This article is an extract from The Project Finance Law Review - Edition 3. Click here for the full guide.
To fully appreciate project agreements, it is important to understand their significant role in a project finance transaction, which is essentially a non-recourse financing arrangement, meaning that the lenders are not lending primarily upon the creditworthiness of any particular sponsor of a project. Why would lenders provide hundreds of millions of dollars towards a project without recourse to a creditworthy entity? Because in project finance, the nature of the project generates a predictable revenue stream, and it is this revenue stream and the underlying asset generating that revenue stream that is the primary basis of the credit. The construction and operation of an electric power generation facility is the classic example of an asset type that is often the subject of a project finance transaction.
It is against this backdrop that one can see the critical role of the core project agreements in a project finance transaction. The core project agreements are designed to lock in that predictable revenue stream. They must work together to allocate the risks that can affect the value of the revenue stream inherent in the construction and operation of a project to those parties best equipped to take on and mitigate that risk.
However, constructing a project that will generate revenue is only one part of the equation. You cannot assign a value to a project's revenue stream without understanding how consistent that revenue stream will be, and how much it will cost to build, operate and maintain it.
II Engineering, procurement and construction contracts
An engineering, procurement and construction (EPC) contract does exactly what the name implies. The project owner, typically a special purpose entity, contracts with a single contractor that will be solely responsible for all of the engineering, equipment and materials procurement, and the construction of the project. In most cases, these contracts are referred to as 'fully wrapped' obligations, meaning that even though the contractor may subcontract significant portions of the work to others, it remains solely responsible for all of the work, including the work performed by others. This single point of responsibility had been traditionally favoured by lenders and project sponsors. If the completion of a project was delayed or the project was found to be defective, lenders and sponsors had recourse to a single creditworthy entity and the security it provided, avoiding being caught in the middle of a dispute between the contractor and one of its subcontractors concerning the root cause of the underlying issue.
However, this does not come without consequence to the project. To accept the risk of performance for all of its subcontractors, a contractor will often build a risk premium into its pricing. This risk premium will affect the value of the revenue stream of the project. As a result, over the past few years some projects have been project-financed with a bifurcated EPC contract. In a bifurcated structure, typically, the major equipment procurement portion of the work is carved out of the EPC contractor's work scope and the project owner directly contracts with the equipment supplier for this portion of the work. The EPC contractor's work scope is then limited to the balance of the project. While this approach can lower the overall project's construction costs and thereby enhance the overall project's revenue stream and value, it does shift some of the construction risk onto the project owner. Lenders and project sponsors in these cases need to be wary of getting caught in a 'finger-pointing' scenario whereby a project is delayed or not performing properly and the EPC contractor and the equipment supplier are blaming each other as the root cause of the issue, leaving the lenders and the project owner stuck in the middle of the dispute.
In addition to traditionally providing the project with a fully wrapped single point of responsibility for the construction of the project, the other most important aspect of an EPC contract is that it provides cost and schedule certainty. Project-financed EPC contracts are most typically fixed-price contracts that include a guaranteed completion date. Harkening back to our project sponsor's desire to create a project with a predictable revenue stream, it is easy to understand the significance of contracting with a reputable contractor who will guarantee the project's completion date at a fixed price.
At its core, an EPC contract is therefore a fairly straightforward contract: the project owner and the contractor agree that the contractor will engineer, procure and construct a 500 megawatt gas-fired combined cycle electric power generation facility for the owner at a fixed contract price of US$X million dollars and will guarantee completion of the project in Y months. That is a simple agreement, so why are EPC contracts typically hundreds of pages long? The essential simplicity of the EPC contract is complicated by hundreds of 'what-ifs'. What if the work is delayed or the cost increases and it is not the contractor's or one of its subcontractors' fault? What if the owner causes the delay or changes the scope of work? What if there is a force majeure event? What if the project does not perform as expected? These concerns and hundreds of others have caused EPC contracts to become lengthy and complex legal documents.
In drafting or reviewing an EPC contract, it is critical to focus on the circumstances that could result in a change in the fixed price, a change in the guaranteed completion date or a shift in any portion of the construction risk back onto the project owner and, indirectly, the lenders. It is also critical to take note of the project owner's recourse for the contractor's failure and the security for that recourse. With this in mind, let us consider some of the more material provisions of an EPC contract.
i Scope of work
It is important that the EPC contract includes a clear, comprehensive and detailed scope of work. While detailed engineering is part of the contractor's EPC scope, the scope of work exhibit (sometimes called design basis) must accurately detail the specifications of the project. Disputes between project owners and EPC contractors routinely involve questions of whether something was intended to be part of the contractor's scope or not.
