before a blow is struck".

6.2.4 Other studies have highlighted this. Audit Scotland in 2008 found some projects without an authoritative business case and concluded that there was scope to increase the quality of project appraisals generally ^[16] . In 2011, out of a sample of 55 projects, it found continuing evidence of gaps in the availability of time and cost information at initial approval stage for a number of the projects examined ^[17] . It found similar conclusions in relation to local authorities in a 2013 report ^[18] . In that report, Audit Scotland also found that many councils do not have established processes for developing and using business cases.

6.2.5 This can cause a number of problems. The most obvious of which is that it increases the risk of cost overruns in the construction itself. Indeed, Audit Scotland said in 2008:

"There needs to be clarity about the overall value and purpose of the project, its contribution to business goals and the optimum balance of cost, benefit and risk for its effective delivery. Inaccurate cost and time estimates at this stage undermine effective appraisal and value for money… Once a contract is agreed, significant changes to a project are likely to be costly and disruptive, and may not represent value for money".

6.2.6 The critical nature of defining the project scope and brief is well acknowledged. In this chapter we look at some of the key elements that underpin a successful brief. All of this work should lead to a proper business plan for the project giving a good estimate of quality, time scales and likely cost.

Design-led procurement

6.2.7 We have written about our vision for an approach which achieves better collaboration in design-led, efficient and effective public sector construction procurement and which has regard to sustainability in all senses of the word.

6.2.8 By 'design-led' procurement, we mean a procurement process in which it is recognised that a consistent focus on achieving high quality in design processes and outcomes can potentially deliver a very significant range of benefits. These can include reduced capital, maintenance and lifetime running costs, increased functionality and efficiencies in service delivery, flexibility and better environmental performance as well as greater user satisfaction and a positive impact on communities.

6.2.9 Design-led projects are often assumed to be more costly, focussed on unnecessary quality or more complex in construction. In fact, a good design-led project begins by fully considering the needs of users and future users, and employs innovation and careful judgment to deliver the best product within budget. This ensures that buildings are not only fit for purpose, but future-proof. Furthermore, good design methods can facilitate the closer collaboration between procurers, suppliers and end users, before solutions are specified, which ensures that proposals are fully tested, and meet users' needs.

6.2.10 Design-led procurement requires that proper value is given to the quality of design proposals at tender analysis stage and that design is afforded proper consideration throughout the delivery period. Design costs often account for a fraction of the long-term project costs, but design can often have the biggest impact on efficiency, sustainability and overall success.

6.2.11 Indeed, the relationship between good design and controlling costs is long established. In 1998, the Property Advisers to the Civil Estate said that:

"Professional fees might… represent 1 or 2 per cent of the life cycle cost. Therefore the relatively minor additional cost of procuring higher quality services, in particular design services which focus on optimising the balance between capital cost and maintenance costs, will be far outweighed by long- term savings." ^[19]

6.2.12 Much more recently, a study of a primary care design project published in September 2013 ^[20] , found that innovative design allowed a sizeable reduction in the gross internal floor area required, whilst importantly gaining the confidence of stakeholders in the design. This reduced the construction costs alone by more than 22 times the design fee to stage C. ^[21]

6.2.13 But quite apart from the risk of cost overruns, inadequate design briefs also increase the risk that the end product will not adequately do the intended job.

6.2.14 The very best design briefs are developed in a way which involves the end users of the facility from the outset. End users in this context mean not only those who will occupy a building, or use a facility, but crucially also those who will maintain it.

6.2.15 For all but the most specialist of projects, those design briefs should also be outcome-based. In other words, a brief should set out what activity the facility should support, rather than specifying in great detail how this should be achieved. This then gives design teams greater scope for innovation.

6.2.16 Importantly, defining not only what the criteria are, but what success looks like, in language which is easy to understand, makes it easier for designers to come up with workable designs, and for the client to assess their worth.

6.2.17 Architecture and Design Scotland and Health Facilities Scotland currently work with the NHS to develop such design briefs - known as SCIM (Scottish Capital Investment Manual) Design Statements - for health infrastructure projects and monitor the progress of the project against these aims and healthcare design guidance. These design statements are required as part of the business case process by the Scottish Capital Investment Manual used by the NHS. We believe that there is much that other parts of the public sector can learn from this work.

Case Study: Royal Edinburgh Hospital Campus: Mental Health Services Design Statement

Architecture and Design Scotland supported NHS Lothian to form a SCIM Design Statement for the re-development of mental health services at the Royal Edinburgh Hospital.

The project team consulted with key managers at the hospital, clinical staff, the hospital's patients' council, as well as others, such as local advocacy groups for users of mental health services.

From that consultation process, a set of 'non-negotiables' for patients, staff, visitors, and for alignment to wider policy objectives was agreed. For each agreed 'non-negotiable', a series of benchmarks was also agreed. These set out the criteria which must be met, or gave views (written or pictorial) of what success might look like.

For example, one 'non-negotiable' for patients related to the ward layout:

"The wards must be welcoming and friendly. The layout should encourage interaction between patients and staff such that it feels like 'help is always at hand'.

The wards must offer attractive and therapeutic environments and encourage free, easy use and movement. The design and layout of these spaces must ensure that all parties feel safe and that the activities in one area do not negatively impact on those in another".

