Harry Randle - S09476257

Research Proposal

The assessment of risk and uncertainty in construction projects

1.0 - Introduction
1-1 - Rationale
The construction process has always been fraught with risk and uncertainty; it remains one of the sectors most likely to suffer cost overruns (Memon, Rahman & Azis 2011). It has been suggested by Dey (2002) and Hackett, Robinson & Statham (2007, Ch. 6) that this high likelihood of cost overruns can be attributed to the technical constraints, number of stakeholders and the construction process itself. Alternatively, Wilkinson & Reed (2008, Ch. 4) along with Atrill (2006, Ch. 10) argue that the long operating cash cycle and capital needs involved in construction projects introduce the main sources of potential cost overruns. These sources of cost overruns may be defined as risk and uncertainty and are inherent in construction projects. They are currently assessed using subjective means, based on risk perception which is highly influenced by peoples belief, attitudes,judgement is further compounded by the
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entrepreneurial nature of the UK construction sector and its reluctance to adopt formal risk and decision analysis procedures (Byrne, 1996, Ch. 1). This subjective and informal attitude to risk analysis can be seen throughout the construction process, be it simply adding a relatively arbitrary percentage to a cost plan (Kirkham, 2007, Ch. 10 & Ashworth, 2010, Ch. 13) or the perception that risk analysis and management should only be used on larger construction projects (Kirytopoulos, Leopoulos & Malandrakis, 2001). Again, this attitude is compounded by the blurring of roles in the project team, Ashworth & Hogg (2007, Ch. 9) argue that the responsibility for risk assessment and management is unclear and may be divided between Quantity Surveyor and Project Manager, as no formal industry wide procedure has been adopted. Ashworth & Hogg (2007) also attribute the consistent inability of the construction sector to meet clients needs in terms of cost, time or quality to a lack of risk management.

and

feelings (Akintoye & MacLeod,1997). This

Harry Randle - S09476257

Research Proposal

The current financial crisis has had wide reaching effects on the construction sector; current estimates for output show negative figures for the next 18 months (Table 1), this is to be revised further downwards due to continued unrest in the Eurozone as it struggles with severe structural debt problems.

posed by real estate lending is especially important, as exposure to this type of lending has been increased through the use of financial instruments such as synthetic Commercial Mortgage Backed Securities (CMBS), these instruments ensure an investor can gain leverage for aggressive speculation (Nomura Sec., 2006) a view that is echoed by the CRE Finance Council (2004). It is likely that lending criteria will remain centered around the four Cs as put forward by Isaac (2003, Ch. 4). However, it may be hypothesised that developers and construction companies with a clear history and understanding of the Risk Control Process (Smith, Merna & Jobling 2006, Ch. 4) will find finance easier to place. With the above in mind, this study proposes that a more methodical and objective approach be taken to the assessment and management of risk. This will be done using modelling techniques that are familiar to the financial industry, this may partially alleviate fears institutions have over their exposure to real estate lending, whilst providing more accurate cost estimates to clients.

Table 1 - Experian & CPA Growth Forecasts for Construction Output

Fordham (2011)

These structural debt problems along with the newly implemented BASEL III banking accord mean banks will be required to hold significantly more capital from 2013, it is likely the rate of lending for real estate projects will decrease over the long term by -1.3% from an already low figure (imf.org, 2011). Another consequence is a tightening of lending criteria as institutions become more risk averse and understand the real risks that are inherent in commercial real estate lending, as expressed by the Federal Deposit Insurance Corporation (2006) and Shapiro, Davies & Mackmin (2009, Ch. 12). The acknowledgement of the increased risk
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Harry Randle - S09476257

Research Proposal

1.2 - Benefits
Such a change will not take place without financial or regulatory incentives. It may be argued that such incentives are available, and include: Accuracy - The risk is modelled on a project specific basis, allowing project risk to be accounted for, this will allow a more accurate risk allowance to be gauged. Justification - A client or lending institution will be able to see the justification of the risk allowance and risk profile, how it has been calculated and what is included. Standardisation - The proposed modelling techniques will be based on methods already used in the financial sector, this will allow direct comparison with other investment types and risk profiles. Opportunity - A Construction Consultant that offers this service has the opportunity to be involved early on in the project and is best placed to offer advice on risk mitigation and value engineering strategies. Thus, winning extra work in fields that may not currently be defined as core business.
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1.3 - Aims and Objectives

Aim To develop a theoretical model to identify and quantify risk factors in the construction sector. Objectives To review risk assessment methods currently used in the construction sector. To produce a model based on research that will quantify identified risk factors.

