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RISK-SHARING RULE IN PROJECT CONTRACTS
Kiyoshi Kobayashi, Toshihiko Omoto

Masamitsu Onishi

Graduate School of Management
Kyoto University
Yoshida-Honmachi, Sakyo, Kyoto, 606-8501, Japan

Dept. of Urban Management
Graduate School of Engineering, Kyoto University
Yoshida-Honmachi, Sakyo, Kyoto, 606-8501, Japan

Abstract: In this paper, the risk sharing rules are investigated to characterize the contractual structure of the projectcontracts. The authors exclusively focus upon the GCW and the FIDIC forms, which can be regarded as typical examples
of incomplete contract forms. Risks involved in construction works are classified into exogenous and endogenous ones.
The paper claims that clear differences in both contract forms in coping with endogenous risks can be found, while there
are no essential differences in dealing with exogenous ones. The paper concludes by summarizing the remaining
research issues to be scrutinized in the future.
Keywords: Risk sharing, Project Contracts, Incomplete Contracts, Renegotiation

1. INTRODUCTION
The traditional contract theory has assumed that acontract should contain the agreements as to how to deal
specifically with all expected incidents which may, or may
not, occur in the future. If the parties to a contract intend
to contain all agreements for uncertain situations, acontract document may become extremely complex.
Moreover, in the case of large-scale projects that have somuch uncertainty, it is in fact impossible to draft acontract [1]. Rather, a contract cannot help being
incomplete contract [2].
For the reasons described above, incomplete contracts
do not provide specific responses for all contingencies
but the rules to cope with contingencies. There areseveral rules, which should be contained in an incomplete
contract, but one of the most important ones is therisk-sharing rule.
In this paper, the risk sharing rules are investigated tocharacterize the contractual structure of projectcontracts. The author exclusively focus upon the GCWform (The Standard Form of Agreement and General
Conditions of Government Contract for Works of
Building and Civil Engineering Construction) [3] and the
FIDIC
form
(Federation
Internationale
desIngeniers-Conseils) [4], which can be regarded as typicalexamples of incomplete contract forms.
2. METHODOLOGY
2.1 Exogenous risks

In a project, there are many unforeseen contingencies
such as geological conditions, nature, change of design
or scope of work, law and so on. We call them exogenous
risks because parities to a contract cannot control themcompletely. It is impossible to describe such unforeseen
contingencies in a contract, thus a contract cannot help
being an incomplete contract.
Instead of providing for all unforeseen contingencies,
risk-sharing and renegotiation (variation) rules arecontained in incomplete contract. The parties makedecisions considering the gains that they can get whensuch an unforeseen contingency occurs under thevariation and the risk-sharing rules described in thecontract. It would not be efficient for a contract to allow
variations for all risk events. In fact, most contracts do
not allow variations for many risk events. Which eventsshould be allowed as a variation depends on thecharacteristics of each risk event. In an incomplete
contract, following two rules are important to cope withthe occurrence of exogenous risks: 1) Who should bear aloss, 2) Whether a contract variation should be allowed
or not.
2.2 Endogenous risks
A project contract, as an incomplete contract, has thefollowing three important features:
1) The contractor must complete the work in compliancewith the description of the works and within the time forcompletion. The contractor is prohibited to cancel thecontract in both GCW and FIDIC forms, whatever may
happen, other than the very limited situations like theemployer¶s non-payment for over a certain period of time.