The accompanying benchmarks for successful design to meet this criterion are that:

• Staff working spaces should be, primarily, in patient areas, with limited use of private offices and 'staff only' areas.
• On entering the ward there should be an immediate welcome.
• The spaces and routes within the ward should not feel unduly clinical, with soft furnishings, colour, art and natural light being used to enhance the therapeutic environment.
• Although private areas (such as bedrooms) need to be a step away from public circulation, they must not feel distant from help. They should be relatively close to a social, shared area where staff and patients mix.
• There should be good sound attenuation between rooms.
• There should be no spaces where one might feel 'cornered'.
• Endless corridors with closed doors are not wanted. Patients need to be able to find staff easily (with a photo provided of an example of a design to be avoided).

The design of this facility is still in progress. However, we are told that the clear focus that this briefing and assessment process brings to the project is seeing ongoing improvements in the quality of the proposition being developed.

Design and build

6.2.18 Of course, there are some specific considerations if a project is being delivered under a 'design and build' contract. The advantages of design and build to the public sector are clear - it is in some ways a simpler undertaking for the contracting authority and achieves relative certainty about price, as design risks are by definition passed to the contractor. This can be a positive outcome for both parties.

6.2.19 That is not necessarily always the case, however. Several stakeholders have emphasised the need for design and build to be used both appropriately, and competently. As one interviewee summed up:

"There are occasions when design and build is perfectly sensible. But the more complex the project, the less likely it is you'll get a solution through design and build which meets the client's requirements. Design and build contractors are good at putting up buildings, they are not so good at understanding the core business of the client… who needs to articulate very clearly what the required standards are, and then monitor their delivery, otherwise the design and build contractor's motivation is least cost".

6.2.20 Or, as one industry representative put it:

"The problems with design and build often come from a lack of brief from the client - you end up with design-as-you-build".

6.2.21 So, whilst design and build may be an attractive model for some clients, a contracting authority using design and build to deliver projects still needs to be an intelligent client. It still needs to have done the due diligence to understand its own requirements and to be able to articulate these in clear briefs. One stakeholder went so far as to say that:

"This form of contract likely needs stronger design skills in house (in comparison to a traditional procurement where the client has a direct relationship with an architect to assist them in this) in order to better brief for design and ensure the most appropriate design is being developed. Clients without any in-house design skills can lack the knowledge and confidence to appropriately direct the design outcomes."

6.2.22 The client also still needs to have sufficient knowledge of the marketplace to understand the 'right' price it should be paying, and have sound project management skills to ensure the project progresses as it should.

Pre-market engagement with industry

6.2.23 Once the client has determined what it needs from its intended facility, the next step is to determine how this can best be delivered.

6.2.24 It is important that the procurement strategy is developed in such a way that it allows the client to get the best product possible and the best value for money. This could be by taking advantage of emerging technologies, for example - or by ensuring that work is split into lots which are of suitable sizes to allow firms to put together competitive bids. It may even be the case that a particular need could be fulfilled by the use of an existing standard design - tailored, as appropriate, to the specifics of the case.

6.2.25 There can be clear advantages in involving potential contractors in this discussion - they are often the parties with the key market intelligence.

6.2.26 And yet, this sort of strategic pre-market engagement happens all too rarely in construction. Sometimes, this is because of a perceived risk that it might put contractors in an advantageous position. We have found some good examples of it in practice, however - such as in the creation of the recent national biomass energy supply agreements, and in the way in which minor works are awarded from that same agreement - which demonstrate that pre-market engagement is possible and can deliver significant benefits.

Case Study: Biomass Energy Supply Agreements

A national framework agreement, providing for the design, build and operation of renewable heat installations was awarded by Scottish Procurement, on behalf of the public sector, early in 2013. It is noteworthy for two main points of engagement with industry which underpin it.

Firstly, before even advertising the framework, open invitations to a number of workshops across Scotland were extended to both potential suppliers and potential clients, during which participants were invited to discuss the likely requirements, their experiences of similar projects, and suggest points for the contracting team to consider.

These discussions, around issues such as competing standards, in turn informed the development of the procurement strategy, so that when the contract was advertised, Scottish Procurement was confident of being able to attract competitive bids which would both meet public sector requirements, and promote market consistency and growth.

Secondly, the procedure for using this framework is unusual, in that it specifically includes a 'pre-commercial' stage. A client's initial scoping and draft project brief is shared with all of the framework service providers, so that they may choose to engage in further development of the brief, visiting the site and contributing their thoughts on how best to shape it to achieve the intended outcome.

This may be an iterative process. At the end of it, however, the client should have a significantly improved - or at least tested - project brief. This is then used as part of a 'normal' mini-competition.

Work at 59 sites has so far been tendered in this way, delivering around 70mW of power. Annually, these projects are expected to save £900,000 and bring about a 7,500 tonne reduction in carbon dioxide emissions, exceeding what was expected when the framework was awarded.

A focus on whole life cost

6.2.27 Throughout the procurement process - from project conception to contract award, the public sector focus should always be on the whole life cost of an asset - that is to say, the costs of constructing, owning, operating, maintaining and disposing of the asset. Again, this is something which Audit Scotland has previously commented on. In 2008, it said:

"Explicit consideration of whole-life costing within project appraisals and benchmarking project costs remains relatively unusual… Public bodies should build whole-life costs into business cases and subsequent project reporting." ^[22]

6.2.28 This recommendation remains fundamental to achieving best value for money (the Property Advisers to the Civil Estate estimated the capital cost of a building to be typically only 10-20 per cent of the cost of owning and operating it over its expected life ^[23] ) and so we believe it to be worth repeating here, and worth underlining that where this is not already happening, it should, as a matter of priority.

