Strategies for Implementing Performance Specifications: Guide for Executives and Project Managers (2013)

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27 The preceding chapter focused on the implementation of performance specifi cations from the agency’s perspective. However, performance specifi cations, particularly those including warranties or other postconstruction responsibilities, will also present unique risks and challenges to the construction industry. Convincing industry to take on new roles and responsibilities is crucial to the successful implementation of perfor- mance specifi cations. Quite often the industry’s risk appetite determines the success of implementation. Contractors and sureties with limited experience may decline to com- pete or may price the risk into their bids. New specifi cations or contracting methods that shift responsibility to industry may have to be introduced in a gradual or stepped process for industry to gain the required skills and experience. From a risk perspec- tive, contractors must consider two important issues: managing subcontractor and supplier relationships and meeting bonding requirements. These issues are discussed in the follow ing sections. 3 INDUSTRY CONSIDERATIONS Chapter Objectives This chapter addresses the following questions: • What challenges and risks do performance specifi cations pose to prime contractors? • What concerns does the surety industry have regarding long-term bonds? • What are the alternatives to traditional performance or warranty bonds? • What can be done to garner industry support for performance specifi cations?

28 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS MANAGING SUBCONTRACTOR RELATIONSHIPS RELATIVE TO PERFORMANCE REQUIREMENTS Subcontractors and suppliers play a major role in the successful implementation of performance requirements. Prime construction contractors assume the contractual responsibility for meeting performance guarantees. However, the parties that typically have the skills to achieve those guarantees are specialty subcontractors and sup pliers. These specialists may have proprietary technology or products, or they may have built their businesses into “centers of expertise” in a given area of performance. This arrange ment can create several pragmatic challenges in how to “flow-down” contrac- tual performance requirements to subcontractors and suppliers. Limitation of Liability Perhaps the biggest challenge is that suppliers of technology or products are not will- ing to take major commercial risks that could result in liability far in excess of their contract price. Suppliers commonly condition their willingness to furnish goods or technology on a particular project to an agreement by the prime contractor that the supplier will have a contractual limitation of liability (frequently capped at 100% of their contract price) for any deficiency attributable to the supplier. Such conditions create potential gaps in liability, which can cause problems in obtaining recourse for a performance failure. On industrial projects such as power and petrochemical plants, limitations of liabil- ity are an accepted part of the contracting landscape between owners and contractors. However, the public sector has not widely adopted limitations of liability for prime contractors (the exception being a handful of megaprojects on which limitations of liability were required to obtain adequate price competition). Therefore, on highway rapid renewal projects, the prime contractor will likely have to assume the risk for the gap between the supplier’s limited liability and the liability incurred if the supplier fails to meet the performance guarantee. This gap risk is significant because of the large dif- ference in the contract price of a purchase order vis-à-vis a prime construction contract. In theory, a trade subcontractor is justified in requiring an overall contractual limi- tation of liability. To date, however, most subcontractors have not made overall liabil- ity caps part of their contracting philosophies. Subcontractors are nevertheless very sensitive to how much liability they are willing to incur for delay damages, or other discrete damages, associated with their performance on a given project. They pay par- ticular attention to delay-related liquidated damages amounts in the prime contract, and they generally expect to negotiate a lower value for liquidated damages exposure than the prime contractor has assumed in its contract with the owner. This is especially important for large projects where the liquidated damages may be a large daily value. Flow-Down of Contractual Provisions Another challenge that prime contractors experience in obtaining subcontractor/ supplier compliance with performance specifications is the flow-down of contracting terms. Prime contractors often handle flow-down responsibilities with simple language saying, in effect, the subcontractor is bound to provide to the contractor whatever the

