Transcription
In this lesson, we'll go over the main construction contracts in the mining industry. The construction is usually divided into three main activities: engineering, procurement, and construction. And these three main construction activities are performed by specialist construction firms. So, there are three alternatives for the sponsor to carry out the construction contracts.
First, the sponsor can hire and supervise each specialist firm on its own to carry out these construction activities. Another alternative is to enter into an engineering, procurement, and construction contract with the EPC firm. And finally, what we usually see in the mining industry is that the sponsor enters into an engineering, procurement, and construction management agreement, or EPCM agreement, with the EPCM firm.
The first alternative, where the sponsor hires and supervises each specialist construction firm on its own, is not a popular alternative in the context of project finance transactions. So, let's review the differences between the EPC and EPCM contracts.
Now, in the EPC structure, the sponsor will enter into the EPC contract with the EPC firm, and the EPC firm will enter into the construction contracts with the subcontractors that will carry out the construction activities, such as engineering, procurement, and construction. So, it is not just one firm that carries out the whole construction process. And instead, there will be numerous firms involved in engineering, procurement, and construction. And the EPC firm ensures the full integration of the construction activities.
The main advantage of the EPC contract is a single point of responsibility for the project. If there is a problem with the construction of the project, then it will be the responsibility of the EPC firm. Let's review the main terms of the EPC contract now.
The EPC contract is a turnkey contract, and the EPC firm guarantees the work of subcontractors. So, it is a fully wrapped contract where the EPC firm handles every aspect of the engineering, procurement, and construction. The turnkey contract means that the EPC firm will deliver a project ready for operation once the construction is complete. The sponsor only has to turn the key to start the project's operations.
The cost of the project in the EPC contract is typically fixed. This means that the sponsor, the EPC firm, and most importantly, the lender know in advance what will be the total cost of the project. Under the EPC contract, the EPC firm will be responsible for the construction cost overruns. Therefore, the EPC contract is called a fixed-price contract.
The EPC contract is date certain, so the project has to be built and ready for operation by a certain date. This has certain advantages for the sponsor, especially when the sponsor incurs penalties for construction delays, which is typical in project finance transactions. For example, in power projects, the power off-taker will penalize the sponsor if the project is delayed and not ready to generate power by the date indicated in the power off-take agreement. And remember, when the project borrows money from the lender, we have to pay interest on the money borrowed. So, the project delay means more interest has to be paid to the lender. Therefore, the construction contract must be date certain in project finance transactions.
When it comes to the payment terms, usually the payment to the EPC firm is made in accordance with the performance milestones. For example, the first payment will be made when we give the notice to proceed to the EPC firm. This will be followed by smaller payments as EPC makes progress with the project construction, and then the final payment will be made when the project is accepted by the sponsor.
Since EPC is a turnkey contract, there will be extensive testing done before the sponsor can accept the project, which will be well documented in the contract. This is to make sure that the project operates according to the performance requirements set in the contract. The contract will include the minimum and guaranteed level of performance, and the project can reach substantial completion if the project can achieve the minimum performance level.
The project is typically ready to operate at substantial completion. The substantial completion is the stage when all the physical and electrical works have been completed, and the project has passed all the reliability and performance tests. So, the project is ready to operate at substantial completion. There are still small items, such as painting, cleanup, and other works that need to be completed, that do not affect the project's performance. These small items are called punch list items.
At final completion, all the punch list items have been resolved, and the project has been approved by the lender's engineer. At final completion, all the remaining payments to the EPC contractor are released.
Another distinctive feature of the EPC contract is delay and performance penalties, and these are called liquidated damages. As we said, the EPC contract is a date-certain contract. However, if there is a delay in the construction, then all the penalties that have to be paid by the sponsor to the third parties will be paid by the EPC firm. The delayed damages include the penalties that have to be paid to the off-taker, the debt cost that has to be paid to the lender, and the loss of profit that the project company suffers because of the construction delay.
Delay liquidated damages are based on dollar-per-day calculations. In addition to the delay damages, there will be performance liquidated damages if the project does not achieve the guaranteed performance. Usually, the performance penalty is the difference between the value of the project at the guaranteed performance level and the actual performance level.
The project company has the right to reject the project if the project does not achieve the minimum performance level. A typical penalty if the project is rejected is reimbursement of all the cash payments that have been made to the EPC contractor.
Since the EPC firm will be supplying the equipment, the EPC contract will also include warranties. Warranties are guarantees that equipment defects will be repaired or replaced at the cost of the contractor. Usually, warranties are given for one or two years.
