EPC Contracts
Engineering, Procurement And Construction Contracts
EPC Contracts are project finance documents that establish a contractual framework between owner and contractor that transfers all design and construction risk to the contractor. Their efficacy in managing risk makes EPC Contracts the construction contract of choice for project financings.
Overview of EPC Contracts
Engineering, Procurement, and Construction Contracts or EPC Contracts are construction contracts that enjoy almost universal inclusion in project finance documents, They have emerged as the construction contract of choice in project financings that involve major international development projects. The increasing popularity of EPC Contracts is not due to the turnkey delivery method, which is the reason most often cited, although turnkey delivery is an appealing feature in EPC Contracts.
While much of the discussion focuses on the turnkey delivery of completed construction projects, attributing their unparalleled acceptance to turnkey delivery is a simplistic view of EPC Contracts and, more broadly, project finance documentation. The biggest reason for their overwhelming acceptance is the transfer, to the extent contractually possible, of all of the design, engineering, and construction risk from the project company who owns the project, to the EPC contractor that builds it.
An EPC Contract is a risk mitigation and management tool in the form of a project document. In fact, EPC Contracts were specifically conceived to transfer risk to the contractor. They make the contractor responsible for all project activities from the design phase all the way through the construction phase. Specifically, they make the contractor responsible for all design, engineering, procurement, construction, commissioning and handover activities of the project, leaving the owner with no responsibilities save for turning the key at project delivery.
Another reason for the widespread use and acceptance of EPC Contracts is that they are strongly preferred by project finance lenders. Project lenders are much more comfortable providing project financing when construction contracts have fixed prices and required dates for completion. Less risk to the lender means the likelihood of your project finance loan being approved increases substantially.
Structure of EPC Contracts
Under EPC Contracts, the project company enters into the contract with the EPC contractor. This is the only contract entered into by the project owner. The EPC contractor, in turn, enters into numerous subcontracts with subcontractors and materials suppliers for the performance of all or a portion of the work as specified in the EPC contract.
The structure of EPC Contracts allows the project owner to manage risk more effectively and allows the contractors to allocate and specialize in the work they undertake. Under common EPC Contracts, the contractor has full control of the design, procurement, and construction of the project from inception to completion.
Transfer of Liability
The primary purpose of using EPC contracts for major construction projects is to transfer essentially all of the project design and construction risk from the project owner to the EPC contractor. The contractor should be solely responsible for all design, procurement, engineering, construction, testing and commissioning of the facility.
As a result, the EPC contractor is liable for any defects or problems with the project. As a practical matter, the contractor cannot then seek to deflect blame to a third party. If the contractor consists of more than one entity (which is frequently the case in large-scale projects), it is important that each entity is jointly and severally liable to the owner.
The contractor is usually fully responsible for the entire design of the facility. The EPC contractor will thus be responsible for errors in any preliminary design or FEED (even though the preliminary design or FEED is likely to have been prepared by separate design consultant engaged by the owner). It is equally likely that the contractor will be required to provide a fitness for purpose warranty (which should be covered by professional indemnity insurance). This is consistent with the fundamental principle that the facility is, as an absolute obligation, required to satisfy the output specification as set out in the contract.
Fixed Contract Price
EPC Contracts require a fixed price which means that cost overruns or savings are the sole responsibility of the contractor. Further, the contract price should only be subject to increase in the event of specific and narrowly defined circumstances.
Fixed Completion Date
The EPC contractor should be under an obligation to complete the project, including all testing of the completed project by a fixed completion date. Failure on the part of the contractor to complete the project by the required date should -and almost always does – entitle the owner to claim damages for the delays, which are typically subject to an agreed cap. As with increases in the contract price, the completion date should only be extended in certain narrowly specified circumstances.
Contractor Claims
Because the primary reason for using EPC Contracts is to affect the transfer of as much risk as is practicable from the owner to the contractor, they severely limit the scope and circumstances under which contractors can make claims for additional time and money.
However, contractors will remain entitled to additional recovery, including additional time and money, for certain events which include owner’s default, change orders requested by the owner or the occurrence of force majeure events.
Owner Requirements & Remedies
Because the contractor performs all of the project design work the typically specifies precisely what is to be built, including the standards which must be achieved and performance requirements of the finished project in a document called Owner’s Requirements. The more detailed the Owner’s Requirements the more likely that the owner will get the project it wanted. However, this does expose the owner to claims for variations and extensions of time for changes to the Owner’s Requirements.
Again, as a result of the risk being transferred to the contractor, the contract price is generally higher than it would for other forms of construction contracts. Because the owner is paying more, it will want remedies under the contract to recover its losses if things go wrong. Specific remedies available to the owner include the imposition of liquidated damages, which are used for time delays and poor performance and reliability.