29 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS contractor is obligated to provide to the owner. A performance specification can be so simple as to require only one trade to accomplish it. However, far more often a number of players (including both designers and trade contractors) need to coordinate to achieve the performance specification. This arrangement raises the following questions: • Who is truly contractually responsible to meet the specifications? • How will the coordination efforts take place to ensure compliance? • How much leeway does one party have in its performance when it could affect another’s performance? Consider, for example, the tolerances that apply to each party’s work. If a perfor- mance specification is tied to steel and concrete operations, are normal industry toler- ances sufficient to achieve the specification, or should one of the trades be subject to tighter tolerances? Using simple flow-down language does not allow these issues to be carefully thought through and considered, creating a gap in responsibility. Incentives and Disincentives A reciprocal issue is how to handle incentives and disincentives when they relate to subcontractors and supplier performance. The prime contractor may simply flow- down verbatim whatever is in its prime contract (subject to the limitations of liabil- ity already discussed). That approach does not work well when achievement of the performance requirement can occur only through the cooperation of a number of players. The better practice is to have a meaningful discussion with the party that is most capable of achieving the performance requirement about what can be done to ensure that it is accomplished, and then to select an appropriate contracting method for achieving this result. Warranties Another challenge relates to how to handle warranties on performance specifications that flow from subcontractors and suppliers. Depending on the length of the warranty and the type of performance specification, the question arises of how the owner and prime contractor gain access to the subcontractor and supplier. Two common best practices address this issue. One is to specifically discuss the warranties with the sub- contractor and supplier and determine how they will be administered after construc- tion completion. The other is to give the owner the contractual right to deal directly with the subcontractor and supplier after construction completion, during the war- ranty period, through an assignment of the warranty provision in the prime contract and the relevant subcontracts. Managing Performance Specifications The final major challenge relates to how prime contractors manage the process of eval- uating and achieving performance specifications. Those who think carefully about the process, and identify which of their subcontractors and suppliers are vital to achieving the specification, will generally do well. They will have coordination meetings and de- velop specific contractual language and execution plans with this interdisciplinary pro- cess in mind. Those who treat the specification trivially, leaving the subcontractors and

30 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS suppliers to figure out compliance and coordination, will often find themselves strug- gling to determine how to meet their contractual requirements to the owner, likely without any recourse of going back to the subcontractor or supplier. BONDS, GUARANTEES, AND OTHER MECHANISMS Agencies have faced challenges finding bonds and other forms of guarantees to sup- port programs that use a combination of performance specifications and warranties. Typically, agencies have required a warranty bond to guarantee that contractors will perform their warranty obligations during the warranty period. The bonds are secured through a surety, which guarantees that if the contractor fails to perform during the warranty term, it will be responsible for the cost of remedial work to the limits of the warranty bond. How the bond limits are determined varies from agency to agency, and the methodology may vary depending on the component being warranted. For example, bond values may be set in the following ways: • Total dollar value of the warranted work (i.e., full value of the contractor’s contract); • A percentage of the total dollar value; • The lower value between a percentage of the contract value and a set dollar amount (i.e., 5% or $2,000,000); or • The estimated cost to perform a repair. Contractors, however, have found it difficult to obtain such bonds or other suit- able guarantees of performance for long-term obligations. Little research has been published on this issue. But a combination of information from the existing literature and information from subject matter experts in the surety and insurance industry sup- ports the conclusion that this challenge stems from two primary factors: • Unique risks in using performance specifications. Performance specifications on highway projects present unique risks to the industry, regardless of the scope or duration of the contractor’s performance responsibilities. Depending on the way the contract is structured, these risks have the effect of limiting the pool of contrac- tors who are willing or able to enter into contracts with the agency. These risks also have a pragmatic impact on the willingness of an entity—such as a contractor, manufacturer, or corporate parent—to provide financial security that backstops the contractor’s obligations. • Bond and insurance marketplace. The surety and insurance marketplace currently has a limited appetite for providing security vehicles to support the long-term performance obligations desired by agencies, particularly when those vehicles are tied to the performance of assets over their design life. The surety market has historically been unwilling to underwrite long-term exposure unless the contrac- tor is large and well capitalized. Moreover, entities that have created alternatives to performance and warranty bonds, such as subcontractor default insurers, have been unwilling as yet to expand their product lines to cover long-term warranties based on performance specifications.

