Main model contracts for project implementaion

Projects in the field of renewable (alternative) energy are often not entirely transparent and understandable for potential participants. One of the most frequently asked questions, which requires explanation and clarification, is the possibility of implementing the project, using the EPC contract model (as an option – EPCM-contract) in the construction of solar power plants. The purpose of this publication is to provide an accurate definition of what the EPC or EPCM contract model is, their varieties, advantages and disadvantages for the customer and contractor, and the specifics of using it in practice.

Realization of investment projects: main models of contracts, especially their application

Different forms of contracts are used in the international practice of the realisation of multiple projects in order to regulate the relations between the contracting parties in the field of the construction management and supervision. The same model contracts may be applied to the implementation of solar energy projects in Ukraine. Besides, one can define  main model contracts, which include and regulate  the relations between the contracting parties at all stages of the solar power plant installation process (project development, procurement, construction):

  • EPC (abbreviation of “engineering (here and hereafter used with the meaning of project development), procurement, construction”) contract.
  • EPCM (abbreviation of “engineering, procurement and construction management”) contract.
  • EPCS (abbreviation of “engineering, procurement and construction supervision”) contract.
  • PCM (abbreviation from “project construction management”) contract.

It is necessary to remember that there are not uniform or standard terms in the classification of the construction contracts, which would be enshrined in the legislation, neither on international level nor on national one. For example, in terms of the solar power plant construction. EPC contract is a unique model contract which determines a fixed price and deadlines enough precisely and exactly. It also stipulates clearly that just the contractor shall assume all risks and liabilities referring to the project construction process. At the same time, other types of model contracts can often intermix their terms with one another and with the terms of EPC contract.

In general, the analysis of the statistics shows that in the cases of the contract conclusion when the client needs to accomplish the full-scope cycle of construction works, EPC or EPCM contracts are used more frequently than other model contracts.

Модели договоров проектов ВДЕ

Main features of EPC contract:

  1. Fixed price, as the practice shows, is a lump sum in most of the cases. Besides, it is necessary to notice that in spite of the definition of a fixed price as a lump sum, the presence of the estimate in the project development process is not completely excluded. Furthermore, just the contractor is responsible for any excess of the stipulated expenses for materials, hardware and performing works. Force majeure, modifications of the work scope and the volume of works, which are initiated by the client, cases of the client’s failure to meet its commitments stipulated in the EPC contract terms shall be considered as the exceptions.
  2. The upper limit of the contractor liability is determined by the contract price in most of the cases. However, the cases, when the stipulated limit of the contractor liability comprises only the part of the EPC contract price, are possible.
  3. The contractor possesses by a considerable independence in the construction realisation. Besides, the influence of the client on the EPC contractor (subcontractor) is minimal.
  4. According to the EPC contract provisions, the EPC contractor assumes a major part of the risks (including disbursements and contingent expenses).

The EPC contract, in most of the cases, is concluded when the client does not have the personnel, which would be able to manage the project construction management, lack of construction and manufacturing capacities and does not want to interfere with performing work or have an influence on it, letting the contractor carry all risks. The EPC contract is, in addition, one of main model contract forms for the implementation of the projects, which are funded by banks or other financial establishments (especially when the case of project financing takes place). It is conditioned by the fact that the lending banks strive to minimise the number of risks assumed directly by the borrower. From the point of view of the owner of a future solar power plant, the EPC model contract is the most convenient also for the reduction of the implementation period for the projects bringing “green tariff” into practice.

There is the number of reasons, which prevent the contractor companies from concluding EPC contracts:

  1. There is a high degree of economic and political risks with underdeveloped labour market and a poor offer of the services necessary for performing work in the country, where the contractor abroad shall realise the project (the situation is very typical for developing countries).
  2. There are the complications and the unpredictability of the conditions in the process of a non-typical project implementation. Besides, it is impossible to determine the scope or the volume of work necessary to be performed.
  3. The underdevelopment of the supply of local building and assembly organisation can cause the necessity to involve a considerable number of subcontractors, in particular, local ones, in the construction process.