Handover, Testing & Performance Guarantees
While construction projects generally provide detailed procedures for completion and handover, it is not uncommon in project financings with EPC Contracts to require mandatory testing and commissioning, especially in the case of complex power and engineering plants. Testing is typically required before handing the project over to the owner to determine if the installation is performing as intended before acceptance, and again after taking over to ensure it continues to function as intended.
The requirements which must be satisfied for the completed work to be accepted by the project owner must be clearly stated. The tests on completion should be used to demonstrate that the prescribed requirements have been satisfied. At a minimum, the contractor should also obtain all consents and approvals, including the building completion certificate which allows the project to be operated for its intended purpose as a condition precedent to taking over.
Revenue will only be generated if the facility is effectively operated and satisfies the prescribed output requirements including standards of reliability and efficiency. It is therefore important that EPC contracts contain guarantees that are backed by performance liquidated damages if the required standards are not met. As with delay damages, performance liquidated damages are typically subject to an agreed cap.
Limits of Liability
EPC contracts are frequently used for major infrastructure and complex facilities. As a result, there are usually huge financial implications if the project is delayed or in some way defective. As a result, contractors will generally wish to cap or limit their liability to protect themselves from becoming insolvent.
Because EPC Contracts are frequently used for major commercial, industrial and infrastructure projects, there are often monetary implications for project delays or defects in construction which are so substantial that contractors must either limit their liability or potentially face insolvency.
Force Majeure in EPC Contracts
In cases where the project company’s obligations are largely limited to paying the contractor, force majeure provisions should be included in EPC Contracts and should be common to all project finance documents. To the extent such provisions are not aligned, and there are significant gaps in liability which are retained by the project company, it is customary for the project lenders to require some form of sponsor support or guarantee to cover the exposure. The parties to an EPC Contract should be aware that consequences for a force majeure event during project construction can be severe but are usually manageable because a force majeure event will simply increase construction costs and delay completion.
This risk is minimal and can be allocated among project participants prior to the commencement of the project. Conversely, force majeure events during the operations phase could lead to an insolvent operator. The contract should impose an obligation on the party affected by the force majeure event to take all possible steps to overcome the event, including the reasonable expenditure of funds. The failure to perform contractual obligations because of the event, however, will typically prevent such a party from being in default.
Advantages and Disadvantages of EPC Contracts
For the project company, the most important advantage gained from using EPC Contracts is the almost total assignment of design and construction risk to the EPC contractor.
Another significant advantage of EPC contracts is that it establishes a structure whereby the project company only contracts with and engages only one contractor, who in turn manage all the relationships with subcontractors. This assignment of work makes managing the project considerably easier for the project sponsor. Project sponsors oversee the project and evaluate progress and performance as the contractor carries out the project.
EPC Contracts also centralize all of the control over the design, development and construction in the hands of the EPC contractor. This contract arrangement is an advantage to contractors who have more control over the design, product selections and the selection of subcontractors and suppliers. So, while EPC Contracts do assign more risk with the coordination of the design, EPC contractors are in a position to exercise a great deal of control to efficiently lower construction costs.
While principals can benefit from the single point of responsibility for the delivery of the project, they do lose involvement with the design process, adding potential risk if the project’s design is crucial. Principals should ensure they carefully mark out the project’s milestones to avoid lifecycle costs and scope changes being easily overlooked. Also, as the contractor performs the design and construction, the usual checks and balances present during such projects do not exist for the owner.
For the project company, the most important advantage gained from using EPC Contracts is the almost total assignment of design and construction risk to the EPC contractor.
Another significant advantage of EPC contracts is that it establishes a structure whereby the project company only contracts with and engages only one contractor, who in turn manage all the relationships with subcontractors. This assignment of work makes managing the project considerably easier for the project sponsor. Project sponsors oversee the project and evaluate progress and performance as the contractor carries out the project.
EPC Contracts also centralize all of the control over the design, development and construction in the hands of the EPC contractor. This contract arrangement is an advantage to contractors who have more control over the design, product selections and the selection of subcontractors and suppliers. So, while EPC Contracts do assign more risk with the coordination of the design, EPC contractors are in a position to exercise a great deal of control to efficiently lower construction costs.
While principals can benefit from the single point of responsibility for the delivery of the project, they do lose involvement with the design process, adding potential risk if the project’s design is crucial. Principals should ensure they carefully mark out the project’s milestones to avoid lifecycle costs and scope changes being easily overlooked. Also, as the contractor performs the design and construction, the usual checks and balances present during such projects do not exist for the owner.