31 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS Unique Risks in Using Performance Specifications and Long-Term Warranties Regardless of whether the contractor’s performance obligations are secured through a bond, corporate guarantee, letter of credit, or some other financial instrument, the first question to consider is the nature of the risk associated with providing such finan- cial backstop. The factors used to assess the risks of performance specifications and long-term warranties include a determination by the contractor, and those providing financial backstops, of the following: • The ability to achieve the performance standards by objective means and measur- able standards; • The impact on performance by factors outside their control; • An objective historical baseline to assess the ability to meet the performance standards; • Expectations and criteria clearly set forth by the agency in the contract; • The ability to demonstrate and validate the efficacy of the contractor’s work years after the work is performed; and • The balance between risk and reward opportunities. The risks associated with performance specifications can heavily influence the abil- ity of a contractor to provide a suitable guarantee of its performance, particularly when the guarantor is providing financial support for a long-term warranty. The pri- mary risk areas are as follows: • Measurement technology and sampling. The inability to ensure that the contrac- tor’s performance can be precisely tested, measured, and sampled—either because technology does not allow it or because the agency has yet to implement available technology—means that the contractor and its guarantors face the uncertainty of meeting the agency’s expectations. A related concern is whether the samples taken will be consistent and representative of overall performance. • Factors outside of industry control affecting long-term performance. The inability of the contractor to predict or control how the facility will perform or be used can have a significant impact on long-term warranties. For example, if the warranty does not have exclusions for preexisting conditions (e.g., pavement base, drain- age systems), extreme events, inaccurate traffic predictions, or inadequate design by others, the contractor and its guarantors will be reluctant to provide suitable long-term guarantees. • Combination of performance and prescriptive specifications. When performance and prescriptive requirements are combined, contractors are in effect being asked to provide guarantees that the constructed facility will perform as expected when they have not fully controlled the design. This lack of control affects appetite for risk assumption. • Inability of small contractors to assume risks. As projects and programs be- come more complicated, particularly in terms of providing financial backstops of

32 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS performance, smaller contractors may be unable to participate in any meaningful capacity, particularly if their bonding companies resist. • Inability to predict performance based on engineering properties or other parameters measured at the time of production or installation. The relationship between engi- neering properties and performance can be tenuous. The risk is that the predictions will not remain valid over the life of a warranty, particularly if the warranty is expected to approach a design life of multiple decades. The combination of these risks creates a high level of uncertainty for third parties in the business of providing financial support for contractor’s performance obliga- tions. This is particularly true when the overall duration of the performance obligation is extended beyond the normal construction period to assume risks for warranty or maintenance obligations. Bond and Insurance Marketplace The public-sector construction industry in the United States has long relied on per- formance bonds to secure the faithful performance of a contractor’s obligations. Performance bonds and warranty bonds are three-party agreements in which the surety guarantees to the owner (the obligee) that the contractor (the principal) is capable of performing the contract and protecting the obligee from financial loss if the principal does not perform. Bonds are credit instruments and are underwritten in a manner similar to bank loans. Underwriters generally consider three factors: • Capacity. This factor considers the ability of the contractor to perform the obliga- tions of the contract. Evaluation criteria include the contractor’s technical skill, management, qualifications of personnel, employee retention, and exposure and progress on other contracts. • Capital. This factor considers the financial strength of the contractor as it relates to its ability to fulfill the terms of the contract. Evaluation criteria include the contractor’s financial condition, working capital, debt structure, liquidity, and leverage. • Character. This factor considers the historical performance of the contractor. Eval- uation criteria include experience and reputation, industry niche, length in busi- ness, and relationships with subcontractors. These underwriting factors can influence a surety’s decision to provide either per- formance or warranty bonds on projects that use performance specifications. The Surety & Fidelity Association of America (SFAA) issued a white paper titled Statement Concerning Bonding Long-Term Warranties, which framed the issue as follows: Some public owners have proposed special warranty requirements in excess of the standard one year warranty of the entire work. Under these warranties, the contractor is responsible for correcting defects in its work that are due to faulty materials and workmanship (materials and workmanship warranty) or correcting any shortfall from established specifications (performance war- ranties). It is often difficult to determine where the line is between faulty

