Compensation Events in NEC4 Construction Contracts

Compensation events are an important process in the NEC (New Engineering Contract) suite. They allow for adjustments in price and time in response to pre-specified events and changes to the project.

The idea is that both the contractor and the employer’s interests are protected. The fair and transparent process surrounding compensation events encourages collaborative working, which is a central tenet of the NEC suite.

Compensation events are specific to the NEC suite. There are similar clauses in the JCT and FIDIC suites, but they work slightly differently.

What are compensation events in NEC contracts?

Compensation events are specific events listed in the contract that could affect the timescale and cost of the project. They’re not usually based on contractor fault. They can be based around employer faults, though they don’t have to be. Compensation events can also be triggered by events unrelated to either party, like unexpected weather or site conditions.

The compensation events specified will vary from project to project, but these are some examples.

Client-induced compensation events

• Changes to the project scope mid-project
• Access to the site is not available when planned
• The employer doesn’t provide all the necessary information

Party-neutral compensation events

• Valuable or historical objects discovered on site
• Unforeseen weather conditions
• Changes to the law that affect the work

During the project, either the contractor or the project manager can notify a compensation event. There are strict timescales and procedures laid out in the contract that must be followed.

Typically, the contractor must notify the project manager of a compensation event within eight weeks of becoming aware of it. If they’re late with this notification, their entitlement to financial or time compensation may lapse, unless it’s an event the project manager should have notified.

Once the event has been notified, the contractor issues a quotation for the change in cost and/or time. The project manager then assesses the quote and either agrees or negotiates for changes.

Once any changes have been agreed, the compensation is finalised and any adjustments are made.

Compensation event reimbursements are based on defined cost (calculated on a projection of the impact on the project and contract). It breaks down the actual cost of doing the extra work, before any profit, then adds a small percentage on top.

This means the contractor gets a fair and transparent payment for the extra work, and the client can see exactly where the cost has come from.

What are the benefits of compensation events in construction projects?

As long as they’re used correctly, there are some major benefits to compensation events. They can significantly reduce risk to both the contractor and the employer, and encourage collaborative working.

Active risk management

Compensation events encourage contractors to be proactive with the early identification and resolution of changes that could affect project completion. By flagging events early and working collaboratively to resolve them, projects are more likely to complete successfully and on time.

Clarity and transparency

By defining specific compensation events, the contract makes it clear when the contractor is entitled to more time or money. This reduces ambiguity and disputes compared with traditional contracts.

Real-time decision making

Compensation events mean that any extra time or money the contractor is entitled to is agreed quickly, during the project work. This gives both parties much better control of project planning and budget management.

Fewer end-of-project disputes

Because events are dealt with financially as they occur, disputes over reimbursement after the project has completed are far less likely.

More predictable cost and timing

Using pricing based on defined cost makes it easy to plan and adjust for changes. This gives the employer a better view of costs, and lets the contractor plan better.

What are the potential pitfalls of compensation events? 

Although there are some major benefits to using compensation events, there are downsides too – especially if procedures aren’t followed closely.

Strict timings

NEC contracts specify strict time limits for notification of compensation events and contractors can lose their entitlements if they miss these limits. When events can develop gradually or are not immediately obvious, these limits can seem harsh.

Complex admin

The procedural requirements – including notifications, quotations, programme updates and assessments – require strong record keeping and good contract management. Poor documentation or missed communications can easily result in entitlement being lost. Contract management software like Sypro can be a huge help here.

Reliance on projections

Compensation event assessments rely on forecast costs rather than actual ones. This can lead to disputes if either party thinks projections are exaggerated or unrealistic.

Risk of delay due to disagreement

If the project manager and contractor cannot agree on the quotation, compensation events can get stuck in the system. This can create tension between parties and financial problems for the contractor.

How are compensation events applied? 

We mentioned the process for applying a compensation above. Let’s have a look at each step in a bit more detail.

Step 1: Notification

Either the contractor or the project manager can notify a compensation event. If the project manager identifies the compensation event, they notify the contractor. Usually, they’ll instruct them to prepare a quotation.

If the contractor identifies the event, they have to notify the project manager within eight weeks of becoming aware of it. They must also say which specific compensation event they are applying for.

Regardless of who identifies the event, it must include a clear description of the event and its cause.

Step 2: Project manager decision

Within a week of receiving a contractor’s notification the project manager has to respond with whether they accept it as a compensation event or not. They can reject it if the contractor is at fault, if there’s no effect on time or cost or if it’s not a listed event.

Step 3: Quotation submission

If the compensation event is accepted by the project manager, the contractor has up to three weeks (extendable by agreement) to submit their quotation. It must include the expected changes to the defined cost and any impact on the completion date.

The quotation is prepared based on the dividing date, which is set as the date of notification. This is to separate costs already incurred from future costs.

Step 4: Project manager assessment

Next, the project manager has two weeks (unless otherwise agreed) to respond to the quotation. They can either accept it as-is, reject it with reasons or provide an alternative assessment of the time and cost impact.

Their assessment must be reasonable and follow contract procedures.

Step 5: Implementation

The compensation event is implemented when either the project manager accepts the contractor’s quotation, the project manager notifies their own assessment to the contractor or the contractor’s quotation is automatically accepted because the project manager hasn’t responded within the timescale.

Once implemented, the price and time adjustments made by the compensation events are final unless challenged by dispute

How do compensation events link to early warnings? 

Early warnings are a proactive risk management system whereby either the contractor or the employer flags up unexpected potential problems before they begin to affect the project.

Events raised as early warnings can become compensation events if they’re the events specified in the contract. If a compensation event occurs and the contractor hasn’t raised an early warning when they should, their claim can be reduced.

The NEC contract is designed for early warnings and compensation events to work in tandem. If compensation events are identified and raised early through early warnings, their impact can be reduced.

Conclusion

Compensation events are an important part of the NEC suite. If you use NEC contracts, you need to understand how they work, and how they’ll affect the day-to-day running of your project.

If you want to know more, our compensation events webinar is packed with valuable insights on how to manage them effectively.

Contract management software like Sypro is designed to make managing compensation events simple. It tracks events in real time, and stores all the data you need so you have easy access to it at any point in your project.