ENGINEERING, PROCUREMENT, CONSTRUCTION CONTRACT:

TOOL 2OF PROJECT FINANCE

2Shalini Wunnava, LL.M. (Banking and Finance), National Law University, Jodhpur.

TABLE OF CONTENTS
Table of Contents2
INTRODUCTION......................................................................................................................1
Allocation Of Construction Risk: The Turnkey (Or Engineering, Procurement, And
Construction [EPC]) Agreement............................................................................................3
ENGINEERING, PROCUREMENT & CONSTRUCTION CONTRACT..............................5
Each Contract Has Stand Alone With Boiler-Plate Provision................................................5
Engineering Contract.........................................................................................................5
Procurement Contract.........................................................................................................6
Construction Contract........................................................................................................6
Precedence Of Clauses...........................................................................................................7
Scope Of Contract For Off-Shore Constructions...................................................................8
Commencement Of The Works Notice To Proceed Clause................................................9
Contract Price, Payments, And Variations...........................................................................10
TYPES OF TURNKEY CONTRACTS...................................................................................12
Lump-Sum Turnkey Projects...............................................................................................12
Engineering Procurement And Construction Management Projects (EPCM).....................12
FIDIC AND TURNKEY CONTRACTS.................................................................................15
Balancing Of Risk Between Employer And Contractor......................................................15
Employers View..................................................................................................................16
Contractors View.................................................................................................................17
EPC and PPP........................................................................................................................17
Athens Generating Co. v. Bechtel Power Corp........................................................................19
Background..........................................................................................................................19
The Ruling............................................................................................................................19
Conclusion............................................................................................................................21
Indiantown Cogeneration Facility...........................................................................................22

McDermott International Inc. v. Burn Standard Co. Ltd.........................................................23

Background..........................................................................................................................23
The Ruling............................................................................................................................23
Conclusion............................................................................................................................24
CONCLUSION........................................................................................................................26

INTRODUCTION
Project financing may be defined as the raising of funds on a limited-recourse or nonrecourse
basis 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
Project financings typically include the following basic features
1. An agreement by financially responsible parties to complete the project and, toward
that end, to make available to the project all funds necessary to achieve completion.
2. An agreement by financially responsible parties (typically taking the form of a
contract for the purchase of project output) that, when project completion occurs and
operations commence, the project will have available sufficient cash to enable it to
meet all its operating expenses and debt service requirements, even if the project fails
to perform on account of force majeure or for any other reason.
3. Assurances by financially responsible parties that, in the event a disruption in
operation occurs and funds are required to restore the project to operating condition,
the necessary funds will be made available through insurance recoveries, advances
against future deliveries, or some other means.
A project financing requires careful financial engineering to allocate the risks and rewards
among the involved parties in a manner that is mutually acceptable. 3 The business of project
financing is founded upon the identification, assessment, allocation, negotiation, and
management of the risks associated with a particular project. Indeed, as project finance
lenders look to the revenues generated by the operation of the financed project for the source
of funds from which that financing will be repaid, the whole basis for project financing
revolves around an understanding of the future project revenues and the impact of various
risks upon them. Risk is a crucial factor in project finance since it is responsible for
unexpected changes in the ability of the project to repay costs, debt service, and dividends to
shareholders. Risks must be identified in order to ascertain the impact they have on a
projects cash flows; risks must be allocated, instead, to create an efficient incentivizing tool
2 JOHN D. FINNERTY, PROJECT FINANCING: ASSET-BASED FINANCIAL ENGINEERING , 1 (John
Wiley & Sons, 2007).
3 World Bank,