33 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS workmanship and materials versus inadequate design, use beyond expecta- tions or maintenance issues (SFAA 2003). While noting that the surety industry understood the desire for quality assurance, SFAA concluded that bonded long-term warranty requirements limit bond availability, thus limiting competition for construction contracts and ultimately increasing costs. SFAA highlighted the pragmatic issues associated with a surety’s underwriting process and how that process does not align with long-term bonds. According to SFAA, “As the duration of the bonded obligation becomes longer, and the surety must assess the contractor’s operation for periods of time well into the future, the certainty of the judgment will be lessened” (SFAA 2003). After examining the risks, as well as assess- ing capacity, capital, and character, the surety industry has major concerns about the overall uncertainty of the contractor’s financial situation. SFAA representatives noted during an interview with the authors that the time periods within which bonds are underwritten can also create major underwriting challenges, regardless of the amount of coverage applied over and above the normal 1-year warranty and bond period. Surety commitments (and underwriting decisions) are made at the time of bid. On a reasonably large project, that can mean that the overall commitment (with only a 1-year warranty) may be 2 to 3 years. The surety takes on the risk of the financial condition of the contractor during that procurement and contract execution time period. If an agency adds on an additional warranty obli- gation of, say, 5 years after completion of the project, then the surety is at risk for the contractor’s financial condition for potentially 7 to 8 years. The surety is likely to have difficulty underwriting and assessing such arrangements. In addition to the underwriting uncertainties, the SFAA paper expressed surety concerns over the method of payment for the work under long-term performance- based warranties. The paper noted that under most contracts, the contractor is paid fully on final completion, leaving no contract balance to fund any warranty work. If a surety is obligated to step in and complete the warranty work, then it cannot avail itself of contract funds to mitigate its losses as it would if the default took place during contract performance and before final payment. The SFAA paper noted that to compensate for the increased risk due to the dimin- ished certainty of underwriting and the method of payment, sureties typically raise their underwriting standards and provide long-term bonds only to the largest and most financially sound contractors. As a result, smaller contractors who are otherwise quali- fied to do the work are sometimes shut out from bidding on these projects. To mitigate these issues, the SFAA paper recommended the following: • Warranties should be limited to 1 year. • Any warranty of more than 1 year should be only from the supplier of the equip- ment or material and explicitly excluded from the prime contractor’s bond. • Warranties from the prime contractor in excess of 1 year should not be back- stopped by a performance bond. Instead they should come from a specific war- ranty bond required at final acceptance of the construction project. That would enable the bonding company to underwrite the financial condition of the contrac-

34 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS tor at the time the warranty bond is placed and not years earlier. The amount of a warranty bond should be commensurate with the long-term warranty and not the entire project (i.e., the value of the warranty should correspond to the reasonable, expected cost of implementing the warranty work). The interview with SFAA also confirmed that sureties have major issues with war- ranty bonds. The SFAA representatives noted that the amount of the bond (and the underwriting associated with it) is commercially challenging. Not enough money can be made in the premium for the level of effort required. The general view of sureties is that they generally are willing to provide warranty bonds as a service to their existing clients in good standing, but they do not view it as a separate market focus. The conclusions of the SFAA white paper are supported by a survey of several bonding companies (Bayraktar et al. 2006). The survey confirmed the reluctance of sureties to provide long-term warranty bonds because of the detailed underwriting reviews needed, and also when the length of the warranty is extended. Interviewees noted a concern that warranty work is funded by contractors out of working capital and that this can jeopardize the contractor’s financial status. They also expressed con- cern that the reasoning for providing warranty bonds is not based on sound under- writing practices; instead they cited “responses to competition,” “holding on to market share,” and “fear of losing large premium producers.” The survey also noted a high probability that small companies will be eliminated from warranty projects because of risk and underwriting concerns. The recommendations from this survey include the following: • Decreasing the warranty period to a maximum of 3 years; • Having a renewable annual warranty bond after 3 years; and • Treating warranty requirements as a separate line item on the project, which would help fund the warranty expense and be an additional incentive to the contractor. Regardless of whether an agency is considering performance bonds that cover warranty obligations or separate warranty bonds, the effect on contractors is another issue to consider. Carrying a bond reduces the contractor’s overall bonding capacity, and many contractors have expressed concern that warranty projects will reduce their capacity to take on future work. In some cases these bonding concerns have precluded contractors from bidding or have contributed to lower numbers of bidders on war- ranty projects. Alternatives to Bonds and Insurance Surety bonds are not extensively used outside of North America. Elsewhere, contract obligations are secured by letters of credit or similar demand instruments that function like letters of credit. These instruments are irrevocable commitments by the issuing bank to a third-party beneficiary (the agency) on behalf of a customer of the bank (the contractor) to meet demands for payment. These instruments are for smaller percent- ages of the contract price (5% to 10%) than a typical performance bond (100%) and are generally tied to a date specific (generally 1 year, subject to renewal on a yearly basis), payable on demand of the owner. Unlike surety bonds, which are three-party

