India: Infrastructure And Energy Quarterly (April, 2015)

Last Updated: 15 October 2015
Article by DSK Legal

Engineering, Procurement and Construction:

Contemporary Challenges in Engineering, Procurement and Construction Arrangements

Engineering, Procurement and Construction (EPC) forms the soul of project development across various sectors, which is critical for sustaining the robust growth of the Indian economy. The success of any project is directly dependent on the successful implementation and completion of EPC. EPC contracts are the tool to achieve this purpose. In this article it is our endeavor to highlight some of the challenges involved in an EPC arrangement  from the perspective of the project developer and the contractor.

The two critical components of project development are time & cost. The parties would always seek to avoid delay in project completion and cost overrun.

The roles and responsibilities of the project developer and the contractor are agreed to in this context (i.e. cost and time) having  due regard to the risks involved in a specific project. Thus, principally, the EPC contract is all about efficient risk management by the project developer and the contractor.

Risk management involves the following aspects:

a) Identification of risk – It is imperative to identify the risks under various categories that are associated with the specific project including by way of reference to and extensive analysis of the pre-feasibility and feasibility study/ies conducted for the said project.

b) Risk analysis – Determination of the nature of risk and its likely impact to enable the parties to decide on the party that is best suited to take the risk.

c) Risk allocation – Risk is allocated to create an efficient environment for the parties involved in the project such that the party who gains the maximum for taking the risk or is in the best position to manage the risk, will take the said risk.

d) Managing the Risk- Upon the risk being allocated to a party the said party has the ability to manage the risk appropriately by sharing the risk or the consequences of the risk with a third party.

Types of Risks

For the sake of brevity, we have categorized the contemporary risks that we intend to deal with in this article under the following heads: (a) Financial Risks; (b) Regulatory/Policy Risks; and (c) Other Risks.

Financial Risks

Interest Rate and Exchange Rate

Every project requires huge capital investment, bulk of which is raised in the form of debt where the interest rate has been spiraling up. According to recent market trends, many projects are being funded by way of external debt in foreign currency. Such external debts come at floating interest rate being benchmarked to the LIBOR, an acceptable benchmark under the ECB Regulations prescribed by the Reserve Bank of India. Further, the unprecedented change in exchange rate, more particularly the rising value of the United States Dollar against the Indian Rupee, has adversely impacted costs of such borrowing. The profitability of any project is impacted to a large extent by these factors. The commonly accepted method to address the interest rate and exchange rate fluctuation is entering into of hedging contracts by the party taking the risk on price of the project.

Inflation Rate

Another major financial risk is the rate of inflation which has a huge impact on the commercial dynamics of the project as it affects the pricing of the material inputs for the project. The rate of inflation in past few years has been growing in unwarranted manner. By way of illustration, the price of cement which is an essential raw material for most projects has risen sharply in past few years.

The different formulae linked with various indices are prescribed under the Model EPC Agreement for determination of price  adjustment. However, it is essential to ascertain whether these formulae are close to the contractor's procurement model as prices may differ from region to region. Further, the indices used for benchmark prices may not be realistic thereby creating serious risks.

Regulatory/Policy Risks

The recent decision of the Supreme Court whereby the coal blocks allocations made since 1993 were cancelled has created a sense of fear amongst project developers that the project, after being awarded, could still be affected by the courts based on factors to which the contractor may not be privy. It is seen that such risks are not specifically identified and allocated in the EPC Agreements as these are project risks inherent to the role of the project developer. However, the implication of such risk does not remain confined to the project developer but has trickling effect on others including the contractor. These risks could be mitigated by the contractor inter alia by way of consequential loss insurance policy being obtained by the contractor or by seeking a security from the project developer. But for the project developer, the only practical risk mitigation remedy seems to be obtaining consequential loss insurance policy. Thus, it is important to assess if cancellation of the grant of the project of the impact on a project due to a court order/regulatory action can be insured under consequential loss insurance policy and the cost of premium for such policies as it has direct impact on the profit margin of the project developer.

As far as environmental clearances/consents are concerned it is always advisable to ensure that the project has received such clearances/consents before the commencement of EPC work.

Further, in an EPC contract, the responsibility to obtain local permits and clearances are sought to be shifted to the contractor. The process for obtaining local permits and clearances may be cumbersome and may delay the project. EPC contractors should factor this risk and seek suitable protection by way of adjustment of time and price.

Another important policy risk is uncertainty with regards to fiscal incentives offered by the Government (Central, State and local). Many projects across different sectors enjoy various fiscal incentives pertaining to income tax, excise duties, custom duties, stamp duties etc. These are fiscal policies of the Government and are subject to change in future on account of the social, economic and political conditions prevailing at the relevant time. Withdrawal of such incentives has bearing on the cost of development of the project. Therefore, the price for the project should factor all incentives that can be categorically identified and variation in these incentives should be allowed as factor for price adjustment.

Other Risks

There has been a rising trend of consortium bidding. Consortium bidding was considered beneficial from taxation point of view as supply of capital goods by foreign bidder to the owner, being import of equipment was not considered to give rise to payment of income tax by foreign supplier under Income-Tax Act, 1961. However, Income Tax Act applies to income derived by an association of persons in India. Recent rulings on the subject suggest that such consortium will be treated as an association of persons and therefore, income from offshore supply becomes taxable in India. The Authority for Advance Rulings (AAR) in its ruling in 'Alstom Transport SA' on June 7, 2012 applying the 'look at' approach of Supreme Court in Vodafone case, held that a contract for design, manufacture, supply, installation, testing and commissioning of signaling/train control and communications systems is a composite contract and income from offshore supply was taxable in India, even though property in such goods was transferred outside India. Earlier in the case of 'Linde AG' on March 20, 2012 in case of consortium bidding, AAR had reached a similar conclusion based on facts of that case. Therefore, it is imperative that due care is exercised in structuring the EPC contracts in case of consortium bidding, taking the potential tax exposures into consideration.

Different governing laws and jurisdictions in different contracts for same project may pose unnecessary risks for a project. For example, in case of consortium bidding, the consortium partners enter into a consortium agreement to govern their inter-se relationship. If the consortium agreement is governed by laws of a foreign country and EPC contract is governed by Indian laws, this may cause serious problem as to interpretation of responsibilities of partners and enforcement of contract.

Further, while it is common to have mediation mechanism being resorted to before invoking arbitration, creation of multi-layered structure for dispute resolution in pre-arbitration stage may cause substantial delay. Further, institutional arbitration is expected to scores better than leaving appointment of arbitrator to the discretion of parties under an ad-hoc mechanism. Qualification of arbitrator and their integrity is essential for an efficient and fair adjudication. Selection of arbitrator in an ad-hoc manner may adversely affect this process. Therefore, parties should consider opting for institutional arbitration wherein arbitrators are to be selected from a panel of arbitrators.

Conclusion

In view of the above, it is important to upfront identify and suitably address all the risks so identified in relation to a specific project with prudent risk management and appropriately worded contracts. It is in this context one may note that the disputes in relation to EPC contracts currently pending are reported to involve Rs. 1 Lakh Crores.

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