1|Page

for the parties involved. Cash flows can be affected by risk, and if the risk has not been
anticipated and properly hedged it can generate a cash shortfall. If cash is not sufficient to pay
creditors, the project is technically in default. If a project participant takes on a risk that may
affect performance adversely in terms of revenues or financing, this player will work to
prevent the risk from occurring.4 From this perspective, project finance can be seen as a
system for distributing risk among the parties involved in a venture. In other words,
effectively identifying and allocating risks lead to minimizing the volatility of cash inflows
and outflows generated by the project. This is advantageous to all participants in the venture,
who earn returns on their investments from the flows of the project company.
Most of the time allocated to designing the deal before it is financed is, in fact, dedicated to
analysing (or mapping) all the possible risks the project could suffer from during its life.
Above all, focus is on identifying all the solutions that can be used to limit the impact of each
risk or to eliminate it. Risk allocation is also essential for another reason. This process is a
vital prerequisite to the success of the initiative. In fact, the security package (contracts and
guarantees, in the strict sense) is set up in order to obtain financing, and it is built to the
exclusive benefit of original lenders.5 Therefore, it is impossible to imagine that additional
guarantees could be given to new investors if this were to prove necessary once the project
was under way.
The process of risk management is crucial in project finance, for the success of any venture
and is based on four closely related steps6 1) risk identification, 2) risk analysis, 3) risk
transfer and allocation of risks to the actors best suited to ensure coverage against these risks,
and 4) residual risk management. The agreements embodying the risk allocation should be
assessed as a whole, with a view to: (a) providing that significant risks are allocated to those
parties that are best able and most motivated to assume them; and (b) reducing the residual
risks in the project to a level that the sponsors and lenders can prudently manage.

4 I.N.D. WALLACE, CONSTRUCTION CONTRACTS: PRINCIPLES

AND

POLICIES

IN

TORT

AND

CONTRACT, 401 (Sweet & Maxwell, London, 1986).

5 JOHN DEWAR, INTERNATIONAL PROJECT FINANCE, 314 (Oxford University Press, 2011).
6 Supra n. 1, at 124.

2|Page

An essential aspect of the project finance lawyers role in helping the parties reach a
bankability assessment involves reviewing the project, and in particular its underlying
documentation, in order to identify its potential and fundamental risks and to determine if,
and how appropriately, those risks have been allocated among the parties. 7 Because the ability
of the project company to produce revenue from project operation is the foundation of a
project financing, the contracts constitute the framework for project viability and control the
allocation of risks. Contracts that represent the cost of fuel and other inputs to the project
company are of particular importance because these contracts affect cash flow.
ALLOCATION

OF

CONSTRUCTION

RISK:

THE

TURNKEY

(OR

ENGINEERING,

PROCUREMENT, AND CONSTRUCTION [EPC]) AGREEMENT

A turnkey agreement also known as EPC (engineering, procurement, and construction) is a
construction contract by which the SPV transfers construction risk of the structure to the
contractor. In exchange for a set fee, the contractor guarantees the SPV the following8:
I.
II.
III.
IV.

The completion date

The cost of the works
Plant performance
A warranty period (usually between 12 and 24 months) after the plant has been accepted
by the SPV, where plant maintenance and replacement of parts are granted for free by the
contractor.

As far as guarantees on completion dates, when the pre-established construction time is up,
one of two possible situations can occur9
1. The plant meets minimum performance standards.
2. The plant does not meet minimum performance standards.
In addition to these guarantees, there may be coverage against technological risk. 10
Transferring this type of risk to third parties is always quite complex, in particular if the
7 Supra n. 4, at 315-16.
8 STEFANO GATTI, Project Finance in Theory and Practice: Designing, Structuring, and
Financing Private and Public Projects, 49 (London: Elsevier, 2013).
9 Id. at 121

3|Page

projects base license is extremely innovative. In concrete terms, the options available are the
following11
1. To ask independent technical advisors their opinion on the effectiveness of the technology
2. To oblige the technology supplier to pay penalties either in one lump sum or proportional
to the patent value of the technology
3. To oblige the contractor to provide performance guarantees on the technology that are
incorporated in the construction contract (wrapping or wraparound responsibility)
Wrapping (or wraparound responsibility) is what provides lenders with a real guarantee.

12

With this type of contract, the contractor is required to ensure that the plant corresponds
exactly to design and technical specifications listed in the license agreement for use of knowhow with the SPV. Of course, when contractors give this guarantee, presumably they are
familiar with the technology to be developed, and as a result the SPV will clearly face higher
construction costs. When the technology in question is absolutely new, there is no wrapping.
No contractor, however reliable, would be able to offer an SPV such a broad guarantee. In
these cases, the venture can be financed only if the sponsors guarantee total recourse to
lenders during the construction phase. Such recourse is eliminated only if the plant proves
functional once construction is complete.
Of course, the judgments of technical consultants do not constitute legally binding
guarantees. Nonetheless, if a panel of experts unanimously supports the validity of the
technology with initial due diligence of technological features, the project stands a greater
chance of success than if the response is general skepticism. Penalties paid by suppliers,
whether lump sum or proportional, have a greater impact on the SPVs cash flows. However,
it should be said that the amount of these penalties is always less than the overall value of the
project. Therefore, lenders should not rely too heavily on these figures to recover their
investments in case of setbacks.