ii Change orders
The basic premise of an EPC contract is that the contractor will provide all of the engineering, procurement and construction services necessary to complete the project for a fixed price and with a guaranteed completion date. There are, however, limited circumstances that would entitle the contractor to a change in the price or schedule pursuant to a change order. These change order circumstances should be narrowly and clearly defined, and include a clear process. Standard change order circumstances include unknown and unforeseeable subsurface conditions, unknown pre-existing hazardous substances, force majeure, owner-caused delay, change in law, and scope changes approved or directed by the owner. Any other circumstances that could result in a price or schedule adjustment should be sceptically viewed by project sponsors and lenders.
iii Guaranteed completion and delay liquidated damages
There are three completion milestones that are typically specified in an EPC contract, with detailed criteria for each and a process to certify achievement. The first hurdle is typically called mechanical completion. Mechanical completion is achieved when a project has been constructed and individual systems have been checked out to the point where the project is ready to begin its performance testing. While mechanical completion is an important step in the completion process, it is really just a prelude to the significantly more material milestone of substantial completion (sometimes also referred to as commercial operation or provisional acceptance). Therefore, it is unusual to have delay liquidated damages associated with the failure to meet mechanical completion by a certain date. Substantial completion, on the other hand, is a materially more significant hurdle. At substantial completion the project has not only achieved mechanical completion but it has also satisfactorily completed its performance testing. The performance tests are designed to demonstrate that the project can generate the expected output while also achieving certain efficiency requirements, all the while satisfying any environmental requirements. In an electric generation facility project, these tests are normally measuring electrical output and also heat rate at varying conditions. A reliability test is also often performed.
Substantial completion is the most critical milestone in a project-financed construction project. It is at substantial completion that the project shifts from a construction project to an operating asset, commencing commercial operation and generating revenue. It is at substantial completion that risk of loss, and custody and control of the project, shifts from the EPC contractor to the project owner. It is a major event in any project financing.
Given the significance of the event, an EPC contract usually includes a specified guaranteed substantial completion date with delay liquidated damages due from the contractor for each day of delay. Delay liquidated damages act as an incentive for the contractor but also a protection for the project sponsors and lenders, replacing the lost revenue and covering debt service and other losses during the delay. Delay liquidated damages are often capped at a percentage of the contract price.
Final completion is the last major construction milestone. After substantial completion, often some small non-material work remains to be completed. These 'punch-list' items are deferred until after substantial completion. When all of the work, including any punch-list item, has been completed, the project will have achieved final completion. It is unusual to have delay liquidated damages associated with the failure to meet final completion by a certain date.
iv Minimum performance levels and performance liquidated damages
To achieve substantial completion, the contractor must demonstrate that the project has successfully completed its performance testing. What if the test results for output and efficiency are close but not 100 per cent achieved? Typical EPC contracts will specify certain minimum performance levels whereby the contractor can achieve substantial completion notwithstanding that 100 per cent of a certain performance level has not been achieved. If the EPC contractor has achieved substantial completion by satisfying the minimum performance levels but not the full performance levels, the contractor will be granted a cure period, typically in the 180-day plus range, to cure the performance shortfall. If, after the cure period, the contractor has still failed to meet the full performance criteria, it will have to pay certain performance liquidated damages (sometimes called buy-down liquidated damages). These performance liquidated damages should be assessed to approximate the loss in the revenue stream associated with the shortfall. As with delay liquidated damages, performance liquidated damages are often capped at a percentage of the contract price. There is often also an aggregate cap on delay and performance liquidated damages.
Most often the contract price is paid monthly based upon the achievement of certain milestones. Other EPC contracts will have the contract price paid monthly based upon the completion of certain aspects of the work. In any event, the contractor will need to certify completion and also provide conditional lien waivers, conditional only on payment. As security for its performance, EPC contracts will provide that the project owner may retain a portion of the amount due. This is typically in the 5 to 10 per cent range and is often paid to the contractor upon the achievement of substantial completion, with some held back to cover the cost of punch-list items. In lieu of actually withholding the payment, it is common for the EPC contractor to provide an escalating letter of credit.
vi Contractor security
In addition, the contractor will be required to provide either a payment and performance bond, or a suitable parent guarantee covering all of its payment and performance obligations under the EPC contract.
vii Limits on liability
An EPC contractor's overall liability limit is often 100 per cent of the contract price. It has become increasingly common for this overall limit on liability to step down to a lower amount upon the achievement of substantial completion. Indemnity and warranty are typically carved out of the limitation.