Because of the reasons listed above the EPC contractors do not want to assume the risks on the project implementation, especially the risks resulting from the failure of local subcontractors to meet their commitments, taking into consideration the high level of the EPC contractor liability (unlimited or restricted by the contract price) and the fact that the rate of the EPC contractor fee does not exceed 10-15% of the total price stipulated in the EPC contract.

The EPCM (engineering, procurement, construction management) model contract

The EPCM contract contains less strict requirements to the contractor compliance with the deadlines set for the accomplishment of construction works. Moreover, the client shall have a considerable power that allows participating in the project realisation management: the client company has the right to decline or to approve the choice of subcontractors, supervise over their activities, set requirements directly to them. As a rule, the subcontractors are selected through tender in this case. There are several forms of the EPCM model contract:

  1. According to this form of the EPCM contract, the EPCM contractor provides only the services on the construction project management. Besides, the client concludes most of the contractor agreements on its own behalf, assuming the risks resulting from a contractor’s failure to meet its commitments. This form of the EPCM contract transfers the majority of risks, including the estimated cost overruns and the project implementation delays, to the client.
  2. The EPCM model contract, as a variety of the EPC contract, is based on the principle “cost plus fee”. The main features of this form of the EPCM model contract are listed below:
    • The contractor is compensated for all expenses related to the construction of the project and, in addition, receives the fee, that is calculated on the basis of the agreed rate of return.
    • The fee paid to the contractor for the project realisation management may be determined as a fixed value stipulated in the contract.
    • Detailing the structure of the contract price, one defines the fee paid directly to the contractor as a fixed value, whereas the expenses related to the volume of project construction works accomplishment shall not be determined.
    • The EPCM contractor acts as the EPC contractor. The EPCM contractor company concludes the agreements with the subcontractors on its own behalf and shall be responsible to the client for the cases of the subcontractors’ failures to meet their commitments.
    • The total of the EPCM contractor liabilities is determined by the value of its fee (in some cases by the part of the fee if it is stipulated in the contract). The cases, when the breach of the EPCM contractor obligations stipulated in the contract takes place because of a gross negligence or intentionally, and it is established, are considered as exceptional ones.
  3. The EPCM model contract as a variety of the EPC contract with the fixed EPCM target price is also based on the principle “cost plus fee”, but besides, the target total value of the expenses related to the construction works performing is determined. The main features of this form of the EPCM model contract are listed below:
    • The contract price shall consist of two parts: namely, the fee, which shall be paid to the EPCM contractor and direct costs comprising the total of expenses related to the project construction (the purchase of the hardware, including solar batteries, inverters and metal structures for the installation of solar modules; materials and performing works).
    • Only the fee, which shall be paid to the EPCM contractor, is the fixed value within the contract price structure.
    • The total of expenses related to the project construction is not limited strictly. It is a variable cost and may be higher or lower than the value stipulated in the contract. If the total of direct expense overruns the value stipulated by the contract, the difference shall be subtracted from the contractor fee. Nevertheless, the contractor shall not reimburse the total of the cost overruns. The risks resulting from the total of the contract direct cost overrun are shared between the contractor and the client in this way.
    • If the EPCM contractor is able to ensure cost saving without decreasing the quality of performing works, the contractor company shall receive the benefit calculated as a percentage of the cost savings.
    • The contract can stipulate the total value of maximum overspending limit, namely the diapason, within which actual expenditure overrun is acceptable. If the total of the expenditure overrun does not exceed the limits of this diapason, the forfeits shall not be deducted from the contractor fee.
    • The application of the stipulation on maximum overspending limit to the EPCM contract has also another aspect. The total of cost saving for which the EPCM contractor shall not receive the benefit is also determined in the contract.
    • If one considers the client’s discretion in the project realisation management, it is almost the same as in the case of the EPCM contract basing on the principle “cost plus fee”.
    • The total of the EPCM contractor liabilities is determined by the value of its fee. The cases, when the breach of the EPCM contractor obligations stipulated by the contract takes place because of a gross negligence or intentionally and it is established, are considered as exceptional ones.

