25 May 2011

Bankable EPC contracts in the power sector

There are a number of contractual approaches that can be taken to construct a power station or wind energy facility, one of which is the use of an engineering, procurement and construction (EPC) contract, being the most common form of contract used to undertake construction works by the private sector on large scale and complex infrastructure works using project finance.

In summary, an EPC contract sets out the design, technical specifications and performance criteria for a project. The major advantage of an EPC contract is that it provides for a single point of responsibility as the EPC contractor remains responsible for constructing a project that is capable of performing as designed notwithstanding any omission in the detailed design.

A bankable EPC contract is an EPC contract with a risk allocation between the EPC contractor and the project company that satisfies the lenders. The theoretical principle of risk allocation in project finance is that risks should be carried by those who are best able to control or manage them (for example, the risk of late completion should be borne by the EPC contractor, unless this late completion arises from events out of its control, such as force majeure).

When assessing the bankability of an EPC contract, lenders will examine a wide range of factors and assess the EPC contract in its entirety. Accordingly, given that the EPC contract should be assessed in its entirety, it is difficult to state in isolation whether one approach is or is not bankable. However, generally speaking, lenders will consider the following factors when assessing the bankability of an EPC contract:

  • 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 or its parent;
  • large caps on liability; and
  • restrictions on the ability of the contractor to claim extensions of time and additional costs.

An EPC contract addresses all of the above factors in one integrated package.

Ideally, lenders would like there to be no cap on liability of the EPC contractor. However, given the nature of the EPC contract and the inherent risks to the contractor involved, most EPC contractors will not enter into contracts with unlimited liability.

Lenders are also concerned with the ability (or rather the lack thereof) of the EPC contractor to claim additional costs and/or extensions of time as well as the security provided by the contract for its performance. The lenders will require a greater amount of equity support from the project sponsors if they are not satisfied that the risk has been adequately allocated.

In addition, lenders will look for security over the land and the equipment constructed on the land, such as mortgage bonds and special and general notarial bonds. It is also critical to select a contractor with sufficient knowledge and expertise to execute the works, taking cognisance of the monetary value of EPC contracts and the adverse consequences if problems arise during construction. The lowest price should not be the only determining factor when selecting an EPC contractor.

Despite the above, it is important to note that the EPC contract is one of a suite of inter-dependent project agreements necessary to develop a power project. Each project agreement is not self contained, but in fact affects the other project agreements and as such, the contracting structure of the project must be reviewed as a whole. Accordingly, it is vital that the EPC contract properly interfaces with the other project agreements required to ensure that the project as a whole is bankable

Kieran Whyte, Director, Finance, Projects and Banking
Emma Dempster, Associate, Finance, Projects and Banking

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