6.2.29 Of course, the point has been made to us on several occasions that the best value options over the whole life of an asset often cost more upfront. A combination of constrained public finances and funding arrangements for the public sector - in particular, the separate treatment of capital and revenue funding - do not necessarily incentivise investment in the best value options over the whole life of an asset. Several bodies, such as the Westminster Sustainable Business Forum ^[24] have looked at this relationship.

6.2.30 These points are far wider than can be addressed by this report - or indeed by the Scottish Government acting alone. But we do not believe them to be valid reasons not to undertake proper whole life cost analysis. Indeed, in times of financial constraint, it is arguably even more important to understand the impact which capital investment decisions made today will have on revenue funding for years to come.

6.2.31 Key to increasing the public sector's capability in this area will be improving its understanding of how its assets perform over a number of years. Chapter 9 of our report deals with recommendations to improve the use and understanding of data. Building Information Modelling (discussed in chapter 8) can also help, as the UK Government's "Soft Landings" ^[25] approach has been trying to achieve. Chapter 8 also discusses the importance of considering whole life costing for a truly sustainable approach.

6.2.32 Recommendation:

Design and whole life costing should be afforded appropriate priority in any construction procurement process. A comprehensive business case and procurement strategy, focusing on desired outcomes and whole life costs should be developed. This will require the earliest possible engagement between clients, users, designers and contractors.

6.3 Framework agreements

6.3.1 Framework agreements have been a key part of the procurement landscape in Scotland following the McClelland report, and are being used widely in the construction sphere.

6.3.2 We have had significant, and mixed, representations on the role that frameworks play. From an industry perspective, one might cynically summate that a framework agreement is good if you are one of the named suppliers, and bad if you are not.

6.3.3 But there are also some genuine and understandable concerns. With framework agreements typically lasting for several years, the impact on a firm of not winning a place on a framework agreement can be far greater than the impact of not winning a one-off contract. Smaller firms can feel this the most keenly, particularly if they have a history of working for the public body in question.

6.3.4 On the flip-side, of course, those firms who do successfully win places on a framework agreement have the opportunity to tap into a steady flow of work for the next few years, potentially to grow and to employ more people in their local area.

6.3.5 For its part, the public sector has been virtually unanimous in its view of framework agreements - they are more efficient in getting projects to market and they facilitate the development of more integrated supply chains offering opportunities for clients to benefit from improved value for money arising from simplified 'call-off' processes and potentially from economies of scale, but also for firms in the supply chain to develop business relationships with each other creating an environment that encourages capacity and innovation.

6.3.6 And indeed, there are many examples of framework agreements which have achieved exactly this. They are an integral part of the way in which the Scottish public sector procures, and we fully support their role in the procurement process.

6.3.7 There is already a good deal of guidance available to public sector purchasers on the setting up and use of framework agreements as part of the Procurement Journey on the Scottish Government website, and in Scottish Procurement Policy Note ( SPPN) 05/2010.

6.3.8 However, across the board, more needs to be done to ensure that when framework agreements are used, SMEs' access to work is considered, and, wherever possible, SMEs are given a reasonable opportunity to bid for work. Some framework contracts do this already, and lessons should be learned from these.

6.3.9 Economic impact cannot currently be used as a contract award criterion - for example, a contracting authority cannot use the fact that a firm is a local SME as any part of the basis on which it awards it a contract, or a place on a framework.

6.3.10 However, frameworks can be set up to make it easier for that same local SME to compete, fairly, for some of that work. For example, the framework might be split into a number of lots on the basis of geography or value of work, or decisions taken not to aggregate demand to a level at which SMEs cannot realistically compete. This should always be a key consideration in developing procurement strategies - particularly in remote and rural communities.

6.3.11 Another concern raised with us is that some frameworks are set up - at significant cost to all parties concerned, but then the volume of work envisaged does not materialise. Whilst this will sometimes happen as circumstances change, it is clearly undesirable, and should be avoided. In particular, we are told that some contracting authorities set framework agreements up, or enter into them, with the intent of using the terms agreed as a bargaining tool with which to obtain better rates from firms not part of the agreement. Whilst this may drive some short term savings, undermining the standing of frameworks is unlikely to lead to long-term benefits.

6.3.12 Recommendation:

Guidance on best practice in the use of framework agreements should always be followed, in particular in allowing opportunities for SMEs to participate.

6.3.13 Existing guidance on the use of frameworks, such as SPPN 5/2010, should be built upon and tailored to a construction setting. This should aim to ensure that frameworks follow best guidance, in a way which does not discriminate against Scottish SMEs. The guidance should take account of the findings of the report by the Working Group of the UK Government Procurement and Lean Client Task Group on the Effectiveness of Frameworks. ^[26] Assessment of how well contracting authorities are performing in this regard should be developed as part of the Procurement Capability Assessment.

UK-wide frameworks

6.3.14 A specific issue which has been raised is the use of UK-wide frameworks, or the use by public sector bodies in Scotland of frameworks set-up by regional purchasing bodies outwith Scotland - the latter an issue which also exercised

Cuthbert and Cuthbert, who concluded that:

"Unless there are very good reasons to the contrary in any specific case, Scottish purchasing organisations should not adopt framework agreements which have been negotiated by regional purchasing bodies elsewhere in the UK" ^[27] .

