03 Dec 2009

The changing climate of risk allocation in infrastructure projects

by Owen Hayford

The weather, regulatory and market-related risks caused by climate change will bring about a reallocation of risk in infrastructure projects.

Whether one is a climate change believer or sceptic, it is undeniable that there are real risks—not just weather-related, but regulatory and market risks—that prudent participants in the infrastructure sector must consider.

Weather-related risks

Weather-related risks are the risks of rising sea levels and severe weather events that directly and physically impact infrastructure projects. Severe weather events include heatwaves, frosts, heavy rainfall, draughts, floods, hail, thunder storms, tropical cyclones, bush fires and extreme winds. It seems that infrastructure located around our coastal fringes will be particularly exposed to these risks. 

A recent report by the Commonwealth Department of Climate Change, Climate Change Risks to Australia's Coasts, suggests that a predicted 1.1m rise in sea levels by 2100 will threaten 250,000 houses, 120 ports, 1800 bridges, 5 power stations/substations and a number of water treatment plants, airports and industrial zones within 200m of the coastline.

As the number and severity of these events increase due to climate change, owners and operators of infrastructure will incur greater repair costs as well as business interruption costs. The industry is likely to respond to weather-related risks in several ways.

Investors in infrastructure projects will require more detailed risk assessments to be conducted on the impacts which climate change will have on the project.

Designers will be expected to adequately consider weather-related risks as part of the design process in order to discharge their duty of care. The standard of care expected of a reasonably competent designer of infrastructure will extend to the consideration of foreseeable climate change risks. Even so, owners are likely to impose express obligations on designers to consider such risks. We are also likely to see greater prescription in technical specifications for facilities on the weather-related events that the facility must be capable of withstanding.

In the same vein, designers and builders will find that the content of "fitness for purpose" warranties will become more onerous going forward as the foreseeability of more severe weather events increases.

It is also likely that there will be a greater focus on weather-related events in force majeure, extension of time and relief event clauses, during the construction, operation and maintenance of infrastructure projects. For example, will damage caused by storms be covered? How violent must a storm be to fall within the definition of a covered event? Would a power outage during the operation phase be covered under one of these clauses? In this regard, it is likely there will be greater alignment between these sorts of relief provisions and the design requirements of a project. For example, if the design requirements require an alternative energy power supply to be provided, one would not expect force majeure relief to extend to power outages.

Finally, owners and operators of infrastructure will increasingly focus on weather-related risks in operating and maintenance plans and will seek alternative sources of power and other inputs needed to ensure continued operation of an infrastructure facility.

Regulatory-related risks

Regulatory-related risks are the risks that Government responses to climate change will negatively impact upon a piece of infrastructure. The Rudd Government's Carbon Pollution Reduction Scheme (CPRS) is an example of a government's response to climate change. Other examples include the recently enacted mandatory renewable energy targets and the introduction of new efficiency and energy use standards.

It is clear that the CPRS will produce winners and losers. One of the greatest concerns of the CPRS is that it will increase the cost of doing business in Australia. In particular, the CPRS is likely to cause the price of emissions-intensive raw materials, such as cement and aluminium to increase. Price increases are also expected for transport and power costs as businesses seek to pass on the cost of emissions permits.

Parties seeking to protect themselves in this regard may wish to include tailored "rise and fall" clauses in the contracts that entitle them to additional money on account of such price movements. However, one potential complication is the extent to which a change in law clause coupled with a rising and fall provision might give rise to double recovery.

It is also likely that there will be attempts to allocate or share these risks contractually, and attempts to pass on the costs associated with climate change regulations. Owners and operators of facilities requiring the purchase of permits under the CPRS will want to clearly allocate responsibility between themselves for the purchase and surrender of these permits. The party responsible for purchasing and surrendering the permits will want the other to co-operate to the greatest extent possible to minimise emissions and, hence, the number of permits which must be purchased.

Owners and purchasers of facilities may require warranties from their contractors and manufacturers in relation to the emissions that the facility or equipment will produce. Owners and purchasers may also want indemnities in respect of excess emissions or performance guarantees.

The allocation of risk arising from a change in law is likely to assume greater importance. Most operators of emissions-intensive facilities have already reviewed their offtake and sale contracts to assess their ability to pass to their customers the additional costs associated with the Government's proposed CPRS. Parties will want to ensure that new contracts clearly allocate the risk of increased costs due to regulatory changes arising from climate change. When negotiating changes in law provisions, consideration will need to be given to whether increased costs should be passed through in their entirety, or whether there should be some "pain-share" arrangement to motivate both parties to minimise the additional cost.

Market-related risks

Market risks arise from the market's response to the weather and regulatory risks, and include

  • higher costs for property damage and business interruption insurance; and
  • higher costs for certain goods and services as businesses seek to pass on the costs caused by Government regulation.

Demand for more comprehensive property damage and business interruption insurance will increase. Expect greater detail in infrastructure contracts on the weather-related events which the property damage and business interruption insurances must cover. The issue of liability for insurance cost increases is also likely to assume greater attention, together with provisions entitling relief from insurance obligations where insurances cease to be available on commercial terms.

The infrastructure industry is likely to undertake more detailed risk assessments on the impact that climate change may have on a project's revenue and costs. For example, parties considering whether to invest in a port facility may want to consider the impact which climate change might have on demand for the goods that are expected to pass through the port.

Finally, it is likely that a scheme similar to the Green Star Scheme for buildings will be developed in relation to infrastructure. If this occurs, we will see similar issues in relation to contractual allocation of responsibility for achieving a particular rating, as we presently see within the commercial building industry. This is because no single party in the contractual structure is likely to have the ability to guarantee a particular rating without the co-operation of the other parties involved in the design, construction, operation and maintenance of the facility.

Conclusion

Climate change creates new risk for infrastructure projects and as a result of these different risks, industry practice and contractual risk allocations will evolve.

It is important for the infrastructure industry to start considering these risks. Only then can they begin to protect themselves against the serious financial and commercial consequences that may flow as a result of climate change.

Thanks to Eammon Atkinson for his help in writing this article.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.