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 guaranteed level. Failure to comply with any requirements will usually result in the contractor incurring monetary liabilities.
Due to the flexibility, the value and the certainty derived to sponsors and lenders, EPC Contracts are being used as the main form of construction contract by project sponsors bidding for projects under South Africa's Renewable Energy Independent Power Producer ("RE IPP") Procurement Programme.
This paper is set out in two parts. Part 1 outlines the current context of renewable energy policy and legislation in South Africa, lessons learned from the lenders' bankability requirements and other key issues arising in relation to EPC Contracts in the context of the RE IPP Programme. Part 2 sets out the key features of EPC Contracts in the context of renewable energy projects more broadly.
Although the RE IPP Programme covers a number of types of renewable energy technologies (discussed further over the page), this paper focuses specifically on wind energy and the key issues arising in EPC Contracts for wind projects.
PART 1 - RENEWABLE ENERGY IN SOUTH AFRICA AND THE RE IPP PROGRAMME
On 17 March 2011, the South African Government approved the Integrated Resource Plan 2010 ("IRP") for electricity. The IRP outlines the Government's plan to increase South Africa's total installed electricity capacity from 260 TWh in 2010 to 454 TWh in 2030, an increase of more than 170% over the 20 years. Of this amount, 42% of the new installed capacity is planned to be sourced from renewable energy. The Government's key policy mechanism for achieving the targeted amount of installed capacity of renewable energy is the RE IPP Programme.
RE IPP Programme - overview
Under the RE IPP Programme, Bidders submit Bid responses to construct and operate renewable energy projects and sell power to Eskom.
The renewable energy technologies comprising the RE IPP Programme, and their envisaged split, are set out below:
|Technology||Proposed amount||Percentage allocation|
|Concentrated Solar Power||200MW||5.3%|
|Small hydro (<10MW)||75MW||2%|
|Small Projects IPP (max MAW)||Total threshold of 100MW||2.8%|
Each of the renewable energy technologies comprising the RE IPP Programme have a set minimum capacity and maximum installed capacity.
The RE IPP Programme is comprised of five phases, pending subscription by Bidders of the total allocation of MW for each technology. All allocations for each form of technology are made available during the each Bid submission phase. Where an allocation is undersubscribed, the remaining MW will be made available to Bidders in the following phase.
The First Bid Submission Date was 4 November 2011 and the first selection of 28 Preferred Bidders was announced at COP 17 in Durban on 7 December 2011. Preferred Bidders were initially required to finalise all of their contractual arrangements by 22 May 2012 and to reach financial close by 19 June 2012. However, the date for financial close has subsequently been extended and remains outstanding, with Preferred Bidders requested to extend their Bid validity period until the end of October 2012.
The Second Bid Submission Date was 5 March 2012, and 19 Preferred Bidders were announced on 21 May 2012. Preferred Bidders were initially required to reach financial close by December 2012, but this date has been extended to 18 - 28 March 2013. The Third Bid Submission Date has also been extended from 1 October 2012 to 7 May 2013.
RE IPP Programme - proposed update
It has been recently reported that the DOE is proposing to procure an additional 3200 MW of renewable energy capacity by 2020, over and above the 3725 MW being procured currently under the RE IPP Programme.
On 9 October 2012, Engineering News reported:
Addressing a South Africa-Spain Business Summit in Johannesburg, Department of Energy (DoE) acting chief director Thabang Audat said the proposal had been sent to the National Energy Regulator of South Africa (Nersa) for its concurrence on the additional allocation.
He was unable to provide details as to how the new allocation would be divided between the various renewables technologies, but said this breakdown would be provided in a Ministerial determination, which would be published in Government Gazette within seven working days of Nersa's concurrence.
The new renewables allocation meant that there would now be more than 4 360 MW of capacity available for future bidding rounds, with the next round scheduled to close in May, 2013.
Prior to this extension only 1 165.6 MW of capacity remained unallocated under the REIPPP, following two bidding rounds during which a total of 47 projects were named as preferred bidders.
Wind Farm Projects
A wind farm typically comprises a series of wind turbines, a substation, cabling (to connect the wind turbines and substation to the electricity grid), wind monitoring equipment and temporary and permanent access tracks. The wind turbines used in commercial wind farms are generally large slowly rotating, 3 bladed machines that typically produce between 1.5 MW and 3 MW of output. Each wind turbine is comprised of a rotor, nacelle, tower and footings. The height of a tower varies with the size of the generator but can be as high as 100m. The number of turbines depends on the location of the wind farm and capacity of the turbines.
The amount of power a wind generator can produce is dependent on wind availability and speed. The term "capacity factor" is used to describe the actual output of a wind energy Facility as the percentage of time it would be operating at maximum power output.
Wind farms need to be located on sites that have strong, steady winds throughout the year, good road access and proximity to the electricity grid.
