EPC Best Practices
Best practices to optimize your EPC contract to mitigate risk and achieve energy project success.
By Laura Fraher
Power and energy construction projects are risky. Like any other construction project, management and proper allocation of risk among project participants is key to the success of the project.
This critical process begins with the proper drafting of the project contract. The standard contract used for power and energy construction projects is the engineering, procurement and construction (EPC) contract. In its classic form, the EPC contract establishes a one-stop shop for the design and construction of the project – the EPC contractor is responsible for the engineering (design of entire power plant), procurement (purchase, installation and performance of all equipment) and construction (construction of the plant).
Selecting the appropriate contract model and pricing structure to include in the EPC contract to meet the unique needs of your project is critical to its success.
Step 1: Select Your Contract Model
The Full Wrap: Under a “full wrap” or “turnkey” model, the EPC contractor fully provides all 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 from start to finish and delivers a finished product that simply requires the owner to turn the key and begin operations.
An obvious benefit to an owner using this model is that the contractor assumes all responsibility and risks for major equipment. In the event of a major equipment defect or failure, the buck stops with the EPC contractor and the owner will not expend extra resources pursuing multiple parties to determine responsibility.
Another significant advantage to this model is that sharing resources has significant cost benefits – with all the work being completed under the umbrella of a single contract, major equipment can be shared (no need for repeating the expense of mobilizing and demobilizing cranes for individual tasks) and so can manpower resources (the crew pouring concrete for a building or wiring the electrical for a system can be employed for other buildings and systems, too).
But this model also presents drawbacks for an owner. A contractor that assumes all the responsibility and risks for major equipment will only do so in exchange for compensation, meaning an increased overall cost for the project as the contractor adds a risk premium to his fixed price.
The Partial Wrap: In a “partial wrap” scenario, the EPC contractor does not have full responsibility for the entire project. Typically, the EPC contractor assumes the responsibility and risks for engineering and construction, but not for procuring the major equipment. The owner may purchase the major equipment and assign the purchase orders to the EPC contractor, or the owner may already have the equipment in its possession. In either scenario, the EPC contractor is relieved of the obligation to procure the equipment and obtain the relevant warranties but is still responsible for installation.
The partial wrap approach is best suited for owners who already have possession of major pieces of equipment, or for projects that require standard pieces of major equipment that the owner can procure directly less expensively. By relieving the contractor of equipment procurement and associated risks, the EPC contractor’s risk premium should decrease, resulting in a more favorable pricing model for the owner. On the other hand, if equipment malfunctions, the possibility of the EPC contractor and equipment supplier pointing fingers at each other — rather than solving the problem as efficiently and economically as possible — presents a real risk for owners.
Step 2: Select Your Pricing Model
There are many pricing models that can be selected for your EPC contract. At opposite ends of the spectrum are the fixed-price model and the target-price model, with a variety of other options available. It is also quite common for EPC contracts to utilize different pricing models for different phases of the project.
The Fixed-Price Model: The simplest approach is the fixed-price model. In this type of contract, the EPC contractor agrees to perform the entire project for a fixed price.
The benefits to an owner of a fixed-price model are obvious: The owner gets the entire project for a determined price and costs are set at the signing of the contract. However, owners must be wary. This model is only appropriate where significant planning and engineering have been invested before contract; without a complete concept and detailed scope and specifications, a fixed-price model is very risky for an owner.
Importantly, the owner must anticipate that in a fixed-price model the contractor will only provide exactly what is detailed in the contract. If unforeseen scope items, or unknown environmental or plant conditions are discovered after contract signing, it can be incredibly difficult to control the cost of the additional work and it can dramatically impact your project schedule.
Also, if the specifications are not painstakingly clear, the risks to the owner increase in myriad ways. The contractor will be incentivized to purchase the least expensive material and equipment that satisfy the specification requirements and to take shortcuts in the design, procurement and construction processes to meet schedule. All of which can have significant consequences on the quality of the project.
Target-Price Model: The target-price model is a cost-reimbursement model established through an open-book estimate process. Typically, the contract cost is subject to a sharing mechanism: If the project is completed for below the pre-established “target price” the contractor shares in the savings in the form of a bonus. If the project is completed for above the pre-established “target price” the contractor shares in some portion of the final costs that exceed the target price.
Target pricing is a good option for fast-track projects because it does not require a fully defined concept and fully developed specifications at the time of contracting. But, the obvious downside for an owner is the significant unknowns with respect to establishing the final contract price.
This model is only effective if there is a truly open-book process, allowing both the owner and contractor to realistically evaluate the potential costs of the project. Likewise, a fair and clearly defined sharing mechanism that fully incentivizes both parties to realistically project the final cost and time to complete the project and to meet those projections is necessary.
Power and energy projects face unique and extraordinary challenges. A contract that establishes the parties’ agreements and expectations regarding allocation of liability is key to a project’s success. Before project commencement, owners should carefully analyze budgets and risks to ensure they have selected the contract and pricing that is most optimal.
Laura C. Fraher is a senior attorney in the trial and construction group at Shapiro, Lifschitz & Schram, focusing on complex commercial and construction litigation. She has extensive experience in civil litigation at both the trial court and appellate level. Additionally, Fraher drafts construction contracts for large-scale commercial and residential construction projects. Contact her via email at email@example.com.