This edition takes a closer look at EPC contracts, their key features, risks and lessons learnt.
Under an EPC contract, the principal or owner engages a contractor to design and deliver the project into an operational state. This type of contract is at times described as a 'turnkey' contract as, at completion of the project, the Principal can simply 'turn a key' to commence operation.
The primary feature of an EPC contract is its single point of responsibility whereby the Principal engages with only one contractor. The EPC contractor (the Contractor) will then manage all the subcontractor relationships on behalf of the Principal.
The structure benefits the Principal in the following ways:
For the Contractor, this type of contract is attractive due to:
One of the main risks to the Principal in an EPC contract is the risk of default by the Contractor. Two key factors that contribute to an increased default risk are a low profit margin and weak project controls.
As identified in Restructuring News – Construction: October 2018, the overall construction sector continues to operate in a thin margin environment due to higher input costs and fierce competition. To combat this, some contractors have invested in innovation and new technology such as drones and Building Information Modelling (BIM) that were intended to increase efficiency. In practice these technologies have not yet yielded a significant improvement in productivity. As a result, downward pressure on margins has remained.
As a flow-on from thin profit margins, we have observed that many industry players have not adequately invested in upgrading their accounting and financial project control systems to accommodate for the more complex and high risk EPC projects.
Furthermore, KPMG has observed the importance of dedicated full-time Commercial and Contract Management Professionals who are experienced in managing contract variations. However, in order to minimise costs, there have been instances where contractors delegate this role to less experienced project managers who do not have the required expertise. This often results in weaker project control and increased project risk exposure, continuing the cycle illustrated in the diagram above.
Good governance, including hard and soft controls are important success factors on construction projects. Weak governance – such as a lack of ownership and accountability – increases the risk of project failure. It is our observation that soft controls like role modelling and achievability are as important in projects as the more recognised hard controls, like systems and processes.
An example of a weak soft controls environment is one where there is a culture of avoiding the communication of 'bad news' to senior management, despite there being a robust reporting process in place. This often results in senior management lacking awareness of the true status of their projects, and is exacerbated by inadequate second and third line assurance activity. Altogether this results in a failure to identify and solve issues in a timely manner, and ultimately, to project failure.
It is rarely appropriate for the Contractor to assume ownership of all the risks. A 'good' EPC contract is one that assigns risks to the party best placed and best qualified to manage that risk.
From researching recent contractor defaults, a common factor in these defaults has been the assumption of risks by the Contractor that they were not resourced or equipped to manage. The Principal should ensure that the Contractor has both skills and capacity to manage the identified risks, and the balance sheet capacity to absorb any additional ‘unknown’ risks that may arise. This applies particularly for larger, more complex, and EPC projects.
Features of a 'good' EPC contract:
The use of collaborative contracting (or Alliance Contracts) is one way to improve the likelihood that risks will be managed by those who are most qualified to do so.
As mentioned previously, recent failures in a number of EPC projects have been attributed to weak governance and controls. We have reviewed some of these project failures and can draw the following lessons for EPC contractors:
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