Brexit beckons

This article was originally published in 360°view.

After the initial shock of Britain’s decision to leave the EU, an uneasy calm is returning. However, the impact on capital programmes, both in the UK and globally, will be profound and long term. The construction industry’s ability to adapt accordingly will be crucial.

When Britons voted to leave the EU in June, both the UK and its European trading partners were plunged into a period of acute uncertainty.

Within hours, Britain’s Prime Minister had resigned, billions were wiped off the UK stock markets and sterling had slumped in value against both the dollar and the euro.

The days that followed saw a succession of business leaders make dire predictions, and the Governor of the Bank of England describe the UK as suffering from “economic posttraumatic stress disorder.”

Sentiment in the UK construction sector was hit hard, but has since recovered. In July the UK Construction Purchasing Managers’ Index, a closely-watched barometer of industry reaction, fell at its fastest level in seven years. Yet by September it had sprung firmly back into growth territory ^[1].

Bounce or business as usual?

The impact of the referendum result on levels of work was equally mixed, with official figures showing that UK construction sector output rose by 0.5 percent in July but fell by 1.5 percent in August ^[2].

Such mixed sentiment in the sector has led some commentators to conclude that the initial gloom following the referendum result was overblown.

“What was all the fuss about?” they ask, while arguing that Britain and the EU will divorce amicably with little economic fallout.

But such a stance underestimates the scale – and length – of the challenge ahead.

Brexit will be a process, not an event. It will take several years and involve countless, as yet unknown, elements that those responsible for capital programmes must identify and adapt to.

Uncertainty will continue to be the norm and for the construction sector, business as usual will not be an option.

While primarily an issue for the UK and other EU countries, the global nature of supply chains will ensure the Brexit effect ripples out much further afield.

For organisations planning a capital investment programme – whether in the real estate, infrastructure or natural resources sector – the lack of clarity about what the future holds is currently the greatest challenge. But those already delivering programmes face different and more tangible issues, which are set to impact in four key areas.

1. Supply chain

The supply chain is the lifeblood of a construction project, and it’s essential that clients respond to the current environment by showing leadership – engaging with and reassuring their contractors.

The construction industry supply chain’s interim payment system means it is more exposed to any erosion in confidence or deferral of investment than other sectors. With contractors usually receiving the bulk of their payment in arrears after work is done, suppliers are often viewed as financing much of project delivery.

That financial burden, coupled with what the Royal Institution of Chartered Surveyors (RICS) describes as the worst construction skills crisis in almost two decades, is putting increasing strain on supply chain capacity ^[3].

With clients and their funders now exercising extreme caution when making investment decisions, tender prices are likely to reduce in the medium-term, and thus increase the threat of contractor insolvency.

The aim should be to establish the financial robustness of the supply chain while also strengthening relationships within it.

In other words, clients should seek to put an arm round their suppliers, while simultaneously keeping their eyes wide open for any sign of weakness.

2. Contract commitments and liabilities

In normal times, contracts offer protection for both clients and suppliers – a bulwark against unpleasant or unexpected change.

However an event as seismic as the UK’s surprise vote for a Brexit may test existing contracts, and their interpretation, to the limit.

The referendum result, and its as yet unknown consequences, may not have been foreseen in the drafting of some contracts or procurement strategies.

Alternatively, parties may seek to argue that unexpected changes in statute introduced as part of the Brexit process could invalidate certain contractual agreements.

Clearly such a prospect represents a major liability for clients, so it is essential they review thoroughly all existing contracts for any such exposure.

This should be done as part of a contract “health check” or scenario testing of the baseline cost, scope, risk and schedule to give the client a clear picture of what they have paid for, and – based on an updated risk management profile – what their future commitments and liabilities will be.

Such a detailed assessment will be an invaluable protection against a supplier seeking to renegotiate or break a contract. It will give advance warning to the client of where their risk lies, and by identifying where the supplier’s risk lies, will also provide a powerful lever for negotiation in the event of a dispute.

