Project Finance is generally provided on a non-recourse or limited recourse basis, via the incorporation of a specific purpose vehicle (SPV), in an effort to insulate the sponsors of an industrial project from the risks of extraordinarily large or complex ventures. Because the usual guarantees do not play a central role in that context, it is essential for the project to be structured so as to secure a sufficient volume of cash flow to cover the project's operating cost and the repayment of the debt incurred by the SPV over the agreed tenure. This translates into very practical constraints that must be addressed by the executive team in charge of assembling a sound contractual structure. Sorting out these constraints takes any sponsors a long way on the road to the bankability of their project. They may not get everything in order. But the further they remove risks for the lenders, the fewer guarantees they will have to provide and the more debt they will be able to raise. A satisfactory assessment of those core elements should thus be a prerequisite to any commitment to an industrial project, be it as a lender, a shareholder, or a contractor. In the first part of this article, we have examined how the feedstock of industrial projects should be procured so as to enhance bankability. Not only should the feedstock be acquired at an affordable and foreseeable price: the choice of the project's provider and of its location should be made so as to greatly reduce risks associated with availability of the feedstock in sufficient quantity and with its transportation up to the project's site. In this second part, we now look for bankability in the negotiation of the contract for the project's EPC.
Second Milestone: ABC of EPC
EPC refers to the project's engineering of both the inside (production process) and outside (infrastructure) battery limits, procurement of materials for construction and of equipment for production, and construction (be it an industrial plant, a mine, a service infrastructure). As these components are closely knit together, they are addressed within a single agreement that distributes responsibilities between the SPV and the contractor in accordance with the level of risk and costs that each party is willing to assume. In an EPCM Agreement for example, the contractor is hired to provide engineering, procurement and construction management services. Other companies are mandated by the SPV to provide construction services in their respective field of expertise, and their performance is managed by the EPCM contractor on the SPV's behalf. The SPV has more control over its project under an EPCM solution and as a result assumes more risk, including as to the price for which those subcontractors will be able to complete construction. Oppositely, the EPC Agreement attributes to the EPC contractor full responsibility for the EPC work, including the portion thereof which is performed by the subcontractors that such contractor chooses to hire. Lenders tend to prefer EPC Agreements because they provide clarity on liability issues without having to sort out responsibilities among subcontractors. Also, the EPC work is preferably performed for a fixed price known from the onset, which ensures that the capital invested into the project will be sufficient to permit its completion. EPC Agreements concluded for a fixed price are however generally quoted more expensively than EPCM Agreements. This is because the contractor tends to build a margin into the EPC price to account for its potential liability in connection with cost overruns or construction delays. Lenders and investors also pay great attention to the EPC contractor's credibility and financial solvency, to ensure that it will be able to complete the whole EPC work on time and on budget or to bear the consequences of its failure to do so. Devil being in the details, close attention must be paid to sections of the EPC Agreement that could otherwise defeat its purpose.
Ensuring completion and performance
Several provisions are included in the agreement to entice the EPC contractor to complete its work on time and with the expected performance (both as to the quality and the quantity of the output). Delay liquidated damages, for example, are penalty payments which are charged to the contractor in case of late delivery. Their daily, weekly or monthly amount (depending on the parties' negotiations) is multiplied by the number of such periods by which the project is delayed, and accumulated up to a negotiated cap until completion. Those damages decrease the payment to which the contractor would otherwise be entitled for the EPC work. Performance liquidated damages work in a similar fashion, but aim to compensate the SPV for delivery of an underperforming plant. A minimum standard of performance is generally agreed upon, which must be met for the plant to be considered delivered. That minimum standard is below the optimal standard that is targeted by the agreement and that would entitle the contractor to payment of the full EPC price. If, after attempts to correct any defects, the minimum performance is met but the optimal standard is still missed, an amount of performance liquidated damages proportionate to such underperformance is owed by the contractor to the SPV (and thus deducted from the full amount of the EPC price). Certain parameters must be complied with for clauses providing such liquidated damages to be enforceable. And in any event, these damages do not ensure completion of the project and are of little use in case of the EPC contractor's insolvency. The project's lenders and investors thus tend to require that additional security be built into the EPC Agreement. For example, when an advance payment is made by the SPV to cover the early stages of construction, it is common to have the contractor issue a letter of credit which guarantees the reimbursement of the advanced sums in case of failure. Another form of security consists in retaining a portion of any progress payment due to the contractor throughout construction. Such a retention is generally agreed to among the parties or even imposed by legislation. This amounts to generally 10% of each such payment in Canada (for example S 4 of British Columbia's Builders Lien Act). The retention generates an increasing stack of cash which can either be paid out to the contractor upon satisfactory completion or used to hire a third party to finish the project. One may also consider subscribing a construction bond, which is a form of insurance provided by a third party to cover defaults under the EPC Agreement. It can also be used for the same purpose of funding the completion of the project or the correction of deficiencies in the EPC work.
