EPC performance guarantees and shortfall remedies - 4 items for your checklist
Pass/fail or buydown?
Some EPC performance guarantees ("PGs") require absolute compliance and impose unlimited make-good obligations on the contractor until attained. In other cases, the contractor is able to buy-down non-compliance by paying performance liquidated damages ("PLDs"), assuming that a defined minimum performance level ("MPL") has been reached (below which make-good remedies will continue to apply).
It is therefore critical for owners to:
- accept buy-down only where the shortfall is inherently compensable by the payment of PLDs. For example, a product quality PG may appear to be amenable to buy-down on the assumption of a linear relation between quality and price; whereas for many products compliance with a fixed quality benchmark is an absolute requirement of product marketability, justifying a pass/fail approach;
- consider imposing some conditions on the contractor's right to buy down, even after the relevant MPLs have been reached, for example by requiring a minimum number of re-testing/make good cycles; and
- appreciate that the incremental PLD rates may not fully compensate them for the losses suffered (for example because contractors will insist on rates/discounting periods designed to ensure debt coverage only). In such cases, equity investors will need to be comfortable that MPLs are set at value which provide for an acceptable worst-case return, and that any equity loss is not exacerbated by "cap gaps" of the kind mentioned below.
Mind the cap gap
PLDs will usually be subject to an agreed sub-cap. It is important to ensure that the cap value will be sufficient to cover the gap between the MPLs and corresponding full PGs in all cases (or at least under an acceptable range of downside sensitivities).
When to apply PLDs
In thermal power and process/refining projects (renewables are different), owners face a choice as to when to apply PLDs. Some owners apply PLDs at the completion of initial performance testing. That enables the performance bond value to be stepped down early and brings forward the date on which the project can be financially rebalanced. If further improvements are subsequently achieved by the contractor during initial operation, PLDs already paid will need to be refunded pro-rata. In project-financed deals, contractors may be nervous about the recoverability of such unsecured repayments from an SPV and may delay handover in order to optimise final PG results.
An alternative approach is to defer the application of full PLDs until a time-limited, post-handover improvement process has been completed. The owner's future PLD entitlements are secured by some combination of extended bonding and deferred payments. PLDs are then calculated on the basis of any residual PG shortfalls after improvement. The refund issue is thereby avoided and commercial operation may commence earlier, as the contractor is less concerned about optimising performance before handover.
However, one potential challenge with this deferred PLD approach is the loss of compensation for the gradually decreasing performance shortfall which occurs between handover and the completion of improvements. In the power sector especially, this is often addressed by the imposition of interim PLDs, calculated on a per diem rather than NPV basis.
Performance shortfalls may result from defects in licensed process technology rather than EPC "hardware", and the resulting disputes over causation and apportionment can be very complex to resolve. It is therefore critical to include clear language in the EPC defining the extent of any technology wrap by the contractor and allocating the burden of proof as to any residual unwrapped risk.