EPC contracting in the power sector – some practical considerations
Energy, Utilities, Mining and COP28
EPC contracts in the GCC's energy sector often face challenges like output ambiguities, cash flow issues, and risk allocation problems. The article recommends clear contract terms, balanced payments, & contract administration to address these issues.
Law Update: Issue 363 - Energy, Utilities, Mining and COP28
Euan Lloyd Partner,Construction & Infrastructure
EPC Contracts are typically used to deliver energy projects in the GCC, on the basis that the EPC Contractor is expected to deliver a “turnkey” solution, on time and for the required quality, with the Owner’s principal obligations focused on undertaking inspections, issuing approvals and paying the Contract Price.
Although this seems like a straightforward proposition and EPC projects are successfully delivered, EPC projects (in both the power sector and more generally) can become beset with difficulties.
In this article, we briefly highlight some (often interconnected) reasons that can create “problem projects”, together with some potential solutions.
EPC Contracts are output based agreements whereby the EPC Contractor is required to deliver a facility that satisfies the agreed output requirements.
Although this is the fundamental requirement of an EPC Contract, we are aware of EPC Contracts in which the output requirements are open to interpretation. This therefore constitutes a potentially fertile ground for disputes, not least as the satisfaction (or otherwise) of the output requirements is the acid test against which the EPC Contractor’s performance is assessed.
As a related point, performance liquidated damages are typically triggered if the minimum output requirements are not achieved (and this can also trigger an event of termination).
However, ambiguities can also arise in this regard. For example, we have encountered uncertainties as to: (i) whether performance liquidated damages relate to the performance of the entire facility or whether they are confined to individual components of the facility (this can be problematic if, say, different components of a facility adequately perform but there are difficulties with overall synchronization); and (ii) the nature of the performance tests that are required to be performed (and whether they have, in fact, actually been properly performed (i.e., on account of the absence of adequate records)).
Although engaging the cheapest bidder as well as “back-loading” payment terms can obviously be an attractive proposition for the Owner, this can be a short-sighted approach as it can deprive the EPC Contractor of cashflow and result in the EPC Contractor being exposed to financial difficulty. This, in turn, will almost certainly negatively impact on the Project, particularly in the form of increased claims, delays while quality may be compromised.
As well as directly impacting on the EPC Contractor itself, lack of cashflow will cascade down the supply chain, particularly as most subcontractors and suppliers (who may be undertaking very significant parts of the Project) are likely to be engaged under “pay when paid” payment terms.
“Pay when paid” payment regimes are often opaquely drafted and can therefore be abused. Indeed, it is relatively straightforward for an unscrupulous EPC Contractor to contend that it has not received any payment from the Owner (or payment for a particular subcontractor’s/supplier's scope) and to therefore stall on its obligation to make payment to its supply chain.
The Owner can seek to mitigate this position by including a right of audit in the EPC Contract that provides transparency regarding how payments from the Owner have been distributed by the EPC Contractor and reserving the right (but not the obligation) to make direct payments to subcontractors/suppliers if the Owner reasonably considers that amounts due have not been paid by the EPC Contractor to its subcontractors/suppliers. Subcontractors and suppliers are also well advised to seek to mitigate the absolute nature of “pay when paid” regimes (i.e., by inserting limitations in respect of duration and/or value).
While most risk will be transferred to the EPC Contactor by the very nature of EPC Contracting, a complete transfer of risk may not be cost effective (i.e., as risk will be priced) or prudent (i.e., the EPC Contractor may not be well placed to manage a risk).
Risk allocation that should therefore be carefully considered in an EPC Contracting context. In this regard, risks to specifically consider include whether or not: (i) the EPC Contractor should assume full responsibility for the adequacy and accuracy of a complicated and detailed FEED (or initial design), even though the EPC Contractor was not afforded sufficient time during the tender phase to do so (noting also that the Owner would have a direct right of recourse against the engineering consultancy that prepared the FEED); and (ii) the EPC Contractor should accept the entire risk of ground conditions, even though it may not have been possible for the site conditions to be properly evaluated during the tender phase.