6.3.15 We have already noted in this chapter the importance of frameworks to the public sector. However, where Scottish, regional or local framework agreements do not exist, purchasers may turn to UK-wide or other frameworks to meet their needs and potentially reduce opportunities for Scottish firms.

6.3.16 We accept that there are some circumstances in which it is appropriate to use a UK-wide, or other regional framework. The economies of scale offered by such frameworks may make their use manifestly the sensible choice, or they may offer something highly specialised and not readily available in the Scottish market-place, some may even be Scottish-led. There are also some national frameworks which are alert to the potential impact they may have on local supply chains and have developed key performance indicators ( KPIs) to monitor and encourage access to opportunities within their framework.

6.3.17 Whilst contracting authorities cannot legally discriminate in favour of firms because of their location or size, we do believe that wherever possible, Scottish SMEs should be given a fair and reasonable opportunity to bid for work.

6.3.18 This argument can also logically be extended to Scotland-wide frameworks, which may not be as attuned to the various regional economies as a more localised framework - although it should be noted that even national frameworks can be broken into regional lots.

6.3.19 There is a balance to be struck, however, between the additional benefits which might be achieved by ever-increasing local procurement, and the efficiencies which might be offered by larger framework agreements.

6.3.20 We do not attempt to say where this equilibrium is to be found. It varies in each instance, and depends on factors such as the capacity and competition within the 'local' market, the anticipated demand within that area, and price.

6.3.21 Price is always, rightly, a key consideration in any public procurement decision, and the recent squeeze on public finances has no doubt brought it into sharper focus. We are keen, however, that in undertaking their cost-benefit analysis, contracting authorities should place sufficient value on improving access to the local market - both in terms of growing a competitive market base to respond to future tenders, and also in terms of the value inherent in supporting economic growth.

6.3.22 Recommendation:

When used inappropriately, UK-wide frameworks and frameworks negotiated by regional purchasing bodies elsewhere in the UK can have the effect of preventing SMEs from participating in public procurement. Guidance should be developed and implemented on the appropriate use of such frameworks. This guidance should pay particular heed to the value of growing local economies.

6.4 hubCos

6.4.1 hubCos are described in appendix 3, and will clearly be an important part of the construction landscape in Scotland over the coming years. In the spring of 2013, we asked each hubCo what the value of its pipeline of work was - collectively it already amounted to more than £1.5 billion at that stage.

6.4.2 The hubCos are still relatively young (indeed the South-West hubCo was formed only in late 2012), and it is too early to pronounce definitively on their efficacy. However, there is undoubtedly tremendous potential for hubCos to deliver real value for money - building still further than framework agreements on the Egan principles of long-term partnering. hubCos can also potentially get projects to market more quickly than can traditional procurement exercises.

6.4.3 A hubCo's performance is monitored by its territory partnering board (made up of representatives of the public sector participants), and measured by a series of KPIs. These show that hubCo projects are successfully delivering socio‑economic and environmental benefits. Figures supplied to us by the Scottish Futures Trust in May 2013 show that out of £50 million worth of projects recently delivered and procured by hubCos, some 74 per cent of the prime cost value was awarded to SMEs (who were able to tender for 82 per cent of total tendering opportunities). Notwithstanding this performance in providing work for SMEs, there may be a case for setting minimum contract values for taking projects through hubCos in order that small projects can be awarded using traditional means of procurement.

6.4.4 Some concerns have been expressed to us about hubCo operations, however. For example, there is a specific issue relating to the payment of design fees. Under the standard hubCo operating model, designers do not get paid their design fees until financial close. This means that they have to bear a heavy cash flow burden for anything up to a year.

6.4.5 We have had significant representation from the design community on this issue, and we agree that it is not a reasonable or sustainable way of working. We are reassured that hubCos and the Scottish Futures Trust recognise these concerns, and we understand that a potential solution is close to being found.

6.4.6 Other, more general, concerns have also been expressed to us concerning how the public sector can be sure that hubCos are delivering value for money, particularly given the length of the hubCo agreements (potentially up to 25 years).

6.4.7 We have been told that there are several key points in the development of a hubCo project where value for money is assessed. We understand that all new projects must be benchmarked against comparable projects before the initial 'new project request' is submitted. We further understand that during hubCos' development of the project, pricing reports and further comparisons must be produced, and that prior to the submission of the stage two price, a minimum of 80 per cent of the prime cost must have been tendered. Compliance with value for money measures must be achieved for every project, and is reported as a KPI monitored by each hubCo's Territory Partnering Board, which could potentially remove the hubCo's right to exclusivity if performance is not up to standard.

6.4.8 These arrangements seem broadly sensible, although it does strike us that there is still some scope for standards to vary amongst hubCos, and we would suggest that there is potentially therefore a greater role for the National Programme Board, which oversees the hubCo programme, both in ensuring that value for money is being consistently achieved across the five different territories, and in ensuring that it is seen to be achieved.

6.4.9 That latter point is particularly important, as public and industry confidence in the operation of the hubCos will be key to their success. There is much concern in the industry at the moment about the effect of being "locked-out" of public sector work for 25 years. We are told that procedures for refreshing the hubCo's supply chains are in place, but this is clearly not widely known or understood; we would suggest that this needs to be better communicated to the industry at large.

