An engineering, procurement, and construction (EPC) contract for a power project defines how its risks will be allocated and the scope of work to be performed by both parties. This article begins by detailing several kinds of risk that are typically the subject of lengthy negotiations and concludes with two case studies of dispute resolution, which is needed when good contracts are poorly executed. We hope that these descriptions of construction contract risk prove helpful during your next negotiation for a new plant or major plant upgrade.
Carrots and sticks
EPC contracts are two-way streets. Contractors normally seek to have their agreements provide bonuses for beating a project’s schedule deadlines and/or performance standards. Such provisions balance other provisions for payment of predetermined “liquidated damages” that are typically required by owners as insurance against nonperformance. Contractors are liable if the plant is commissioned late or cannot operate at its guaranteed capacity and heat rate at full load.
Owners are willing to reward contractors with a share of the “bonus” revenues generated by a project that comes on-line earlier than expected. For their part, contractors are willing to accept liability for liquidated damages because the plant’s construction schedule and performance are under their control (barring legal delays or an act of God). The magnitude of the liquidated damages is usually sufficient incentive for the EPC contractor to build a plant that meets the guarantees.
Naturally, EPC contractors cover their own risk by insisting on liquidated damages clauses in contracts for major plant equipment. Equipment vendors guarantee the performance of their individual units, but it is ultimately up to the EPC contractor to tie those units together into a power generation system with a minimum capacity and maximum heat rate.
Performance guarantees usually have a tolerance band, to allow an owner to provisionally accept a completed plant and begin selling its output. Provisional acceptance is followed by a grace period, during which the EPC contractor adjusts equipment and systems as necessary to enable the plant to meet contractual performance guarantees. If the plant still cannot meet those guarantees by the time of final acceptance, the contractor normally would be required to “buy down” the shortfall in plant performance at the specified liquidated damages rate.
Typically, an EPC contract has zero tolerance for a plant that cannot operate without exceeding permitted levels of air, water, and noise pollution. If it cannot meet all emissions guarantees, it cannot be accepted, even provisionally. Supply contracts for major equipment have their own emissions guarantees.
Similarly, there is zero tolerance for a project being late. The project schedule is a heavily negotiated item of the EPC contract. Because schedule guarantees are only partially backed by equipment vendors’ delivery dates, most of this type of risk is borne by the EPC contractor.
By the milestones
The common thread in nearly all large power projects is a series of milestones that the EPC contractor must reach on the road to commercial operation—and final contractual payments. Each milestone has checks, balances, and risks that together ensure compliance at a certain time with the terms of the EPC contract. These milestones are typically:
- Mechanical completion
- Performance testing
- Provisional acceptance
- Commercial operation
Mechanical completion. Mechanical completion signifies the successful completion of start-up and commissioning of all plant systems. After each system is turned over from the EPC contractor to the project’s start-up organization, it is checked out, calibrated, and commissioned. Often, the EPC contractor is also tasked with providing hands-on training to operators of the new plant. Having the operators participate in start-up gives them invaluable plant-specific experience, as well as an opportunity to identify “punch list” items to be included in the package of test and commissioning data that accompanies each system to its next stop: performance testing.
A punch list is usually developed for each system prior to its turnover. Items on the list represent jobs that need to be done by the EPC contractor but ones that are not so urgent that leaving them undone would affect personnel safety or the plant’s operability or permit compliance. Examples include building access platforms for maintenance, touch-up painting, landscaping, and site cleanup.
Each item on a punch list is carefully considered; indeed, a single item is often the subject of long negotiations among the plant’s owner, EPC contractor, and operator to determine whether it is necessary and included in the contractor’s scope of work. The contractor can complete tasks on the punch list after performance tests are conducted and the plant is accepted by the owner.
During start-up and commissioning, the suppliers of boilers, turbines, pumps, and motors fine-tune their gear in an integrated environment, usually with units connected to the grid. This step is critical because it sets the baseline values of capacity, heat rate, and emissions metrics to be verified by performance testing.