While onerous EPC Contracts can quickly result in contractual rights accruing in favour of the Owner, Owners should carefully consider whether it is actually beneficial to the Project for it to strictly enforce its contractual entitlements.
For example, a delay may have been caused on account of the occurrence of an EPC Contractor risk event. However, the deduction of delay damages, before hand-over, may be counter-productive as this step is likely to create an adversarial relationship and deprive the EPC Contractor of much-needed cashflow. Further, any deduction of delay damages from the EPC Contractor: (i) may mean that the EPC Contractor is no longer incentivised to complete the Works as expeditiously as possible (particularly if the agreed cap has been exhausted); and (ii) is likely to result in the EPC Contractor deducting delay damages from its subcontractors. As above, this may have a detrimental impact on performance (including in terms of quality) and hinder the completion of the Project (thus delaying the inception of a revenue-generating asset).
In a similar vein, we have experience, in the context of onerous and backloaded payment regimes, of Owner’s departing from what was contractually agreed and either amending the payment structure or making on-account payments. This begs the question as to why a more balanced payment regime was not introduced in the first place.
In any event, it is important that any such arrangements are carefully documented to reflect the true commercial intention (i.e., to prevent arguments to the effect that payment demonstrates acceptance of the Works or the Owner has waived its right to subsequently deduct liquidated damages).
Concerns are often expressed regarding the adequacy of the administration of some Projects, including in respect of alleged bias displayed by contractor administrators (i.e., by way of broadly interpreting the scope to deny variation claims and ignoring "acts of prevention" by the Owner that have caused or contributed to delays and/or cost overruns).
If the EPC Contractor considers that the EPC Contract is not being fairly administered, it is important that the EPC Contractor strictly follows the prescribed procedure for challenging the decisions that it disagrees with. This point is made even more significant as EPC Contracts frequently state that a determination becomes binding unless it is challenged within a prescribed timeframe.
Aside from the determination of EPC Contractor claims, it is imperative that performance on site is closely monitored. If issues of non-performance can be identified early, it is invariably far easier to address incidences of non-compliance at the outset by ensuring that appropriate rectification measures are put in place, while the implementation of such rectification measures needs to be closely monitored.
Additionally, close monitoring of the Project typically unearths the root causes of non-performance (i.e., the EPC Contractor’s failure to pay its subcontractors/supply chain) and the successful completion of the works will be facilitated if the causes of non-performance can be addressed as quickly as possible.
Alternatively, if confidence is lost in the EPC Contractor’s ability to actually complete the Project (i.e., on account of liquidity issues (which may arise if the EPC Contractor has under-priced the Works)), it may well be prudent for the Owner to take decisive action.
Among other things, a well-drafted EPC Contract will provide for clear grounds for removing part of the EPC Contractor's scope as well as termination and will also outline the consequences of this action. In particular, the Owner should have sufficient security in place that can be called upon to cover the upfront costs arising out of termination for cause (such as the cost of engaging a replacement contractor), while the Owner should also have a clear basis upon which to recover any other cost and expense arising out of the termination (including any additional cost to complete).
However, termination can be the easy part and real challenges can be encountered in the context of completing the Project. Accordingly, an EPC Contract should not be terminated without a coherent and "stress-tested" contingency plan being in place, which addresses the appointment of a replacement EPC Contractor (as well as obtaining the necessary licences and approvals for the replacement contractor to proceed with the works) and also anticipates the terminated EPC Contractor’s likely combative response to its termination.
In our experience, decisive action regarding the replacement of a non-performing EPC Contractor should be taken as early as possible - once the Works are relatively well advanced (but are not nearing completion) the "balance of power" can easily swing in favour of the non-performing EPC Contractor, thus making termination an unappealing option. This is primarily because few contractors in the market are willing to take on unfinished projects (including on account of supply chain issues), while the Owner may well be concerned about losing "single point responsibility" (i.e., as an incoming EPC Contractor is highly unlikely to accept responsibility for the Works performed by its terminated predecessor).
For further information,please contact Euan Lloyd.
Published in November 2023
