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Select the Best Contract Model to Mitigate Risk and Achieve Energy Project Success

Power and energy projects are inherently complex, requiring proper allocation of risk among participants.
By Gregory S. Seador
September 7, 2022
Topics
Risk
Legal and Regulatory
Business

Power and energy projects are inherently complex and risky. Therefore, management and proper allocation of risk among project participants are essential to success.

Careful drafting of the engineering, procurement and construction (EPC) contract is a critical first step in managing risk. The standard contract format used for power and energy construction projects is the EPC contract. In its traditional form, the EPC contract makes the EPC contractor responsible for the entire project, including engineering (design of the power plant), procurement (purchase, installation and performance of all equipment) and construction (construction of the plant).

EPC contracts can, however, employ different contract models and pricing structures, each of which carries differing levels of risk for project participants. Selecting the appropriate contract model and pricing structure to meet the unique needs of the project is important.

Contract Models

The full wrap model: Under a full wrap or “turnkey” model, the EPC contract creates a one-stop shop for the design, procurement and construction of the project. The EPC contractor is responsible for and provides the detailed engineering design of the project, procures all the equipment and materials necessary for the project and then constructs and delivers a functioning facility to the owner. The EPC contractor is responsible for the project from start to finish and assumes all responsibility and risks. This includes designing the project in accordance with the agreed scope book, ensuring all equipment and the facility meet the performance guarantees and providing the owner with a warranty on all of the EPC contractor’s work, in addition to delivering to the owner the manufacturer’s warranties on the equipment.

The partial wrap model: Under a partial wrap model, the EPC contractor does not accept total responsibility for the entire project. For example, in a partial wrap, the EPC contractor may be responsible for engineering and construction but not for procuring the major equipment. In this scenario, the owner purchases the major equipment and then either:

  1. Agrees with the EPC contractor on the terms by which the EPC contractor is willing to accept an assignment of the purchase orders for the equipment; or
  2. Provides the equipment to the EPC contractor and the EPC contractor installs it. In this second scenario, the EPC contractor is relieved of the obligation to procure the equipment but is responsible for the integrity of the design and installation of the equipment.

In a partial wrap model, the owner assumes greater risk because it no longer has a single entity responsible for the entirety of the project. If, for example, equipment does not achieve the required performance guarantees or is defective, there is the possibility of a dispute between the owner and EPC contractor regarding the cause and responsibility for the defective performance.

Fixed, Firm and Target Price Models

There are various pricing models included in EPC contracts. Commonly used pricing models in EPC contracts are “fixed,” “firm” and “target” prices:

Fixed price: In an EPC contract using the fixed-price model, the EPC contractor agrees to perform the entire EPC scope of work for a fixed price, subject to increases for owner changes and other circumstances as determined in the contract. The EPC contractor assumes 100% of the risk of the cost of the work exceeding the agreed fixed price. Because the risk of cost increases rests exclusively with the EPC contractor, the original fixed contract price will of necessity include dollars to cover that risk.

Firm price: Under a firm-price model, the owner and the EPC contractor agree to a fixed price subject to an adjustment for escalations of specified commodities. For example, if there is a risk that the cost of certain key building elements, such as steel, may sharply escalate, the EPC contract will often include a steel escalation clause that sets forth the circumstances under which the contract price will be increased and the formula to be used to adjust for escalation. With the dramatic inflation in the cost of building materials due to the impacts of the COVID-19 pandemic, EPC contacts regularly include COVID-19 escalation clauses in which the parties address the risk of pandemic-related cost impacts and delays and allocate the risk among them.

Target price: A target-price model is typically used in EPC contracts for extremely large projects. When this model is employed, the parties agree to engage in an open-book estimate process to arrive at a non-binding target price for the project. The contract is a cost reimbursement contract in which the EPC contractor is paid for all allowable costs, including overhead. The EPC contractor’s fee is typically reduced if the project costs exceed the target price. In this model, the owner carries the risk of the ultimate cost of the project while the EPC contractor’s risk is limited to its fee recovery.

Power and energy projects are technologically and commercially challenging and risky. It is important that project participants evaluate the plusses and minuses of the different contract models and pricing systems and determine the most appropriate approach for their project. Failure to do so can often result in an unsuccessful, overbudget project.

by Gregory S. Seador
Gregory Seador is in Shapiro Lifschitz & Schram’s Washington, D.C. office. He is an experienced trial attorney with more than 15 years of complex litigation experience and is member of the firm’s Litigation and Trial, Construction and Power & Energy Construction groups. A litigator with an emphasis on serving the construction sector, Seador’s practice is focused on complex litigation matters, including those on behalf of governmental and private owners, regional, national and international contractors, construction managers, subcontractors and design professionals, among others. .

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