Australia: EPC Contracts In The Australian Renewable Energy Sector – Wind Farms, part 2

BANKABILITY

A bankable contract is a contract with a risk allocation between the contractor and the project company that satisfies the lenders. Lenders focus on the ability (or more particularly the lack thereof) of the contractor to claim additional costs and/or extensions of time as well as the security provided by the contractor for its performance. The less comfortable the lenders are with these provisions, the greater amount of equity support the sponsors will have to provide. In addition, lenders will have to be satisfied as to the technical risk. Obviously price is also a consideration, but that is usually considered separately to the bankability of the contract because the contract price (or more accurately the capital cost of the wind farm) goes more directly to the bankability of the project as a whole.

Before examining the requirements for bankability, it is worth briefly considering the appropriate financing structures and lending institutions. The most common form of financing for infrastructure projects is project financing. Project financing is a generic term that refers to financing secured only by the assets of the project itself. Therefore, the revenue generated by the project must be sufficient to support the financing. Project financing is also often referred to as either "non-recourse" financing or "limited recourse" financing.

The terms "non-recourse" and "limited recourse" are often used interchangeably, however they mean different things. "Non-recourse" means there is no recourse to the project sponsors at all and "limited recourse" means, as the name suggests, there is limited recourse to the sponsors. The recourse is limited both in terms of when it can occur and how much the sponsors are forced to contribute. In practice, true non-recourse financing is rare. In most projects the sponsors will be obliged to contribute additional equity in certain defined situations.

Traditionally project financing was provided by commercial lenders. However, as projects became more complex and financial markets more sophisticated, project finance also developed. Whilst commercial lenders still provide finance, governments now also provide financing either through export credit agencies ²² or trans or multinational organisations like the World Bank, the Asian Development Bank and European Bank for Reconstruction and Development. In addition, as well as bank borrowings sponsors are also using more sophisticated products like credit wrapped bonds, securitisation of future cash flows and political risk insurance to provide a portion of the necessary finance.

In assessing bankability, lenders will look at a range of factors and assess a contract as a whole. Therefore, in isolation it is difficult to state whether one approach is or is not bankable. However, generally speaking the lenders will require the following:

• 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 and/or its parent
• Large caps on liability (ideally, there would be no caps on liability, however, given the nature of EPC contracting and the risks to the contractors involved there are almost always caps on liability)
• Restrictions on the ability of the contractor to claim extensions of time and additional costs.

An EPC contract delivers all of the requirements listed above in one integrated package. This is one of the major reasons why they are the predominant form of construction contract used on large-scale project financed infrastructure projects. Again, lenders have become comfortable with the interface risk in a split EPC structure and will focus on the remedies for underperformance in the WOM.

Sponsor support

In certain cases, it may be necessary to provide sponsor support to strengthen the capacity of the project company to satisfy its obligations to the banks and to have a "bankable" project. Forms of sponsor support may include equity subscription agreements (base and standby equity), completion guarantees of whole or part of the debt until the project commences commercial operation, bank guarantees to support completion guarantee and cost overrun guarantees/facility. Completion guarantees, for example, ensure that the lenders will be paid back a set amount if the facility does not reach completion or the repayment of scheduled debt service, of principal plus interest, if completion is delayed. Other forms of support may be incorporated where the sponsor is a party to a key project contract (such as a construction contract, O&M agreement or offtake agreement) by requiring the sponsor to provide additional guarantee letters of credit or corporate support to underpin the project.

BASIC FEATURES OF AN EPC CONTRACT

The key clauses in any construction contract are those that impact on time, cost and quality.

The same is true of EPC contracts. However, EPC contracts tend to deal with issues with greater sophistication than other types of construction contracts. This is because, as mentioned above, an EPC contract is designed to satisfy the lenders? requirements for bankability.

EPC contracts provide for:

A single point of responsibility. The contractor is responsible for all design, engineering, procurement, construction, commissioning and testing activities. Therefore, if any problems occur the project company need only look to one party – the contractor – to both fix the problem and provide compensation. As a result, if the contractor is a consortium comprising several entities, the EPC contract must state that those entities are jointly and severally liable to the project company.

A fixed contract price. Risk of cost overruns and the benefit of any cost savings are to the contractor?s account. The contractor usually has a limited ability to claim additional money, which is limited to circumstances where the project company has delayed the contractor or has ordered variations to the works.

A fixed completion date. EPC contracts include a guaranteed completion date that is either a fixed date or a fixed period after the commencement of the EPC contract. If this date is not met the contractor is liable for Delay Liquidated Damages (DLDs). DLDs are designed to compensate the project company for loss and damage suffered as a result of late completion of the wind farm. To be enforceable in common law jurisdictions ²³ , DLDs must be a genuine pre-estimate of the loss or damage that the project company will suffer if the wind farm is not completed by the target completion date. The genuine preestimate is determined by reference to the time the contract was entered into.