35 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS agreements in which the surety is obligated to the owner and the contractor, letters of credit run only to the benefit of the owner. As a result, letters of credit can generally be drawn on quickly and easily, since a contractor can validly raise few defenses to stop a draw. Letters of credit are a viable way of guaranteeing long-term obligations and war- ranties and have been used in large public-private partnerships to secure operations and maintenance commitments by developers. However, several challenges with their use remain: • Collateral requirements. Because these instruments are not written on the basis of leveraging assets, the contractor may need to have substantial collateral in place to secure the letter of credit. Consequently, a $2,000,000 letter of credit can, in effect, tie up $2,000,000 in operating capital for the length of the warranty. As a result, only the largest contractors will likely be capable of supporting multiple long-term warranties or maintenance agreements with collateral committed for a lengthy time. • Risks of the letter of credit being drawn on. With surety bonds the contractor has the right to argue that it is not in default of a warranty or maintenance obligation. However, the demand feature of a letter of credit generally means that the agency has the right to draw on the letter of credit if it believes in good faith that it is correct in its position; the contractor will have to argue about its rights later. This places substantial emphasis on the underlying risks associated with performance specifications, as already discussed. Default Insurance and Efficacy Insurance Subcontractor default insurance (SDI) emerged about 15 years ago in response to perceived deficiencies with subcontractor performance bonds. The default of a major subcontractor can affect the overall project schedule, expose the general contractor to liquidated damages or other delay-related damages, and affect the work of other sub- contractors. Faced with an imminent default by a subcontractor, a general contractor typically makes a demand on the subcontractor’s performance bond. Ideally, the surety should be ready, willing, and able to step in and remedy the default. But criticisms have emerged that the surety’s response time is too slow given the urgency of the project schedule. Addressing these perceived shortcomings of surety bonds, Zurich Insurance Group created an SDI policy known as Subguard. It works as a two-party agreement between the contractor and insurance company, with the contractor procuring the policy as the named insured. The general contractor is responsible for prequalifying the individual subcontractors and suppliers and bringing them into the agreement. Coverage commences on a formal declaration of default, but the general contractor is not required to terminate the subcontract. This type of product is a hybrid of insurance and surety. It gives an owner the right to access an insurance policy in cases of a predetermined default, with fewer pro- cedural defenses available to the contractor than in a surety situation. Subject matter experts were consulted to assess the suitability of SDI for long-term warranties or

36 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS maintenance agreements on highway projects using performance specifications. At present, no such product exists, and concerns remain as to whether such products would be viable given the nature of the risks. In other industry sectors, power generation in particular, insurance products have been created based on efficacy (i.e., insuring the performance of a system or project). These products have been used by extremely sophisticated contractors who are well established financially and can absorb large financial risks. Such insurance products are not known to be available for the highway sector yet. Given the nature of the contracting community, this type of product will not likely be available for smaller contractors. Current Practices Information derived from the NCHRP 10-68 study on pavement warranties demon- strates an evolving process among the states for warranties and securing the obliga- tions of the contractor (Scott et al. 2011). Some current practices are as follows: • Prequalification of future work. Instead of using a separate financial instrument to secure performance, Florida ties performance during the warranty to prequali- fication for future work through the use of a guarantee. If the contractor fails to perform the required remedial work, the contractor is precluded from bidding on future state work for a period of 6 months or until the remedial work is completed, whichever is longer. Several agencies in other states have considered using this pro- gram as well, but it does not work in every case. In Florida, most contractors work only in-state; thus they are motivated to work things out with the state. States that contract heavily with out-of-state contractors, or where in-state contractors have alternatives in other states, may not find this guarantee as compelling. • Pay-for-performance. Minnesota has used a pay-for-performance specification: the contractor is paid a portion of the costs at the time the item is placed and then is paid on a graduated scale over time if the item performs to expectation. Minnesota implemented this alternative for warranties on its I-494 design-build project. • Retainage. North Dakota has, for some of its projects, held a 1% retainage for the duration of the warranty in lieu of any bonds or other security. • Use of extended performance bonds. Some state agencies, including those in California and North Carolina, have extended performance bond coverage to warranties of 1 year or less. The challenge with this approach is that the penal sum of the performance bond may be substantially more than the value of any potential warranty work; having this bond outstanding ties up bonding capacity. Recommendations for Addressing Risks Related to Long-Term Performance Guarantees Several issues relate to the use of bonds, insurance, guarantees, and other mecha- nisms with contracts based on performance specifications, particularly those contain- ing long-term warranty or maintenance obligations. Given the current state of the surety and insurance markets and availability of products, the risks associated with