While the plant is being tuned, fuel is consumed and electrical energy is delivered to the grid through the local, interconnecting utility. For bearing the risk of paying for the fuel, the owner is rewarded by the revenues generated. But because the plant may start up and shut down many times during the tuning phase, the grid operator must consider its output unreliable, and the plant itself not dispatchable. Accordingly, the owner is paid for kilowatt-hours at a lower, “avoided-cost” rate. Because these revenues may not fully offset the cost of fuel, it is not uncommon for a contract to stipulate that the EPC foot some of the fuel bill if the duration of tuning becomes excessive.
Mechanical completion is a critical milestone in the lifecycle of a power project, and not just because it precedes performance testing. It is also an opportunity for the owner to make sure that other contractual obligations—training operators, and delivering O&M manuals, for example—have been met by the EPC contractor. Mechanical completion often is certified by a piece of paper attesting that both the owner and the EPC agree that the plant is ready for performance testing.
The conditions required for mechanical completion status usually include the following:
- The EPC contractor has finished all tasks (including operator training) in its scope of work, except for the items on punch lists.
- The work is mechanically and electrically sound, plant start-up is complete, and all systems can be operated as specified.
- The plant can be operated in compliance with all relevant laws and permits and without damage to persons or property.
- The plant has synchronized to the grid.
- The contractor has provided draft copies of station manuals and O&M manuals.
Performance testing. Performance testing gives the EPC contractor an opportunity to prove that the plant meets performance guarantees for capacity, heat rate, and emissions.
Performance testing entails operating the power plant at full load using normal procedures while measuring its fuel consumption and energy and pollutant outputs over a short period of time—4 hours, for example. Ambient conditions and fuel content are also recorded, and that data is then used to adjust the three measurements for comparison with guaranteed performance levels. In many cases, the plant is also run for an extended period—say, 100 hours—to make sure that all systems and components work properly, both individually and in concert, and to detect “lemons” at the steep, early end of the reliability “bathtub” curve.
Successful completion of performance testing gives the EPC contractor an opportunity to stop the accumulation of liquidated damages if the plant is finished after the guaranteed completion date, or to claim a bonus payment if the plant is completed before it.
As during fine-tuning in the mechanical completion phase, the plant owner provides the fuel for performance testing and reaps the rewards of generation revenues it produces. Again, the receiving utility pays for kilowatt-hours at an avoided-cost rate, because the output is considered unreliable. At this stage, though, if revenues do not compensate for the cost of fuel, the difference is typically absorbed by the owner.
Provisional acceptance. There is usually a 95% provisional acceptance level for capacity and a 105% provisional acceptance level for heat rate. As mentioned, all guaranteed emissions levels must be met, and the plant must be operated in compliance with permits before the owner will grant provisional acceptance of the plant to the EPC contractor.
If capacity and heat rate are not at the 100% guaranteed performance level when first tested, but within the range for provisional acceptance, the EPC contractor usually has until the date of final acceptance to achieve the 100% levels through tuning, adjustments, or modifications. After that date, the contractor will have to buy down any difference at the liquidated damages rate stated in the contract, as mentioned earlier.
Punch list items also have to be completed by the final acceptance date, which may be as long as one year after the provisional acceptance date.
Commercial operation. Provisional acceptance occurs when the results of performance testing are verified. Verification may take some time because the technical data must be analyzed by the owner’s engineer and an independent engineer. The EPC contractor retains care, custody, control, and the risk of loss while the test results are being verified. When test results verify that the guaranteed performance levels have been met, provisional acceptance is granted retroactive to the date of successful completion of performance testing.
Upon provisional acceptance, care, custody, and control transfer to the owner. The commercial operation phase begins when the plant is dispatched or given a generation schedule by the grid operator, following notification of the interconnecting utility.
In the case of a plant that delivers energy under a power-purchase agreement (PPA), the off-taker typically will verify results of the performance testing to confirm that the actual capacity meets the requirements of the PPA. In some cases, the off-taker is only notified that the results met the requirements of the PPA before commercial operation begins.
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