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Report | February 2018

Key features of EPC contract

EPC or turnkey construction contracts enable construction works of large-scale and complex infrastructure projects, where a contractor is obliged to deliver the complete facility to a developer who needs to only turn a key to start operating the facility.<br /> <br /> Engineering, procurement and construction (EPC) contracts are the most common form of contract used to undertake construction works of large-scale and complex infrastructure projects. Under an EPC contract, a contractor is obliged to deliver the complete facility to a developer who needs to 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. <br /> <br /> Most international projects today are procured on the basis that one contractor assumes total responsibility for the design and execution of the works, including all engineering, procurement, and construction, so that the contractor effectively provides a fully equipped facility ready for operation at 'the turn of a key'. Generally with an EPC contract, the client has less say over the project design and the contractor takes more risk.<br /> <br /> On an EPC project, the client may seek tenders based on performance specification and then have no input into the design, other than if variations are instructed. Payment can be on a lumpsum or cost reimbursable basis, or some other basis, but generally the client would be likely to seek a fixed price, lumpsum agreement where the responsibility for cost control is taken by the contractor. This gives the client a relatively risk-free arrangement, with one point of responsibility and cost certainty. They can therefore operate the contract with the minimum resource. The client's main risk lies on the specification upon which the contract is based. If the specification is not well developed and concise, the quality and performance of the completed development may be compromised. Generally, EPC contracts are used on engineering and infrastructure projects, or industrial projects, where the aesthetics of design might be considered less important to the client than performance and cost certainty. EPC contract is divided into two separate contracts - onshore and offshore. The responsibilities of the offshore contractor are limited to the supply of design and engineering services 'offshore' (i.e., outside the country where the project is located) and the supply of offshore plant, equipment and materials ('equipment'). <br /> <br /> <span style="font-weight: bold;">Contracting methods in power plant construction can be classified into two:</span><br /> <ul> <li>Traditional approach (design-bid-build)</li> <li>EPC/ packages approach:</li></ul><br /> <span style="font-weight: bold;">Traditional project approach:</span> Design-bid-build, also called as design-tender, is a project delivery method in which the agency or owner contracts with separate entities for each design &amp; construction of a project. Design-bid-build is the traditional method for project delivery and differs in several substantial aspects from design-build. There are three main sequential phases to the design-bid-build delivery method - design phase, bidding phase and construction phase. <br /> <br /> The potential problems of design-bid-build are:<br /> <br /> i.)&nbsp;&nbsp;&nbsp; Failure of the design team causes construction costs <br /> and potential cost increases during the design phase <br /> and could cause project delays. Redesign expense <br /> can be disputed.<br /> ii.)&nbsp;&nbsp;&nbsp; As the general contractor is brought to the team post design, there is little opportunity for input on effective alternates being presented?<br /> iii.)&nbsp;&nbsp;&nbsp; Pressures may be exerted on the design and construction teams, which may lead to disputes between the <br /> architect and the general contractor.<br /> iv.)&nbsp;&nbsp;&nbsp; When viewed from a timeline perspective, the traditional project approach has three drawbacks: <br /> <br /> The two major functions, engineering &amp; construction, are performed at different times. <br /> The total project schedule is longer because of multiple bidding phases. <br /> Due to this multiple division, usually it depends <br /> on the contractor consultant who tends to be conservative and firm over the design, which results in higher cost.<br /> <br /> <span style="font-weight: bold;">Besides the above potential problems, following are the benefits of traditional approach:</span><br /> <ul> <li>The design team is impartial and looks out for the interests of the owner.</li> <li>Ensures fairness to potential bidders and improves decision making by the owner by providing a range of potential options. </li> <li>Assists the owner in establishing reasonable prices for the project.</li> <li>Uses competition to improve the efficiency and quality for owners.