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2) To implement a project for the owner and to get andstart a project for the contractor, investments are needed
beforehand. Such investments are valueless for otherprojects, thus, are called relation-specific investments.
3) To make a contract enforceable, a third party such asa court must verify the contingencies or the behaviors of
the parties. Some of the agreements in a contract such as
the time for completion or the amount of payment areverifiable by the court. But it is often the case with aproject that the verifiability is not guaranteed. In thiscase, it is difficult for the court or the third party to settle
a dispute based on the information about thecontingencies which have been realized. Such a situation
can be described as being observable but unverifiable.
The factors of prohibition of cancellation of contract,
relation-specific investment, unverifiability have close
relationship with each other. If such factors are containedin a contract, one of the parties may take advantage ofanother party's investment and make a breach of contract
intentionally, that is called a hold-up problem [5], or they
may conceal the information that leads to disadvantages
to themselves, that is called a moral hazard. Such risks as
to lead to a hold up or moral hazard are raised by theboth parties¶ strategic behaviors and, therefore, we callthem endogenous risks. In an incomplete contract, bothexogenous and endogenous risks must be considered toachieve efficiency for a contract performance.
2.3 Project Contracts as Incomplete Contracts
Project contracts do not allow cancellation offered by thecontractor. If an unforeseeable contingency causes aloss, the parties intend to solve the problem of loss
sharing according to the clause of variation and dispute
resolution in accordance with the contract. In an
incomplete contract, the significances of providing
variation rules and dispute resolution rules in a contract
are of the following three points: 1) If exogenous risks
realize, the parties can complement the efficient variationand dispute resolution. 2) Providing variation rules makes
the structure of contract very simple. 3) Proper design ofan initial contract and variation rules gives the parties
incentive to comply with the contract. In other words,
optimal design of a contract prevents endogenous risks.
3. PROJECT RISK
The principal makes a planning and preliminary survey
and design prior to the project implementation. The
contractors estimate the cost based on the information at
the time of the bid and submit an offer. The awarded
contractor takes charge of the project from preparation tocompletion. Principal often makes kinds of payments;
advanced and interimand final. The contractor is obligate

to repair the defects found in a certain period of time after
the completion. The project proceeds as shown in Fig-1.
In this figure, major project risks are categorized and theirperils and hazards are shown in the order of the flow thatthey occur.
Focusing on the peril of the risks, major project risks areclassified into five categories: politics, economics,
society, force majour, contract. Political risk means thatsuch a peril has a political factor i.e. policy changes, andso on. It is difficult for private contractors to foresee sucha risk. Social Risk means that its peril involves a social
problem such as a fossil discovery, pollutions, protests,
and so on. This risk occurs throughout the project. Forcemajour risk means that its peril is force majour such as
earthquake, flood, weather, war, general strike, and so on.
Contractual risk means that its peril or hazard is theparties¶ behaviors. Careful preliminary surveys anddesigns and proper plan and management can reduce thecontractual risks to a certain extent. But the contractual
risks cannot be avoided even though the parties¶ havemade the best efforts to eliminate them by use of theirability to foresee or the information available. In thissense, a contractual risk is recognized as an exogenous
risk. But if the parties make negligence intentionally, morelarge-scale risk can happen. A risk that gives incentive fora moral hazard or a hold up is recognized as an
endogenous risk. In reality, it is difficult to distinguishexogenous and endogenous risks.
4. EXOGENOUS RISKS AND VARIATION
4.1 Risks and Risk Sharing Principles
The problem of risk sharing is recognized as that who
should bear a loss when a risk occurs [6]. Posner andRosenfield [7] have proposed that the risk sharing in thecontract law result in a problem that which party would
bear a loss if they could have foreseen that contingency.
In other words, the problem are 1) Which party can
prevent or control the risk more efficiently and 2) If therisk cannot be prevented or controlled, which party is in abetter position to protect himself against the loss. We canderive the risk sharing principles as follows: 1) The party
who can assess and control the risk should bear it. (Wecall it the first principle.) 2) If none of the parties cannot
assess or control the risk, the party who can bears it
easier or procure the insurance frommarket should bear it.
(We call it the second principle.) Especially, in the casethat the principal is a public sector, it has usually morecapability for bearing the risk and is expected the to play
the role as a deep pocket under the second principle.