6.4.10 The National Programme Board also has a key role to play in ensuring that as the hubCos are now all moving into a fully operational phase, they are able to learn lessons systematically from each other about how best to make the model work.

6.4.11 Recommendation:

Further guidelines about certain aspects of the operation of the hubCo model should be developed.

The guidelines should include:

• Continuation of the work to develop a solution to the issue of the delay in payment of design fees until financial close
• Consideration of expanding existing arrangements for monitoring performance, the achievement of value for money and design quality and the continued compliance with the terms of the original contract advertisement
• The exchange of information between hubCos to reinforce best practice and share ideas
• Consideration of the desirability of setting minimum contract values to be delivered by hubCos.

6.5 'Self-delivery'

6.5.1 We have come across repeated concerns about the practice of awarding main contracts for small projects to large firms who then immediately sub-contract to smaller, or more local, firms. This can build in an unnecessary layer of overhead and profit.

6.5.2 Smaller firms have also told us that in such circumstances they are often getting a raw deal from acting as a sub-contractor - by contracting directly with the client, they assert that they would benefit from greater control of their own projects, and a higher margin, whilst the client would benefit from a lower cost and a direct relationship with those carrying out the work.

6.5.3 Scottish Water has embarked upon a programme designed to create fit-for-purpose supply chains that increase what they refer to as 'self-delivery' of programmes of work by alliance and joint venture partners, rather than significant work passing through primary contractors to sub-contractors. It achieves this by specifying and contracting on the basis of an approved level of direct delivery which it believes provides the most efficient allocation of work between "self-delivery" and the use of the sub-contractor market.

6.5.4 Scottish Water expects to achieve efficiencies from project costs through productivity improvement, reduced fee on fee, innovation and a more aligned and partnering engagement by pursuing this route.

6.5.5 Of course, there are some risks. It could mean that less work ends up filtering through to the smaller, local firms - although Scottish Water tells us that the evidence to date is that they are tending to contract more directly with SMEs. We understand that the proportion of SMEs in the Scottish Water supply chain has increased from 60 per cent to 71 per cent over the past few years, with over 90 per cent of total spend going to business that have locations and resources in Scotland.

6.5.6 As part of the fit-for-purpose supply chain design, Scottish Water has created regional-based contractor frameworks covering the Highlands, Argyll and Islands. These are specifically designed for smaller value capital work. We understand that Scottish Water intends to create further regional frameworks covering the Borders and the North-East.

6.5.7 The key to this SME strategy will be continuing to ensure that contracts are of a suitable size and nature for SMEs to perform.

6.5.8 However, one reason often cited in favour of contracting with a larger firm which then sub‑contracts is that it simplifies the project management for the client, who only has to deal with one firm, instead of a multitude (in the case of aggregated projects). There is clearly some merit in this argument, although, regardless of who is delivering a contract, clients will always still need some contract management capacity. It has also been put to us that clients sometimes favour larger contractors as they instinctively feel that they provide greater reassurance of standards - such as in health and safety or financial stability.

6.5.9 The Scottish Water approach offers potential, and should be explored.

6.5.10 Recommendation:

The potential for savings to be delivered from clients enforcing the 'self‑delivery' of contracts by main contractors should be investigated, with particular reference to the work being undertaken by Scottish Water.

6.6 'New models' of procurement

6.6.1 The UK Government is currently trialling three models of construction procurement - Two Stage Open Book, Cost Led Procurement; and Integrated Project Insurance ^[28] . Some elements of the processes included in these trials are already being used by parts of the public sector in Scotland.

6.6.2 In the Two Stage Open Book model, framework suppliers are asked to provide an outline brief and cost benchmark for a project, from which one is chosen to work up a proposal on the basis of an open book cost. A key outcome anticipated through the use of this model is to reduce supply chain bidding costs even further.

6.6.3 In cost-led procurement, the client puts in place a framework agreement with one or more integrated supply chain teams, with selection based on the ability both to beat a prescribed cost ceiling in the first project, and to achieve further cost reductions in later projects through continuous improvement. For each project, provided that at least one of the supply teams can beat the prescribed cost ceiling, whilst maintaining the required quality, it is selected to deliver the work (if more than one can, they are scored on their bids). If none of the teams on the framework can beat the cost ceiling, the project is advertised normally.

6.6.4 Integrated project insurance is a new form of insurance which covers cost overruns up to an agreed liability cap. Key to the delivery of projects under this model is an assurance team which monitors and reports to the insurer on the key project risks.

6.6.5 These trials are of interest, although they are not yet at a sufficiently advanced stage for us to have formed a view on their effectiveness.

6.6.6 Recommendation:

Developments in the UK Government's trials of its three 'new methods' of procurement should be monitored and guidance developed for their use in Scotland, if appropriate.

6.7 Contract selection, terms and conditions

Contract forms

6.7.1 Through our many stakeholder engagement meetings it has become obvious that public sector clients are using a myriad of contract forms.

6.7.2 In some cases, there has been a clear selection process applied to contract choice which addresses the nature of the work, the procurement method and the risks lying within a project.