Typically, the EPC contractor will also provide certain limited protection against defects in design, workmanship and components during a negotiated period following substantial completion. The length of an EPC contract warranty can vary greatly based on the nature and technology of a particular project, but it generally covers a period between 12 and 48 months and includes an extended warranty period subject to a cap for defects that have been corrected during the original warranty period. For large pieces of equipment directly procured by project owners in projects that follow a bifurcated structure, it is traditional for the equipment supplier to provide different warranty periods at predetermined prices. For more complex projects the project warranty can also address serial defects and root cause analyses. The period and scope of an EPC contract warranty is a very important aspect of the EPC contract, given the potentially significant adverse impacts to project cash flows resulting from outages caused by defects during the months immediately following substantial completion.
ix Engineering, procurement, construction and management contracts and other pricing structures
Outlined above are the standard material provisions found in most project-financed EPC contracts. There are, however, some deviations, including engineering, procurement, construction and management contracts, which are not wrapped contracts, as well as alternative pricing arrangements with some sharing of risk. Clients and contractors will often ask if finance can be obtained for these structures. The answer is that finance is potentially available for anything, but the more the structure deviates from the standard and the more risk that the project owner assumes for construction, pricing and schedule, the more recourse the lenders will expect from the project sponsors.
III Supply or feedstock agreements
Supply or feedstock agreements are normally significant contracts in a project finance transaction. Almost all projects in this arena require some kind of fuel or feedstock that is converted into a product revenue stream once a project has completed construction and has begun commercial operation. Dramatic swings in feedstock costs can materially affect the value of a project's revenue stream and the feedstock's unavailability can be the death knell of a project.
Supply or feedstock agreements therefore achieve two primary goals. First, they often fix feedstock pricing with either a fixed price or a bandwidth of pricing. This pricing certainty helps lock in the predictable revenue stream necessary for project financing. Second, and just as importantly, these contracts help ensure the availability of the feedstock necessary for the project to be started up and tested prior to substantial completion to the extent that this obligation remains with the project owner and, thereafter, to generate its product and therefore generate revenue. Projects of this nature are commonly constructed in remote locations and therefore transportation of the feedstock is also a key component to ensuring its availability.
As with EPC contract pricing, when reviewing supply or feedstock agreements it is critical to understand the circumstances that can change pricing over the term of the agreement. These agreements are typically long-term contracts. The preferred pricing model is a fixed price for the input, subject only to escalation over time. Alternative arrangements include bandwidth pricing with a floor and a ceiling price. The less certain the pricing, the less certain the value of the revenue stream and the more recourse will be required from the project sponsors.
Some inputs or fuels may need to be transported by rail; some may need extensive lateral pipelines; others may need special long-term hauling arrangements. To the extent that rail or lateral pipelines will need to be constructed, the same sensitivity with respect to substantial completion under the EPC contract should be applied to the construction of these transportation facilities. The agreements must clearly set out the third party's obligations to obtain the necessary property rights, permits and approvals for the construction and operation of the facilities within the schedule requirements necessary to support the substantial completion date of the project.
In conjunction with securing the necessary transportation rights, project owners and lenders will need to be sure that the supply of the feedstock is available to its project when and if needed. As a result, these supply agreements are typically supply-or-pay arrangements, whereby the supplier has the obligation to supply the feedstock at the agreed delivery point or either provide replacement feedstock or pay the project owner damages. The quality of the feedstock is often important as well.
Poor quality input can lead to inefficient production or in some cases premature equipment failure. Supply agreements should, therefore, include detailed specifications for feedstock quality, and put in place procedures to test and ensure the quality specifications of the feedstock being delivered.
Any disruption in the delivery of feedstock meeting the necessary specifications can have a material impact on the project's revenue stream and its viability. It is critical, therefore, for a project owner to contract with reputable creditworthy entities and to enter into agreements with limited and very narrowly defined circumstances of excused performance.
i Operations and maintenance agreements
An operations and maintenance (O&M) agreement provides much of the same function during the operations phase of a project as the EPC contract does during the construction phase. To ensure the predictable revenue stream necessary for a project financing, it is important to fix the costs to operate and maintain the project as much as possible. Much like an EPC contract, pursuant to an O&M agreement, a special purpose entity project owner engages a reputable and creditworthy service provider to provide all of the operation and maintenance services necessary for the project. Most often these agreements are similar to fully wrapped EPC contracts. Under a typical O&M agreement, the service provider will commence providing services just prior to substantial completion of the project during the project's start-up and testing phase. Once the project achieves substantial completion and commences commercial operations, the service provider becomes the primary entity responsible for the project's operations and maintenance.
The pricing for O&M services is most commonly a monthly fee plus cost reimbursement. Given the significance to the bottom line due to variations in the cost reimbursement portion of the payment, particular attention is often given to the budget process in O&M agreements. Commonly, the project owner and service provider agree in advance on an annual budget and the service provider will not be compensated for cost expenses that deviate from it. The exceptions to this are limited to minor and immaterial deviation amounts, expenses incurred to remediate an emergency or urgent situation, or costs and expenses incurred pursuant to a budget amendment approved by the project owner in advance.
O&M agreements will most often have a term in the five-year range with the potential for extension. Unlike the EPC contract, the project owner will, however, have the right to terminate the agreement without cause prior to the expiration of the term without significant penalty.