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planning

invitationcommencement
award
for bidpreparation
preparation
constrution
designfor construction
for bidpolitics

upper plan, law, tax risk
currency (payment) risk
management of procuring finance (A)currency (agent's management) risk
obtaining license (P)obtaining license (A)license risk

economyplace and time of procurement (A)price risk
procurement of finance (A)interest rate risk
risk hedged by exchange rate contract (A)exchange rate risk

completion

maintenancesurvey (P)societyarcheological, geologica, biological discovery risk

consideration of effect to the environment, accounting tolocal inhabitant (P)environment/protest riskbuying up the site having a margin of time (P)site procurement risk
disaster riskforcemajourweather risk
war, general strike risk
appropriate and accurate survey (P)APC risk
For errors risk
survey/design risk

careful draftin g of c ontract (P)accurate survey, appropriate design (P)appropriate instruction (P)employer

instruction risk
quantity/design change risk

providing/survey/design to avoide thechange (P)swift decision-making/settlement (P)late issuance of drawing/instruction/Permission

consideration of finance condition/ficancial procurement plan (P)princilpal's finacial procurement risk
management of project (A)damage risk for objective

contract

strict management (A)performance riskskill and care to accomplish the required
performance (A)Proper and reasonable plan/administration (A)contractor

defect liability risk

management risk
reasonable plan/management (A)damage for other facilities/third parties
safe and reasonable plan and management (A)labor accident risk

ficancialcertification (P)consideration of agent's fiancial condition (A)agent's financial procurement risk
making contractors cordinate with each othe r (P)coordination with other c ontractors (A)interference risk with other contractors

otherscomprehension of subcontractor's
financial condition (A)default risk of subcontractor

being copyrighted and patented for design (P)being copyrighted and patented forconstruction (A)patent/copyright risk

Bold-line arrows show the stage in which the peril of each risk occurs. Dotted arrows show the hazards and the stage inwhich they occur. (P) and (A) show the hazards of the principal and the contractor.

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Table-1 M ajor Risk Events and Risk-Sharing / Variation Rules

Risk Event
Upper Plan

Result
L
C
2
Y

R
(P)

C
(Y)

2
2
2

Y
Y
Y

(*)
(P)
-

(*)
(*)
-

GCW (1989)
Relating clauses

Depending on laws

R
(P)

C
(Y)

P
P
P

Y
Y
Y

FIDIC (4th edition)
Relating clauses
44.1 Extension of Time forCompletion
55.1 Variations, 52.1 Valuation of
Variation
70.2 Subsequent Legislation
70.2 Subsequent Legislation
71.1 Currency Restriction

(A)

(N)

No clause

Law
Tax
Currency
Restriction
Foreign
remittance
License of P

1

N

-

-

1

Y

(P)

(Y)

P

Y

License of A

1

N

(A)

(N)

A

N

Price

1

Y

*

Y

*

Y

26.1 Compliance with Statutes,
Regulations
8.1 Contractor¶s General
Responsibilities
70.1 Increase or Decrease of Cost

Interest rate
Exvariation
FossilDiscovery
Pollution

1
1
1

N
N
Y

(A)
(A)
P

(N)
(N)
Y

(A)
A
P

(N)
N
Y

72.1 Rates of Exvariation
27.1 Fossils

1

Y

P

*

*

*

ProtestMovement
Siteprocu-rementNaturalDisaster

1

Y

P

Y

P

Y

19.1 Safety, Security and Protectionof the Environment, 51.1 Variations
20.4 Employer's Risks

1

Y

P

Y

2 Possession of Site
18 Change in the WorkP

Y

42.2 Failure to Give Possession

2

Y

P

Y

P

Y

20.4 Forces of Nature, 20.3 Loss or
Damage Due to Employer's Risks

Weather

2

Y

P

Y

P

Y

War
GeneralStrike
APC

2
2

Y
Y

-

-

18 Change in the Work
19 Extension of Time
25 Damage by Disaster
18 Change in the Work
19 Extension of Time
No clause for domestic
No consideration