</li></ul><br /> <span style="font-weight: bold;">Approach:</span><br /> EPC has emerged as the delivery method of choice for executing system projects in all market sectors. It implies that a single entity has complete responsibility for a project from start to finish. In the EPC contract, the EPC firm assumes overall responsibility for the project, thereby relieving the customer of this burden and risk. The customer deals with a single-point contact. In this EPC approach, as responsibility rests on a single person or agency, communication between engineering design, procurement and construction activites begins immediately, which makes accelerating the project schedule without imposing greater risk. EPC can be more cost-effective when the value of the risk assumed by the contractor is considered, along with the early revenue-generating benefit of the accelerated project schedule. The movement away from the typical 'design/bid/build' method to EPC and design-build has altered the traditional relationships among the owner and the contractor. These altered relationships have shifted the risks assumed by each party in traditional construction contracts. But, because of their flexibility in the value the EPC contract, it is continuing to be the predominant form of contracts used on large-scale infrastructure projects. Even though the EPC lumpsum, turnkey agreements look to the contractor to provide a 'turnkey' project, there are certain activities that often remain under the owner's control which can have a significant effect on the project's cost and schedule. Most contracts provide that the project owner has responsibility to provide adequate site access for the contractor. <br /> <br /> <span style="font-weight: bold;">Why split a contract?</span><br /> The split structure is designed to reduce exposure to local taxes on offshore equipment, or any design work performed outside the host country, becoming subject to local taxes. The classes of taxes, both direct and indirect, that an EPC contractor and a project company may be exposed to in the host country include: value added taxes, withholding taxes, technology transfer taxes, import and stamp duties, local construction and property licence fees and duties, and onshore income or profits tax. Other commercial considerations may drive the split structure, such as avoidance of local 'red tape' requirements and costs associated with obtaining permits, approvals, and submitting designs to local government authorities in the host country.<br /> <br /> Splitting EPC contracts is not appropriate for every project. Indeed, in some jurisdictions a mere reference in an onshore contract to an offshore contract (or vice-versa) can defeat the tax advantages that the split structure is intended to achieve. This scenario may normally be avoided through careful drafting of the contract. Appropriate local taxation and legal advice should always be sought before deciding whether to split an EPC contract into two or more contracts to take advantage of taxation savings and other commercial benefits. A reduction in contract price under the split approach is typically attractive to a project company, but this reduction must be weighed against the costs and risks involved in splitting.<br /> <br /> A split structure can be initiated at any time prior to execution of the project documents. Ideally, a project company and an EPC contractor would reach agreement on the terms of the single EPC contract (and scope of work) and then the arrangements split into onshore and offshore components. This can lead to hastily-drafted split contracts, as the project parties have concluded their commercial deal and wish to start work as soon as possible. As the project company is the major beneficiary of the split structure (lower contract price), on its face the project company is better placed to assume the risk of the split structure failing. <br /> <br /> <span style="font-weight: bold;">Basic features </span><br /> The key clauses in any construction contract are those which impact on: time, cost&nbsp; and 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 an EPC contract is designed to satisfy the lenders' requirements for bankability. <br /> <br /> <span style="font-weight: bold;">EPC contracts provide for:</span><br /> <br /> i.&nbsp;&nbsp;&nbsp; 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 needs to look up to only one party - the contractor - to both fix the problem and provide compensation. <br /> 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 <br /> project company. <br /> <br /> ii.&nbsp;&nbsp;&nbsp; A fixed contract price - Risk of cost overruns and the benefit of any cost savings go 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. <br /> <br /> iii.&nbsp;&nbsp;&nbsp; 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 <br /> EPC contract. If this date is not met, the contractor is liable for liquidated damages. Liquidated damages are designed to compensate the project company for loss <br /> and damage suffered as a result of late completion of <br /> the power station. <br /> <br /> <span style="font-weight: bold;">Characteristics of EPC contract:</span><br /> <ul> <li>A fixed completion date </li> <li>A fixed completion price </li> <li>No or limited technology risk</li> <li>Output guarantees </li> <li>Liquidated damages for both delay and performance </li> <li>Security from the contractor and/or its parent </li> <li>Large caps on liability </li> <li>Restrictions on the ability of the contractor to claim extensions of time and additional costs.</li></ul><br /> <span style="font-weight: bold;">Phases </span><br /> Turnkey projects consist of several phases; they start with feasibility studies and engineering works, and end with the final commissioning of the project. In an EPC turnkey contract, those phases include a number of interfaced business processes e.g. marketing, sales and customer service. The various phases in the execution of a turnkey project are as follows:<br /> <br /> a.