Operation & Maintenance Agreements Overview
Operation & Maintenance Agreements (O&M Agreements) are project finance documents that establish a contractual relationship between the project company and a professional management company to operate and maintain the project.
Operation & Maintenance Agreements fulfill a similar role in the operations phase of the project as EPC Contracts serve in the construction phase. Before the completion of construction, the project company must decide on the operational structure of the project. There are essentially three options.
- The project company or one of the stakeholders can operate and maintain the project;
- The project company can operate and maintain the project with the assistance of consultants; or
- The project company can contract with a professional operator to manage and maintain the project.
Project sponsors and project companies who want to strengthen the likelihood of project loan approval should always utilize Operations & Maintenance Agreements to engage a professional operator with the expertise needed to operate the project at the highest level. Even if the project company or project sponsor have the experience to operate the project, they will almost always get better results with third party operators. Without exception, project lenders strongly prefer professional third-party operators. In fact, many project lenders will not approve project financings without Operation & Maintenance Agreements.
Ideally, the operator will be a professional operating company with expertise and experience operating and managing projects which are not dissimilar to yours, in a not dissimilar location. It may be permissible for the operator to be one of the project stakeholders but it is not advisable, because of potential conflicts of interest. It may also be permissible for the project company to operate and maintain the project themselves. Engaging third-party professional operators to perform the work pursuant to Operation & Maintenance Agreements is almost always the right choice.
Properly drafted Operation & Maintenance Agreements are the most effective tool used to mitigate and manage operating risk in project finance.
Key Features of Operation & Maintenance Agreements
Operation & Maintenance Agreements (O&M Agreements) are typically short-term contracts, ranging in duration from two to five years, that establish a contractual agreement between the project company and a professional operator to provide operation and maintenance services for the project. They set forth the range of operator’s duties and responsibilities, along with the compensation, which is usually a fixed fee. O&M Agreements also sometimes provide for performance-based fees and conversely liquidated damages for failure to meet required performance benchmarks.
O&M Agreements do not usually require or contemplate the transfer of project employees to the contractor. Instead, the contractor typically adds a layer of management over the existing personnel structure. Some Operation & Maintenance Agreements may also obligate the operator to maintain the project assets, even extending to the cost of routine replacement of small, low-value parts or equipment. Such features require more monitoring to ensure that the outputs are being achieved and usually involve higher onboarding costs.
Operation & Maintenance Agreements Operator Obligations
The most substantial contractual obligation on the part of the operator in Operation & Maintenance Agreements is to operate and maintain the project for the term of the O&M Agreement. Of paramount importance is whether or not the responsibilities of the operator are set forth in sufficient detail. Operation & Maintenance Agreements must address terms such as:
- Operating procedures;
- Maintenance of the facility, including major overhauls;
- Responsibility for procurement of spare parts;
- Performance levels and performance guarantees to be met by the operator
- Interface with the construction contractor(s) prior to handover;
- Owner’s option to extend the term;
- Reporting requirements to the owner, lenders and government authorities;
- Maintenance of the continuing relationship with government authorities and utility suppliers;
- Compliance with operational requirements imposed by government regulators.
Compliance with operational requirements imposed under the regulatory regime (for example, compliance with environmental controls and local ownership and industry participation requirements) and other project documents.
The description of the operator’s obligations is often complex and requires significant project management and technical expertise to enumerate. A simpler approach is to generally describe the operator’s requirements and relating them to the performance results required by the agreement and including anything else that is necessary and incidental to that performance.
This approach to broadly describe terms that should be technically listed in detail could potentially expose the project company to claims for additional compensation for work beyond the scope of the contract. Thus, care should be exercised when oversimplifying is a possibility. Project Sponsors should engage technical and legal consultants who can properly draft Operation & Maintenance Agreements.
Finally, parties to long-term Operation & Maintenance Agreements should be aware of the possibility that changes will occur that could affect the long-term nature of the operation, such as political regime change or regulatory change. In anticipation of such instances, the operator’s entitlement to relief and additional compensation must be clearly stated in the Agreement. In a perfect world, those entitlements will be balanced by the entitlement of the project company under an offtake agreement or other project documents.
Owner’s Obligations
The primary obligation of the project company under an Operation & Maintenance Agreement is to pay the Operator. Payment will be made from project revenues and should be limited to those amounts to the extent practicable. There will probably be other continuing obligations, such as the supply of utilities, fuel, water and other consumables. The O & M Agreement should also provide for any other specific obligations on the part of the project company.
There may be an obligation for the project company to provide the initial spare parts inventory, which should align with the spare parts inventory that is to be provided by the construction contractor under the EPC Contract. There may also be an obligation on the owner created by the Offtake Agreement to maintain records related to the Operator’s compliance with matters that may affect the owner’s payment obligations under the Agreement.
Operation & Maintenance Agreements should also provide payment mechanisms for payment of owner-supplied spare parts, major overhaul expenses, costs arising for work performed by the Operator that are beyond the scope of services described in the Agreement, changes in law and other factors that give rise to necessary adjustments to the payment provisions.
Fully Wrapped Agreement
A fully wrapped Operation & Mantenance Agreement is one where all of the obligations and responsibilities for the operation and maintenance of the project are clearly transferred to the operator, and both the project company and the project lenders have a direct line of recourse to the Operator. Assume, for example, that key aspects of the operation and maintenance of the facility (particularly those that may impact on the performance of the facility) will be performed by a third party under a different agreement.
