Tuesday, November 22, 2011

Basic features of an EPC contract


EPC CONTRACTS

Basic features of an EPC contract
The key clauses in any construction contract are those which impact on:
  • time
  • cost, and
  • quality.
The same is true of EPC Contracts. Engineering, Procurement & Construction (EPC) Contracts are in the nature of Turn-Key Projects, having a combined scope of work involving services & supplies. 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.
Brief description of Engineering, Procurement and Construction

EPC Contracts provide for:
  1. 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.
  1. 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.
  1. 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 facility. 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 facility is not completed by the target completion date. The genuine pre-estimate is determined by reference to the time the contract was entered into.
DLDs are usually expressed as a rate per day which represents the estimated extra costs incurred (such as extra insurance, supervision fees and financing charges) and losses suffered (revenue forgone) for each day of delay.
In addition, the EPC Contract must provide for the contractor to be granted an extension of time when it is delayed by the acts or omissions of the project company. The extension of time mechanism and reasons why it must be included are discussed below.
  1. Performance guarantees.
The project company’s revenue will be earned by operating the facility. Therefore, it is vital that the facility performs as required in term of output, efficiency and reliability. Therefore, EPC Contracts contain performance guarantees backed by performance liquidated damages (“PLDs”) payable by the contractor if it fails to meet the performance guarantees. The performance guarantees usually comprise a guaranteed production capacity, quality and efficiency.
PLDs must also be a genuine pre-estimate of the loss and damage that the project company will suffer over the life of the project if the facility does not achieve the specified performance guarantees. As with DLDs, the genuine pre-estimate is determined by reference to the time the contract was signed.
PLDs are usually a net present value (NPV) (less expense) calculation of the revenue forgone over the life of the project. For example, for an ammonia and urea plant if the production rate of urea is 50 tonnes less than the specification, the PLDs are designed to compensate the project company for the revenue forgone over the life of the project by being unable to sell that 50 tonnes of urea.
It is possible to have a separate contract that sets out the performance requirements, testing regime and remedies. However, this can create problems where the EPC and the performance guarantees do not match. In our view, the preferred option is to have the performance guarantees in the EPC contract itself.
PLDs and the performance guarantee regime and its interface with the DLDs and the delay regime is discussed in more detail below.

  1. Caps on liability.
As mentioned above most EPC contractors will not, as a matter of company policy, enter into contracts with unlimited liability. Therefore, EPC Contracts for process plant projects cap the contractor’s liability at a percentage of the contract price. This varies from project to project, however, a cap of 100% of the contract price is common. In addition, there are normally sub-caps on the contractor’s liquidated damages liability. For example, DLDs and PLDs might each be capped at 20% of the contract price with an overall cap on both types of liquidated damages of 30% of the contract price.
There will also likely be a prohibition on the claiming of consequential damages. Put simply consequential damages are those damages which do not flow directly from a breach of contract but which may have been in the reasonable contemplation of the parties at the time the contract was entered into. This used to mean heads of damage like loss of profit. However, loss of profit is now usually recognized as a direct loss on project financed projects and, therefore, would be recoverable under a contract containing a standard exclusion of consequential loss clause. Nonetheless, care should be taken to state explicitly that liquidated damages can include elements of consequential damages. Given the rate of liquidated damages is pre-agreed most contractors will not object to this exception.
In relation to both caps on liability and exclusion of liability it is common for there to be some exceptions. The exceptions may apply to either or both the cap on liability and the prohibition on claiming consequential losses. The exceptions themselves are often project specific, however, some common examples include in cases of fraud or wilful misconduct, in situations where the minimum performance guarantees have not been met and the cap on delay liquidated damages has been reached and breaches of the intellectual property warranties.