10 DENNIS CAMPBELL

ET. AL.,

International Project Finance, 5 (New York: Transnational

Publication, 2010).
11 Id. at 78.
12 Supra n. 7, 58-59.

4|Page

ENGINEERING, PROCUREMENT & CONSTRUCTION CONTRACT

Engineering, procurement and construction, together with testing and start-up, are the four
broad, general phases of project construction. It is not surprising therefore that the types of
construction-related contracts are generally structured to cover these phases.2 There are three
general types of constructionrelated contracts used in a typical project financing:
engineering, procurement, and construction. A fourth, called commonly an EPC is one
contract that covers all three phases engineering, procurement and construction. The latter
type is often called a fast track construction contract.
There is no accepted definition for each of these terms in the construction field. The term
turnkey tends to mean the most extreme form of placing design and construction
responsibility on the contractor, such that after completion the employer need only turn the
key to commence operation of the constructed facility. Notwithstanding this, the term
turnkey will be used here to describe the more general global arrangement of placing all
design, procurement and construction responsibilities on one contractor.
EACH CONTRACT HAS STAND ALONE WITH BOILER-PLATE PROVISION
Engineering Contract The engineering contract provides a project company with
professional assistance in project design, bidding and review and administration of the work.
Specifically, it provides for boiler plate provisions such as the
i)
ii)
iii)
iv)
v)
vi)
vii)
viii)
ix)

the preparation of preliminary and general project designs;

preparation of specifications;
preparation of initial cost estimates;
preparation, solicitation and analysis of bids for work and supplies;
preparation of detailed drawings for bidding purposes;
review of detailed drawings produced by suppliers;
scheduling of work;
inspection and testing; and
during the construction phase, administration of the construction contract for the
project company.

This is primarily because all project construction work, including engineering work, is
included in a broad, turnkey construction contract in which the contractor is a single point of
responsibility for all construction phases.

2 Supra n. 1, at 513.

5|Page

Procurement Contract The procurement contract provides for the orderly procurement of
work and supplies for a project. The contract specifically needs to includes provisions such as
the
i)

require the architect/ engineer to establish bidding procedures for machinery,

ii)
iii)

equipment, material and supplies;

to perform an economic analysis of the bids;
to coordinate export licenses and other governmental authorizations necessary for
the export or import of materials, supplies, machinery and equipment to the

iv)
v)

project site;
schedule and monitor delivery dates;
make transportation arrangements for delivery of materials, supplies, machinery

vi)

and equipment to the project site; and

coordinate financial matters, such as scheduling cash needs, reviewing invoices
and administration of accounting records.

A separate procurement contract is not used often in a project financing, for the same reasons
that a separate engineering contract is not used. That is, all procurement work is included
under the scope of the turnkey construction contract, and funds are typically not available for
procurement work until a financial closing occurs.
Construction Contract The construction contract is the contract that governs the complete
construction of the project. As such, the contractor agrees in the construction contract to
provide all constructionrelated services, including
i)
ii)
iii)
iv)
v)
vi)

construction supervision,
labour and management,
construction facilities,
tools and supplies,
site investigation, and
field engineering.

In the conventional contracting procedure for a major project, the project developer, or a
Contracting Authority uses an architect and/or consulting engineer to draw up the design for
the project, with detailed drawings, bill of quantities, etc., based on which a bid for the
construction is invited; any specific equipment required is procured separately. But even if
the Sponsors or Contracting Authority have the experience to arrange the work under separate
contracts and coordinate different responsibilities between different parties, this is not usually
acceptable to lenders in project finance who want there to be one-stop responsibility for