In EPC contracts, the EPC firm will be required to furnish the performance bond, usually from a commercial bank or insurance company, which is usually equal to 10 or 15 percent of the project cost. If the EPC cannot fulfill its obligations, the bank or insurance company will compensate the project company.
There will be extensive coverage of force majeure events in the EPC contract, and typically the force majeure risk is taken by the sponsor in the EPC contract. The lender will also want to have step-in rights in the EPC contract. If the sponsor is in default, then the lender may wish to step into the project and replace the sponsor to cure the issue that is causing the default. This will give the opportunity for the lender to resolve the problems that are causing the default to make sure that the construction of the project continues.
So, these are the main terms of the EPC contract, and as you can see, the EPC contract is all about risk allocation. Usually, we reallocate all the major construction risks to the contractor under the EPC contract. Obviously, the more risk we allocate to the EPC contractor, the more expensive the EPC contract will be.
Let's now discuss the main terms of the EPCM contract. Under the EPCM structure, the project company will contract the EPCM firm for engineering services, and it will also contract directly with the construction company to carry out the construction of the project and sign the supply agreement with the equipment supplier.
Under the EPCM structure, the EPCM firm is responsible for the basic and detailed design, in assisting the project company with procurement and construction. The EPCM contract is essentially a consulting contract, and this is different from the EPC contract where we've got the EPC firm that carries out engineering, procures equipment, installs the equipment at the site, and carries out the construction activities. The main responsibility of the EPCM, apart from designing the project, is to manage and coordinate equipment procurement and construction activities.
The project costs in the EPCM contract are typically based on the hourly rates of the employees that will be providing the engineering services to the sponsor. In terms of timing and scheduling, the EPCM contract is usually based on a best-effort basis, and this means that if, for example, there's a delay in the project, then it is unlikely that the sponsor will be compensated by the EPCM for that delay. The EPCM firm is not responsible for the scheduling delay or project costs; this is the responsibility of the sponsor.
Under the EPCM structure, delay risk may be passed on to the equipment supplier and construction company. However, compared to the risk allocation under the EPC contract, a significant residual risk will remain with the sponsor. There will be some liquidated damages for the design and performance; however, this will be much lighter compared to the EPC contract.
When it comes to security, only parent guarantees are typical in EPCM contracts. It is unusual that third-party guarantees, such as a letter of credit or bank guarantees, are given to the sponsor under the EPCM structure.
Let's now summarize what we have learned so far about the EPC and EPCM contracts. The advantage of the EPC contract is a single point of responsibility, which eliminates the interface risk that is present when we've got a large number of contractors. Also, as we mentioned earlier, all the major risks are allocated to the EPC contractor. The main disadvantage of the EPC contract is its price, since the contractor will be taking almost all of the construction risks, he will include significant contingencies in the price of the contract.
The main advantages of the EPCM contract are low cost and flexibility. However, from the point of risk allocation, the main risks will remain with the project company.
Having now reviewed the EPC and EPCM main terms and risk allocation, we may ask the question: why do companies use EPCM contracts if they want to raise debt financing? EPCM contracts are especially prevalent in the natural resource industry. Well, there are several reasons for that.
First of all, during market conditions when demand is high for construction services, the construction companies are not interested in offering EPC services. EPC contracts are complex and risky projects for the contractors, so in periods of greater project activity, contractors can make large profits on a risk-free basis under the EPCM structures. Next, EPC contracts are more expensive than EPCM contracts, so experienced contractors tend to select EPCM services. And finally, an EPC contract may be difficult to do for certain mining projects which involve complex engineering and flexibility is required.
So, the question that must be asked is: if the EPCM contract is bankable? And bankability means the risk allocation in the contract that satisfies a lender. There is little that the project company can do with respect to the risk allocation under the EPCM structure. However, there are risk mitigation steps that lenders take when they finance a project with EPCM contracts.
Since EPCM is a riskier option for the project company, the lender typically will want to see an experienced construction firm that will be providing the EPCM services. The lender wants to see an experienced sponsor team that will be dealing with the EPCM contractor, and the lender wants to see experienced subcontractors and equipment suppliers. So, experienced sponsors and subcontractors mitigate some of the risks in the EPCM contract.
Also, there will be incentives given to the EPCM company, suppliers, and contractors to complete the project within the budget and schedule, and this is another risk mitigation strategy. However, with all these risk mitigation strategies that can be employed by the sponsor in the EPCM contract, a significant construction risk will still remain. And usually, this means that the lender will require security from the sponsor. The security will be in the form of completion guarantees, cost overruns guarantees, and other guarantees that basically transfer the construction risk from the lender to the sponsor during the construction phase of the project.