Contractual structure for projects under the RE IPP Programme
An overview of the typical contractual structure for a project financed renewable energy project is set out in Part 2. The outline below relates specifically to the contractual structure used under the RE IPP Programme. Under the RE IPP Programme, Bidders are also required to submit as part of their Bid the detailed heads of terms of the contracts that they would enter into with their contractors, equipment suppliers and other subcontractors if selected as a Preferred Bidder. In most cases this will be comprised of a detailed heads of terms for an EPC Contract and an Operating and Maintenance ("O&M") Contract.
If a Bidder is selected as a Preferred Bidder, it will negotiate and prepare fully termed EPC and O&M Contracts based on the detailed heads of terms submitted as part of their Bid.
Preferred Bidders will be required to enter, as project company, into the following non-negotiable agreements with the relevant counterparties in order to reach financial close and develop the Facility:
- Power Purchase Agreement ("PPA") with Eskom;
- Implementation Agreement ("IA") with the Department of Energy ("DoE");
- Transmission Agreement or Distribution Agreement (as relevant, depending on which network the Facility will connect to); and
- Direct Agreement,
(together "the Project Documents").
Key issues and 'lessons learned' under the RE IPP Programme to date
We have set out below some of the key requirements that Preferred Bidders will be required to meet as the project company under the Project Documents, including our experience of the lenders' bankability requirements from Phase 1 and Phase 2 of the RE IPP Programme, and consider the effect of these requirements and how they may be flowed through to the relevant contractors. The terms "Buyer" and "Seller" are used below in relation to obligations set out in the Project Documents, referring to Eskom and the project company respectively. The capitalised terms used in this section relate to defined terms from the Project Documents.
Overriding pass-through of obligations from the Project Documents
To limit gaps in liability and minimise the need for additional sponsor support, project companies will seek to ensure that the EPC Contracts used in respect of RE IPP Programme projects are bankable, in particular the obligations, risks and liabilities under the PPA and other Project Documents must be passed through to the contractor to the fullest extent that is possible and commercially feasible. The overriding "pass through" principle is that the contractor must take account of the PPA and other Project Documents in performing the EPC Contract and must not put the project company in breach of those documents. The EPC Contract should provide for an acknowledgement of pass through and assumption of risks by the EPC Contractor. We recommend that the following clause be included:
"The Contractor has reviewed the terms of the Power Purchase Agreement, Implementation Agreement, [Distribution Agreement or Transmission Agreement] and Direct Agreement (Project Documents) and, subject to specific limitations agreed in this Contract; assumes those risks relevant to the Works which are assumed by the Owner under the Project Documents; will perform its obligations under the Contract in such manner as to allow the Owner to comply with its obligations under the Project Documents regarding completion of the Facility; and must not do anything to prevent or interfere with the Owner's performance of its corresponding obligations under the Project Documents."
There are three categories of obligations, risks and liabilities that should be passed through to the contractor:
- explicit obligations;
- risks or potential liabilities, but no specific obligations; and
- requirements to take certain action to allow the project and the project company to comply with the requirements of the Project Documents.
If a particular risk cannot be passed through to the contractor, the risk will need to be mitigated by some other means, such as through insurance and/or by the provision of some additional form of sponsor support.
'Pass through' and linked entitlements
Where any entitlements of the contractor arise as a result of the project company being entitled to relief under the Project Documents, including in relation to events of Force Majeure, as well as for Compensation Events, System Events or Unforeseeable Conduct, to avoid gaps in liability under the Project Documents and the need to provide additional sponsor support, the contractor's entitlement under the EPC Contract should be linked to, and limited by, reference to what the project company (as the Seller) receives under the Project Documents, rather than what the project company is or may be entitled to. We recommend that the following clause be included, subject to the project company being required to comply with the process for claiming relief under the Project Documents:
"the Contractor agrees to accept in full and final satisfaction of any Pass Through Claim, the amount agreed or determined as payable under the Project Documents."
The definition of 'Force Majeure' under the PPA is an exclusive and relatively restrictive definition. For further discussion about force majeure clauses generally, please refer to the force majeure section in this paper below.
To minimise the risk of the project company being required to grant an extension of time to the contractor when the project company is not able to obtain relief under the PPA, the definition of force majeure in the EPC Contract should be back to back with the definition in the PPA.
In addition, given that the PPA does not provide a right to terminate for an extended force majeure, lenders will generally require that no such right to terminate is provided in the EPC Contract or, if such right is provided, that additional sponsor support is also provided.
If an event of Force Majeure occurs prior to the Scheduled COD, the PPA allows for an extension of time by postponing the Scheduled COD for 'such time as shall be reasonable for such a Force Majeure event, taking into account the likely effect of the delay' (clause 16.5).
The Seller will also be entitled to relief if, during any 12 month period, the cumulative duration of Force Majeure events or their consequences (each of which event must last 24 hours or longer) exceeds 60 or more days and the Seller is not entitled to bring a claim under any insurance policy is required to hold under the PPA in respect of those Force Majeure events. In such circumstances, clause 16.9 of the PPA provides the Seller with an entitlement to an extension of the Term and/or other relief from the Buyer to 'place the Seller in the same overall economic position as it would have been in but for such Force Majeure event', provided that any compensation must not be in monetary form and the total extension of the Term must not exceed ten years.
