Power project developers often negotiate the engineering, procurement, and construction agreement (EPC) at the same time as other project contracts. Depending on the project type and contracting paradigm, a developer (owner) must align key EPC terms with some or all of the following: (1) power purchase agreement (PPA), (2) interconnection agreement, (3) major supply agreements, and (4) operations and maintenance (O&M) agreement.
This article will evaluate the EPC as an exercise in risk allocation, and then highlight issues for alignment with the PPA. In future articles, we will identify areas that overlap between the EPC and other project contracts.
I. EPC Agreement and Risk Allocation
Owners must approach major project contracts holistically and allocate risks to the party who can mitigate that risk. A party that accepts a risk must, in turn, protect against it wherever possible. For example, a party might mitigate risk through price adjustments, more insurance, or further risk allocation to third parties. Any gaps in risk allocation between project contracts may create financing challenges. They may also cause schedule delays, additional costs, revenue losses, contractor disputes, or off-taker liabilities.
The owner looks to the EPC contractor to deliver a timely completed, fully operational, legally compliant, on-budget, revenue-generating power project. Invariably, the engineering and construction phase is fraught with risks concerning schedule, cost, and implementation. Among other things, an owner must anticipate incurring significant capital expenses while laboring under tight timing and financing constraints. Early missteps can undermine viability or erode profitability, long before the project begins to generate revenue.
Thus, an owner may look to the contractor to accept such risks by requiring a fixed contract price, guaranteed completion dates, and performance guarantees. At the same time, the owner will impose liquidated damages and other damages for delays and technical shortfalls. Of course, as the owner pushes risk onto the contractor, the contractor may act defensively through price increases, schedule float, and aggressive change order use.
The owner must weigh whether to accept the pricing premium and longer delivery times in exchange for some price and schedule certainty. The owner must also collaborate with its engineering consultant and the contractor to develop a technical specification that provides clear, achievable project outcomes. And if the owner needs project financing, then the owner will work with lenders and equity investors to ensure the risk allocation leads to a bankable project and project contracts that will work as intended.
II. EPC Agreement and Power Purchase Agreement (PPA)
A PPA is a long-term electricity supply agreement between a power producer and a buyer, or “off-taker.” Ordinarily, this contractual mechanism provides a project with stable cash flows following the commencement of commercial operation.
The off-taker is typically either a load-serving utility, a large commercial or industrial end user, or a power marketer. The off-taker signs up to buy all or a portion of a project's output for an extended term. To ensure the project will meet the buyer's power and pricing requirements, the project developer may commit to provide the off-taker with schedule guarantees, expected energy guarantees, and capacity guarantees.
For projects that anticipate construction activities, the PPA addresses two distinct phases: the pre-Commercial Operation Date (COD) construction phase and the post-COD operation phase. The interface between the EPC and the PPA is keenly experienced during the pre-COD period when the schedule is at risk and project performance must be assured.
a. Schedule Milestones – EPC's Substantial Completion Date and PPA's Commercial Operation Date
The EPC guaranteed substantial completion date often aligns with the PPA guaranteed commercial operation date. EPC substantial completion usually means that a project is available to begin operation and has met a suite of conditions. Ordinarily, all that remains are “punch list” items, final testing, and other project close-out activities.
PPA commercial operation usually means that the owner has completed all commissioning activities and that the facility is operating at or near its nameplate capacity and expected facility output.
If the owner misses a guaranteed milestone under the PPA or the EPC, each project contract may impose schedule liquidated damages until the milestone is satisfied. A delay that continues for too long may mature into a default, leading to termination rights and other remedies.
To ensure that guaranteed milestones in both agreements reinforce each other and do not create any gaps, an owner should consider the following:
- The EPC guaranteed substantial completion date and PPA guaranteed COD should either match or require delivery prior to the guaranteed COD. For example, if the PPA has a June 1st guaranteed COD, then the EPC guaranteed substantial completion date must occur either on June 1st, or some earlier date. An EPC milestone that occurs later than the guaranteed COD may lead to lost revenue and schedule liquidated damages.
- The EPC should narrowly define change order conditions. Change orders may allow a contractor to extend delivery beyond the guaranteed COD. Since an owner must typically grant change orders for owner-caused delays, the owner should ensure its own prompt performance and that of its other contractors, major suppliers, agents, and personnel.
- The EPC should include a clearly drafted and internally consistent technical specification, scope of work document, and project schedule. These documents are crucial for minimizing contractor confusion and disputes as well as lessening change order risk and delays.
b. Schedule Liquidated Damages
If the contractor misses the EPC guaranteed substantial completion milestone, then schedule liquidated damages will likely accrue under both contracts. The owner should align the liquidated damages amounts under both agreements so that PPA damages will flow through to the contractor.
Otherwise, the owner must absorb liquidated damage payments payable to the off-taker, while not recovering the amount from the contractor who accepted the schedule risk. And since the contractor likely priced in contingency to account for schedule liquidated damages, without a flow through provision, the owner risks double payment.
c. Project Performance – Substantial Completion Conditions, Capacity Testing, and Performance Guarantee
Under both agreements, the performing party must satisfy conditions before the other party will certify the milestone. Thus, performance criteria comprising EPC substantial completion should align with the relevant COD conditions under the PPA. Chief among these EPC conditions is the satisfaction of commissioning, testing, and turnover obligations.
The owner relies on the contractor's capacity and energy output tests to certify PPA compliance. Thus, technical personnel for both the contractor and the owner should scrutinize procedures and results to ensure accuracy, consistency, and transparency. And if the PPA requires it, a third party should provide an independent assessment to confirm the project is operational.
For PPAs that authorize commercial operation at some capacity threshold less than 100 percent, the parties may negotiate a post-COD cure period. During this time, an owner may keep working to achieve up to 100 percent contracted capacity.
If the owner – through its contractor – fails to achieve 100 percent contracted capacity, then the PPA may impose a capacity shortfall payment for each megawatt below a specified threshold. This one-time payment represents an owner buy-down for lost production capacity over the PPA term. The PPA should also set a lower boundary of acceptable project capacity, below which would be a default.
To support that PPA requirement, the EPC should require recovery plans following the initial capacity test, assigning cost responsibilities and establishing damages or other remedies. If the off-taker is willing to accept a range of performance under the PPA, the EPC could make the post-COD recovery plan optional.
By allowing the contractor either to elect a capacity shortfall payment or to make good on its delivery obligation at 100 percent, the contractor may be able to minimize cost overruns. If the contractor can meet a range of acceptable performance outcomes, then the contractor could save the other parties money by building less contingency into the fixed price.
The owner, off-taker, contractor, and facility lenders must all coordinate to align financial incentives, capacity shortfall payments, and minimum acceptable performance outcomes. To do this, the parties must synchronize the parallel terms of the PPA and the EPC to avoid any gaps.
In the end, the EPC should flow through the PPA performance guarantees, capacity shortfall payments, and default provisions wherever possible. Just as the owner should avoid being “caught in the middle” when it comes to schedule delays, so also should the owner ensure that the contractor accepts the risk of underperformance if it cannot deliver a project at 100 percent.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.