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There are several key success factors to manage EPC contracts. These types of contract are often referred to as Engineering, Procurement and Construction (EPC) contracts or Turnkey contracts. A properly drafted EPC contract ensures the contractor have limited ability to bring claims for extensions of time and additional cost.
Organisations are adopting a form of ‘risk transfer’ to achieve a sustainable competitive advantage in today’s competitive times. This involves outsourcing to make another party the ‘bearer’ of risk – i.e. appointing a contractor company that offers a ‘one-stop shop’ solution – to undertake the whole scope of a project by being the main contractor an managing the entire range of sub-contractor agreements.
Such certainty is highly desirable from a lender’s perspective as this means that the facility should be completed on time and within budget. If this is not the case, the consequences of time and cost escalations should be borne by the contractor (who is likely to be liable for performance and delay liquidated damages) and not the owner (i.e. the borrower).
Managing EPC Contracts
Under an EPC contract, the contractor is responsible for the design, construction and completion of the facility for a fixed contract price and by a fixed time for completion. Hence, upon completion, the facility is ready to begin operations. The key success factors in managing EPC contracts include:
- Single point responsibility
- Full design responsibility
- Employer’s Requirements
- Fixed contract price
- Fixed completion date
- Tests on completion
- Performance guarantees
- Caps on liability
- Performance security
- Intellectual property
- Contractor’s Rights of Termination/suspension
- Owner’s Rights of Termination/suspension
- Defects liability period
Single point responsibility
The contractor should be solely responsible for all design, procurement, engineering, construction, testing and commissioning of the facility. This means that the contractor will be liable for any defects or problems with the facility, removing the possibility of the contractor seeking to deflect blame to a third party. If the contractor consists of more than one entity (which is frequently the case in large scale projects), it is important that each entity is jointly and severally liable to the owner.
Full design responsibility
The contractor is usually fully responsible for the entire design of the facility. The contractor will thus be responsible for errors in any preliminary design or FEED (even though the preliminary design or FEED is likely to have been prepared by separate design consultant engaged by the owner). It is equally likely that the contractor will be required to provide a fitness for purpose warranty (which should be covered by professional indemnity insurance). This is consistent with the fundamental principle that the facility is, as an absolute obligation, required to satisfy the output specification as set out in the contract.
As the contractor takes on the design risk the owner will control what is to be delivered by a document usually titles “Employer’s Requirements”. This will describe the facility and standards to be achieved as well as the performance requirements. The more detailed the Employer’s Requirements the more likely that the owner will get the facility it wanted. However, the owner will also be more exposed to claims for variations and extensions of time for changes to the Employer Requirements.
Fixed contract price
The risk of cost overruns (and equally savings) are normally on the contractor’s account. As such, the contract price should only be subject to increase in specific and narrowly defined circumstances (such as variations and acts of prevention by the owner).
Fixed completion date
The contractor should be under an obligation to complete the facility (including satisfying all tests on completion) by a prescribed date. Failure to complete should entitle the owner to claim delay damages (which are typically subject to an agreed cap). As with escalations in the contract price, the time for completion should only be extended in certain narrowly specified circumstances.
Tests on completion
The requirements which need to be satisfied in order for the Works to be taken over need to be clearly stated. The tests on completion should be used to demonstrate that the prescribed output requirements of the facility have been satisfied. As a minimum, the contractor should also have obtained all consents and approvals (including the building completion certificate) for the facility to be legally operated for its intended purpose as a condition precedent to take over.
Revenue will only be generated if the facility is effectively operated and satisfies the prescribed output requirements (including in terms of reliability and efficiency). It is therefore important that EPC contracts contain guarantees and that these guarantees are backed by performance liquidated damages if the required standards are not met. As with delay damages, performance liquidated damages are typically subject to an agreed cap.
Caps on liability
Many contractors will not enter into any contract which does not contain an aggregate cap on liability (which may be the contract price or a percentage of it) with certain categories of loss excluded from that cap (i.e. public liability claims, gross negligence as well as consequential and indirect losses). Caps on and exclusions of liability are typically subject to commercial negotiation but in most jurisdictions in the GCC there may be scope for agreed liability caps to be opened up and reassessed by the competent court or arbitral tribunal so that the compensation payable equates with the true loss suffered. However, in our experience, such agreed liability caps are typically respected and upheld.
The contractor is normally required to provide an unconditional payable on demand performance bond, as security for the owner should it have a claim against the contractor, including for delay or performance liquidated damages. A parent company guarantee may also be required if there are concerns regarding the financial strength or technical capabilities of the contractor.
It is imperative that the owner has clear rights (i.e. through the granting of a license or the transfers of IP rights) to use the contractor’s designs for any purpose in respect of the facility (including in respect of the maintenance and the expansion of the facility). The contractor should indemnify the owner against any loss suffered arising out any intellectual property breaches.
Contractor’s Rights of Termination/suspension
The contractor typically has limited rights to terminate (i.e. in respect of non payment, prolonged suspension at the owner’s convenience and force majeure) with the exercise of any such right by the owner usually being subject to the lender’s step-in rights.
Owner’s Rights of Termination/suspension
The owner usually has far broader rights of termination, including in respect of any material breach (which has not been remedied upon the expiry of the relevant cure period) or upon the exhaustion of the cap on delay or performance liquidated damages. The owner may also have a right of termination for convenience. Additionally, the consequences of termination (including the payment/compensation regime and practical steps) should be set out. The Owner will also typically require the right to suspend the works to take into account unforeseen circumstances which occur during the construction phase (i.e. the unavailability of financing).
Defects liability period
A defects liability period of between 12 and 24 months is common. However, the defects liability period is sometimes extended if defects are corrected during the defects liability period and it is important that the owner ensures has adequate security in place (i.e. retention monies or a performance bond) that it can call upon if the contractor fails to remedy defects during the defects liability period. Owners should also be aware of attempts by contractors to exempt themselves from all further liability regarding the facility on the expiry of the defects liability period, which is contradicting statutory limitation periods.
Managing International EPC Contracts in the Global Power Industry is a 3-day training course held from 23-25 September 2019 (Kuala Lumpur). This course can furnish delegates with a thorough understanding of the key components and their interactions of an EPC contract and will provide focus on the key project management issues required for successful project delivery. Attention is on open dialogue and collective problem solving relative to case examples and class exercises. This course has been designed to provide an immersive, value adding experience to delegates who attend.
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