The term ‘traditional contract’ in the construction industry refers to the well-worn groove of employer-led design before employing a contractor to build that design, with the employer retaining design responsibility. Of course, there is the design and build route whereby the contractor is employed, usually to take on the employer outline design, before undertaking the detailed design then moving into the build phase.
Numerous variations on the above exist in the industry, but what about if the employer or end client knew what they wanted and could provide standards against which the contractor should deliver the scope? Why not simply tender on this basis? The employer offers criteria to meet performance standards or outcomes and then leaves the rest to the contractor. The contractor takes the project through design, delivery, and commissioning before handing the keys over to the employer.
In infrastructure contracts, these types of ‘turnkey’ contracts or EPC (Engineering, Procurement and Construct) are similar to design and build contracts but viewed as more extreme in the risk-sharing model. The employer has much less say over the design, but they take less risk with this passed almost entirely over to the contractor.
EPC contracts are more prevalent in the infrastructure market as functional requirements far outweigh aesthetics, i.e., think process plants capable of handling a certain capacity per day, power stations that should produce an output or oil and gas in terms of drilling, extracting, and delivering at a specified rate.
However, in this setup, whilst tenderers are invited to bid based on achieving the stated requirements, as all risk transfer passes over to achieve the required outcomes, the client is not absolved of risk from this point as the contract will only be as good as the information that sits within it. Get this wrong or find yourself in a place where you need to change the outcomes or performance criteria, and the consequences are likely to be a high cost.
The diagram below gives an indicative idea of the typical structure of an EPC contract. The owner will be the one ‘handed the keys’ and who will operate the asset on an ongoing basis, the lender’s input is apparent, the owner’s engineer is optional and dependent on the structure of the individual contract but a prudent measure to employ these services for any owner/client.
The EPC contractor will then employ their designer (or may deliver this in-house), the supply chain and any vendors required, i.e., those supplying materials, plant, or anything else needed on a direct basis.
In addition to the above, there is another variant of EPC being EPCM, with the ‘M’ being management. This differs from the organisational chart above because the Employer/Client is entirely hands-off and employs an EPCM Contractor who effectively operates the project on a management contracting basis, ensuring compliance with the client’s outcome statements and functional specifications by the parties throughout project development and delivery.
The EPCM contractor is not directly involved but is responsible to the employer/client on a professional service basis to act on the employers’ behalf when coordinating the detailed design and then overseeing the build phase. Contractual relationships will need to be established for the EPCM contractor to have the power to step in and instruct parties under the separate contractual arrangement that these parties have with the employer.
In terms of payment under this type of management contracting, the EPCM contractor is typically paid on a cost-reimbursable basis, a percentage of the overall budget or fixed monthly fees, for the duration of pre post-construction commencement.
As noted above, getting specifications correct is essential. Still, there are different approaches, including the more traditional or ‘closed’ approach where specifications can run into many pages and volumes bound into the contract. However, whilst this works for one-off contracts, updating specifications can be time-consuming and inefficient if you have repeat work or programmes of work.
Performance or ‘open’ specifications describe the result required or that is to be achieved by the contractor. There are by reference common standards against which they are to develop the design solution. However, the contractor can innovate and adopt more efficient ways to design the works whilst still delivering the result. Potentially this can offer better value for the employer if the result is achieved, but whole life costs need to be considered against any reduction in capital expenditure.
In this type of setup, employers will maintain the common design standards or products against which contractors will need to design. Contracts can include a dividing date by which the contractor can design and is not obligated to consider later revisions of products or standards. Alternatively, they can include clauses that require the contractor to take due cognisance of any revisions, the risk of which they would need to include in their priced submission.
In terms of good practice when drafting performance specifications:
- Be careful to ensure the desired outcome is unambiguous and the performance can not be achieved by providing the minimum required, i.e., not operationally efficient in terms of the minimum but through a loophole in the outcome statement.
- That compliance with standards is required to be evidenced as part of project delivery.
- You include a method or description as to how it can be tested, the performance criteria have been met, and this should be practicable and achievable.
- That any design produced that meets the outcome is capable of being integrated into any existing infrastructure requirements.
- That reference is made to access requirements, any constraints the stakeholders need to be engaged with. Plus, sustainability objectives, quality requirements and standards, and technological standards, including futureproofing.
