Compensation events are often viewed as client risks. Whilst this is not strictly correct, it is true that they often lead to an increase in the contract price and extension of time.  The NEC4 Engineering and Construction Contract (ECC) recognises the effect of a compensation event may result in a reduction of expenditure (defined cost) ^[1] by the contractor. However, the contract makes provision for a reduction to the prices^[2] only for specific compensation events^[3]. The subcontract version^[4] of the ECC contains similar provisions. In this article the author explains which of the events listed in the ECC core, main and secondary option clauses can result in a lowering of the contract price^[5] and examines how these events should be managed.

Compensation events – core clauses

There are only two compensation events listed under clause 60.1 which the contract allows a reduction in Prices^[6]. These events are:

• 60.1(1) – a change to the scope instructed by the project manager
• 60.1(17) – the project manager notifies a correction to an assumption stated for a compensation event

An instruction to change the scope leading to reduced prices is most likely to emanate from An omission of work. An instruction to omit work and subsequently transfer that work to others is likely to be a breach of contract and the client would not be entitled to a reduction in the prices.^[7]

The project manager may also instruct a change to the scope in response to a value engineering proposal made by the contractor under clause 16.1. If the contract is main option A or B the prices, are reduced in accordance with 63.12.^[8]  If the contract is main option C or D, the prices are not reduced.^[9]

Compensation event 60.1(17) provides an equitable remedy when the project manager’s assumption stated for a compensation event that is too uncertain to forecast reasonably proves to be wrong. ^[10]

Compensation events – main option B & D

There are three compensation events that relate specifically to the bill of quantities and as such appear within main option B & D. However, only two allow for reduced prices namely; compensation events 60.4 and 60.6.

Clause 60.4 deals with differences between the final total quantity of work done and the quantity for that item stated in the bill of quantities. Providing the difference does not arise from a change to the scope the matter is treated as a compensation event when the difference is both large^[11] and there is a change to the defined cost per unit quantity. If the defined cost per unit quantity is reduced, the rate in the bill of quantities for that item is reduced.

Clause 60.6 states three reasons why an instruction by the project manager to correct a mistake in the bill of quantities is a compensation event:

• A departure from the rules for item descriptions in the method of measurement
• A departure from the rule for division of work in the method of measurement
• To resolve an ambiguity or inconsistency

Compensation events – secondary options

 The secondary option clauses include three scenarios where a compensation event may lead to reduced prices:

• X2.1: a change in the law after the contract date
• X12: multiparty collaboration

    - an instruction from the core group to change the partnering information (X12.3(6))

    - a change by the contractor to its programme to comply with a revised timetable (X12.3(7))

Notification

The project manager and the contractor are responsible for notifying the other of compensation events.  If a compensation event results from the project manager or supervisor giving an instruction or notification, issuing a certificate or changing an earlier decision, the project manager must notify the compensation event (clause 61.1). For all other compensation events, the contractor should notify the project manager. Failure to notify the project manager within the timescale stated in the contract^[12] results in the contractor not being entitled to a change to the prices or the completion date (clause 61.4).

Applying the rules for notifying compensation events (clause 61.1) it can be seen that three out of the seven aforementioned compensation events which may lead to reduced prices, must be notified by the project manager:

• 60.1(1) – a change to the scope instructed by the project manager
• 60.1(17) – the project manager notifies a correction to an assumption stated for a compensation event
• B/D 60.6 – project manager gives an instruction to a correct a mistake in the bill of quantities

For compensation events under clause 60.4, X2 and X12, it seems the project manager would be reliant on the contractor to notify as these clauses do not describe any of the types of communications stated in clause 61.1. A strict interpretation of clause 61.1 suggests the project manager is not authorised to notify these events. Compliance with the obligations under clause 10.2^[13] would of course resolve this issue. However, it would be understandable if a contractor did not want to notify a compensation event which it knew would lead to reduced prices.

Assessment for omitted work

It is a common misconception that an assessment for a compensation event resulting from an omission of work from the scope is dealt with simply by omitting the item from the pricing document.^[14] The default method for assessing all compensation events is to apply the rules for defined cost as stated in clause 63.1.^[15] The principle behind this approach is to place the Contractor in a position where it is neither commercially advantaged or disadvantaged by the compensation event.