EPC Contracts illustrate how project financings are complex transactions involving amounts that can reach hundreds of millions or even billions of dollars, and project documents that are extremely complex and expensive. When you engage Global Trade Funding to provide project finance our deal team not only arranges the financing, they also draft and arrange the project finance documents. If you need project financing and a solid deal team to help you put it all together, it’s time to bring us onboard. To get started Request Project Financing today.
Questions We Answer About EPC Contracts
Although EPC Contracts have become the construction contract form of choice in project financings they remain foreign to many project sponsors, investors and other stakeholders because they are non-traditional construction contracts that don’t conform to the standard types of construction contracts that were the mainstays for decades. With so many questions arising out of the increased use of EPC contracts, we have attempted to anticipate some of the most questions, and they are listed below. We have also endeavored to answer as many of these questions as possible on this page. If you have questions that weren’t answered, please visit our Question and Answer page for additional discussion.
- What are EPC Contracts?
- Why are EPC Contracts included in project finance documents?
- Are EPC Contracts the same as turnkey fixed-price contracts?
- How are change orders handled with EPC Contracts?
- Can completion dates be extended under EPC Contracts?
- For what types of projects should EPC Contracts be used?
- Where can you find EPC Contract templates?
- How do EPC Contracts work?
- What are the advantages and disadvantages of EPC Contracts?
- What are the basic provisions of EPC Contracts?
- How do EPC Contracts differ from alternative construction contracts?
- What are the standard provisions of EPC Contracts?
- What is the definition of an EPC Contract?
- Are performance guarantees required in EPC Contracts?
- Why are EPC Contracts so strongly preferred by project lenders?
- What are the procedures for drafting EPC Contracts?
Project Finance Learning Center
Project finance was first used in 1299 when an Italian merchant bank provided the project financing to finance the development of English silver mines. England repaid the Italian merchant bank who funded the project with the output from the mines. Project financing has been used to finance thousands of projects since those silver mines, including such notable projects as the Panama Canal and North Sea oil platforms. Our Project Finance Learning Center includes information we hope will improve understanding of this type of finance.
Definition of Project Finance
Project finance is not as well understood than it should be due largely to the fact that there is no consensus definition of project finance. Perceptions of what constitutes project financing vary depending on the definition of project finance you first learned. We list three of the most widely accepted definitions below.
A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.1
The raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.2
The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project.3
Project Finance Questions & Answers
Project Finance Lexicon
Accounts Receivable
Accounts Receivable is money owed to a company by a customer for products and /or services sold. Accounts receivable is considered a current asset on a balance sheet once an invoice has been sent to the customer.
Accounts Receivable Factoring
Accounts Receivable Factoring is a method of Trade Financing where a company sells their accounts receivable in exchange for working capital. The purchaser of the receivables relies on the creditworthiness of the customers who owe the invoices, not the subject company.
For details go to Accounts Receivable Factoring »
Advance Against Documents
Advances Against Documents are loans made solely based on the security of the documents covering the shipment.
Asset Based Lending
Asset Based Lending is a method of Trade Financing that allows a business to leverage company assets as collateral for a loan. Asset-based loans are an alternative to more traditional lending which is generally characterized as a higher risk which requires higher interest rates.
Cash Against Documents
Cash Against Documents is the payment for goods in which a commission house or other intermediary transfers title documents to the buyer upon payment in cash.
Cash in Advance
Payment for goods in which the price is paid in full before shipment is made. This method is usually used only for small purchases or when the goods are built to order.
Cash with Order
Cash with Order is the payment for goods whereby the buyer pays when ordering and in which the transaction is binding on both parties.
Commercial Finance
Commercial Finance is defined as the offering of loans to businesses by a bank or other lender. Commercial loans are either secured by business assets, accounts receivable, etc., or unsecured, in which case the lender relies on the borrower’s cash flow to repay the loan.
Confirmed Letter of Credit
A Confirmed Letter of Credit is a Letter of Credit issued by a foreign bank, which has been confirmed as valid by a domestic bank. An exporter whose form of payment is a Confirmed Letter of Credit is assured of payment by the domestic bank who confirmed the Letter of Credit even if the foreign buyer or the foreign bank defaults.
Consignment
Consignment is a delivery of merchandise from an exporter (the consignor) to an agent (the consignee) subject to an agreement by the agent that the agent will sell the merchandise for the benefit of the exporter, subject to certain limitations, like a minimum price. The exporter (consignor) retains ownership of and title to the goods until the agent (consignee) has sold them. Upon the sale of the goods, the agent typically retains a commission and remits the remaining net proceeds to the exporter.
For details go to Consignment Purchase »
Cross-Border Sale
A Cross-Border Sale refers to any sale that is made between a firm in one country and a firm located in a different country.
