Milestones on the road to commercial operation

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.

Resolving disputes

Should there be any misunderstanding about any of the milestones, the first step is to review the dispute resolution provisions of the EPC contract. In international EPC contracts, the two most common forms of dispute resolution are an expert determination by an engineer or a dispute review board, and arbitration.

If a dispute involves technical or any other specialized issues, appointing an engineer as an impartial fact-finding and -evaluating expert can facilitate an early resolution. The engineer’s independence, which most arbitral tribunals value highly, can encourage both parties to narrow the issues and reach a settlement with no need for a costly arbitration. The engineers’ neutral fact-finding procedure can be binding or nonbinding.

A dispute review board is a private, voluntary, and confidential procedure commonly used in the context of an ongoing long-term relationship. The board comprises an informed standing group of experts who can quickly deal with disputes as they arise. Dispute review boards are commonly used in the construction industry and in high-value outsourcing contracts. Their determinations may be binding or simply advisory.

Arbitration involves the adjudication of rights by a tribunal of one or several arbitrators with the power to render a decision that is final and binding on both parties. The parties must specifically agree in writing to submit their dispute to arbitration. A possible exception is when one of the parties is a sovereign state or state-controlled enterprise, in which case the parties’ consent to arbitrate may be based on an investment protection and promotion treaty or an investment law. Arbitration is a preferred alternative to dispute resolution in the national courts of one of the parties because neither party has the “home court” advantage. Furthermore, settlement of the dispute is entrusted to arbitrators who may have significant experience resolving international power project contract disputes.

The two parties’ agreement to submit their dispute to arbitration can take either of two forms. One is a specific clause—an arbitration clause—in the original contract between them in which they agree to resolve all future disputes by arbitration. The other is a separate contract between the parties after a dispute has arisen stating their intention to submit that dispute to arbitration The latter is called a submission agreement, or clause compromissoire.

The importance of drafting an effective and enforceable arbitration clause should not be underestimated. A properly drafted arbitration clause makes the method of resolving future disputes more predictable. A poorly drafted clause, on the other hand, can result in unnecessary costs and delays representing the time spent arguing about the dispute resolution mechanism rather than the substance of the dispute itself.

It is increasingly common to find contract language that specifies arbitration for dispute resolution accompanied by clauses requiring both parties to pursue certain nonbinding efforts to resolve their dispute before arbitration can begin. These are often referred to as “multistep” dispute resolution clauses.

Typical multistep procedures require the parties to try to settle their dispute through negotiation. They also identify the level of corporate management at which the negotiations should take place and set time limits for their completion. Should negotiation efforts fail, the clause may even call for the parties to enter into mediation or proceed directly to arbitration. If the clause calls for mediation and the parties cannot reach a settlement within the stipulated time, or if one party refuses to participate, the dispute goes to arbitration.

Tell it to the judge

Dispute resolution is as much art as science. Following are two case studies from the international arena that should make this clear.

Case #1: Ready—or not—for commercial operation. Late in 2001, Comphania Paranaense de Energia Ltda. (Copel), a Brazilian mixed-capital company, stopped making monthly capacity payments under a PPA it had signed with UEG Araucaria Ltda., a joint venture of El Paso do Brasil Ltda., Petrobras, and Copel itself. At the center of the dispute was a 469-MW combined-cycle power project at Araucaria, near Curitiba in the southern Brazilian state of Parana, owned by the joint venture. Copel holds the electricity supply concession for the state.

In addition to arguing that the PPA itself was invalid under Brazilian law, Copel pleaded that the plant had not been built in compliance with the terms of its EPC contract. Initially, Copel—the off-taker—made capacity payments to UEG Araucaria. Then, at the direction of the state government, it stopped, putting Copel at default under the PPA.

At this point, UEG Araucaria terminated the PPA (in compliance with its terms) and invoked its dispute resolution clause. The clause called for the parties to negotiate first and, if that failed, to submit the dispute to arbitration in Paris before a three-person tribunal under rules of the International Chamber of Commerce.