In most of the cases, one does not assign a full scope of work (or its significant part) for one subcontractor to get the maximum cost saving. This model contract is the compromise between the EPC contract and the EPCM contract basing on the principle “cost plus fee” (the upper limit of the target value, in addition, is not determined). Some sources define this form as the EPC contract with target price.

Other varieties of the EPC contract

EPC and EPCM model contracts condition the conduct of the full-scope cycle of works (including engineering, provision of necessary equipment and materials and the full cycle of construction works) by the contractor in order to realize the project of a solar power plant. However, the cases when the client ensures on its own the execution of a certain part of work related to the project implementation: e.g., the project development or the supply of the hardware (solar panels, inverters, other items). It is proper, in particular, to the contractors abroad, who are ready to perform the design work and the provision of the hardware, but do not want to bring the responsibility for performing the cycle of the construction works. Therefore, it is recommended to use so-called “abridged” model contracts:

  • The EP (abbreviation of “engineering, procurement”) contract.
  • The EC (abbreviation of “engineering & construction”) contract.
  • The EPCS (abbreviation of “engineering, procurement & construction supervision”) contract.

Sometimes the client conducts a certain part of work related to the solar energy project implementation on its own or divide this volume of work between several contractors. For example, the client shall realise the construction site preparation on its own, one contractor shall conduct the development of the photo power station project and the provision of hardware, other contractor shall ensure performing the construction work volume. In general, If all volumes of work are divided between the contractors in this way, the total cost of the project realisation can be lower than in the case when the EPC contractor conducts all process of the realisation of an analogous project because each of several contractors assumes much less risk than the EPC contractor. This approach has also another aspect. This way of the project construction (the conclusion of agreements with several independent contractors) conditions the increase of the risks related to the cost of the project, which are assumed by the client. When the first contractor performs the assigned works with a poor quality or with the delay, it is possible that the second contractor will come to a halt in performing the works (if the works are performed in succession) and the prolongation of the project implementation period or the increase in the cost of work (if it is necessary to correct the mistakes of the prior contractor). Besides, the situation, when it is difficult enough to establish the failure of a certain contractor, especially in the case when the defect occurs within the interface between the work scopes, which are performed by different contractors, is also possible.

What makes EPC Contracts special?

There are various types of FIDIC contracts that are divided into books: Red Book, Yellow Book, Silver Book etc. based on different functions, needs of the project and contracting parties’ cooperation models.

FIDIC pro forma contracts are based on balance of interests of the parties. They regulate vast majority of issues that may arise during engineering, procurement and construction in sufficient detail. These documents are simple, well structured and do not require drafting of separate contract, however they may be amended by the parties if necessary.

Contractor’s turnkey responsibility principle makes EPC contracts convenient and attractive for employers. EPC contract is based on concentration of three elements of the project implementation in hands of one person (contractor): Engineering, Procurement (of equipment and materials), and Construction. Thus, the contractor under the EPC contract undertakes to deliver an operational facility to the employer on a turnkey basis. At the same time, the EPC contract is beneficial for the contractor too as a higher price may be set for the integrated chain of services and profit optimisation.

EPC contracts vs Ukrainian law

In practice, the parties usually define that the EPC contract is governed by the English law or other foreign jurisdictions. The Ukrainian law does not contain a comparable to the EPC contract. Within the meaning of the Ukrainian law, the EPC contract is a mixed contract, which contains terms and conditions of several types of contracts: on engineering services, construction, design work, and supply. Therefore, if parties determine that the EPC contract is governed by the Ukrainian law, all the law-established essential conditions of the abovementioned contracts shall be included into the text thereof. Furthermore, standard terms and conditions of the international EPC contract shall be reviewed as they contain the concepts and provisions that fail to comply with Ukrainian law.