DLDs are usually expressed as a rate per day, which represents the estimated extra costs incurred (such as extra insurance, supervision fees and financing charges) and losses suffered (revenue forgone) for each day of delay.

In addition, the EPC contract must provide for the contractor to be granted an extension of time when it is delayed by the acts or omissions of the project company. The extension of time mechanism and reasons why it must be included are discussed later.

Performance guarantees. The project company?s revenue will be earned by operating the wind farm. Therefore, it is vital that the wind farm performs as required in terms of output and reliability. Therefore, EPC contracts contain performance guarantees backed by Performance Liquidated Damages (PLDs), payable by the contractor if it fails to meet the performance guarantees. These performance guarantees usually comprise a guaranteed power curve and an availability guarantee guaranteeing the level of generation of electricity ²⁴ .

PLDs must also be a genuine pre-estimate of the loss and damage that the project company will suffer over the life of the project if the wind farm does not achieve the specified performance guarantees. As with DLDs, the genuine pre-estimate is determined by reference to the time the contract was signed.

PLDs are usually a Net Present Value (NPV) (less expenses) calculation of the revenue forgone over the life of the project.

For example, if the output of the plant is 5 MW less than the specification, the PLDs are designed to compensate the project company for the revenue forgone over the life of the project by being unable to sell that 5 MW.

PLDs and the performance guarantee regime and its interface with the DLDs and the delay regime is discussed in more detail below.

Caps on liability. As mentioned above, most EPC contractors will not, as a matter of company policy, enter into contracts with unlimited liability. Therefore, EPC contracts for power projects cap the contractor?s liability at a percentage of the contract price. This varies from project to project, however, an overall liability cap of 100% of the contract price is common. In addition, there are normally sub-caps on the contractor?s liquidated damages liability. For example, DLDs and PLDs might each be capped at 20% of the contract price, with an overall cap on both types of liquidated damages of 30% of the contract price.

There will also likely be a prohibition on the claiming of consequential damages. Put simply, consequential damages are those damages that do not flow directly from a breach of contract, but which were in the reasonable contemplation of the parties at the time the contract was entered into. This used to mean heads of damage like loss of profit. However, loss of profit is now usually recognised as a direct loss on project financed projects and, therefore, would be recoverable under a contract containing a standard exclusion of consequential loss clause. Nonetheless, care should be taken to state explicitly that liquidated damages can include elements of consequential damages. Given the rate of liquidated damages is pre-agreed, most contractors will not object to this exception.

In relation to both caps on liability and exclusion of liability, it is common for there to be some exceptions. The exceptions may apply to either or both the cap on liability and the prohibition on claiming consequential losses. The exceptions themselves are often project specific, however, some common examples include in cases of fraud or wilful misconduct, in situations where the minimum performance guarantees have not been met and the cap on delay liquidated damages has been reached and breaches of the intellectual property warranties.

Security. It is standard for the contractor to provide performance security to protect the project company if the contractor does not comply with its obligations under the EPC contract. The security takes a number of forms including:

• A bank guarantee for a percentage, normally in the range of 5–15%, of the contract price. The actual percentage will depend on a number of factors including the other security available to the project company, the payment schedule (because the greater the percentage of the contract price unpaid by the project company at the time it is most likely to draw on security, ie to satisfy DLD and PLD obligations the smaller the bank guarantee can be), the identity of the contractor and the risk of it not properly performing its obligations, the price of the bank guarantee and the extent of the technology risk
• Retention, ie withholding a percentage (usually 5%–10%) of each payment. Provision is often made to replace retention monies with a bank guarantee (sometimes referred to as a retention guarantee (bond))
• Advance payment guarantee, if an advance payment is made
• A parent company guarantee - this is a guarantee from the ultimate parent (or other suitable related entity) of the contractor, which provides that it will perform the contractor?s obligations if, for whatever reason, the contractor does not perform.

Variations. The project company has the right to order variations and agree to variations suggested by the contractor. If the project company wants the right to omit works either in their entirety or to be able to engage a different contractor, this must be stated specifically. In addition, a properly drafted variations clause should make provision for how the price of a variation is to be determined. In the event the parties do not reach agreement on the price of a variation, the project company or its representative should be able to determine the price. This determination is subject to the dispute resolution provisions. In addition, the variations clause should detail how the impact, if any, on the performance guarantees is to be treated. For some larger variations the project company may also wish to receive additional security. If so, this must also be dealt within the variations clause.

Defects liability. The contractor is usually obliged to repair defects that occur in the 12 to 24 months following completion of the performance testing. Defects liability clauses can be tiered, ie the clause can provide for one period for the entire wind farm and a second, extended period for more critical items.