&nbsp;&nbsp;&nbsp; Development phase - The development phase is the first stage of the EPC project process and covers the important aspect of engineering. This can be viewed as an extension of a detailed planning process. The engineering phase produces a range of deliverables, which includes several activities like feasibility study, estimation, designs, drawing, specification, data sheet and test results.<br /> <br /> Having made the decision to execute a project on a turnkey basis, the employer appoints a consultant and states his requirements in the form of a design brief. The consultant then expands the brief into a more explicit ôemployers requirementsö, taking into account the project development phase during which design responsibility is handed over to the EPC contractor.<br /> <br /> b.&nbsp;&nbsp;&nbsp; Financing stage - The employer has to achieve financial closure, which involves the promoters bringing in their own funding in the shape of equity as well as organising loans. This should ideally precede or proceed in parallel with the negotiation process.<br /> <br /> c.&nbsp;&nbsp;&nbsp; Negotiation stage -The consultant incorporates the employer's requirements into the bid documents and brings out a notice for pre-qualification. This is done so that only established parties are short listed as bidders then a notice inviting tender is issued by the consultant on the employer's behalf. The shortlisted contractors are then required to submit a two-part proposal. The technical bid contains details of all deliverables and processes. Those technical bids that are found satisfactory are put through the commercial bidding process. The price bids finally determine the contract award.<br /> <br /> d.&nbsp;&nbsp;&nbsp; Contract agreement - After the contract is awarded, the two parties, i.e. the employer and EPC contractor, sign the contract agreement. The contract includes the term and mode of payment for the works. It also defines the warranty terms and tenure in addition to damages that would be payable if the contractor deviates from the contract in terms of specified design or commissioning schedule etc. The contract covers interest payable to the turnkey contractor in case the employer is not able to release funds in time.<br /> <br /> e.&nbsp;&nbsp;&nbsp; Design and manufacture of equipment - After the contract is signed, the contractor assumes the responsibility for satisfying the employer's requirements. This is done by first verifying the incomplete bid package or basic design and then expanding that into a complete description of the required project in the form of residual and detailed design, engineering drawings, diagrams, specifications, purchase orders and matters.<br /> <br /> f.&nbsp;&nbsp;&nbsp; Procurement - After finalisation of all design-related parameters, procurement works begin. The contractor is responsible for supplying equipment and procuring all the equipment from sub-vendors. In this process, the EPC contractor also assumes responsibility for inventory and materials management. Procurement becomes important because it is here that project management can be most effective in cutting time without compromising quality. <br /> <br /> g.&nbsp;&nbsp;&nbsp; Construct - Once the project and related subsystems have been designed, manufactured and supplied, construction begins. These include pre-installation of the project at the identified site.<br /> <br /> h.&nbsp;&nbsp;&nbsp; Training - The contractor has to impart training to a team of engineers/technical staff of the employer at the site during the pre-commissioning and commissioning of the project. In addition, training programs are also arranged at the supplier's works.<br /> <br /> i.&nbsp;&nbsp;&nbsp; Commissioning and handing over - The final stage of EPC contract. Once the pre-commissioning, commissioning trials of the individual equipment and overall systems are complete, the contractor has to commission the project as per terms of the contract. The contractor has to conduct the trial run/reliability run, i.e. trials at full load/varying load for defined periods as per the contract. Following its demonstration, the project is handed over to the customer.<br /> <br /> j.&nbsp;&nbsp;&nbsp; Performance guarantees -After successful commissioning and acceptance of the project, the warranty period begins. The turnkey contractor gives a guarantee on all parameters of the project affecting fixed and variable costs. Guarantees are given on overall project performance, not just on individual equipment performance. At the end of the warranty period, the relationship between the contractor and the employer continues only if EPC contractor also bags the operation and maintenance (O&amp;M) contract. Given the huge responsibility and accountability in setting up a project, the success of EPC mode in project execution depends largely on effective project management. This enables the project team to examine the cost-time trade-off without compromising on quality.<br /> &nbsp;<br /> <span style="font-weight: bold;">Conclusion</span><br /> The key clauses in any construction contract are those which impact on successful accomplishment of project: - time, cost and quality. The same is true of EPC contracts. But EPC contracts tend to deal with issues with greater sophistication than other types of construction contracts. An EPC contract is designed to satisfy the lenders' requirements. <br /> <br /> <br /> <span style="font-weight: bold;">Author: <br /> Ashok Upadhyay, </span>PhD Scholar and Deputy Director (Generation), M.P. Electricity Regulatory Commission, Bhopal, (M.P)<br />
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