Ensuring price certainty
Several clauses of an EPC Agreement can potentially undo the promise of a fixed price. Because this may threaten their project's bankability, the sponsors will want to close the door on any bad surprises. The first lock must be placed on the scope of work, which is addressed via a crucial exhibit to the agreement consisting in the technical description of the project's EPC work. That description must be precise enough and supported by as many engineering and technical details as possible for both parties and a potential future arbitrator or judge to easily ascertain the nature of the work and the level of performance expected from the contractor. But it must also be sufficiently encompassing to include all essential components of the project and thereby avoid any argument from the EPC contractor that any such component was not included in the scope nor paid for by the agreed EPC price. Once that scope of work is properly drafted, the sponsors must ensure that minor alterations do not trigger a price escalation. Change Orders are thus another item that deserves a closer look. During the course of a project's EPC, the parties might discover that changes are required to the scope of work, either due to a wrong estimation, a previously unknown obstacle... or simply because the sponsors have changed their minds. The EPC Agreement must provide a process through which the parties analyze the substantiality of the required modification and determine whether that modification entitles the contractor to require the issuance of an order by the SPV to change the scope of work. Because a Change Order then triggers a proportionate adjustment of the EPC price, it is of utmost importance to draft that process so that such an order might only be granted in instances where (i) the need for a modification is not due to poor performance of its duties by the contractor, (ii) the change in question is essential for the project's completion or optimization and (iii) the related additional work is substantial enough to justify an increase of the price. Lastly, let us note that a contractor may be relieved from its obligations (generally through extension of the period granted for completion) when performance is hindered by an Act of God (under Common Law) or a situation of Force Majeure (under Civil Law), meaning an unforeseeable and insurmountable event beyond the control of both parties. In such a situation, the contractor will be excused from the delay and the associated costs. It is important to ensure that only exceptional events may be invoked, and the SPV's legal counsel is generally well-advised to actually draft the relevant clause in consideration of the project's specifics, excluding certain events that should be anticipated and accounted for by the contractor (for example, weather conditions which might be considered extreme in most parts of the world but are actually foreseeable at the location of the project's site).
Out of the EPC Agreement
The engineering of a project is a multistep process, which starts with a feasibility study demonstrating that the venture can actually be completed from a technical and economic perspective. It is important that a credible and reputed engineering firm be entrusted with such study, not only to convince potential investors at a project's early stages, but to launch such project on the right technical basis and assumptions. These assumptions may even be refined prior to calling for tenders from potential EPC contractors, by ordering a more fulsome analysis called Front End Engineering Design or FEED. The specifications of that FEED allow the SPV to develop a precise and realistic scope of work, and to obtain bids for such work which are much more accurate than those which would be tendered on the basis of a preliminary analysis. Therefore, the more thorough the engineering made prior to funding, the more credible the project and its final price become...which goes a long way to improving bankability. Credibility issues might also affect bankability when the technology involved is not proven (when it has not been successfully resorted to in the past for similar projects). In order to assess these matters, potential lenders and investors will require that the SPV hire and pay for the fees of an independent engineer or technical advisor. This part must be played by a reputed firm that will assess the venture from a technical standpoint, issue an opinion on its feasibility, and monitor its construction so as to ensure that progress payments are drawn from the credit facilities only when the agreed upon milestones have been achieved.
Negotiating an EPC Agreement that secures a project's cash-flow should bring its sponsors closer to the finish line. Of course, many other pieces must be arranged strategically for an industrial project to reach financial close. In the third and final part of this article, we will therefore shift our focus to other parts of the bankability puzzle, and examine in particular how the terms for the offtake (purchase) of the project's future production should be negotiated.
- Allocating Risks in Public-Private Partnerships, The Global Infrastructure Hub Ltd (GI Hub), June 2016; - Public-Private-Partnership In Infrastructure Resource Center; - Project finance in theory and in practice, by Stefano Gatti 2nd edition, Academic Press - Principles of Project Finance, by 2nd edition, E.R. Yescombe, Elsevier Science & Technology Books; - Project Finance Teaching Note, Bruce Comer, 1996; - THE Construction Contract Book: How to Find Common Ground in Negotiating Design and Construction Clauses, Second Edition, by Daniel S. Brennan et al., Chicago : American Bar Association, Â©2008; - Construction Bonds: What Every Contractor and Owner Should Know, by Robert Jenkins, Q.C. and Andrew Wallace, P.Eng.