6.7.3 In others, it appears that there has been much less thought and planning and rather a continuation of "tried and tested" historic practice, regardless of whether the contract type is the best fit or approach for the project in question. It is noticeable in some sectors that newer contract forms such as NEC3 and PPC2000, which promote a partnership approach to project delivery, are less widely used.

6.7.4 We do not seek to promote any particular contract form, but we find it self-evident that thought must be given to the pros and cons of whichever contract form is used for a given project.

6.7.5 Recommendation:

Thorough consideration of options must be applied to contract selection as part of the pre‑commercial stage.

6.7.6 To help achieve this recommendation, an updated comparison matrix of the main standard contract types currently available should be compiled and regularly reviewed and maintained.

6.7.7 We also believe that by recording the contract types being used for contracts awarded through Public Contracts Scotland ( PCS) (see paragraph 7.3.9), greater intelligence on the usage of contracts could be accumulated and the public sector could more readily share experiences of different contract types and how well they have delivered. This will in turn help to make future contract selection more informed and the public sector client more confident in selecting the contract type most appropriate for the project.

6.7.8 Support should be available to authorities in contract selection decisions, making clear that ownership of risk and decision-making will still rest with the individual contracting authority.

6.7.9 On project completion and during post-occupancy evaluation, contracting authorities should also consider how well their selected contract type has delivered for them. This should be done in terms of quality of the end-product, value for money of both the project and the resource required to contract manage it, the collaboration it allowed and whether it delivered any additional benefits such as innovation. This learning should then be applied to future projects.

Risk allocation and contract amendment

6.7.10 Another issue with current practice in contracting is the level of modification to which some standard contracts are being subjected. This is often intended to shift more risk on to the contractor.

6.7.11 Sometimes this may be appropriate. However, this is not always the case. Risk should lie with the party most able to understand and manage it, and if that is with a contractor, be priced accordingly.

6.7.12 Chapter 7 discusses the need for skilled and capable teams to be involved in every construction exercise. Part of their role is to understand both the risks involved in a project, and the risk appetite of their organisation.

6.7.13 That level of understanding informs the decision-making process on risk allocation in contracts. Once the level of risk has been quantified, an organisation might judge that the likely cost in choosing to accept that risk itself is less than the cost of paying another party to manage it - just as the government self-insures the civil estate, rather than paying for commercial insurance, for example.

6.7.14 However, therein lies a key point. We have been told - anecdotally, at least - that some client authorities view the current economic climate as an opportunity to pass risk off to contractors wholesale, without them then having an opportunity to price accordingly.

6.7.15 Public sector buyers clearly have an obligation to get the best deal for the taxpayer that they can. This must be sustainable, however. Risks will often not be realised, but inevitably sometimes they will be. If contractors have accepted these risks without explicitly factoring them into their prices, there is a very real danger of this driving undesirable behaviours - cutting corners on quality in an effort to claw that cost back elsewhere, for example.

6.7.16 Alternatively, just as some clients are alleged to be using their current market strength to push risk on to contractors, so the main contractor might use its market position to push that risk to sub‑contractors, and so on down the supply chain until the risk lies wholly inappropriately with the party least able to manage that risk, and most vulnerable should that risk materialise. This can lead to insolvencies and significant disruption to the planned programme for the project

6.7.17 If - as some people have suggested to us - this is reflective of current practice in some areas, it is clearly neither sustainable nor desirable.

6.7.18 Recommendation:

There must be an open, mature and reasonable discussion between parties when deciding on the allocation of risk.

6.7.19 On the part of the client, this means accepting that the party who accepts the risk should be fairly compensated for so doing.

6.7.20 There is a role for industry, too, in addressing its own behaviour. We speak in chapter 10 about the need for contractors to act reasonably towards their supply chain - and so, just as the public sector client should engage in constructive discussion about allocation of risk with the contractor, so too should the contractor with its supply chain.

6.7.21 The amendment of contracts presents two further main risks. Firstly, that additional clauses may be incompatible with the remainder of the contract, and may lead to contractual disputes, or to clients being liable for costs which they thought that they had passed to the contractor.

6.7.22 Secondly, that, as the complexity of the contract increases, parties to it face increasing legal costs. Indeed, one Scottish contractor told us that in both 2011 and 2012 their legal bill charged to contracts was six times higher than it was in 2006.

6.7.23 Whilst not in any way seeking to diminish the rights or duties of either party to a contract to protect their interests with appropriate contract conditions, we do believe that there has to be a greater recognition of the pressures which can be caused by over-zealous amending of standard forms of contract.

6.7.24 Recommendations:

Any variations to standard forms of contract should be kept to a minimum and used only when absolutely necessary to take account of the particular circumstances of the project.

We also recommend that any such amendments should be clearly highlighted within contract documentation so that client and contractor are clear on the variations being imposed to the standard terms.

Painshare / Gainshare

6.7.25 The construction industry has a background of confrontational attitudes between client and contractor. This is not an issue which the public sector alone can resolve and indeed it would be naïve to think that cultural attitudes can be changed quickly.

6.7.26 However, we have seen evidence of good practice which incentivises both parties to work constructively towards the same ends. One way in which this is achieved is by the use of so-called 'painshare / gainshare' arrangements, whereby the 'pain' of cost overruns is shared, as is the 'gain' of savings.

