A recent trend in the mining sector has been the shifting sands around the preferred approach to procurement and construction risk, often associated with macro economics and industry factors. Rather than there being a single dominant theme, these changes are characterized by a blend of new and old approaches. In this article, we highlight those most commonly encountered.
Changes have arisen as a result of the global financial crisis and the subsequent volatility in the global economy and in commodity prices. Mining, metal and other resources are increasingly available only in more far flung places in less developed countries. This usually brings very substantial infrastructure development requirements in order to get products to market. Often, there is an associated desire to move some of the risk and costs which were traditionally viewed as corporate in nature to government or third party debt/equity. This influences how both financial arrangements and construction contracts on such projects are structured.
The main options
By way of recap, there are fundamentally two core approaches to construction contracting (regardless of the funding structure (for example, project finance, PPP, on balance sheet etc)):
(a) EPC contracting: In most other industries, the dominant trend for the last 20 years has been for contracts to be let on an EPC (engineer, procure and construct) basis, sometimes known as lump sum turnkey contracting. The idea is that, once the construction and testing phases are over, the owner can simply "turn the key" to start up the plant/facilities, which will then begin to operate and generate revenue. These contracts are fixed price and date certain and, in both traditionally and project financed projects, seek to pass down as much risk and design responsibility as reasonably possible to the contractor who will carry out the design and construction work. Such contracts maintain a single point of contractual responsibility, which is helpful should any claims arise, and also mean that the construction obligations are transferred to the party best placed to manage the construction risk
Multiple EPC contracting: The multiple EPC contracting approach will probably be the most favourable sub-alternative solution where a single EPC contract cannot be managed due to the market or the procurement structure. Typically this arises because of the sheer project scale, constraints in the contracting market, or timing requirements driving the letting of one of the works packages before the balance of works packages is ready. It could also be influenced by the current project finance environment's emphasis on EPC contractors' credit ratings and banks' exposures to them and their significance to bankability. This route will require particularly thorough discussions with technical advisers about the optimum package size, how the project can best be "diced and sliced" and the financial and technical management of interface risks; and
b) EPCM contracting (and management contracting variants thereof): The mining and other resource industries have long favoured EPCM (engineering, procurement and construction management) contracting as the main alternative to EPC contracting. Under the EPCM structure, a single EPCM contractor is appointed to engineer and manage the project and the owner or employer lets works packages directly. The packages are then managed by the EPCM contractor. There are a small number of large, multinational contractors who specialise in this approach. Broadly, the employer retains the cost and schedule risk, but the schedule risk can be reduced by linking some part of the EPCM contractor's fee to achieving the programme and by a variety of other means. However, this alternative is far more challenging when used in a project financing scenario and in such a situation is likely to require substantial other balance sheet and/or equity support;
Client-delivered contracting: A slightly different approach, known as client-delivered contracting, is also sometimes encountered in the mining and resources industry. Whilst this is essentially the same as EPCM contracting, the employer tends to either appoint a more traditional professional team (consisting of, for example, an engineer, specialist designers and a project manager) or to carry out all or part of the professional team's role in-house alongside the works contractors
The above are relatively standard approaches, with the options varying depending on the specifics at the point the project is let. For example, in recent years we have seen:
- Market constraints driving a move towards EPCM (and a loosening market increasing EPC appetite);
- Commodity price peaks causing parties to lean towards EPCM (and the converse with the pricing cycle); and
- Limited recourse/PPP finance (especially in the context of mining transport/infrastructure developments) encouraging a move to EPC.
Alongside these market factors, the scale of project requirements and risks obviously will be important but we see these playing less of a part than has traditionally been the case (where the procurement route tended to reflect procurement fashion or project specifics more than macro economic factors). Against this background, we are seeing a number of secondary influences
- Project scale may mean it will be difficult to build more than one or two credible bidding consortia and sometimes the only players likely to be capable of providing EPC wraps for mega deals are those with substantial explicit or implicit state support
- Where factors such as the above drive serious (albeit quasi-artificial) restrictions on the contracting market, this may perversely undermine the value of the EPC wrap available. Growing contractor bargaining power means that both contractual and practical considerations may lead to unfavourable or unenforceable terms
- The mix of the market and macro political and economic conditions can offer up some surprises. Some projects that look challenging due to sheer scale may produce unexpectedly strong EPC bids on very cheap terms (especially where there is a combined EPC and finance offer or requirement). One reason for this may be the level of political stimulus and push for growth amongst the major economies in which the world's major EPC contractors reside. This desire, coupled with the muscle and attraction of ECA (export credit agency) finance, which can be harnessed to EPC bids, continues to be a dominant theme.
The only constant will be change, but more and more, we find that the procurement and risk allocation drivers have tended to be led more by macro political and economic or financial factors, than by procurement theory or engineering requirements.