Harry Randle - S09476257

Research Proposal

2.0 - Literature Review

2.1 - Risk and Uncertainty
Risk and uncertainty are central to construction. The bespoke nature of buildings ensure each project has its own risk prole which brings with it a new set of challenges (Kirkham, 2007 Ch. 4). Unfortunately, it may be argued that the construction industry sometimes fails to truly understand these terms and what they represent, using them in a rather colloquial manner (Byrne, 1996, Ch. 3). Uncertainty - In the context of construction, uncertainty usually refers to estimating uncertainty (Smith, Merna & Jobling, 2006, Ch. 1). Akintoye & MacLeod (1997) go a little further and propose that construction contains few true uncertainties, only varying degrees of risk. Uncertainties present should be converted to risks using a Judgmental Risk Analysis Process (Oztas & Okmen, 2005). Risk - A scenario that exists where a range of probable outcomes are known, each impact capable of being quantied. Nemuth (2008) expresses risk as: Risk = Probability x Impact

It should be noted that the construction sectors view of risk is simplistic when compared to that of the nancial sector, this is surprising given the collaboration that is needed between the sectors. Jorions FRM Handbook (2009, Ch. 1) classies risks into 3 sub-categories: Known Knowns - Risks that can be properly identied and measured. Known Unknowns - Risks that arise through volatility or correlations (Crouhy, Galai & Mark, 2005, Ch. 14). Unknown Unknowns - This category is reserved for systemic risks. Byrne (1996) may incorrectly class these as uncertainties, they are better dened as Knightian Uncertainties or immeasurable risks. The above sub-categories receive no more than a cursory mention in Smith, Merna & Jobling (2006) and remain absent from most other literature, including Byrne (1996). Possibly the most in depth study of risk factors that are foreseeable at pretender stage was undertaken by Elhag, Boussabaine & Ballal (2005), 67 factors where identied, along with a Severity index. This comprehensive study will form the basis of the risk model under study.
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Harry Randle - S09476257

Research Proposal

2.2 - Risk Management Process

To consider the identication and quantication of risk, rst the control and management process must be understood. The construction industry uses a simple 4 stage process as shown in gure 1, Nemuth (2008) conrms this risk control process is used in the construction industry, irrespective of project size. This appears to be a simplication of the risk control and management process as instituted in BS6079-3 (BSI, 2000).
Figure 1 - The Risk Control Process

Risk Identication - Ashworth & Hogg (2007) say this stage is usually fullled during a risk workshop. This workshop will usually take the form of an open discussion where all members of the design team will come together and assess both the project specic and systematic risks (McLaney, 2009, Ch. 6). Risk Analysis - In this stage both Byrne (1996) and Smith, Merna & Jobling (2006) concur that the results from the previous stage should be analysed with various scenarios, probabilities and costings being attributed to each risk. Risk Response - This study will accept the proposed risk response procedures of Ashworth & Hogg (2007, Ch. 6). This SADE (Shrink, Accept, Distribute, Eliminate) response is used industry wide It is also referred to by other authors as ERIC and TTTT.

Smith, Merna & Jobling (2006)

This theoretical process in translated into various stages with no single individual taking control (Ashworth & Hogg, 2007), it may be hypothesised this is because the risk control process spans all RIBA stages. In practice these stages might be interpreted as: Risk Review - Risk is a function of time and probability (Byrne, 1996), thus, as the project progresses so does the overall risk prole and exposure to risk. For this reason the risks must be reviewed and updated regularly (Akintoye & Macloeod, 1997)