6.7.27 The gain sharing element of this equation has the potential to be a particularly strong driver of innovation in the supply chain. This is used successfully in the health sector as part of the Frameworks Scotland contracts, amongst others. In Frameworks Scotland contracts, gainshare is split 50:50, although the sharing is limited to the first five per cent of savings, so as to incentivise accurate initial costings.

6.7.28 Recommendation:

Specific guidance should be developed to help contracting authorities to decide when and how to use painshare / gainshare arrangements.

6.8 Payment terms

6.8.1 The issue of prompt and fair payment to contractors and sub-contractors has received much political and media attention in recent times. This is unsurprising - cashflow is critical to the success of businesses at any time; in the current economic environment where finance can be extremely difficult to raise, it is a constant worry for many firms in the construction industry. You do not need to look far to find examples of otherwise sound firms failing due to cashflow shortages - often caused by delayed payment.

6.8.2 The Scottish Government's efforts in recent years to standardise its contractual payment terms to 30 days, and to aspire to pay all suppliers within ten days ^[29] are broadly welcomed, acknowledged and appreciated by the industry. Other public bodies have adopted similar strategies.

6.8.3 We are told, however, that not all public bodies have adopted even the 30 day payment term - or if they have, that they are not necessarily meeting this objective.

6.8.4 Recommendation:

All public bodies should adopt a maximum 30 day payment term to their suppliers, as detailed in Scottish Procurement Policy Note 08/2009, and this should form the target against which performance in meeting payment terms is monitored as part of procurement capability assessments (unless shorter targets have already been adopted by the organisation in question).

6.8.5 Payment to main contractors from public sector clients is only a small part of the problem, however. There is an endemic culture of extended payment terms in the construction industry (which is not necessarily the same thing as late payment), particularly from larger (tier one) contractors, to sub-contractors. Recent research by University College London ( UCL) found that:

"as a whole, construction firms take much more trade credit (from their suppliers) as a proportion of their balance sheet than do firms in the rest of the economy. They also give much more credit to their customers as a proportion of their balance sheet… Tier 1 firms were found to be net receivers of trade credit, whereas tier 2 firms were found to be large net providers of trade credit… In other words, it is highly likely that the trade credit flow from tier 2 to tier 1 contractors substantially exceeds in size the trade credit flow from suppliers outside the construction industry to tier 2 contractors". ^[30]

6.8.6 We believe that this has to change. Most importantly, it has to change because the pressures which it is placing on sub-contractors are unsustainable and can cause insolvencies and damage to the economy as a whole, but also because such practices are inherently unfair.

6.8.7 We recognise that this change cannot happen overnight - the same UCL report also found that:

"Construction firms are relatively undercapitalised, compared with firms across the rest of the UK economy… This is most especially the case for tier 1 contractors and for large contractors. Undercapitalisation both puts firms at more risk of financial failure and limits their ability to invest in business models requiring injections of capital".

6.8.8 Those major contractors should consider themselves on notice, however - if their business model relies on extended payment terms to sub-contractors to make money, it needs to change.

6.8.9 In large part, of course, this is a problem of industry's own making, and it is rightly for industry to address. We discuss this further in chapter 10.

6.8.10 But there are some steps which the public sector can take. Legislation is already in place, in the form of the Late Payment of Commercial Debts (Interest) Act 1998, as amended earlier this year by the Late Payment of Commercial Debts (Scotland) Regulations 2013.

6.8.11 However, this still puts the onus on the party who has not been paid promptly to seek a resolution. Often, we are told that smaller firms and sub-contractors are reluctant to do this for fear of impacting on future business opportunities. We believe that there is more, therefore, which the public sector could do. Indeed, our one early response to Ministers was in relation to this point, so important do we view it.

6.8.12 Recommendation:

The use of Project Bank Accounts should be trialled in Scotland.

6.8.13 This recommendation was accepted by Ministers in April 2013, and we understand that suitable trial projects are now being identified to participate in the pilot.

6.8.14 Project Bank Accounts are ring-fenced bank accounts from which payments are made directly and simultaneously by a client to members of the supply chain. This removes the incentive for main contractors to withhold or delay payment, and thus there is the potential to unlock the flow of cash throughout the supply chain and assist the solvency of sub-contractors and suppliers. We recommend that this trial is monitored and assessed for suitability for future wider application.

6.8.15 There are also other ways of working being developed to help address this issue - such as supply chain financing. Supply chain finance currently has a role to play in the short-term in helping the industry to adapt to shorter payment terms, but we do not believe that a scheme which requires sub-contractors to pay a financing fee to access funds they should be receiving anyway is fundamentally fair, and it should not be endorsed as a long-term solution.

6.8.16 A final issue in relation to payment terms is the current effectiveness of management of contract terms which require prompt payment down the supply chain, and levels of compliance currently being achieved in public sector contracts.

6.8.17 Much evidence has been shared with us of clauses being included in main contracts which refer to payment terms by the contractor to the supply chain, but these appear not be widely enforced, managed or monitored by the client except on an informal basis as sub-contractors raise issues directly with client organisations.

6.8.18 Part of the explanation for this may be either that inadequate resource is allocated to contract management, and / or that the hand-offs from those placing the contract to those managing it are insufficient.

6.8.19 Recommendations:

Public sector clients need to ensure that there is a clear understanding between those involved in pre-contract award stage and those involved in delivery on the public sector requirement for fair payment.

Contractual terms between client and main contractor should consistently outline fair payment terms for supply chain participants.