P
P

Y
Y

44.1 Amount or Nature of extra oradditional work
20.4 Employer's Risks
20.4 Employer's Risks

1

Y

P

Y

P

Y

12.2 Not Foreseeable PhysicalObstructions or Conditions
11.1 Inspection of Site

Contract
Documents

1

Y

P

Y

(*)

(*)

Failure ofsurvey/design
Instruction
Failure

1

Y

P

Y

P

Y

5.2 Priority of Contract Documents
8.1 Contractor's General
Responsibility
17.1 Setting-out
11.1 Inspection of Site

1

Y

P

Y

P

Y

8.2 Site Operations and Methods ofConstruction

Quantitative
Change

1

Y

P

Y

P

Y

44.1 Amount or Nature of extra oradditional work, 51.1 Variations

No clause for domestic
contract
No clause for domestic
contract

21 Change of contract amountfor fluctuation of prices andwages

17 Variation of Conditions
18 Change in the Work
17 Variations of Conditions
18 Change in the Work
18 Change in the Work17.1 Special Condition not
specified in documents
18 Change in the Work
19 Extension of Time17.1 Inconsistency of drawings
and Errors or Omissions inDocuments
17.1 Revelation of Conditiondifferent from Design
18 Change in the Work16.1 Duty of Variation of
improper contract
19 Extension of Time
24 Variation of Payment
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Additions

1

Y

P

Y

18 Change in the WorkP

Y

Delay of
Drawing/
Instruction/
Permission
Delay of
Payment

1

Y

P

*

P

Y

1

Y

P

Y

13.3 Inspection of Material
Quality, 14.4 Inspection
27 Inspection/Trade28.3 Payment
36 Contractor¶s failure of Nonrepayment of payment

P

Y

Default of P

1

Y

-

-

No provision for public sector

P

Y

Damage for
Objective

1

N

A

N

23 General Damage

AN

Performance

1

N

P

N

16.1 Duty of Reconstruction
for improper document
27 Inspection/Trade

P

N

DefectLiability
ManagementDamage forother facility

1

N

A

N

37 Defect Liability

A

N

1

N

A

N

A

N

1

N

A

*

38 Damage by Delay of
Implementation
22 Occasional measures
24 Damage for Third Party

A

*

Labor
Accidents

1

N

A

*

A

*

Financial
Procurement
Default of A

1

N

(A)

(N)

A

(N)

1

N

G

N

P

N

Interference 1of othercontractors
Default of S- 1
ubcontractorPatent/Copy 1
right

*

-

(*)

-

(*)

N

(A)

(N)

A

N

4.1 Subcontractor

N

*

*

*

Y

28.1 Patent Rights (No provision forprincipal)

39 Guarantor¶s Responsibility
for Completion
Contractor is obliged to obey
principals¶ coordination.

Usage of Patent Right(Principal bear in case of no
specification.)-385-

44.1 Amount or Nature of extra oradditional work
6.4 Delays and Cost of Delay ofDrawings
70.1 Increase or Decrease of Cost

60.10 Time for Payment, 69.1
Default of Employer, 69.4
Contractor's Entitlement to
Suspend Work69.1 Default of Employer (In reality,
Contractor's Loss)
8.1 Contractor's General
Responsibilities, 20.1 Care ofWorks
20.2 Responsibility to Rectify Lossor Damage
8.1 Contractor's General
Responsibilities, 38.2 Uncoveringand Making Openings, 39.1
Removal of Improper Work,
Materials or Plant,
39.2 Default of Contractor in
Compliance, 48.1 Taking-overCertificate
49 Defect Liability, 50 Contractor to
Search47.1 Liquidated Damage for Delay
19.1 Duty of Prevention of Damage,
22.1 Damage to Persons andProperty
29.1 Interference with Traffic andAdjoining Properties, 30.2
Transport of Contractor¶s
Equipment or Temporary Works
Contractors¶ responsibility except
the case of principal causes theaccident.
8.1 Contractor's General
Responsibilities
Principals¶ responsibility except for
performance.
Clause 31 provides the duty tocorporate with other contractors

