UK: EPC/EPCM Briefing Note

Introduction

This short briefing note sets out the principal characteristics of EPC and EPCM contracts, looking in particular at some of the issues which may inform a potential lender as to the bankability of the project. It assumes, of course, that the project is viable from an economic perspective but that the project structure is not settled.

Engineering procurement and construction contracts have become the favoured procurement method for the delivery of large scale infrastructure projects, particularly those financed with off balance sheet debt. Their time focused, cost certain approach offers a compelling response to the need for what is typically described as bankability.

What do we mean by "Bankability"?

Typically this term is used to describe whether or not a project structure is sufficiently robust to allow a lender to get his money back. Traditionally, lenders have had a clear preference for a structure where one entity takes full responsibility for the delivery of a project and hence the engineering, procurement and construction contract has gained, and largely retained, its popularity. That said, the EPC contract is not alone in offering smart procurement solutions. This note looks at circumstances in which an EPCM contract might be used and, if so, how it might be modified to keep the lender on side.

A single point of responsibility may not be required in circumstances where the project sponsor is sufficiently sophisticated to manage without one or indeed the project is insufficiently complex. It may also be that the nature of the project means that a single point of responsibility is simply not achievable and, in any of these circumstances, it is possible that alternative structures would be viewed.

Under a typical EPC structure the contractor shoulders the risk of design, cost and time (save for a limited set of circumstances in which he is relieved). The employer need not be concerned by competing arguments about why a failure occurred because it is the EPC contractor's obligation to deliver a turnkey solution. He will be responsible for poor design as well as poor construction. A typical contractual structure of an EPC procurement is set out below.

Inevitably the apparent certainty offered by the EPC structure comes at a price and some project sponsors are considering whether the price is too high to pay. They may well prefer to retain some risk in return for a reduced price in situations which may be driven by sector, geographic location or other factors. The project sponsor will be evaluating increased cost and likely reduced equity return against the key benefits of an EPC contract which are price certainty for project delivery and increased likelihood of securing project finance. There has, accordingly, been a change in appetite to pursue projects solely through an EPC structure. It would however, be wrong to suggest that the popularity of the EPC has waned, but so too would be it be wrong not to recognise that there are alternatives to this procurement structure which are gaining market recognition.

The rise and rise of EPCM contracts

EPCM contracts, with or without a target cost mechanism, whilst not replacing the EPC contract as a procurement method of choice, are certainly being viewed as a credible alternative, where lenders are able to get themselves comfortable with the prospect of an enhanced risk profile. A typical EPCM structure is set out below.

EPCM contracts are quite different to EPC contracts. Fairly frequently there is some confusion as to their structure. Most importantly, the contractor does not undertake any physical works but, instead, he acts as a manger of other contractors. In some sectors, most notably the petrochemical industry, there are insufficient contractors with a sizeable enough balance sheet to take on all the risks under the project. This makes EPCM attractive. In large part, an EPCM contract is, in fact, a contract for the delivery of professional services, and so it has many of the characteristics of a service contract. In particular, the payment of a fee for the delivery of the services rendered. Those services are typically the delivery of developing design, the acquisition of equipment and materials and the administration and management of the contracts which are ultimately awarded.

The successful use of an EPCM model arguably requires the employer to have at his disposal more resource than would be the case under a more traditional EPC structure. On paper, of course, the EPCM contractor is being paid to administer the contracts and to manage them but in practice it remains the case that it is in the employer's interest to keep control over and visibility of the various interfaces so as to minimise claims for delay and disruption and additional time and money which this structure cannot eliminate.

It is worth thinking about the matters for which the EPCM contractor avoids liability. The EPCM contractor will not take responsibility for the delivery of works by a scheduled completion date, nor would he take responsibility for the ultimate out turn costs of the project. That said the trend towards the marriage of EPCM contracts and project finance has meant that there is a greater need to incentivise EPCM contractors to achieve over all delivery within time and cost constraints so more and more of these incentives are being used.

Target cost incentives in EPCM structures

Target cost contracting is a method of procurement which delivers an incentive to the contractor for efficient procurement. It means that the contractor has an element of "skin in the game" and is frequently used in conjunction with some form of reimbursable contract. This is a common contracting structure in tunnelling projects where the risk of out turn cost would be difficult to leave with the contractor.

In the context of the EPCM contract it will be apparent that lenders and sponsors alike will have every reason to want to find ways to control cost. There is not the contractual equipment which would be set out in a traditional EPC contract to exert an element of cost control. The EPCM contractor will no doubt be charged with setting his budget for work in conjunction with the employer's costs consultant or quantity surveyors but the EPCM contractor will give no warranty that these budgets will be achieved.

Typically, the EPCM contractor's responsibility is to use reasonable skill and care in monitoring and reporting on costs and their relationship to the budget.

The other central component of the EPCM contractor's role is in the proper co-ordination of packages of works which will be undertaken by the works contractor. In reality, it is difficult to demonstrate that failure in the performance of the EPCM contractor's duties give rise to loss.

On balance......

The clear advantage of an EPCM contract over an EPC contract is that the price paid will be lower than the EPC contract because less risk is being transferred. Incentivisation is now being used as a method for creating a more robust contract structure which does not, in and of itself, create bankability, but which encourages adherence to budget and programme.

Inevitably no one size fits all and a holistic view of the project sponsor's appetite for risk, availability of finance and the lender's own requirements need properly to be ascertained before opting for one structure rather than the other.

Treatment of Risk under EPC/EPCM

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.