PART 2 - EPC CONTRACTS - GENERAL PRINCIPLES AND KEY TOPICS
THE CONTRACTUAL STRUCTURE
The diagram below illustrates the basic contractual structure of a project financed renewable energy project using an EPC Contract.
The detailed contractual structure will vary from project to project. However, most projects will have the basic structure illustrated above.
We note that in some renewable energy projects, particularly wind farms or hydro plants, the EPC Contract may be split into an Equipment Supply Contract (such as a Wind Turbine Generator Supply Contract) and a Balance of Plant ("BOP") Contract, where the performance guarantee element is dealt with in a Warranty Operating and Maintenance Agreement ("WOM"). The principles are essentially the same as set out below and we will discuss specific components later in this paper.
As can be seen from the diagram, the project company will usually enter into agreements which cover the following elements:
- An agreement which gives the project company the right to construct and operate the Facility and sell electricity generated by the Facility. 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 Facility 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 facilities are now being planned and 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 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.
- 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). The project company will in turn undertake to produce a minimum quantity of electricity and, in some circumstances, green products (such as carbon or renewable energy credits). 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. These agreements are financial hedges as opposed to physical sales contracts. Their impact on the EPC Contract is discussed in more detail below.
- A Connection Agreement for connection of the Facility generation equipment into the relevant electricity distribution network ("Network") between the project company and the owner of the Network, who will be either a transmission company, a distribution company, an electrical utility or a small grid owner/operator. The Connection Agreement will broadly cover the construction and installation of connection facilities by the owner of the Network and the terms and conditions by which electricity is to be delivered to the generation equipment at the Facility from the Network ("import electricity") and delivered into the Network once generated by the Facility ("export electricity").
- A construction contract governing various elements of the construction of the Facility, from manufacture and assembly of the key equipment to construction of the balance of the plant comprising civil and electrical works. There are a number of contractual approaches that can be taken to construct a Facility. An EPC Contract is one approach. Another option, as outlined above, is to have a supply contract for key items of equipment such as wind turbines, solar panels or hydro turbines, 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(s). The major advantage of the EPC Contract over the other possible approaches is that it provides for a single point of responsibility. This is discussed in more detail below.
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.
In our experience most projects and almost all large, private sector, facilities use an EPC Contract.
- An agreement governing the operation and maintenance of the facilities. This is usually a longterm Operating and Maintenance Agreement ("O&M Agreement") with an operator for the operation and maintenance of the Facility. 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 RE IPP or utility company whose main business is operating facilities. Therefore, the term of the O&M Agreement will likely match the term of the Concession Agreement or the PPA. In some financing structures the lenders will require the project company itself to operate the Facility. In those circumstances the O&M Contract 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. In other circumstances the project company will enter into a fixed short term O&M Agreement with the manufacturer and supplier of the major equipment supplied, for example, in the case of a wind farm, the wind turbine generators, during which the appointed operator will train the staff of the project company. The project company will take over operation of the Facility on expiry of the O&M Agreement and will perform all functions of the operator save for some support functions being retained by the manufacturer.
- Financing and security agreements with the lenders to finance the development of the project.
Accordingly, the construction contract is only one of a suite of documents relating to a Facility. 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. These interface issues are discussed in more detail later.
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 and/or extensions of time as well as the security provided by the contractor for its performance. The 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. Obviously price is also a consideration but that is usually considered separately to the bankability of the contract because the contract price (or more accurately the capital cost of the Facility) 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, whereas "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 was 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 agencies or trans or multinational organisations like the World Bank, the Asian Development Bank and European Bank for Reconstruction and Development.
Development finance institutions (DFIs) such as DBSA and IDC are involved many projects under the RE IPP Programme as lenders or, in some cases, as financial advisers or equity investors. More broadly, DFIs have a general mandate to provide finance to the private sector for investments that promote development, such as in the form of higher risk loans, equity positions and risk guarantee instruments to private sector investments in developing countries.
In addition, as well as bank borrowings sponsors are also using more sophisticated products like credit wrapped bonds, securitisation of future cash flows 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); and
- 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.
In certain cases, it may be necessary to provide sponsor support to strengthen the capacity of the project company to satisfy its obligations to the banks and to have a "bankable" project. Forms of sponsor support may include equity subscription agreements (base and standby equity), completion guarantees of whole or part of the debt until the project commences commercial operation, bank guarantees to support completion guarantee, and cost overrun guarantees. Completion guarantees, for example, ensure that the lenders will be paid back a set amount if the Facility does not reach completion or the repayment of scheduled debt service, of principal plus interest, if completion is delayed. Other forms of support may be incorporated where the sponsor is a party to a key project contract (such as a construction contract, operating and maintenance agreement, or offtake agreement by requiring the sponsor to provide additional guarantee letters of credit or corporate support to underpin the project.
BASIC FEATURES OF AN EPC CONTRACT
The key clauses in any construction contract are those which impact on:
- cost; and
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 completion does not occur before this date 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 later.
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 terms of output 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. By way of example, for a wind farm project the performance guarantees will usually comprise a guaranteed power curve and an availability guarantee guaranteeing the level of generation of electricity.
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 preestimate is determined by reference to the time the contract was signed. PLDs are usually a net present value (NPV) (less expenses) calculation of the revenue forgone over the life of the project.
For example, if the output of the plant is 5 MW 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 5 MW.
PLDs and the performance guarantee regime and its interface with the DLDs and the delay regime is discussed in more detail below.
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 power projects cap the contractor's liability at a percentage of the contract price. This varies from project to project, however, an overall liability 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 were 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 recognised 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.
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:
- a bank guarantee 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 i.e., 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;
- retention i.e., withholding a percentage (usually 5%– 10%) of each payment. Provision is often made to replace retention monies with a bank guarantee (sometimes referred to as a retention guarantee (bond)) or to make the security package simpler the above bank guarantee is generally used as a standalone security for a value of 15% of the contract price;
- 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.
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.
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, such as the wind turbine blades or the solar panels. Refer also to the discussion regarding serial defects in this paper above.
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.
Force majeure. The parties are excused from performing their obligations if a force majeure event occurs. This is discussed in more detail below
Suspension. The project company usually has the right to suspend the works.
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.
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 of 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 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 executes the works then the contractor will be able to argue that it is not liable for either delayed or defective performance.
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.
© DLA Piper
This publication is intended as a general overview and discussion of the subjects dealt with. It is not intended to be, and should not used as, a substitute for taking legal advice in any specific situation. DLA Piper Australia will accept no responsibility for any actions taken or not taken on the basis of this publication.
DLA Piper Australia is part of DLA Piper, a global law firm, operating through various separate and distinct legal entities. For further information, please refer to www.dlapiper.com