Then the lenders will require a clear allocation and delineation of all obligations and responsibilities for the operation and maintenance of the facility between the parties so there are no gaps where continuing risk or obligations remain with the project company. In project financings, the project lenders will usually require some form of sponsor support if the owner retains significant risk or responsibility for operating and maintaining the facility.
Performance Benchmarks in Operation & Maintenance Agreements
Operation & Maintence Agreements should set forth the operator’s performance obligations, if any. Performance benchmarks typically include items like availability, outages, production levels and other technical, quality, safety and environmental performance criteria. The Agreement should also establish the minimum performance levels that will trigger the owner’s rights to damages or termination under the agreement if they are not met. In some cases, the O & M Agreement may also provide for an upside share mechanism that provides for additional compensation in the event project performance exceeds contractually established levels.
Operation & Maintenance Agreements should reference any performance levels that were achieved by the EPC contractor at handover. Those established levels, adjusted for degradation should establish the baseline of the operator’s performance obligations. For example, for a power project, it is imperative that the technical and legal advisors ensure that the performance testing and performance guarantee and liquidated damages schedules to the agreement are back-to-back with the corresponding schedules to the construction contract.
The O & M Agreement should include provisions that set forth, with as much detail as is practicable, the consequences of a default by the operator in its performance obligations, including liquidated damages or other monetary damages. In most instances, Operation & Maintenance Agreements will specify minimal performance levels below which the operator is deemed to be in default under the agreement, along with the options and remedies which are available to the owner.
Typically, performance requirements include output, availability, outages and other specific performance-related occurrences. The Agreement may also provide for the imposition of liquidated damages if the operator fails to perform to the specified levels. The inclusion of a liquidated damages mechanism under the Agreement is necessarily linked to a limitation of liability clause, which effectively caps the operator’s potential losses in respect of any under-performance by the operator.
Changes To Scope of Agreement
Operations & Maintenance Agreements should provide for adjustments in operator’s compensation when the obligations of the operator are extended or reduced during the term of the Agreement. For example, where amounts paid to the operator are based on the operational efficiency of the facility, the Agreement should make allowances for an adjustment in the payment to the operator where the quality of fuel or other consumables falls below the technical criteria specified in the Agreement.
Similarly, the Agreement should provide for an adjustment in the payment entitlements of the operator where there is a material adverse event (such as change in law), which results in the operator being required to perform obligations beyond the obligations enumerated in the Agreement when it was executed.
To the extent that potential future changes in the Agreement can be anticipated at the time the Agreement is executed, provisions that change any fees or payments as a result of the changes should also be specified in the Agreement. To the extent that potential future changes cannot be anticipated the Agreement should provide a mechanism to determine the resulting price adjustment.
In the absence of any such contractual mechanism, the operator will probably be able to resist the imposition by the owner of the obligation to perform the operator’s changed duties. As a result, it is imperative that the owner includes a suitable contractual mechanism in the Agreement to fairly address such changed circumstances.
Related Entity Provisions In Operation & Maintenance Agreements
If the Operator is also a project sponsor the conflicts of interest cannot be ignored. Should this circumstance arise, project lenders are likely to act to ensure the operator cannot use their alter-ego project sponsor position to avoid obligations or obtain concessions under Operation & Maintenance Agreements.
If this arrangement is what’s intended by the project sponsor it should be addressed in the Shareholder Agreement by and between the project stakeholders and in the loan documents. Although this arrangement would severely impact the bankability of the project.
When the operator and the EPC contractor are the same or related entities, the Agreement should prevent one from relying on a delay or under-performance by the other to obtain relief from the owner under their contract. The agreement should also prevent one contractor from relying on the actions of the other as a defense to a claim by the owner for delay or non-performance.
Contract clauses such as these are called no relief and horizontal defenses provisions. These provisions can be included in O & M Agreements, which should also cause them to be included in EPC Contracts as well or otherwise in a separate coordination or wrap agreement that sets out the coordination and interface obligations of the parties in relation to the project.
Force Majeure in Operation & Maintenance Agreements
In cases where the project company’s obligations are largely limited to paying the operator, force majeure provisions should be included in Operation & Maintenance Agreements 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 O & M Agreement 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. In this event, the operator may not be capable of performing its obligations according to the performance standards in the Agreement. The Agreement 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.
Operation & Maintenance Agreements Key Takeaways
- Operation & Maintenance Agreements are serious, precise documents that can have a significant impact on project loan approval and must be taken seriously.
- O&M Agreements are key project documents that can have a major impact on the bankability of the project as well as the long-term success of the project.
- They are very precise, technical documents that require the attention and expertise of the project sponsor or deal team while it is being drafted and negotiated in order to achieve the best possible results.
- Fully wrapped Operation & Maintenance Agreements allocate all of the obligations and responsibilities for operating and maintaining the project to the operator. Both the project company and the project lenders have a direct line of recourse to the Operator.
- If drafted properly, O&M Agreements provide a payment mechanism for owner-supplied spare parts, major overhaul expenses, costs arising for work performed by the Operator which is beyond the scope of services, changes in law and other factors that require adjustments to the payment provisions.
Project finance is the lending structure that has financed a great many of the massive infrastructure and sovereign projects in emerging market countries throughout the world.
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.
Accounts Receivable Factoring »
For details go toAdvance 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 toCross-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.
Accounts Receivable Factoring »
For details go toInvoice 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 toIrrevocable 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.
Letters of Credit For Imports »
For details go toOpen 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 toPro 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
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