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Table-1 shows how GCW and FIDIC provide for the risk
sharing. We do not find the risk-sharing principles stipulated
in GCW and FIDIC, but we find the risk sharing rules of bothforms are in accordance with the basic principles as
described above. As shown in Table-1, there is no
substantial difference between GCW and FIDIC in the
regard.

that the contractor owes risk, ' - ' means there is no clause, 'Y'
in the column µC¶ means that the contract provides variation,'N' means no variation clause in the contract, ' * ' means theparities share the risk.
5. ENDOGENOUS RISKS AND VARIATION RULES
5.1 Incomplete Contracts and Endogenous Risks

Note that the problem of risk sharing should be analyzed
fromthe two viewpoints: 1) whether risk-sharing rules induce
the parties' efficient behavior (efficiency), 2) whether risk
sharing rule induce fair attitudes to share the consequences
depending on the capability of the parties (fairness). In the
research of contract law, the contract that satisfies efficiency
and fairness at the same time was sought but Sykes [8] have
proved that there does not exist such a contract. But in these
papers, an efficient cancellation of a contract is admitted, butthey did not deal with the project contracts that cancellation
is forbidden.
4.2 Risks and Variation (Renegotiation) Principles
From the general view points of economics of law, incontracts such as project contracts which do not allow
cancellation, a contract variation is justified when thebenefits of both parties are increased. On the contrary, avariation that is aimed to increase the transaction surplus ofonly one party is not justified. We call such a principle as theµvariation principle¶.
Based on the variation principle, if the contractor should
incur a loss due to materialization of a risk which he owes,
variation is not admitted. If such a variation is admitted, 1) the
loss that is caused by the contractor is transferred to theprincipal. Thus, only contractor's transaction surplus
increases. 2) Endogenous risks in that the contractor does
not make efforts to achieve efficiency may occur. If theprincipal should owe the risk, a variation should be admitted
because admitting variation gives the principal incentive to
make an effort to achieve efficiency. And as for the risks
whose hazards do not belong to any party, a variation should
be admitted, 1) if the variation increases the efficiency, or 2)
the variation can induce one party to behave in a manner toachieve efficiency while the other party owes the risk
because of his deep pocket.
Reviewing the Table-1, there is no substantial difference invariation rules between GCW and FIDIC including customs
and business practices. Note that the column of 'result'shows our determination based on the risk sharing andvariation principles. The number 1 in the column 'L' meansthat the risk sharing should be determined based on the firstprinciple of risk sharing, and the number 2 means the second
one. The column 'C' shows the variation rule. The column 'R'
in the GCW and FIDIC columns show the risk sharing rule, 'C'
shows whether there is a variation rule or not. 'P' in thecolumn µR¶ means that the principal owes the risk, 'A' means