For most contracts a rate or lump sum price offered at the tender stage is not equal to the amount calculated using the rules of defined cost. A compensation event for omitted work originally priced at an amount less than its defined cost (plus the contractor’s fee) will result in a reduction greater than the value of the original priced item. Conversely, if the contractor has priced the item at an amount greater than its defined cost plus the fee, the reduction will be less than the tender price for the omitted work. Two examples for main option A are shown below:

Example 1 (omitted work with a tender price lower than defined cost)

• • Original priced item in the activity schedule = £50,000
  • Contractor’s fee percentage = 10%
  • Forecast defined cost assessed for the omitted work = £60,000
  • Change to the prices (defined cost plus the fee) for the omitted work = £66,000
  • Contractor’s net loss due to the compensation event = £50,000 - £66,000 = -£16,000

Example 2 (omitted work with a tender price higher than defined cost)

• • Original priced item in the activity schedule = £50,000
  • Contractor’s fee percentage = 10%
  • Forecast defined cost assessed for the omitted work = £40,000
  • Change to the prices (defined cost plus the fee) for the omitted work = £44,000
  • Contractor’s net gain due to the compensation event = £50,000 - £44,000 = £6,000

If the change in scope is to replace an original item with something different, the compensation event is assessed as the difference between the forecast defined cost of the original item and its replacement.

Applying the rules of defined cost to assess changes to unit rates for items in a bill of quantities (Option B and D) is not so straight forward. This is due to the differences between the rules of the method of measurement used for the bill of quantities and the schedule of cost components for defined cost stated in the contract.  Alternatively, the project manager and the contractor may agree to use rates and lump sums to assess the compensation event thus reducing the time taken to determine the defined cost (clause 63.2).  However, it is recommended that this approach is used only for low value compensation events.

Implementation for omitted work

Implementation is the end of the compensation event process where any change to the prices, completion date and key dates are agreed.  Depending on the main option, the activity schedule or bill of quantities (the pricing document) should be revised. There are generally two recognised methods for revising the pricing document.

Method 1:

Insert a new activity/item with the assessed value of the compensation event as a negative value. For example 1 above this would be - £66,000

Method 2:

Delete the original activity/item and its price and replace it with a new activity/item with the net value of the compensation event. For example 1 above this would be -£16,000

Conclusion

Only certain compensation events allow for a reduction in contract value (see summary table below). This approach in the NEC forms is a subtle and important aspect of risk allocation between the parties. An omission of work from the scope may lead to a reduction of the prices which is greater than the original price of the omitted item. Omitting work can be a source of contention for both parties and needs to be properly managed by project manager and contractor in accordance with the contract.

Summary of compensation events in the ECC which may lead to reduced prices

David Hunter

Daniel Contract Management Services

March 2023

^[1] The meaning of defined cost varies between each main payment option see clauses A/B11.2(23), C/D/E11.2(24) and F11.2(25

^[2] The prices is used to assess the amount payable by the client to the contractor.

^[3] Clause 63.3

^[4] The NEC4 Engineering and Construction Subcontract

^[5] Note that the assessment of a compensation event does not result in an earlier completion date (clause 63.5).

^[6] Clause 63.4

^[7] Van Oord UK Ltd v Dragados UK Ltd [2021] ScotsCS CSIH 50

^[8] The Prices are reduced by an amount calculated by multiplying the assessed effect of the compensation event by the value engineering percentage stated in the Contract Data

^[9] Clause 63.13 – any savings are shared in accordance with the ‘pain/gain’ mechanism described in clause 54.

^[10] Clause 61.6

^[11] If the rate in the Bill of Quantities for the item multiplied by the final total quantity of work done is more than 0.5% of the total of the Prices at the Contract Date.

^[12] Clause 61.3

^[13] Clause 10.2 requires the parties, project manager and the supervisor to act in a spirit of mutual trust and co-operation.

^[14] For main option A and C the pricing document is the Activity Schedule and the Bill of Quantities is used for option B and D.

^[15] Defined Cost varies between the main options but is essentially a set of rules which states what costs the contractor is entitled to recover. The price for a compensation event is its defined cost plus the contractor’s fee.