Intellectual property. The contractor warrants that it has rights to all the intellectual property used in the execution of the works and indemnifies the project company if any third parties? intellectual property rights are infringed.

Force majeure. The parties are excused from performing their obligations if a force majeure event occurs. This is discussed in more detail below

Suspension. The project company usually has the right to suspend the works.

Termination. This sets out the contractual termination rights of both parties. The contractor usually has very limited contractual termination rights. These rights are limited to the right to terminate for non-payment or for prolonged suspension or prolonged force majeure and will be further limited by the tripartite or direct agreement between the project company, the lenders and the contractor. The project company will have more extensive contractual termination rights. They will usually include the ability to terminate immediately for certain major breaches or if the contractor becomes insolvent and the right to terminate after a cure period for other breaches. In addition, the project company may have a right to terminate for convenience. It is likely the project company?s ability to exercise its termination rights will also be limited by the terms of the financing agreements.

Performance specification. Unlike a traditional construction contract, an EPC contract usually contains a performance specification. The performance specification details the performance criteria that the contractor must meet. However, it does not dictate how they must be met. This is left to the contractor to determine. A delicate balance must be maintained. The specification must be detailed enough to ensure the project company knows what it is contracting to receive but not so detailed that if problems arise the contractor can argue they are not its responsibility.

Whilst there are, as described above, numerous advantages to using an EPC contract, there are some disadvantages. These include the fact that it can result in a higher contract price than alternative contractual structures. This higher price is a result of a number of factors not least of which is the allocation of almost all the construction risk to the contractor. This has a number of consequences, one of which is that the contractor will have to factor into its price the cost of absorbing those risks. This will result in the contractor building contingencies into the contract price for events that are unforeseeable and/or unlikely to occur. If those contingencies were not included, the contract price would be lower. However, the project company would bear more of the risk of those unlikely or unforeseeable events. Sponsors have to determine, in the context of their particular project, whether the increased price is worth paying.

As a result, sponsors and their advisors must critically examine the risk allocation on every project. Risk allocation should not be an automatic process. Instead, the project company should allocate risk in a sophisticated way that delivers the most efficient result. For example, if a project is being undertaken in an area with unknown geology and without the time to undertake a proper geotechnical survey, the project company may be best served by bearing the site condition risk itself as it will mean the contractor does not have to price a contingency it has no way of quantifying. This approach can lower the risk premium paid by the project company. Alternatively, the opposite may be true. The project company may wish to pay for the contingency in return for passing off the risk which quantifies and caps its exposure. This type of analysis must be undertaken on all major risks prior to going out to tender.

Another consequence of the risk allocation is the fact that there are relatively few construction companies that can and are willing to enter into EPC contracts. As mentioned in the introduction, some bad publicity and a tightening insurance market have further reduced the pool of potential EPC contractors. The scarcity of EPC contractors can also result in relatively high contract prices.

Another major disadvantage of an EPC contract becomes evident when problems occur during construction. In return for receiving a guaranteed price and a guaranteed completion date, the project company cedes most of the day-to-day control over the construction. Therefore, project companies have limited ability to intervene when problems occur during construction. The more a project company interferes, the greater the likelihood of the contractor claiming additional time and costs. In addition, interference by the project company will make it substantially easier for contractors to defeat claims for liquidated damages and defective works.

Obviously, ensuring the project is completed satisfactorily is usually more important than protecting the integrity of the contractual structure. However, if a project company interferes with the execution of the works, in most circumstances it will have the worst of both worlds. It will have a contract that exposesit to liability for time and costs incurred as a result of its interference without any corresponding ability to hold the contractor liable for delays in completion or defective performance. The same problems occur even where the EPC contract is drafted to give the project company the ability to intervene. In many circumstances, regardless of the actual drafting, if the project company becomes involved in determining how the contractor executes the works, then the contractor executes the works then the contractor will be able to argue that it is not liable for either delayed or defective performance.

As a result, it is vitally important that great care is taken in selecting the contractor and in ensuring the contractor has sufficient knowledge and expertise to execute the works. Given 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.

SPLIT EPC CONTRACTS

The basic split structure involves splitting the EPC contract into an onshore construction contract and an offshore supply contract ²⁵ .

There are two main reasons for using a split contract. The first is because it can result in a lower contract price as it allows the contractor to make savings in relation to onshore taxes; in particular on indirect and corporate taxes in the onshore jurisdiction. The second is because it may reduce the cost of complying with local licensing regulations by having more of the works, particularly the design works, undertaken offshore. In addition, in some countries which impose restrictions on who can carry out certain activities like engineering and design services, splitting the EPC contract can also be advantageous because it can make it easier to repatriate profits.