Clients should ensure that appropriate resources are allocated to contract management and enforcement of terms and conditions of contract.

6.8.20 We are well aware, however, that active 'policing' of payment terms down the supply chain is potentially a resource-heavy activity, and so we would encourage clients to find alternative ways of ensuring that their contract terms are carried out - such as asking contractors to file quarterly reports on their payment performance (backed up by random sampling); regular surveys of named sub-contractors on major projects; or establishing a route for sub-contractors to contact contract managers directly when they have concerns.

6.9 Cash retentions and other project assurance tools

6.9.1 The practice of cash retention is long-standing in construction. It involves the client or main contractor retaining a percentage of the funds due to a contractor or sub-contractor until the end of a designated defects liability period after the completion of work carried out. This acts as a safeguard against that firm failing to return to the site to correct any defects that arise, and the retention should be released as soon as that period is concluded.

6.9.2 Few issues which we have encountered have engendered as much feeling, or such firmly entrenched points of view as those relating to this topic.

6.9.3 Typical views which we have heard from industry are that cash retentions are an outdated anachronism; that if pre-qualification is carried out properly by the client then they will not end up employing a firm liable to insolvency or poor workmanship against which they need to hold a cash retention; that firms are in any case contractually obliged to make good any defects; and that at three to five per cent, the cash retention often represents a firm's entire profit margin on a project.

6.9.4 The Specialist Engineering Contractors' Group in particular has been vociferous for some time now in their view that cash retentions should have no place in modern construction contracts.

6.9.5 For their part, the public sector representatives to whom we have spoken largely view cash retentions as a necessary part of their toolkit for insuring against defects.

6.9.6 The Scottish Construction Procurement Manual, which applies to the central government sector, sets out the need for those procuring construction works to employ project assurance measures:

"Realistically, defects occur in most construction works and project owners therefore need to be assured by measures designed to protect the public purse from becoming liable for defective or sub-standard work and to ensure their projects are completed as contractually-specified" ^[31] .

6.9.7 It does not, however, specify that this should necessarily be achieved by the use of cash retentions:

"Decisions should be project-based and processes should be proportionate to the specific circumstances of the project… Cash retentions or other traditional means of assurance should not prevail purely by default".

6.9.8 The manual also lists some alternative project assurance measures to cash retentions - such as retention bonds, performance bonds, and parent company guarantees.

6.9.9 We consider this position to be basically sound. Contracting authorities must have some means of ensuring that issues that arise following the completion of a project are rectified appropriately, and retentions are clearly one way of achieving this.

6.9.10 However, we are concerned by the potential for cash retentions to be overly burdensome on contractors - if the level of retention is too high, the period of retention too long, or, for example, if cash retention is unnecessarily combined with other project assurance measures.

6.9.11 We also therefore consider that there needs to be clearer guidance available to contracting authorities to help them judge when cash retentions are the proportionate tool to use (and what effect that might have on price) - and equally, when another tool might be more appropriate.

6.9.12 When such tools are being used, this guidance should also cover best practice - for example what level of cash retention, bond and professional indemnity insurance is appropriate.

6.9.13 Recommendation:

Cash retentions should be used only after careful consideration by contracting authorities, and not as a default measure. Whilst contracting authorities have a duty to safeguard public funds, they should also be mindful of the potentially detrimental effects of cash retentions on their contractors. Greater guidance should be developed to help contracting authorities to determine when and how they should use cash retentions and other project assurance tools in an appropriate and proportionate manner.

6.9.14 A second facet of discussion around the use of cash retentions has focussed on their use by main contractors employing sub-contractors. This is discussed further in chapter 10, when we look at what the industry should do for itself.

6.9.15 What is clear, however, is that if cash retentions are being used as they are intended, and not as a profit centre, then the monies withheld should be ringfenced, and held in a transparent trust account.

6.9.16 We have already made a recommendation that the use of project bank accounts ( PBAs) should be trialled in Scotland. We believe that there may be potential for these, or perhaps similar such arrangements to be used to administer cash retentions.

6.9.17 Recommendation:

Lessons should be sought from the trial of project bank accounts in Scotland about how PBAs, or other, similar trust accounts might be used to administer cash retentions.

Project Assurance

6.9.18 Both the McClelland Report, and Audit Scotland in 2008 stressed the need for construction projects to go through Gateway reviews. These are defined on the Scottish Government website as:

"…short, focussed reviews of a programme or project that occur at key decision points in the lifecycle. The Reviews are conducted on behalf of the programme/project's Senior Responsible Owner by a team of experienced practitioners, independent of the Programme/Project Team.

The review is intended to be supportive and forward looking and will take future plans into account but only as future intentions, rather than actualities".

6.9.19 Assessment against the criteria for Gateway Reviews is now mandatory for projects and programmes being taken forward by organisations covered by the provisions of the Major Investment Section of the Scottish Public Finance Manual (those which have a total budget of £5 million or more, inclusive of fees and VAT), with a Gateway Review itself being mandatory for those projects and programmes assessed as potentially high-risk. Mandatory, or not, however, proportionate programme and project assurance is good practice, and should be carried out across the public sector.

6.9.20 Recommendation:

A consistent approach to project assurance should be used for all major construction projects. Gateway reviews should be the benchmark against which other models should be tested

6.9.21 Where methods other than Gateway reviews are used, these should be tested against the rigours of the Gateway review process.