Harry Randle - S09476257

Research Proposal

2.3 - Monte Carlo Simulation

The Monte Carlo Simulation (MCS) is used as a probabilistic analytical technique for the quantication of risks in a project at the risk analysis stage. The mathematics are complex and are studied in more detail by Glasserman (2003, Ch. 1). The MCS is essentially a random number generator that is able to relate those random numbers to probability distributions given by the user, this produces outcomes in the form of relative probability distributions. This allows those involved in the analysis of risk to study possible scenarios and outcomes based on inputs and probability. The MCS is widely used in econometrics to model single variables (Barreto & Howland 2006), and is central to nancial engineering and risk management (Jorian, 2009), in the nancial sector it is used to simulate random variables that are assumed to follow the Markov Process, including stock prices, market risk, investment yields and VaR. Lending institutions also use the MCS to measure credit risk and default rates (Glasserman, 2003, Ch. 9). Currently, the MCS does not form a central part of risk analysis in the construction sector. Ashworth and Hogg (2007, Ch. 6)
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state it should only be used to model uncertain variables and inputs are largely subjective. Such a position is inline with longstanding opinions in the construction sector. However, current MCS modelling software has become considerably easier to use, the availability and quality of data has increased along with the knowledge of the risks undertaken within the construction process. Smith, Merna & Jobling (2006, Ch. 6) show how even a simplistic MCS can now be integrated into the risk analysis process. This position is being increasingly conrmed as papers such as those from Nemuth (2008) and Oztas & Okmen (2005) conrm. As the construction industry becomes more dependent on the nancial industry it may be hypothesised that the nancial industry will require risk assessment methods that it understands and are inline with its own, hence the move and interest in MCS. This study will focus on 5 probability distributions, normal, beta, rectangular, triangular and PERT. These will be used as they best model the risks present in construction, they rely on and reect the most likely nature of construction at the earlier stages.

Harry Randle - S09476257

Research Proposal

3.0 - Methodology

the use of objective historic data with a subjective understanding gained through review of current literature. What is being assessed is simply risk. The risks present will be take from the extensive study by Elhag, Boussabaine & Ballal (2005) and the MCS model will be produced using Palisade softwares @Risk Suite. The model will then be tested using a case study to check for accuracy.

Methodology is the study of method and must answer the fundamental questions of Why, How and What is being researched, the method used must also be justied and t the proposal (Farrell, 2011). In this proposal the Why has already been outlined - to gain a better understanding of construction risk and contingency allowances.

3.1 - Stage 1 - Literature Review

How the research will be conducted presents more of a problem. It would be ideal to compare pre-tender cost estimates with nal accounts to assess the amount of contingency allowance used, the project team could be interviewed to gain an insight into why those contingencies were used and to explain anomalies, the results could then be modelled with a view to forecasting project risk. A method such as this presents its own problems, such as collation and subjectivity of data, time, ethical dilemmas and the realisation that the construction sector may not be willing to accept that risk assessment techniques need to be improved. The second stage of this study will be the production of a model to assess and forecast risk and contingency allowance. The rst stage of this study will be an indepth literature review. Primary and secondary sources will be used, the aim of which is to gain a thorough understanding of risk. If other modelling techniques are highlighted (such as hedonic price modelling via ANN or ARIMA) they will be considered.

3.2 - Stage 2 - Model Production

3.3 - Stage 3 - Verication

The How will therefore be undertaken by way of triangulation (Blaxter, Hughes & Tight, 2006). A method that will combine
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The model will be veried against a case study and the results considered.

Harry Randle - S09476257

Research Proposal

5.0 - References

British Standard Institute (2000) BS6079-3 - Project Management - Guide to the Management of Business Related Project Risk, London: British Standard Institute. Byrne, P. (1996) Risk, Uncertainty and Decision-Making in Property Development, 2nd Edition, Oxon: Taylor & Francis.

Akintoye, A. and MacLeod, M. (1997) Risk Analysis and Management in Construction, International Journal of Project Management, Vol. 15, No. 1.

