Operation & Maintenance Agreements

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.