Brief background on EPC contracts
Engineering, procurement and construction (EPC) contracts are a popular choice for private sector construction of significant infrastructure projects. The contractor under an EPC contract will typically agree to: (i) construct a complete, ready to operate facility that performs to specified levels; (ii) a fixed total price and guaranteed completion date (subject to allowable time and cost extensions under the contract); and (iii) take responsibility for all or almost all design, engineering, procurement, construction, commissioning and testing activities. Monetary liabilities, in the form of liquidated damages, are imposed on the contractor for failures to comply with key contract requirements.
Project sponsors and lenders tend to favour EPC contracts because of their ability to provide flexibility whilst also delivering a high degree of certainty. However, a key disadvantage of EPC contracts is that they often involve a higher contract price than other contract structures. This is the case because the certainty is principally achieved by placing almost all construction risk on the contractor. Consequently, the contractor will typically make higher allowances for risk-related contingencies in the contract price than might be the case under a different contract structure.
Issues in EPCs
The high cost, value and risk of EPC contracts, and the construction projects for which they are typically used, places a significant emphasis on careful consideration of contract structuring, drafting, negotiation and management issues. This includes emphasis on pre-contractual planning of the desired structure. The following are brief summary points on ten of the most important issues in the effective planning and preparation of EPC contracts.
1. Choice of contracting model
An EPC contract is only one of a number of contractual structures that can be used for a major infrastructure construction project. For example – as an alternative to an EPC contract – separate design, supply and construction contracts can be entered into. These may or may not be accompanied by an additional project management contract. A number of factors are relevant to the choice of contract structure, in particular timing considerations, the requirements of lenders, and the availability and identity of contractors. While typically the most popular choice, EPC contracts are not always the most appropriate approach. A conscious choice of contracting model should be made based on consideration of the circumstances of the particular project.
2. Choice of contractor
For many infrastructure projects, there are relatively few construction companies willing and able to enter into an EPC contract due to the high degree of risk and responsibility that must be accepted by the contractor. This circumstance places great emphasis and importance on selecting a contractor with sufficient knowledge and expertise to be able to execute the construction project. Given the typical size and complexity of infrastructure construction projects, 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.
3. Clarity and use of contract provisions (including choice of document)
While the use of template and precedent documents is endemic to contract drafting, there is no ‘magic’ to any existing contract form – no matter how prevalent or well-regarded a form may be in the particular industry or context in which it is typically used. The complexity, value and risk associated with EPC contracts particularly underlines the need to undertake detailed and careful preparation of the final provisions. In addition, the agreed final contract provisions will only be meaningful if they are actually followed during the course of the project. For example, one issue we sometimes see in the Myanmar market is parties adopting a FIDIC construction contract form (often with limited negotiation and customization) and then failing to appoint or appropriately utilize the “Engineer” under the contract. This failure undermines one of the key risk management and dispute resolution aspects of FIDIC forms and renders the choice of a FIDIC form much less useful in practice.
4. Appropriate balancing of performance specifications
EPC contracts usually contain performance specifications detailing the performance criteria that the contractor must meet. However, it will typically be left up to the contractor to determine how those specifications will be met. A balance must therefore be maintained in the specifications between providing enough detail to make sure that it is clear what the project company will receive, but avoiding being so prescriptive that if problems occur the contractor can argue that those problems are not its responsibility (because the problems were caused by the requirements of the specifications).
5. Risk allocation
EPC contracts usually place almost all construction risk on the contractor. However, the project company should always analyse the cost and benefits of allocation of each major risk, rather than automatically assuming that the contractor will bear each such risk. The project company should assess which key risks it is wishes to pay a contingency for to pass off to the contractor, and which risks it is willing to bear itself to lower the risk premium contingency built into the contract price.
6. Force Majeure
Force majeure is not an inherent legal principle, but rather only applies where a force majeure clause has been included in the relevant contract. Where applicable, the scope of what constitutes a force majeure event and the allowances granted in consequence of such an event will depend on the interpretation of the relevant clause. To make proper use of force majeure as a risk allocation and management tool, it is therefore essential to explicitly define in the EPC contract what events are allowable types of force majeure event and what will be the consequence of such events.
7. Construction management expectations
In order to provide a guaranteed price and completion date, the contractor will require independent control over most construction issues. The project company should therefore carefully consider and define its expectations regarding any issues in respect of which it wishes to retain any management rights during the construction process. In doing so, the project company should bear in mind that there is a risk that any direct involvement by it will make it easier for the contractor to claim additional time and costs and/or to argue that the contractor is not liable for delayed or defective performance.
8. Interfacing between project agreements
For more complex infrastructure projects, such as construction of a large electricity generation facility, the EPC contract will be only one of a suite of agreements for the development. It is therefore crucially important that where the activities under two agreements will or may affect each other – that is, where the two agreements ‘interface’ – the relevant provisions have been drafted to limit the risk of negative consequences. Some examples of issues in respect of which interfacing between agreements is usually particularly important are: commencement and completion dates; liquidated damages amounts and trigger points; caps on liability; entitlements to extensions of time; insurance; force majeure; and commissioning and testing regimes.
9. Liquidated damages
Liquidated damages must be a genuine pre-estimate of the affected party’s loss. Pre-determined damages that do not meet this criterion may be considered to be a ‘penalty’ and not enforceable. In Myanmar, the Contracts Act 1872 reflects this concept in providing that contracts may stipulate “penalties” for specified breaches, but that only reasonable compensation not exceeding the stipulated penalty may be recovered for a breach. Pre-estimating likely losses is a non-trivial exercise in the context of a complex infrastructure construction project. However, project companies should still be guided by considerations of reasonableness in negotiating levels of liquidated damages – and also seek to achieve as much clarity as possible in the structure of the liquidated damages under the EPC contract.
10. Government liaison
Major infrastructure construction projects are very often undertaken in relation to government concessions. Where this is the case, one or more government entities will usually be key stakeholders in relation to the operation of the finished project. For example, for electricity generation facility projects the offtaker and/or the transmission system operator may be government entities. In Myanmar, both roles are fulfilled by a single government enterprise, the Electric Power Generation Enterprise. As the future facility operator, the project company needs to develop and maintain an ongoing good relationship with the relevant government entities. However, the EPC contractor does not need a long-term relationship with government stakeholders and will be focused on completing the project on time or earlier and managing the costs to maximise its profit. It is therefore usually more appropriate that the project company is responsible for communication and other liaison with government stakeholders at all times, including during the construction phase. If so, this should be clearly stated in the EPC contract to limit any potential risk of the EPC contractor negatively impacting government relationships.