3. Cost base

There is a serious danger of cost inflation for projects already underway, or at least with funding agreed and in place.

In the UK, input cost inflation has picked up, driven by a sharp fall in the value of Sterling. The Pound slumped to a 31-year low against the Dollar in the wake of the referendum result, and has yet to fully recover against both the Dollar and the Euro.

British construction is heavily reliant on European imports – both of materials and labour. More than 60 percent of building materials used in Britain are imported from the EU, and in 2014 more than 100,000 of the industry’s 2.1m workers came from elsewhere in the bloc ^[4].

Sterling’s post-referendum weakness was quick to filter through to import costs. In August, the annual rate of inflation for raw materials jumped to 9.3 percent, up from 6.2 percent in July ^[5].

Overall construction cost inflation could now rise further if contractors seek to cushion the impact of falling new demand and exchange rate volatility by increasing risk and contingency pricing. So it’s essential that clients work with suppliers to understand where their project resources, major plant and equipment and building materials are being sourced, and when their payment commitment dates are.

Looking further ahead, any weakening of the UK economy or tougher migration controls will make Britain a less attractive destination for foreign labour. A reduction in the supply of skilled workers from abroad would exacerbate British construction’s existing skills shortage and drive up labour costs.

With inflationary pressures looming for construction’s two primary inputs – materials and labour – it’s essential that clients take proactive steps to review their project scope and appreciate the risk to both cost and schedule.

Strategies that reduce the length of time spent on site, such as the use of off-site pre-fabrication, greater automation and end-to-end use of Building Information Modelling (BIM) will be crucial.

4. Project controls

Robust project controls serve a twin purpose – as both guarantor of efficiency and as an early warning system.

They are never more important than in the current climate of uncertainty, and clients should dial up the levels of scrutiny on all aspects of their projects.

In many cases this will mean using existing control tools more intensively – for example holding fortnightly rather than monthly progress meetings – but clients should also review and update their opportunity and risk registers to reflect the new reality.

Clients and their programme managers should also seize this opportunity to revisit their project baselines, using detailed records of the execution plan.

Where problems are identified, corrective action can be taken. Where no problems are found, the client will enjoy a reassurance dividend that will trickle down the supply chain.

Cool heads and considered responses

For all the speculation about the long-term impact of Brexit, the immediate impact is easier to quantify – continuing uncertainty, rising costs, deferred investment and pressure on the supply chain.

While uncertainty itself is a risk factor – and by definition a difficult one to calibrate – its more obvious symptoms can be adjusted for and treated. For organisations currently engaged in capital asset programmes, now is the time to take stock of the situation, identify specific risks and liabilities, and take pre-emptive action.

Construction is a famously cyclical sector, well used to absorbing the peaks and troughs of the economic cycle. The prolonged period of uncertainty triggered by the UK’s vote for Brexit has amplified existing trends rather than created new ones.

For this reason I believe that clients who adopt a measured approach and address the four impact areas outlined above will be able to successfully mitigate many of the risks they currently face.

As the UK embarks on the formal process of Brexit, new challenges will emerge. Individual tactics will need to evolve in response, but an agile strategy that includes robust project controls and a commitment to a collaborative supply chain will enable clients to continually anticipate, adapt and achieve the best project outcomes.

^{[1] http://uk.reuters.com/article/us-britain-economy-pmi-economy-idUKKCN124183}

^{[2] http://www.ons.gov.uk/businessindustryandtrade/constructionindustry/bulletins/constructionoutputingreatbritain/aug2016}

^{[3] https://www.rics.org/uk/news-insight/latest-news/brexit/}

^{[4] https://www.ft.com/content/163334e2-79a7-11e6-97ae-647294649b28}

^{[5] www.ons.gov.uk/economy/inflationandpriceindices/bulletins/producerpriceinflation/august2016}