Pros and Cons to EPC Contracts
In terms of the advantages:
- There is a single point of responsibility for the employer to liaise with, check progress, contract with, and hold ultimately responsible for delivery. The benefit here is also reduced administrative costs.
- For contractors, there is an increasing opportunity to innovate and speed up delivery, maximising project returns.
- For all parties, the benefits of contracting the design and construction expertise together remain.
- For employers, they can contract on a fitness for purpose basis.
- As long as the scope is adequately written, the chances of claims from the contractor to the employer are minimised.
- Running a tender competition this way increases the employers’ options to evaluate the bidders on price alone.
In terms of disadvantages:
- For employers, there is a loss of control and reduced owner involvement over the final design solution.
- As all risks are transferred to the contractor, the employer could face paying a premium, so will need to evaluate the contractor’s assessment of this risk transfer carefully.
- In the event of a claim, the issue is likely to be complex, meaning the dispute is expected to be larger and more costly to resolve.
- As they are typically contracted on a fitness for purpose basis, the commercial risk is high for the contractor. They will have to project to meet the standards on the contract irrespective of the cost or face breach of contract claims.
In EPC contracts, the employer will have secured a level of investment based on the plant being operational and taking revenue from a certain period and based on the outcomes or performance in the contract being achieved. If this is affected, they will seek to recover the costs from the EPC contractor. Rather than pursue a claim for breach of contract, they will add performance-related delay damages to the contract or performance liquidated damages (PLDs) based on clauses related to a performance guarantee.
As with all liquidated damages, they should still represent a genuine pre-estimate of the employers’ costs and not profit the employer. However, on EPC contracts and if there is third party funding, it is generally accepted that loss of profit is a consequential loss and therefore permissible to include in the PLD rate per day etc.
If the performance guarantee can not be met and can not be rectified, the cost of the PLD’s to the contractor can be sizeable as they will need to be calculated over the asset’s lifetime. In such a case, it is usually prudent to cap liability which can vary across different EPC contracts to either a percentage of the overall contract value, the overall contract value itself or the contract value multiplied by a number. Contracts executed on an unlimited liability are unusual as many contractors will not find insurance coverage to back this liability.
For the contractor who seeks to limit their liability, the range of damages is drawn out and becomes more complex. They should include a minimum performance level against which, if they achieve the rate of PLD’s, becomes lower and therefore what is essentially drawn up is a range of damages. However, employers should seek to include clauses that have unlimited liability in terms of make good obligations on the contractors so they cannot settle for a reduced amount of damages and not rectify the underperformance of the finished product.
Timing of when to apply the PLDs needs to be considered. Should it be at completion, or should it be during the testing and commission phase for example? For the employer, they would need to consider at what point they expected the plant to provide revenue, but equally, if it is obvious the plant is not able to reach the performance levels required, they may want to levy damages as an added incentive on the contractor to make good the situation.
In some contract’s strategies can be devised to not delay handover to the client whilst solutions are found to performance issues as the PLDs can only be applied from completion. Through such strategies, supply chains seek to impose pressure on employers in this fashion with an ultimate aim to negotiate acceptance of reduced performance, mitigate potential losses, and accept the project as completed on lower outputs.
However, if underperformance is resolved, the damages will likely have to be paid back to the contractor. There is the added risk of insolvency once payment is restricted to the contractor through the application of damages.
In the case of GPP Big Field LLP v Solar EPC Solutions SL (formerly Prosolia Siglio XXI)  the EPC contractor was contracted on a scope concerning solar generation plants. The employer sought to levy damages based on the contract being delivered late. By the time the dispute proceedings were commenced, the joint venture was insolvent, so the employer sought to bring the claim to the parent company. The issue in question to resolve was, did the insolvency essentially terminate the provision of damages, therefore, absolving the parent company of liability?
The court rejected the argument that the liability for damages no longer applies upon termination, meaning the employer is punished for the decision to terminate the contract, and the contractor and/or the parent company escape from such liability. The overriding principle here is that the employer, upon terminating a contract for poor performance, should not then be punished as a consequence. By way of a previous example, the court cited the case of Edwards-Stuart in Shaw v MFP Foundations and Pilings Ltd , where it was also decided that damages could still be applied post-termination.
Photo by Scott Graham on Unsplash
About Dean Suttling
A member of the Royal Institution of Chartered Surveyors, Dean has twenty years of experience in commercial management and quantity surveying, undertaking roles for contractors, clients, and consultants.