  1. Security.
It is standard for the contractor to provide performance security to protect the project company if the contractor does not comply with its obligations under the EPC Contract. The security takes a number of forms including:
§         bank guarantee or bond for a percentage, normally in the range of 5-15%, of the contract price. The actual percentage will depend on a number of factors including the other security available to the project company, the payment schedule (because the greater the percentage of the contract price unpaid by the project company at the time it is most likely to draw on security ie: to satisfy DLD and PLD obligations the smaller the bank guarantee can be), the identity of the contractor and the risk of it not properly performing its obligations, the price of the bank guarantee and the extent of the technology risk
§         advance payment guarantee, if an advance payment is made, and a parent company guarantee - this is a guarantee from the ultimate parent (or other suitable related entity) of the contractor which provides that it will perform the contractor’s obligations if, for whatever reason, the contractor does not perform.
  1. Variations.
The project company has the right to order variations and agree to variations suggested by the contractor. If the project company wants the right to omit works either in their entirety or to be able to engage a different contractor this must be stated specifically. In addition, a properly drafted variations clause should make provision for how the price of a variation is to be determined. In the event the parties do not reach agreement on the price of a variation the project company or its representative should be able to determine the price. This determination is subject to the dispute resolution provisions. In addition, the variations clause should detail how the impact, if any, on the performance guarantees is to be treated. For some larger variations the project company may also wish to receive additional security. If so, this must also be dealt with in the variations clause.
  1. Defects liability.
The contractor is usually obliged to repair defects that occur in the 12 to 24 months following completion of the performance testing. Defects liability clauses can be tiered. That is the clause can provide for one period for the entire facility and a second, extended period, for more critical items.
  1. Intellectual property.
The contractor warrants that it has rights to all the intellectual property used in the execution of the works and indemnifies the project company if any third parties’ intellectual property rights are infringed.
  1. Force majeure.
The parties are excused from performing their obligations if a force majeure event occurs.
“Force Majeure” shall mean any event beyond the control of the Employer or of the Contractor, as the case may be, and which is unavoidable notwithstanding the reasonable care of the party affected, and shall include, without limitation, the following:
a)    war, hostilities or warlike operations (whether a state of war be declared or not), invasion, act of foreign enemy and civil war.
b)    rebellion, revolution, insurrection, mutiny, usurpation of civil or military government, conspiracy, riot, civil commotion and terrorist acts.
c)    strike, sabotage, unlawful lockout, epidemics, quarantine and plague.
d)    earthquake, fire, flood or cyclone, or other natural or physical disaster
  1. Suspension.
The project company usually has right to suspend the works.
  1. Termination.
This sets out the contractual termination rights of both parties. The contractor usually has very limited contractual termination rights. These rights are limited to the right to terminate for non-payment or for prolonged suspension or prolonged force majeure and will be further limited by the tripartite or direct agreement between the project company, the lenders and the contractor. The project company will have more extensive contractual termination rights. They will usually include the ability to terminate immediately for certain major breaches or if the contractor becomes insolvent and the right to terminate after a cure period for other breaches. In addition, the project company may have a right to terminate for convenience. It is likely the project company’s ability to exercise its termination rights will also be limited by the terms of the financing agreements.
  1. Performance specification.
Unlike a traditional construction contract, an EPC Contract usually contains a performance specification. The performance specification details the performance criteria that the contractor must meet. However, it does not dictate how they must be met. This is left to the contractor to determine. A delicate balance must be maintained. The specification must be detailed enough to ensure the project company knows what it is contracting to receive but not so detailed that if problems arise the contractor can argue they are not its responsibility.
Whilst there are, as described above, numerous advantages to using an EPC Contract, there are some disadvantages. These include the fact that it can result in a higher contract price than alternative contractual structures. This higher price is a result of a number for factors not least of which is the allocation of almost all the construction risk to the contractor. This has a number of consequences, one of which is that the contractor will have to factor into its price the cost of absorbing those risks. This will result in the contractor building contingencies into the contract price for events that are unforeseeable and/or unlikely to occur. If those contingencies were not included the contract price would be lower. However, the project company would bear more of the risk of those unlikely or unforeseeable events. Sponsors have to determine, in the context of their particular project, whether the increased price is worth paying.
As a result, sponsors and their advisers must critically examine the risk allocation on every project. Risk allocation should not be an automatic process. Instead, the project company should allocate risk in a sophisticated way that delivers the most efficient result. For example, if a project is being undertaken in an area with unknown geology and without the time to undertake a proper geotechnical survey, the project company may be best served by bearing the site condition risk itself as it will mean the contractor does not have to price a contingency it has no way of quantifying. This approach can lower the risk premium paid by the project company. Alternatively, the opposite may be true. The project company may wish to pay for the contingency in return for passing off the risk which quantifies and caps its exposure. This type of analysis must be undertaken on all major risks prior to going out to tender.
Another consequence of the risk allocation is the fact that there are relatively few engineering and construction companies that can and are willing to enter into EPC Contracts. As mentioned in the Introduction some bad publicity and a tightening insurance market have further reduced the pool of potential EPC Contractors. The scarcity of EPC Contractors can also result in relatively high contract prices.
Another major disadvantage of an EPC Contract becomes evident when problems occur during construction. In return for receiving a guaranteed price and a guaranteed completion date, the project company cedes most of the day-to-day control over the construction. Therefore, project companies have limited ability to intervene when problems occur during construction. The more a project company interferes the greater the likelihood of the contractor claiming additional time and costs. In addition, interference by the project company will make it substantially easier for contractors to defeat claims for liquidated damages and defective works.
Obviously, ensuring the project is completed satisfactorily is usually more important than protecting the integrity of the contractual structure. However, if a project company interferes with the execution of the works they will, in most circumstances, have the worst of both worlds. They will have a contract that exposes them to liability for time and costs incurred as a result of their interference without any corresponding ability to hold the contractor liable for delays in completion or defective performance. The same problems occur even where the EPC Contract is drafted to give the project company the ability to intervene. In many circumstances, regardless of the actual drafting, if the project company becomes involved in determining how the contractor executes the works then the contractor will be able to argue that it is not liable for either delayed or defective performance.
As a result, it is vitally important that great care is taken in selecting the contractor and in ensuring the contractor has sufficient knowledge and expertise to execute the works. Given the significant monetary value of EPC Contracts, and the potential adverse consequences if problems occur during construction, the lowest price should not be the only factor used when selecting contractors.
  1. Risk Management:
Risk is an uncertain event or condition having a positive or negative effect on project objective, i.e., Scope, Cost, Schedule and Quality. Following are the main risks:
·          Delays in Project Development,
·          Legal & Regulatory Risks,
·          Operational & Maintenance Risks,
·          Force Majeure Risks,
·          Environmental Risks,
·          Cost Overrun Risks,
·          Financial Risks,
·          Market Risks,
·          Commercial Risks,
·          Political Risks,
·          Social Risks,
·          Technological Risks.

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