For instance, let’s consider the concept of “liquidated damages” used in EPC contracting to set the amount of the parties’ financial liability. Liquidated damages are a fixed amount that the party undertakes to pay for delayed performance of works or other obligations per each day of delay.

As there is no definition of term “liquidated damages” in Ukrainian law, there is a risk that collection of such liquidated damages will be impossible or very difficult in case of litigation.

Such mismatches shall be taken into consideration if the contract is governed by the Ukrainian law.

Things to consider when entering into an EPC contract

Despite the fact that the Ukrainian construction market players are already familiar with EPC contracts, employers do not always know what to expect from such contracts. There are several key provisions shall be taken into consideration when entering into the EPC contract and for improving bankability of the project.

Fixed price of the project implementation and limitations on increasing the price.

EPC contract price is usually fixed and set as a lump sum, which imposes more risks on the contractor and gives certain assurance of the final cost of the project. However, the fixed price may change under certain circumstances.

In particular, standard FIDIC contractual terms and conditions entitle the contractor to demand from the employer to pay additional costs in case of variations (changes in the nature of works, change of the project, scope and quality of the works etc.), changes in the legislation, contractor’s costs incurred by the contractor resulting from the employer’s delay or non-fulfilment of obligations, etc.

In this case, the contract often provides for the possibility of additional collection of “reasonable profit” (which is usually 5 to 15 % of the amount of costs) from the employer alongside with such costs. Such clauses may cause an uncontrolled and unpredictable contract price growth.

Therefore, it shall be ensured that vast majority of risks of unexpected costs are assigned to the contractor. At the same time, the circumstances under which the contractor may increase the contractual price shall be exhaustive and clear. Moreover, a cap for maximum increase in the contractual price should be set.

Fixed time for completion and limitation of its extension

EPC contracts usually set the fixed time frames for the works, however, they provide for possible extension of time for completion in certain cases such as variations, exceptionally adverse weather conditions, unexpected lack of staff and materials caused by epidemics or acts of the government, or any delay caused by the employer’s fault.

As above, the common recommendation will be the following: employers shall limit and expressly define in a contract the exhaustive list of events entitling the contractor to an extension of time for completion. Additionally, the contract shall not contain wordings with varying interpretations. For instance, the standard text of the EPC Yellow Book does not define the meaning of “exceptionally adverse weather conditions”, which may be a basis for extension of time for completion. This often leads to misunderstanding and litigations between the contracting parties as to the existence of such event.

Moreover, the contract should include a clause on the “concurrent delay”, which prevents unjustified extension of time when there are two or more causes of delay and at least one of those causes would not entitle the contractor to an extension of time under the general extension of time clause. For instance, if there is a delay which occurred due to the contractor’s fault, and there is also a delay caused by the employer’s actions during the period of the initial delay, the contractor shall not be entitled to an extension of time to the extent of concurrency as the employer’s actions in this case do not actually affect the time for completion. Lack of this clause in the contracts may result in unreasonable extension of time.

Security

Adequate security for fulfilment of the contractor’s obligations is a prerequisite for mitigating the employer’s and prospective investor’s risks. The exact nature of security may vary.

In order to secure the contractor’s obligations, the contract may contain a “retention clause”, which entitles the employer to retain a certain percentage (5 to 15 %) from each payment. Such funds are accumulated and payable to the contractor at later stages of the project, upon expiration of the warranty period, or subject to fulfilment of the other contractual terms and conditions.

Security can also be in a form of a bank guarantee obtained by the contractor for the employer’s benefit, the amount of which is generally 5 to 15 % of the contractual price. The exact amount of the guarantee shall be determined individually in each particular case upon consideration of number of different factors including: existence of any other security, payment schedule, contractor’s reputation, solvency, risk of the contractor’s default etc.