Endogenous risks are affected by the contract structure, so it
is not sufficient to provide only variation and risk-sharing
rules to achieve efficiency. Whole contract structure, whichis composed of the structure of the initial contract, rules ofvariations and the risk sharing, has to be designed to preventthe generation of endogenous risks.
5.2 Differences in Variation Rule
Project contracts provide the procedure of variation, dispute
resolution and remedies to solve conflicts efficiently. BothGCW and FIDIC recognize contractor's right of claim. But wecan find the difference in the procedure of claim.
FIDIC provide the strict and detailed procedure of claim, andcontractor must proceed claims according to the provisionsof the contract. FIDIC clearly establishes the contractor'sright of claims to variations and his burden of proof.
In contrast with FIDIC, GCW form does not contain a claim
provision but provides the contractors¶ right to negotiatewith the principal. GCW does not have the provision of thecontractor¶s burden of proof of variations. In reality, we canfind the basic idea that the principal decides the variations in
GCW form. In Japan, there has been a foundation that the
principal have the ability to prove or verify the variations andthey do not need the contractor's burden of proof. As far as
this foundation exists, efficient variations are achieved
without the strict and detailed procedure like FIDIC form. In
addition, in the case of a public project, the principal have theburden of proof for justification of a variation for the General
Accounting Office. But this is not for the contractor but justfor accountability for taxpayers.
5.3 Verifiability and Variation Rules
We showed a big difference between GCW and FIDIC as tothe contractor¶s burden of proof in relation to the principal¶sability for verification of the claimThe optimal structure of an
incomplete contract depends on the principal's ability.
Kobayashi et al. have proposed the optimal structure ofincomplete contracts for both cases when the principal has
the ability or not.
First, in the case that the principal has the ability to verify
variations, which situation is assumed in GCW form, time forcompletion, design conditions, amount of payment signed in
the initial contract are enforceable. If a variation to the initial-386-

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contract is not admitted, the contractor must keep the time forcompletion. If a variation happens, the variation is made sothat the social surplus i.e. the sum of amount of the increasein social benefit and the cost brought about by the variation
can be maximized and the social surplus is shared according
to the contract. The rules for the surplus sharing may be
flexible but the rule s must be stipulated in the initial contract.
On the other hand, in the case that the principal does nothave the ability to verify variations, which situation isassumed in FIDIC form, it is impossible to make the initial
contract enforceable any more. Differences of perception
between the principal and the contractor of the initial
contract are recognized for the first time when the realcondition is revealed. Thus, the initial contract is designed to
expect the conditions that make costs lowest in feasible
conditions. The initial contract plays a role as the status quoof negotiation process. The initial contract is expected to bechanged fromthe beginning and the time for completion andthe contract amount are always changed to increase in thecase of variations.

[5] Tirole, J.: Incomplete contracts: Where do we stand?,Econometrica, Vol.67, pp.741-781, 1999.
[6] Miceli, T.J.: Economics of the Law: Torts, Contracts,
Property, Litigation, Oxford University Press, 1997.
[7] Posner, R. and Rosenfield, A.: Impossibility and related
doctrines in contract law: An economics analysis,
Journal of Legal Studies, Vol.6, pp.83-118, 1977.
[8] Sykes, A.: The doctrine of commercial impracticability ina second best world, Journal of Legal Studies, Vol.17,
pp-43-94, 1990.

Such a result mentioned above is derived from theassumption that the cost of survey/design or transaction
costs such as negotiation costs of variations are ignored, but
if the principal's ability to verify is just focused, both GCW
and FIDIC are optimal incompletes contract. We have todetermine a desirable type of contract depending on theprincipal¶s ability, transaction / negotiation costs anddesign/ survey costs.
6. CONCLUSION
In this paper, it has been pointed out that the project risks areclassified into two categories: the exogenous risk and theendogenous risk. There is no difference in risk-sharing rules
for exogenous risks between GCW and FIDIC. But there is a
substantial difference in rules to verify variations dependingon the principal¶s ability to verify.
REFERENCES[1] Hart, O.: Firms, Contracts, and Financial Structure,
Oxford University Press, 1995.
[2] Kobayashi, K., Omoto, T., Yokomatsu, M., Wako, T.:
The Contractual Structure and Social Efficiency ofConstruction Works, Journal of Japanese Society of
Civil Engineering, No.688/IV-53, pp.89-100, 2001. (InJapanese)[3] The Central Construction Industry Counsil ofJapan FThe Standard Form of Agreement and General
Conditions of Government Contract for Works of
Builiding and Civil Engineering Construction (inJapanese), 1989.
[4] Federation Internationale Des Ingenieurs Conseils(Conditions of Contract for Works of Civil Engineering
Construction), Part 1 General Conditions, Fourth
edition, 1987.

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