The term EPC stands for ‘Engineer, Procure and Construct’. The key to this concept is that one organization, namely the contractor, undertakes virtually all aspects of the project and provides a single point of communication and responsibility for the owner. The expression ‘turnkey’ describes a procurement route whereby in return for the contract price, the contractor does everything, and simply hands the keys to the control system of the completed working plant to the owner for them to turn to operate the plant.
Siemens’ IGCC power plant in the Spanish city of Puertollano
This form of contracting is generally thought to involve the contractor assuming a greater proportion of the risk than they would in a multi-contract context. However, there are certain limitations to the turnkey/EPC approach that are driven by different factors.
There is currently a huge amount of work for contractors on projects around the world as countries become more concerned about energy supply, and demand continues to increase for more new build combined-cycle and other power plants. As a result, there is great demand for plant, materials, equipment and expertise. Costs are also rising and contractors and manufacturers have near full order books.
This places contractors in a prime position as they shop around for projects that carry the least risk and the most profit. In the last few years, contractors and manufacturers have become more risk averse, and when negotiating contracts are seeking exclusions from and significant caps on liability. More recently, contractors are simply declining to bid for turnkey/EPC contracts. It is clear that the market has changed and with it the bargaining dynamics of the parties involved.
As we shall see below, if power plant owners are required to take back some risk, they will want to assume more control over the design process, and this in turn waters down the single-point responsibility of the contractor. Furthermore, as owners become more involved in the design process we see more protracted design phases for some projects, rendering the alleged ‘fast track’ nature of turnkey/EPC contracts less apparent.
Lack of effective remedies
Defects, delays and failures to meet performance requirements are likely to result in serious consequences for the owner in terms of lost income. Some performance failures may even make it impossible to operate the plant, e.g. a failure to meet required noise and/or emissions minimum levels. The remedies/sanctions available to the owner for these failures must be adequate to compensate them for any losses incurred.
However, some of the remedies/sanctions provided by the turnkey/EPC approach may fail to adequately compensate the owner in certain circumstances, for example: contractor warranties are likely to expire at the end of the defects liability period. This means that the owner is unlikely to be able to pursue the contractor for the cost of defects and the costs of any consequent damage for most of the life of the combined-cycle plant. This, in turn, drives more owner involvement in quality issues and design; liquidated damages are likely to be capped, and not all losses consequent upon a delay are likely to be covered as a result of the contractors’ increased reluctance to accept exposure to the full extent of such losses; termination mechanisms are only effective where there are other contractors available in the market place to complete the works; and ‘rejection – where the owner becomes entitled to all its money back and the contractor must pay to clear the site of the rejected plant – is unlikely to be accepted by contractors on the grounds that, since the plant is proven technology and most unlikely to fail, termination should be an adequate remedy. However, one may argue that the converse may be true. If unproven technology is being procured then perhaps the owner should share in the risk of the plant not working, whereas where the plant is proven technology, a contractor should stand behind its design, grant appropriate warranties and allow the owner the right to rejection if the plant absolutely will not perform.
The single-point responsibility characteristic of the turnkey/EPC approach wraps together most design interfaces. However, problems begin to arise where the owner steps into the territory of the contractor’s ‘single-point responsibility’ by influencing design development or the construction process, or both.
Increased involvement may well be the result of the owner striving to mitigate the risks of problems arising because they experience difficulty in obtaining adequate remedies as seen above. In doing so, however, the owner creates a bigger interface between themself and the contractor, which can create more interface risk for the owner. The owner must therefore balance the gains to be achieved with the risk of creating potential claims for additional time and cost from the contractor, and of undermining the single-point responsibility of the contractor – particularly in relation to design.
There are other procurement approaches that may better achieve particular project objectives, but their application will depend on the specific circumstance of each project.
Concepts of alliance working can bring benefits to the project, especially to the design development and project management functions. As the parties work together in a spirit of mutual trust and co-operation, they will typically begin to introduce formal communication structures, sharing of resources, joint determination of goals and objectives and shared risks.
Alstom’s Kaeng Khoi combined-cycle 2XKA 26-2 plant in Thailand
An owner may apply alliance working at different phases of the project and implement its use to the turnkey/EPC approach. For example, if the owner finds that they will be working on more than two projects with the same supplier, they may wish to enter into long term supply arrangement with that supplier.
The owner can then novate the supply agreement to the turnkey/EPC contractor and end up with a fully wrapped up turnkey/EPC contract. As well as the more obvious financial benefits that may arise from a long-term supply of work, such an arrangement may assuage quality and design concerns on the part of the owner while maintaining single-point responsibility of the turnkey/EPC contractor.
A sanctions approach may engender a narrow perspective of working towards what is best for the contractor rather than for the project. Positive motivation (as opposed to sanctions) through the use of target cost/value mechanisms can motivate the contractor and supply chain to make the best decisions for the project rather than take decisions simply to avoid sanctions.
Although most people understand a target cost/value mechanism to apply to the whole project (in the way it does within the context of the NEC approach), it can also be applied to discrete parts of the project.
Target cost mechanisms can allow the parties to share the price of discrete risks (e.g. geotechnical, weather and regulatory risk). Instead of the contractor increasing its price to assume certain risks, a target cost can be set against each of those risks so that any savings are shared between the parties. The parties agree to share in the pre-agreed cost risk to some degree and to benefit jointly from any savings that are actually achieved as part of their efforts in avoiding those risks or minimizing the consequences of those risks.
Target value mechanisms can also allow the owner and the contractor to share the benefits in early production/generation, efficient engineering design, construction phase cost saving and plant performance. For example, an owner may share the revenue generated by any early completion and operation of a plant or a section of the plant with the contractor.
This may serve as an incentive for the contractor to complete as early as possible, and could result in a reduced overall project programme. In addition, in some jurisdictions the legal provisions that regulate and restrict the imposition of liquidated damages for breach of contract (by excluding clauses which operate as ‘penalties’), do not apply to bonus schemes which reward enhanced performance.
Although these mechanisms are likely to move away from the ‘certainty of price’ principle found in the turnkey/EPC approach, they may generate a more productive and co-operative climate for the achievement of the common project objectives.
The concept of multi-contracting envisages that the works are let in a number of packages. For multi-contracting to work well, the owner must possess (or buy-in) good project management skills.
One advantage of procurement on this basis in the current climate is the scope to tailor risk allocation to the particular requirements of each package. In addition, by reducing contract values it can also help reduce prospective liabilities of the contractors and lead to cost reductions.
Making the right decision
The turnkey/EPC approach can work very well for certain projects, and particularly where the contractor is in the best position to understand, manage and have an impact on the risks allocated to it and is prepared to assume an appropriate level of risk.
If the contractor is not prepared to assume an appropriate level of risk, which is increasingly the case in the current market, an owner may be better advised to, and indeed may have no option but to, consider alternative procurement approaches such as alliance and framework arrangements, target cost/value mechanisms and multi-contracting, or a mixture of the turnkey/EPC approach and one of these.
With a little bit of thought and imagination, such alternative procurement routes may even provide better value for the owner.