Ashworth, A. (2010) Cost Studies of Buildings, 5th Edition, Essex: Pearson Education. Cosimaro, T. and Hakura D. (2011) Bank Behavior in Response to Basel III: A C r o s s - C o u n t r y A n a l y s i s. [ O N L I N E ] Ashworth, A. and Hogg, K. (2007) Williss Practice and Procedure for the Quantity Surveyor, 12th Edition, Oxford: Blackwell Publishing. CRE Finance Council (2004) Borrowers Atrill, P. (2006) Financial Management for Decision Makers, 4th Edition, Essex: Pearson Education. Barreto, H. and Howland, F. (2006) Introductory Econometrics: Using Monte Carlo Simulation, Cambridge: Cambridge University Press. Blaxter, L., Hughes, C. and Tight, M. (2006) How to Research, 3rd Edition, Berkshire: McGraw Hill Education. Dey, P. (2002) Project Risk Management: A Combined Analytic Hierarchy Process and Decision Tree Approach, Cost Engineering, Vol. 44, No. 3, March. Crouhy, M., Galai, D. and Mark, R. (2005) The Essentials of Risk Management, Berkshire: McGraw Hill. Guide to CMBS [ONLINE] Available at: h t t p : / / w w w . c r e f c . o r g / IndustryResources.aspx? id=3348&terms=borrowers+guide+to +CMBS. [Accessed 07 November 11]. Available at: http://www.imf.org/external/ pubs/ft/wp/2011/wp11119.pdf. [Accessed 07 November 11].

Harry Randle - S09476257

Research Proposal

Elhag, T., Boussabaine, A. and Ballal, T. (2005) Critical Determinants of Construction Tendering Costs: Quantity Surveyors Standpoint, International Journal of Project Management, Vol. 23, pp 538-545.

Hackett, M. (Ed.), Robinson, I. (Ed.) and Statham G. (Ed.) (2007) The Aqua Guide to Procurement, Tendering & Contract Administration, Oxford: Blackwell Publishing. Isaac, D. (2003) Property Finance, 2nd

F a r r e l l , P. ( 2 0 11 ) Wr i t i n g a B u i l t Environment Dissertation. Oxford: WileyBlackwell. Federal Deposit Insurance Corporation (2006) Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices [ONLINE] Available at: http:// www.fdic.gov/regulations/laws/federal/ 2006/06notice1212.html. [Accessed 07 November 11]. Fordham, P. (2011) Market Forecast: Stuck in the Mud [ONLINE] Available at: http:// www.building.co.uk/data/market-forecast/ market-forecast-stuck-in-the-mud/ 5026742.article. [Accessed 07 November 11].

Edition, Hampshire: Palgrave MacMillan. Jorion, P. (2009) Financial Risk Managers Handbook - FRM Part I / Part II, 6th Edition, Sussex: John Wiley & Sons. Kirkham, R. (2007) Ferry and Brandons Cost Planning of Buildings, 8th Edition, Oxford: Blackwell Publishing. Kirytopoulos, K., Leopoulos, V. and Malandrakis C. (2001) Risk Management: A Powerful Tool for Improving Efficiency of Project Orientated SMEs. Manufacturing Information Systems: Proceedings of the 4th SMESME International Conference: Denmark.

McLaney, E. (2009) Business Finance: Glasserman, P. (2003) Monte Carlo Methods in Financial Engineering, London: Springer. Theory and Practice, 8th Edition, Essex: Pearson Education.

Harry Randle - S09476257

Research Proposal

Memon, A., Rahman, I. and Azis, A. (2011) Preliminary Study on Causative Factors Leading to Construction Cost Overrun, International Journal of Sustainable Construction Engineering & Technology, Vol. 2, No. 1, June. Nemuth, T. (2008) Practical Use of Monte Carlo Simulation for Risk Management within the International Construction Industry, Grauber, Schmidt and Proske: Proceedings of the 6th International Probabilistic Workshop: Darmstadt. Nomura Securities (2006) Fixed Income Research: Synthetic CMBS Primer [ONLINE] Available at: http:// w w w. s e c u r i t i z a t i o n . n e t / p d f / N o m u r a / SyntheticCMBS_5Sept06.pdf. [Accessed 07 November 11]. Oztas, A. and Okmen, O. (2005) Judgmental Risk Analysis Process Development in Construction Projects, Building and Environment, Vol. 40, pp 1244-1254 Shapiro, E., Davies, K. and Mackmin D. (2009) Modern Methods of Valuation, 10th Edition, London: EG Books. Smith, N., Merna, T. and Jobling, P. (2006) Managing Risk in Construction Projects,
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2nd Edition, Oxford: Blackwell Publishing. Wilkinson, S. and Reed, R. (2008) Property Development, 5th Edition, Oxon: Routledge.