To avoid any gaps in liability arising, the project company should ensure as far as possible that the relief available under the EPC Contract for a Force Majeure event is back to back with the provisions of the PPA.
We recognise that this may be difficult to achieve in practice given the relatively narrow definition of Force Majeure in the PPA and the Self Build Agreement (to be discussed later in this paper).
The definition of 'Compensation Event' under the PPA includes material breaches by the Buyer of obligations under the PPA, including failure to make payments at the relevant time.
Under clause 15.3 of the PPA, the Seller will be entitled to both an extension of time and additional costs (either additional cost incurred by the Seller before the Commercial Operation Date or capital expenditure at any time) for a Compensation Event. Relief under the EPC Contract for a Compensation Event should be back to back with this.
Under clause 15.3.2 of the PPA, the Buyer has the option to make payments for additional costs in respect of a Compensation Event in either a lump sum or by instalments. If the Buyer chooses to pay the amount in instalments, lenders will need to consider how the increased costs during construction or the additional capital costs after the Commercial Operation Date will be financed. To address this issue, we recommend that the following clause be included:
"Subject to the Contractor complying with the notice and other requirements under this Contract, to the extent that the Owner is entitled to claim relief under the Project Documents for any System Event, Compensation Event, Force Majeure and Unforeseeable Conduct, the Contractor is entitled to claim corresponding relief under the Contract mutatis mutandis, irrespective of whether or not the Owner actually claims such relief under the Project Documents, provided that where a payment must be made by the Owner to the Contractor similar to the payment contemplated in clause 15.3.2 or 17.6 of the PPA, the Owner will make payment in the manner contemplated in clause 126.96.36.199.1 or 17.6.1 of the PPA (as the case may be), and not in the manner contemplated in clause 188.8.131.52.2 or 17.6.2 of the PPA (as the case may be). Accordingly, the Owner will not be relieved from its obligations due to its failure to comply with the notice and other requirements under the Project Documents, or its failure to claim relief under the Project Documents."
Under clause 14.1 of the PPA, the Seller will be entitled to relief for a 'System Event', defined as delays in connecting the Facility to the grid and the unavailability of the grid. The definition of 'System Event' specifically excludes circumstances 'caused by any natural force or event'. However, the PPA does not provide any definition of the term 'natural force or event'. In addition, under clause 14.1 of the PPA, the Seller is not entitled to bring a claim in relation to a System Event unless the time that the System Event(s) have endured is greater than the Allowed Grid Unavailability Period for a Contract Year or the period that the Commercial Operation Date is delayed beyond the Scheduled COD.
Given that the duration of the 'Allowed Grid Unavailability Period' is not insignificant, representing 2% of the total hours available in a year, this may be a material issue and may not be able to be fully passed through to the contractor. If the contractor will not accept a full pass through of risks relating to the Allowed Grid Unavailability Period and the exemption for a 'natural force or event', the project company may be required to provide some form of sponsor support.
Under clause 14.1 of the PPA, the Seller will be entitled to both postponement of the Last COD and/or a Deemed Energy Payment for a System Event. 'Deemed Energy Payments' are defined under the PPA as an amount payable by the Buyer to the Seller in respect of Energy Output that would otherwise be available to the Buyer, but for a System Event or a Compensation Event, calculated in accordance with Schedule 6 of the PPA with reference to the Commercial Energy Rate and dependant on the period in respect of which such payment is due and payable.
The method by which the amount of the Deemed Energy Payment is determined is set out in Schedule 6 of the PPA. To the extent that this amount will not cover the contractor's delay costs during a System Event, this will become a risk to the project company which would require appropriate sponsor support.
The term 'Unforeseeable Conduct' under the PPA is broadly equivalent to change in law risk. Like Force Majeure, the matters included in the definition of Unforeseeable Conduct are narrower than would generally be expected and, for example, do not extend to changes in law or tax that are not discriminatory to the project. The EPC Contract should be back to back with this definition.
Under clause 17.5 of the PPA, the Seller will be entitled to compensation or relief from the Buyer to restore the general economic position of the Seller but for the Unforeseeable Conduct. This may take the form of monetary compensation or an extension of time. Note also that if the Seller benefits as a result of the Unforeseeable Conduct, the Seller will be required to pay the value of any such benefit to the Buyer.
As with a Compensation Event, the PPA provides the Buyer with the option under clause 17.6 to pay monetary compensation for Unforeseeable Conduct as either a lump sum payment or in equal monthly instalments for the remainder of the Term. Please refer to our suggested clause above in the context of Compensation Events that addresses this issue.
Under clause 4.6 of the PPA, for every day that the Commercial Operation Date is delayed beyond the Scheduled COD (unless the delay is due to an event of Force Majeure, System Event, Compensation Event or Unforeseeable Conduct), the Operating Period will be reduced by an additional day and the Expiry Date will be brought forward by one day. As a result, the Seller will effectively lose 2 days for each day that the Commercial Operation Date is delayed beyond the Scheduled COD.
The quantum of delay liquidated damages in the EPC Contract must factor in the total loss or revenue to the project due to the reduced number of days, and should also be reviewed by the project technical advisors.
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