The Future of Performance Based Contracting

By Ken Kastman, PE

Nearly everybody likes the idea of performance based contracting (PBC) — the U.S. Department of Defense (DoD), industry, developers, consultants and many regulators. The idea is to step beyond a plodding, prescriptive, formal approach to cleaning up a site (e.g., Superfund or RCRA) to a cleanup approach based on well-defined up-front objectives coupled with incentives to achieve those objectives.

As usual, the devil is in the details, and this relatively new market area is coalescing consistent approaches and service offerings as it moves forward.

How It Started

The idea of PBC started about a decade ago. In the late 1990s, the Navy initiated a formal program and set goals for several years. Other branches of the military started their own programs. Private industry and military contractors retooled their service offerings to respond. Insurance companies and brokers, seeing a new market, also responded.

The idea of performance based contracting is straightforward. According to a Naval Facilities Engineering Command briefing by Rob Sadorra, P.E., in May 2005, the Navy’s PBC program task orders “describe ‘what’ is required (expected outcome) and place the responsibility on the contractor for determining ‘how’ to deliver or meet the desired outcome.”

The program is more of a way of thinking than a precise path forward, and encourages innovation and contractor expertise to achieve the desired outcome. Many tools fit under the umbrella of PBC, including: firm fixed price, lump sum contract, guaranteed fixed price, third-party risk transfer, and environmental services cooperative agreements.

A key element of PBC is risk transfer, especially when the environmental liability of the property is shifted from the responsible party to the contractor. Contractors hedge this risk transfer by securing insurance, typically insuring at several times the conservatively estimated cleanup cost. The cost of insurance is included in the risk transfer contract as well as a significant premium for accepting the risk.

Several private companies have specialized in this complicated liability transfer process. Environmental Remediation Services, Inc. (ERS) contracts for environmental liability and property ownership, typically working with larger engineering and remedial construction companies to clean up the property under their direction. ERS president Edward Allen notes, “Many companies simply want to get their environmental liabilities off of their balance sheets, and this liability transfer mechanism is an extremely attractive option.”

The volume of PBC contracts awarded during the last five years, in both numbers and dollars, has been steadily increasing. The Navy estimates that the percentage of fixed price contracts will increase from 32 percent in 2001 to a target of 67 percent in fiscal year 2006. Ed Malley, vice president of TRC, a private consulting firm specializing in PBC, says the company has 86 sites in their PBC program. The underlying value of cleanup contracts to TRC is $400 million; the estimated redevelopment value is $3.5 billion.

One caveat is that there must be a viable market if redevelopment is a part of a PBC initiative. “We focus where the real estate market is hot,” says Eric Williams of Arcadis, a large private consulting firm.

Arcadis has had $1billion in guaranteed fixed price remediation contracts during the last 10 years. These contracts initially focused on cleanup, but have shifted in the last two to three years to redevelopment of brownfield properties as a natural extension of their cleanup program. Williams indicates that the market is moving beyond individual properties to larger community redevelopments.

On the federal side, the DoD is considering not only cleanup, but also redevelopment of properties in the upcoming BRAC program. An uncertainty will be the level of developer interest in and response to base closures in areas of the country where soft or limited market potential exists.

The Holdouts

Not everybody is comfortable with or convinced of the reality that environmental liability can really be transferred. This discomfort is especially true for large global companies where “bounce backs” occasionally occur. (Bounce backs happen when properties come back after transfer because the new owner has gone out of business or unanticipated property use has resulted in additional issues.) However, at least two large oil companies have transferred, or are considering transferring, a portfolio of retail sites, partially as a means to test the potential of this risk transfer structure.

Similarly, not all consultants embrace PBC. There have been some high profile failures of PBC contracts resulting in litigation. Also, there is a hesitation for large risk-adverse consulting firms to take on liabilities that they did not create.

Some government oversight groups have questioned the performance of PBC. Several key leaders said at the Services Acquisition Reform Act Advisory Committee hearing in May 2005 that performance based contracting was not working. Reasons cited were the lack of incentives and statements of work, ineffective implementation, lower savings than promised, and the large number of sole source contracts awarded without competition.

Notwithstanding the issues and complexity, the market forecast for PBC is bright. Malley estimates that TRC’s business in this area is growing 20 percent per year. Other estimates are similar. With the new BRAC program on the horizon, and the desire of the DoD to grow in this direction, there will undoubtedly be a lot more activity for PBC service providers in the next few years. BFN

Ken Kastman, PE, is national leader of property redevelopment for URS.