The crux of the dispute was Copel’s claim that the plant had not achieved commercial operation. In addition to being the off-taker of the plant’s output, Copel was responsible for building the plant’s natural gas supply pipeline, its water supply system, and a substation and transmission lines to connect the plant to the grid. Copel also was responsible for O&M of the plant and for supplying its fuel, whose specifications were spelled out in the PPA.

Two gas turbines had been purchased on the assumption that the fuel they would be supplied would meet or exceed the requirements of the turbines’ manufacturer. The natural gas to come from a new pipeline from Bolivia was expected to meet those requirements. But when the gas began to flow, it was of poor quality. It became evident that if Copel supplied that gas to the Araucaria plant, both turbines’ warranties would be voided.

At Copel’s direction, a gas conditioning system (GCS) was installed to condition the natural gas to meet the vendor’s specifications. It was ready to provide compliance fuel to the turbines both when the plant was ready for performance testing and at the time of planned commercial operation in September 2002. However, the GCS produced by-products—natural gas liquids such as liquefied petroleum gas (LPG) and naphtha—that have significant value. When the power plant was ready for commercial operation, the facility for storing the LPG had not been completed, so the LPG had to be flared.

Performance testing of the power plant was successful: All capacity, heat rate, and emissions requirements were met, with the GCS supplying acceptable fuel. At this point, UEG Araucaria declared that the plant had achieved commercial operation. But Copel disagreed. When it stopped making monthly capacity payments, it claimed that the plant had not achieved commercial operation because the GCS had not been completed and therefore was unsafe.

Before the parties’ dispute was resolved amicably, the Paris tribunal heard significant amounts of expert testimony from both sides on such issues as the proper functioning of the plant, the requirements for declaring commercial operations under the PPA, the significance of punch list items, and the size of performance bonuses and liquidated damages.

Case #2: River gets dirtier. Who should pay to screen it? In the late 1990s, the cost of modifying a power plant’s water intake structure, incurred by an EPC contractor after the owner declared commercial operation, became the subject of a dispute that ended up in arbitration. After the plant passed performance testing, the owner made that declaration (in compliance with the terms of its PPA), although significant work remained to be done on the structure in order to prevent the PPA from expiring.

This plant, in Colombia, has a net capacity of 220 MW in combined-cycle mode and uses once-through cooling of its steam turbine condenser. It was built by affiliates of a Japanese company for the owner, a joint venture of the Japanese firm and an American company.

Although the plant was able to pass the performance testing mandated by the PPA, tests revealed considerable debris flowing through the intake structure that would make the condenser and the auxiliary cooling system prone to fouling. The original design of the intake structure used fixed screens and trash rakes, which proved inadequate. After the installation of traveling screens, the condenser still experienced fouling, and sand and silt continued to enter the auxiliary cooling system. To successfully complete the performance testing, the contractor had to reverse the flow through the condenser to reduce fouling of the tube sheets.

The continued fouling made it clear that significant modifications to the intake structure were needed to keep debris from entering the plant. Among the steps that the EPC contractor took were placing flow diverters in the river, adding a screen-washing system at the intake structure, and changing the design of the auxiliary cooling system from open-loop to closed-loop with the addition of a small cooling tower.

Naturally, the owner claimed that the modifications were within the scope of work of the lump-sum contract, while the contractor considered his expense a result of changed conditions in the river. The dispute led to arbitration under the Rules of the American Arbitration Association in New York. This case also was settled amicably, but only after significant expert testimony had been presented on the safe operation of power plant intake structures.

—Denis J. King (denis.king@asilea.com) is a principal and founding member of Asilea Resources LLC, a Maryland-based consulting firm. A Registered Professional Engineer, he also acts as an advisor to the K&M Group of Companies. Arif Hyder Ali (aali@crowell.com) is cochair of Crowell & Moring LLP’s International Dispute Resolution Practice. He has represented parties worldwide in international construction, investment, and commercial arbitrations.