37 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS performance specifications on highway projects, and the risk of using long-term war- ranties or maintenance obligations in conjunction with performance specifications, the long-range viability of bonds, insurance, guarantees, and other mechanisms cannot be ascertained with any certainty. Agencies should not simply mandate long-term security instruments without trying to balance the interests of the contracting and the surety/ insurance industries. To develop an implementation program that is workable and viable, agencies should consider doing the following: • Reach out to the surety and insurance markets and determine how best to create sustainable products that will meet the agency’s performance goals. • Balance the qualifications required from builders/operators to obtain favorable terms for long-term performance guarantees (insurance or other instruments) with the need to generate adequate local competition for these services. Insurers value the track record of experienced highway builders and operators (as European- based banks do) and welcome this business, particularly for long-term mainte- nance and operation commitments under a public-private partnership (P3). • Consult with states that have more sophisticated transportation department con- tract offices with mature P3 and long-term operating experience. Those agencies will lead the way for other agencies in determining the best approach to guarantee- ing long-term performance obligations. • Give sureties the means to reevaluate and reprice their commitment to long-term obligations. One option may be to allow the surety to be alleviated from its obliga- tion if the principal’s financial condition erodes to a predetermined level or if the surety no longer underwrites the principal. • Adopt some of the recommendations in the SFAA report. For example, use shorter- term warranty (rather than performance) bonds and structure payment of the war- ranty obligations as a line item. This is similar to the North Dakota approach with retainage. • Decide whether Florida’s prequalification and guarantee model is appropriate within the state to secure financial performance. • Work with manufacturers who are willing to provide product guarantees of performance. GARNERING INDUSTRY SUPPORT Traditionally, agencies retain the risk associated with the performance of a project through the use of standard method specifications under a low-bid contract, and they achieve minimum performance through process control, material testing, and inspec- tion of the work during construction. Performance specifications move away from this traditional model for ensuring performance by transferring performance risk to the industry. The transition from method to performance requirements has been evi- dent in pavement construction. For example, standard quality assurance (QA) speci- fications for pavements require contractors to produce mix designs on the basis of

38 STRATEGIES FOR IMPLEMENTING PERFORMANCE SPECIFICATIONS: GUIDE FOR EXECUTIVES AND PROJECT MANAGERS criteria and tolerances specified by the agency. The specifications allocate responsi- bility for quality control and testing to the contractor and establish targets for con- struction quality characteristics with incentives (disincentives) for achieving higher (reduced) quality compared with the target values. Pavement warranty provisions also shift greater responsibility for post construction performance to the contractor by pro- viding greater latitude in design and construction; in turn, they require that pavement meet or exceed specified performance targets during the life of the warranty. Highway agencies and industry are continually looking for ways to innovate to improve performance. Performance specifications can provide a platform for agency- or industry-initiated innovation. At the lowest level, a performance specification can prescribe new materials, processes, or technology (e.g., mechanistic mix designs for pavement, rapid nondestructive testing methods) to enhance performance, with the agency retaining the majority of performance risk. As the industry gains experience, the agency can gradually eliminate prescriptive requirements and shift performance responsibility to industry. At the highest level, performance specifications eliminate prescription, expressing requirements in terms of end-user or functional end-result requirements and allowing industry the greatest latitude to innovate. This chapter has addressed the obvious risks related to shifting performance responsibility to industry. To successfully implement performance specifications, agencies must collaborate with industry (and suppliers) in setting goals and identifying realistic performance parameters and targets to meet goals. Quite often both agencies and industry need to make initial investments to change roles and responsibilities, develop knowledge and skills, modify standard pro- cedures, and perhaps acquire new equipment or technology. To ease the transition and spread out the initial costs, performance specifications can be phased in over time. For example, as described in Framework for Developing Performance Specifications, an agency may approach the implementation of performance specifications for pavements using a phased or tiered approach that starts with a minimal departure from current practice, then transitions to a substantial shift in technology and business practices to improve performance. The guide further addresses the development and use of incen- tive strategies and payment mechanisms as reward mechanisms in performance speci- fications to motivate industry to enhance performance.