Factoring
Factoring is the selling of a company’s invoices and accounts receivable at a discount. The lender assumes the credit risk of the debtor and receives the cash when the debtor settles the account.
For details go to Accounts Receivable Factoring »
Invoice Discounting
Invoice Discounting is a type of loan that is drawn against a company’s outstanding invoices but does not require that the company give up administrative control of those invoices.
factoring invoices
factoring invoices is one of the most common methods of trade financing. Your company sells their invoices to a factor in exchange for immediate liquidity. The factor who purchases the invoices relies on the creditworthiness of the customers who owe the invoices, not the subject company.
For details go to factoring invoices »
Irrevocable Letter of Credit
Irrevocable Letter of Credit is a Letter of Credit in which the specified payment is guaranteed by the bank if all terms and conditions are met by the drawee.
Letter of Credit
Letter of Credit or LC is the most common trade finance solution in the world. A Letter of Credit is a document issued by a bank for the benefit of a seller or exporter, which authorizes the seller to draw a specified amount of money, under specified terms, usually the receipt by the issuing bank of certain documents within a given time.
For details go to Letters of Credit For Imports »
Open Account
Open Account is a trade arrangement in which goods are shipped to a foreign buyer without guarantee of payment. The obvious risk this method poses to the supplier makes it essential that the buyer’s integrity be unquestionable.
For details go to Open Accounts »
Pro forma Invoice
Pro forma Invoice is an invoice provided by a supplier prior to the shipment of merchandise, which informs the buyer of the kinds, nature and quantities of goods to be shipped along with their value, and other important specifications such as weight and size.
Receivable Management
Receivable Management involves processing activities related to managing a company’s accounts receivable including collections, credit policies and minimizing any risk that threatens a firm from collecting receivables.
Revocable Letter of Credit
Revocable Letter of Credit is a Letter of Credit that can be canceled or altered by a buyer after it has been issued by the buyer’s bank.
Structured Trade Finance
Structured Trade Finance is cross-border trade finance in emerging markets where the intention is that the loan gets repaid by the liquidation of a flow of commodities.
Trade Credit Insurance
Trade Credit Insurance is a risk management product offered to business entities wishing to protect their balance sheet assets from loss due to credit risks such as protracted default, insolvency, and bankruptcy. Trade Credit Insurance often includes a component of political risk insurance, which ensures the risk of non-payment by foreign buyers due to currency issues, political unrest, expropriation, etc.
Project Finance Documents
› EPC Contract
› O&M Agreement
› Loan Agreement
› Offtake Agreement
› Supply Agreement
› Intercreditor Agreement
› Tripartite Deed
› Common Terms Agreement
› Concession Deeds
› Shareholder Agreement
Project Finance Participants & Stakeholders
EPC Contracts Key Takeaways
Allow yourself to daydream for a minute and picture yourself at the Urban Land Institute annual gala accepting the award for the best project financing deal of the year. They compare your deal to the most successful project financings ever. None of those successful deals began with construction cost overruns, a blown construction schedule or construction defects. The importance of EPC Contracts to successful project financings becomes clear in that simple vision.
In Project Finance Documents we provided a great deal of information about project documentation along with an outline summarizing how EPC Contracts and other project documents serve specific standalone roles. But they are also integrated into the complex package that comprises the project documentation. As the preferred construction contract, EPC Contracts are critical to the success of countless large-scale international construction projects. They are also a very important part of integrated project documentation.
EPC Contracts and rest of the project finance documents are also the first part of your deal that lenders see, so they have a tremendous bearing on the approval of project finance loans. Global Trade Funding draws on decades of project finance expertise to conceive and create the project documentation for your deal as part of our integrated project finance services.
That we offer integrated project finance services should convince you that Global Trade Funding is the strategic partner you need to make your development projects successful. We provide unparalleled project finance solutions ranging from simple project loan placement to complex mezzanine financing structures, and international construction and development consulting services for project financings ranging from $20 million to over $2 billion worldwide. We can start putting your project financing deal together today, so Request Project Financing »
EPC Contracts have emerged as the construction contract of choice for major international development projects and project financings. Under EPC Contracts, the project company enters into the contract with the EPC contractor. The primary purpose of using EPC contracts for major construction projects is to transfer essentially all of the project design and construction risk from the project owner to the EPC contractor. Because the primary reason for using EPC Contracts is to affect the transfer of as much risk as is practicable from the owner to the contractor, they severely limit the scope and circumstances under which contractors can make claims for additional time and money. The contractor performs all of the project design work the specifies what is to be built, including the standards which must be achieved and performance requirements of the finished project in a separate document.
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