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Feature | June 2013

Agreement clauses means a lot in EPC contracts

EPC contract in power sector has a very important role in almost all major projects. However, the contractual structure may vary from project to project. How the agreement clauses have a very prominent role for a successful execution of a project and what are various elements in such contracts, Purnendu Chaubey, explores.

Engineering, procurement and construction (EPC) contracts are the most common form of contract used to undertake construction works by the private sector on large-scale and complex infrastructure projects. Under an EPC contract a contractor is obliged to deliver a complete facility to a developer who need only turn a key to start operating the facility; hence EPC contracts are sometimes called turnkey construction contracts. In addition to delivering a complete facility, the contractor must deliver that facility for a guaranteed price by a guaranteed date and it must perform to the specified level. Failure to comply with any requirements will usually result in the contractor incurring monetary liabilities.

According to DLA Piper is a global law firm, it is timely to examine EPC contracts and their use on infrastructure projects, given the bad publicity they have received, particularly in contracting circles. A number of contractors have suffered heavy losses and, as a result, a number of contractors now refuse to enter into EPC contracts in certain jurisdictions. This problem has been exacerbated by a substantial tightening in the insurance market globally. Construction insurance has become more expensive due both to significant losses suffered on many projects and the social and political impact on the insurance market.

However, because of their flexibility, the value and the certainty sponsors and lenders derive from EPC contracts, and the growing popularity of PFI2 projects, the sector specialists believe that EPC contracts will continue to be the predominant form of construction contract used on large-scale infrastructure projects.

Contractual Agreement
If we talk about EPC contracts in the power sector, the majority of the issues are applicable to EPC contracts used in all sectors. Almost all large power projects use an EPC contract. However, the contractual structure may vary from project to project. Moreover, under the EPC contracts, contractor and the developer enter into an agreement, which derives the terms and conditions for successfully execution of a project. Based on the global norms the agreement covers the following elements:

Right to construct and operate the power station and sell electricity:
Traditionally, this was a concession agreement or project agreement with a relevant government entity granting the project company a concession to build and operate the power station for a fixed period of time (usually between 15 and 25 years), after which it was handed back to the government. This is why these projects are sometimes referred to as build operate transfer (BOT) or build own operate transfer (BOOT) projects.

However, following the deregulation of electricity industries in many countries, merchant power stations are now being constructed. A merchant power project is a project which sells electricity into an electricity market and takes the market price for that electricity. Merchant power projects do not normally require an agreement between the project company and a government entity to be constructed. Instead, they need simply to obtain the necessary planning, environmental and building approvals. The nature and extent of these approvals will vary from place to place. In addition, the project company will need to obtain the necessary approvals and licences to sell electricity into the market.

Power Purchase Agreement:
In traditional project-financed power projects, as opposed to merchant power projects, there is a power purchase agreement (PPA) between the project company and the local government authority, where the local government authority undertakes to pay for a set amount of electricity every year of the concession, subject to availability, regardless of whether it actually takes that amount of electricity (referred to as a take or pay obligation). Sometimes a tolling agreement is used instead of a PPA. A tolling agreement is an agreement under which the power purchaser directs how the plant is to be operated and despatched. In addition, the power purchaser is responsible for the provision of fuel. This eliminates one risk variable (for the project company) but also limits its operational flexibility.

In the absence of a PPA, project companies developing a merchant power plant, and lenders, do not have the same certainty of cash flow as they would if there was a PPA.

Therefore, merchant power projects are generally considered higher risk than non-merchant projects. This risk can be mitigated by entering into hedge agreements. Project companies developing merchant power projects often enter into synthetic PPAs or hedge agreements to provide some certainty of revenue, says Damian McNair, Partner, Head of Asia Pacific Finance and Projects Group, DLA Piper. These agreements are financial hedges as opposed to physical sales contracts.

Construction contract governing the construction of the power station: There are a number of contractual approaches that can be taken to construct a power station. An EPC contract is one approach. Another option is to have a supply contract, a design agreement and construction contract with or without a project management agreement. The choice of contracting approach will depend on a number of factors including the time available, the lenders' requirements and the identity of the contractor. The major advantage of the EPC contract over the other possible approaches is that it provides for a single point of responsibility.

Interestingly, on large project-financed projects the contractor is increasingly becoming one of the sponsors i.e. an equity participant in the project company. Contractors will ordinarily sell down their interest after financial close because, generally speaking, contractors will not wish to tie up their capital in operating projects. In addition, once construction is complete the rationale for having the contractor included in the ownership consortium no longer exists. Similarly, once construction is complete a project will normally be reviewed as lower risk than a project in construction; therefore, all other things being equal, the contractor should achieve a good return on its investments.

Agreement governing the operation and maintenance of the power station:
This is usually a long-term operating and maintenance agreement (O & M agreement) with an operator for the operation and maintenance of the power station. The term of the O & M agreement will vary from project to project. The operator will usually be a sponsor especially if one of the sponsors is an independent power producer (IPP) or utility company whose main business is operating power stations. Therefore, the term of the O & M agreement will likely match the term of the concession agreement. In some financing structures the lenders will require the project company itself to operate the facility. In those circumstances the O & M agreement will be replaced with a technical services agreement under which the project company is supplied with the know-how necessary for its own employees to operate the facility.