Furthermore, the balance of the parties’ rights is often ensured by using several separate security types at different project stages with different grounds for collection or release. For instance, the contract may provide:

  • an advance payment guarantee, which is given prior to commencement of the works in the amount of the advance payment (if it is provided for by the contract) and remains effective until a specific stage of the works;
  • a performance guarantee in the amount of 5 to 15 %, which is issued prior to commencement of the works and remains effective until the facility is constructed and taken over by the employer;
  • a warranty bond, which remains in force during the warranty or defects notification period and secures the contractor’s obligations to remedy the defects after acceptance of the works.

An option to receive a Parent Company Guarantee shall be considered as well. It is a guarantee of the affiliated entity of the contractor which provides that it will perform the contractor’s obligations if, for whatever reason, the contractor does not perform.

Regardless of the selected method for securing the obligations, the contract shall set clear and enforceable terms and conditions for foreclosure on the security.

Contractor’s liability

Another important issue is the contractor’s liability for delay and failing to achieve the estimated design capacity parameters or other performance indicators of the project. No limits of the contractor’s liability or setting them at a maximum level (preferably as close to the total price of the contract as possible) will increase the project’s bankability.

If the contractor also acts as an operator under the O&M contract, the contract shall ensure that potential manipulation and shifting off liability or risks under the EPC or O&M contracts are avoided. For instance, penalties under the O&M contract may be much lower than the ones provided for by the EPC contract. This way, the contractor will try to evade liability under the EPC contract and be imposed lower penalties under the O&M contract. In order to avoid this, the EPC contract should forbid release of the contractor and the operator from the liability resulting out of or in connection with breach of any of the contracts.

It should be noted that EPC contracts usually contain some of the abovementioned requirements, however standard clauses must be carefully reviewed in line with law, modified, supplemented and specified on a case-by-case basis with consideration of projects’ peculiarities.

Scope of works

Contractors seek to submit the most attractive and competitive bid to win over the contract. However, following the detailed analysis it often turns out that the specified price includes the limited scope of works. Consequently, the price of the contract may further increase due to the “additional” works necessary to commission the facility. It is recommended to specify the contractor’s obligation to perform all the works provided for by the project documentation in the EPC contract in order to avoid such situations.

Project design documentation

One of the hidden pitfalls of the EPC contract with a foreign contractor is standard engineering clauses of the EPC contract. The difference in approaches to construction engineering (design works) in Ukraine and other countries and its regulation shall be taken into consideration.

A foreign contractor may underestimate the scope of the engineering works or fail to take into account the requirements of the Ukrainian law to the scope and content of the design documentation or the need to adapt the project design, as it often treated as internal document. Such circumstances greatly affect the project implementation time frames. Given the above, the EPC contract shall contain the full scope of the necessary project documentation and the requirements according to which the contractor shall perform the work.

Things to consider when selecting the contractor

Selecting a contractor is one of the most crucial points of the project implementation. Many employers make common mistakes at this stage. In order to avoid failure of the project because of the selected contractor the following basic rules shall be adhered:

First of all, the contractor must be experienced in implementation of similar projects considering scope and technologies used. Secondly, the contractor must have a pool of local subcontracts, experience and history of cooperation with them. Thirdly, the contractor must be familiar the local engineering and construction rules.

As the contractor’s financial liability almost never exceeds its remuneration and does not cover all the employer’s expenses, engagement of the inexperienced contractor may hinder implementation of the project and cause damages for the employer equal to the project’s price.

Lack of experience of cooperation with local subcontractors and lack of understanding of local construction and engineering rules and regulations always causes delays, which might result in no pay-back within the project in some cases (for instance, when renewable energy facilities are constructed).

Therefore, proper contractual strategy combined with the balanced approach to selection of the contractor is a prerequisite for successful project implementation.