Similar to the EPC contract, the O&M service provider will agree to certain performance guarantees including demonstrated availability with liquidated damages for failure to meet the performance guarantees. The liquidated damage amounts are usually materially less than similar liquidated damages under the EPC contract.
The service provider's overall limit on its liability is typically capped at one year's-worth of its fees.
ii Long-term service agreements
In many projects, the major equipment used will require major maintenance after a known period of extended use. In gas-fired power projects, for example, certain parts of the gas turbine will require repair or replacement after a predictable number of hours of use. These repairs can be extensive and the resulting outage for this work could have a material impact on a project; so too would the uncertainty of future costs for these repairs. A project owner and the equipment supplier will enter into a long-term service agreement (sometimes called a contractual services agreement) to ensure the vendors' availability to conduct the repair work; to stock the appropriate unique parts; and to fix the cost associated with the repairs. Under that agreement, the project owner will pay the equipment supplier a monthly fee commencing normally upon substantial completion with a long term of several years. In exchange for this fee, the equipment supplier agrees to perform the planned maintenance services for the covered equipment upon an agreed schedule tied to the operating hours of the project. The services will include all parts, labour and technical services. In some long-term service agreements, the services will also include unplanned maintenance.
These are long-term agreements but they will often include a termination right for the project owner subject to a mutually agreed termination fee.
iii Offtake agreements and power purchase agreements
The agreements discussed above are structured in a project financing to allocate risk and to fix, as much as possible, predictable and material costs. So how do you fix or make predictable a project's revenue stream so that it can be financed? In some instances, given the nature of the project, and its location and the market it serves, there is no offtake agreement or contracted purchaser of the project's product. These types of projects are referred to as merchant transactions. The theory behind the financing is that if it is built, the market for the product is sufficiently known and therefore there is comfort in the value of the revenue stream. Pure merchant projects carry market risk and they are not common. In recent years, many projects in the electric power space have been financed on a quasi-merchant basis. These projects typically receive at least partially predictable revenue for their capacity sales to a regional system operator. Sales for the actual energy generated by the project are then made on the open market. To mitigate this energy market risk further, often hedge agreements are put in place.
The preferred method to fix a project's revenue stream is a long-term offtake agreement. In the electric power sector, these agreements come in the form of power purchase agreements. In an offtake agreement, the project owner agrees with a creditworthy purchaser to sell all of the project's output to the purchaser for an extended term at set predictable pricing.
Offtake agreements are most commonly take-or-pay arrangements, where the purchaser agrees to pay both for the project's capacity to produce the product as well as for the actual delivery of the product at an agreed delivery point. Capacity payments are normally fixed and tied to the demonstrated capacity of the project. These payments are made monthly whether or not the project generates any product. The initial capacity of the project and the resulting capacity payment amount is tied to the performance-testing results of the project used to demonstrate substantial completion under the EPC contract. It is important, therefore, that the testing protocols, performance standards and definitions of substantial completion or commercial operation that are set forth in the offtake agreement align with the same testing requirements, performance standards and definitions set forth in the EPC contract.
Offtake agreements will include follow-up capacity testing procedures during the term of the agreement and the fixed capacity payment can be subject to adjustment in the event of changes in a project's capacity. In addition, and designed to ensure the availability of the resource to the purchaser, offtake agreements will include project availability requirements. Failure to satisfy availability requirements can lead to damages, pricing adjustments and, potentially, default and termination. The project owner and lenders will need these obligations to be passed through and coordinated with the O&M agreement and the long-term services agreement.
The second revenue stream under the offtake agreement is tied to the actual delivery of the product. These payments are typically not fixed and based upon a formula tied to variable operating costs. Some offtake agreements will include floor-and-ceiling pricing for this component.
The product of the project is often critical to the offtake agreement purchaser. As a result, these agreements will impose significant security obligations on the project owner. The amount of the security will change over time but initially it is common to include a significant amount of security and penalties tied to the failure to complete the project's construction and achieve substantial completion by a specified date. It is important here as well that these obligations are aligned with the contractor's obligations to the project owner under the EPC contract.
The offtake agreement is often the most critical document in a project financing because it sets the predictable revenue stream that is the basis of the financing. Therefore, project owners and lenders will need to scrutinise and seek to limit any provisions that can change or waive the purchaser's payment obligations. Defaults and termination events should likewise be clearly and narrowly defined, and limited to material and sustained failures of the project and the project owner.
Some offtake agreements take the form of tolling contracts. In such agreements, the purchaser, rather than the project owner, is responsible for the feedstock. In tolling agreements, the purchaser essentially uses the project to convert its feedstock into the product it requires. As a result, these agreements will have significant provisions detailing the coordination of the operations and maintenance of the project with the supply of feedstock and output production and delivery.