Agreement governing the supply of fuel to the power station:
This is usually a fuel supply agreement, often with the local government authority that regulates the supply of the fuel used to run the power station (eg coal, fuel oil, gas etc). Obviously, if there is a tolling agreement there is no separate fuel supply agreement. In addition, in some markets and for particular types of projects the project company may decide not to enter into a long-term fuel supply agreement but instead elect to purchase fuel in the spot market. This will usually only be feasible for peaking plants and in locations with ample supplies of the necessary fuel. For hydro and wind projects there is also no need for a fuel supply agreement. However, this paper focuses on thermal plants. Many of the issues discussed will be applicable to hydro and wind projects, however, those projects have additional risks and issues that need to be taken into account.

Financing and security agreements with the lenders:
This agreement ensures finance for the development of the project. Accordingly, the construction contract is only one of a suite of documents on a power project. Importantly, the project company operates the project and earns revenues under contracts other than the construction contract. Therefore, the construction contract must, where practical, be tailored so as to be consistent with the requirements of the other project documents. As a result, it is vital to properly manage the interfaces between the various types of agreements.

BANKABILITY
A bankable contract is a contract with a risk allocation between the contractor and the project company that satisfies the lenders. Lenders focus on the ability, or more particularly the lack thereof, of the contractor to claim additional costs or extensions of time as well as the security provided by the contractor for its performance. ôThe less comfortable the lenders are with these provisions the greater amount of equity support the sponsors will have to provide. In addition, lenders will have to be satisfied as to the technical risk,ö said McNair. Obviously price is also a consideration but that is usually considered separately to the bankability of the contract because the contract price, more accurately the capital cost of the power station, goes more directly to the bankability of the project as a whole.

Before examining the requirements for bankability it is worth briefly considering the appropriate financing structures and lending institutions. The most common form of financing for infrastructure projects is project financing. Project financing is a generic term that refers to financing secured only by the assets of the project itself. Therefore, the revenue generated by the project must be sufficient to support the financing. Project financing is also often referred to as either non-recourse financing or limited recourse financing. The terms non-recourse and limited recourse are often used interchangeably, however, they mean different things. Non-recourse means there is no recourse to the project sponsors at all and limited recourse means, as the name suggests, there is limited recourse to the sponsors. The recourse is limited both in terms of when it can occur and how much the sponsors are forced to contribute. In practice, true non-recourse financing is rare. In most projects the sponsors will be obliged to contribute additional equity in certain defined situations.

Traditionally, project financing is provided by commercial lenders. However, as projects became more complex and financial markets more sophisticated project finance also developed. Whilst commercial lenders still provide finance, governments now also provide financing either through export credit agencies7 or trans- or multinational organisations like the World Bank, the Asian Development Bank and European Bank for Reconstruction. In addition, as well as bank borrowings sponsors are also using more sophisticated products like credit wrapped bonds, securitisation of future cashflows and political risk insurance to provide a portion of the necessary finance.

In assessing bankability lenders will look at a range of factors and assess a contract as a whole. Therefore, in isolation it is difficult to state whether one approach is or is not bankable. However, generally speaking the lenders will require the following:

A fixed completion date

  • A fixed completion price
  • No or limited technology risk
  • Output guarantees
  • Liquidated damages for both delay and performance
  • Security from the contractor and/or its parent
  • Large caps on liability (ideally, there would be no caps on liability, however, given the nature of EPC contracting and the risks to the contractors involved there are almost always caps on liability)
  • Restrictions on the ability of the contractor to claim extensions of time and additional costs. An EPC contract delivers all of the requirements listed above in one integrated package. This is one of the major reasons why they are the predominant form of construction contract used on large-scale project financed infrastructure projects.

BASIC FEATURES OF AN EPC CONTRACT
The key clauses in any construction contract are those which impact on:

  • Time
  • Cost
  • Quality.
  • The same is true of EPC contracts. However, EPC contracts tend to deal with issues with greater sophistication than other types of construction contracts. This is because, as mentioned above, an EPC contract is designed to satisfy the lenders' requirements for bankability. EPC contracts provide for:
  • A single point of responsibility. The contractor is responsible for all design, engineering, procurement, construction, commissioning and testing activities. Therefore, if any problems occur the project company need only look to one party the contractor to both fix the problem and provide compensation. As a result, if the contractor is a consortium comprising several entities the EPC contract must state that those entities are jointly and severally liable to the project company.
  • A fixed contract price. Risk of cost overruns and the benefit of any cost savings are to the contractor's account. The contractor usually has a limited ability to claim additional money which is limited to circumstances where the project company has delayed the contractor or has ordered variations to the works.
  • A fixed completion date. EPC contracts include a guaranteed completion date that is either a fixed date or a fixed period after the commencement of the EPC contract. If this date is not met the contractor is liable for delay liquidated damages (DLDs). DLDs are designed to compensate the project company for loss and damage suffered as a result of late completion of the power station. To be enforceable in common law jurisdictions, DLDs must be a genuine pre-estimate of the loss or damage that the project company will suffer if the power station is not completed by the target completion date. The genuine pre-estimate is determined by reference to the time the contract was entered into.

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