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Restructuring News – Engineering, Procurement and Construction (EPC) contracts

Engineering, Procurement & Construction (EPC) Contracts

This edition takes a closer look at EPC contracts, their key features, risks and lessons learnt.

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David Hardy

Partner, Restructuring Services

KPMG Australia

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Overhead view of construction workers examining plans onsite

What are EPC contracts?

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.

Organisational chart displaying the attributes of a 'turnkey’ contract.

Features of EPC contracts

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:

  • Greater visibility over the total project estimated cost and time.
  • The Contractor typically assumes a greater proportion of the delivery and procurement risk.
  • It provides for easier contract management with only one contracted party to manage.

For the Contractor, this type of contract is attractive due to:

  • greater flexibility in the selection of design and other subcontractors
  • increased efficiency as the Contractor often has control over a proportion of the contingency and can make variations decisions more quickly
  • the ability to deliver projects at a lower cost by taking advantage of procurement packaging or structure, bulk discounts, trade gains and value engineering opportunities.

Key risks in relation to EPC contracts

1. The relationship between low profit margin and weak project controls

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.

Key risks in relation to EPC contracts

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.

2. Weak governance and soft controls

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.

3. Inappropriate risk allocation

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.

4. Other key risks

  • Quality – in an instance where the EPC contract prescribes a fixed budget, there is a risk of the Contractor minimising cost and delivering inferior quality outputs.
  • Cost and time overrun – force majeure, delays and other disruptions can lead to time overruns and consequent cost impacts. The accountability for these overruns will depend on the terms of the contract.
  • Design and other subcontractors – whilst Principals can benefit from having a single point of responsibility provided by the EPC contracts, they can lose influence over the detailed design. This can lead to expensive variations if the design is not to expectation.

Lessons learnt

1. Contractual terms

Features of a 'good' EPC contract:

  • Risk allocation – it is important to understand the Contractor’s risk exposure, including:
    • their ability, or the lack thereof, to claim additional costs and extensions of time
    • any performance guarantees or securities provided
    • any exposures to liquidated damages.

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.

  • Clearly defined project scope – to minimise the risk of time and cost overrun, it is important the Principal clearly defines the output, or deliverable, and the expected standards, but not the construction methodology or the suppliers (subcontractors). If the Principal specifies either the construction methodology or the suppliers, it will reduce the cost saving opportunities for the EPC and increase the likelihood of variations claims should those subcontractors fail.
  • Variations clauses – where the Principal has the ability to instruct changes or variations with an agreed-upon method for calculation of the additional cost, e.g. agreed rates for variation work, this can provide greater control over the outcome, and can help to keep the costs of variations under control. Variation cost estimates should ideally be reviewed by an independent Quantity Surveyor to ensure these remain competitive.
  • Project milestones – the Contractor should be required to provide monthly raw data schedule files, schedule quality review scores (e.g. Acumen Fuse scores), as well as regular Schedule Risk Analyses (SRA). This will help to ensure that schedule reporting remains accurate and the Contractor schedule can be trusted.
  • Counterparty review – counterparty default risk can be mitigated through a counterparty review of the Contractor (financials and non-financials, e.g. governance and controls) both prior to execution of the EPC contract, and at key points through the project lifecycle (e.g. through the use of project health checks). Project health checks should be completed by a party external to the Principal’s project team in order to ensure objectivity and avoid optimism and confirmation biases.

2. Governance and controls

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:

  • Ensure clarity of ownership and accountability, e.g. through the use of a ‘Responsible, Accountable, Consulted and Informed (RACI) matrix’.
  • Invest in project controls and commercial and contract management professionals and ensure that they are dedicated to the project – and on site – full time.
  • Implement programs to attract and retain highly-skilled and diverse resources.
  • Establish and maintain an appropriate baseline of training in core project management skills.
  • Invest in a culture of innovation and in technologies aimed at improving project controls and project delivery efficiency.
  • Ensure an uplift in the maturity and effectiveness of project controls by implementing a project assurance framework. This should include independent project health checks.
  • Understand that hard controls are only part of the picture. Soft controls such as role modelling and achievability can be equally important to achieving project outcomes.
  • Invest in risk management training with a view to creating an organisation-wide culture of risk awareness.

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