As mentioned above, the benefits in splitting an EPC contract for tax and licensing reasons primarily arise in certain countries in Asia; there has not, nor is there likely to be given the climatic and geographical conditions, been a project financed wind farm project in Asia. However, a split EPC contractual structure arises in another context in wind farm projects. The manufacturers of the turbines have successfully avoided taking the turnkey responsibility by entering into a supply contract and a balance of plant contract (ie the foundation works, civils and erection etc.) instead of an EPC contract.

There are risks to the project company in this structure. This mainly arises because of the derogation from the principle of single point of responsibility.

Unlike a standard EPC contract, the project company cannot look only to a single contractor to satisfy all the contractual obligations (in particular, design, construction and performance). Under a split structure, there are at least two entities with those obligations. Therefore, a third agreement, a wrap-around guarantee ²⁶ , is often used to deliver a single point of responsibility despite the split.

Under a wrap-around guarantee, an entity, usually either the offshore supplier or the parent company of the contracting entities, guarantees the obligations of both contractors. This delivers a single point of responsibility to the project company and the lenders. However, that agreement is not relevant where the manufacturer of the turbines and the balance of plant contractor are separate entities and neither company will take the single point of responsibility under the wrap-around guarantee. Accordingly, the lenders will want to be satisfied that the interface issues are dealt with in the absence of a single point of responsibility.

KEY RENEWABLE ENERGY SPECIFIC CLAUSES IN WIND FARM EPC CONTRACTS

General interface issues

As noted in the earlier section above, an EPC contract is one of a suite of agreements necessary to develop a wind farm project. Therefore, it is vital that the EPC contract properly interfaces with those other agreements. In particular, care should be taken to ensure the following issues interface properly:

• Commencement and completion dates
• Liquidated damages amounts and trigger points
• Caps on liability
• Indemnities
• Entitlements to extensions of time
• Insurance
• Force majeure
• Intellectual property.

Obviously, not all these issues will be relevant for all agreements. In addition to these general interface issues that apply to most types of projects, there are also power project issues that must be considered. These issues are mainly concerned with the need to burn fuel and export power. They are discussed in more detail below ²⁷ .

Those major renewable energy specific interface issues are:

• Access for the contractor to the transmission grid to allow timely completion of construction, commissioning and testing (grid access)
• Consistency of commissioning and testing regimes
• Interface issues between the relevant government agencies and system operator and the contractor. In particular, whilst the project company must maintain a long term/comfortable relationship with either the government or the system operator, the contractor does not.

Footnotes

²² Export credit agencies are bodies that provide finance on the condition that the funds are used to purchase equipment manufactured in the country of the export credit agency.
²³ For the purposes of this paper, we have assumed the EPC contract will be governed by the law of a common law jurisdiction. Where there are differences between jurisdictions we have adopted the English law approach. Therefore, if an EPC contract is governed by a law other than English law you will need to seek advice from local counsel to ensure the contract is enforceable in the relevant jurisdiction. For example, in both the PRC and Malaysia liquidated damages amounts specified in a contract may be subsequently altered by a court. If a party can show that the liquidated damages amounts will either under or in some cases over compensate a party the court can adjust the damages payable so they more accurately reflect the actual damage suffered by a party.
²⁴ On projects where the supplier or manufacturer of the wind turbine generator is appointed as an operator of the wind farm for a fixed duration, it is not unusual for the availability guarantees to be provided by the operator under the O&M Agreement. This is sometimes referred to as a warranty, operations and maintenance agreement ("WOM"). Refer to the following section for a discussion on Split EPC contracts.
²⁵ For a more detailed discussion on split EPC contracts refer to the DLA Piper International Best Practice in Project and Construction Agreements paper entitled "EPC contracts in the Power Sector" dated April 2004. We have also prepared a paper that deals with the variations and complications in split EPC contracts. You should consult that paper, or ask us for a copy, if you want more information on this topic.
²⁶ This is also called a Co-ordination Agreement, an Administration Agreement or an Umbrella Deed.
²⁷ This discussion assumes the project company will be entering into either a PPA or a Tolling Agreement. However, some of these issues will also be relevant if the project company is entering into hedging agreements for a merchant project. For example, those hedge agreements will likely mandate a date by which the power station must be capable of commercial operation. Failure to comply with this requirement will incur monetary liability. Similarly there may be availability requirements and certain performance guarantees imposed by the hedge. These requirements must be flowed through to the EPC contract.

© DLA Piper

This publication is intended as a general overview and discussion of the subjects dealt with. It is not intended to be, and should not used as, a substitute for taking legal advice in any specific situation. DLA Piper Australia will accept no responsibility for any actions taken or not taken on the basis of this publication.

DLA Piper Australia is part of DLA Piper, a global law firm, operating through various separate and distinct legal entities. For further information, please refer to www.dlapiper.com