6|Page

completing the project satisfactorily, since they do not want the Project Company to be
caught in the middle of disputes as to who is responsible for a failure to the do the job
correctly.
Therefore the Construction Contract in a project-financed project is usually in the form of a
contract to design/engineer the project, procure or manufacture any plant or equipment
required, and construct the project, so creating a turnkey responsibility to deliver a complete
project fully equipped and ready for operation that is a D&B (Design and Building) or EPC
(Engineering, Procurement, Construction) Contract.
PRECEDENCE OF CLAUSES
Another approach to contracting for major projects is to appoint a contracting or engineering
company as construction manager, with the responsibility of handling all aspects of the
construction of the project, against payment of a management fee. The fee may vary
according to the final outcome of the construction costs. Although this may be an
economically efficient way of handling major projects, a variable construction cost is not
acceptable to lenders because of the risk of a cost overrun for which there may not be
sufficient funding, or which adds so much to the costs that the project cannot operate
economically.
The Construction Contract therefore also provides for the work to be done by the
Construction Contractor at a fixed price. Finally Project Completion has to match the
requirements of the Project Agreement for the project to be complete by a fixed date. So the
Construction Contract also provides for a Fixed Project Completion date. Such a turnkey,
fixed-price, date-certain Construction Contract transfers a significant amount of responsibility
(and thus risk) to the Construction Contractor.
Moreover the Construction Contractor has to wrap (i.e., guarantee) the performance of its
own sub-contractors, and is taking extra risk in this respect. These extra risks are clearly
likely to cause the Construction Contractor to build more contingencies into the contract
costings, and hence a higher contract price than the price if the work were done on a cost-plus
basis. Typically the extra cost of such a Construction Contract adds 20% to the estimated cost

7|Page

of a contract which is not on a turnkey, fixed-price, date-certain basis, but the outturn cost of
the latter kind of contract may easily increase by 20%, hence producing the same result.3
Fixed-price, date-certain Construction Contracts are standard in most process plant and
infrastructure projects. Sponsors who want to adopt a different approach normally have to
give lenders a Project Completion guarantee, thus diluting the non-recourse nature of the
transaction. Certain types of projects do not or cannot usually use such contractsfor
example mining and oil and gas extraction projects, as well as projects involving a gradual
investment in a network, influenced by changing demand, such as in telecommunications
projects.
An exception to the turnkey responsibility of the Construction Contractor arises where the
project is being constructed using technology licensed by a third party, which is commonly
the case in refinery or petrochemical plant projects. The Construction Contractor does not
take responsibility for the performance of the plant insofar as this depends on such a thirdparty license. It should be noted that standard forms of Construction Contracts, such as those
produced by the International Federation of Consulting Engineers (FIDIC) are generally not
suitable for project finance, first because they tend to be too contractor friendly, and second
because there are some differences of structure compared to project finance requirements.4
SCOPE OF CONTRACT FOR OFF-SHORE CONSTRUCTIONS
The Construction Contract sets out the design, technical specifications, and performance
criteria for the project, and may offer a fast-track route to construction of the project, since
the contract can be signed and construction can begin before all the detailed design work is
complete.5 Nonetheless the Construction Contractor remains responsible for constructing a
3 Frdric Blanc-Brude, Hugh Goldsmith & Timo Vlil, Ex Ante Construction Costs in the
European Road Sector: A Comparison of Public-Private Partnerships and Traditional Public
Procurement, ECONOMIC AND FINANCIAL REPORT, 46 (EIB, Luxemburg, 2006).
4 JOHN DEWAR, INTERNATIONAL PROJECT FINANCE LAW

AND

PRACTICE , 85, 417 (Oxford

University Press, 2011).

5 JOSEPH A. HUSE, UNDERSTANDING

AND

NEGOTIATING TURNKEY CONTRACTS, 277 (Sweet

& Maxwell: London, 2009).

8|Page

project that is capable of performing as specified, even if something has been omitted from
the detailed description. The Project Company may also have the right to object to detailed
designs as these are produced by the Construction Contractor. Its position here is different to
that of an Off-taker/Contracting Authority.
The Construction Contractor is responsible for employing (and paying) its own
subcontractors or equipment suppliers, although the Project Company may have a right of
prior approval over major subcontractors or equipment suppliers, to ensure that appropriately
qualified subcontractors or suppliers with relevant technology are being used. 6 Construction
insurance should normally be excluded from the scope of the Construction Contract price.
For tax reasons Construction Contracts with international contractors are sometimes broken
into separate parallel contracts, for example for provision of services (such as design) and
equipment, or into an offshore contract for work outside the country of the project, and an
onshore contract for the rest (which would probably be mainly carried out by a local
construction company as sub-contractor to the Construction Contractor). This is acceptable
provided the contracts are clearly linked together and effectively form one whole.
COMMENCEMENT OF THE WORKS NOTICE TO PROCEED CLAUSE
There may be a gap between the time the Construction Contract is signed and the point at
which Financial Close has been reached, and usually the Construction Contractor does not
begin work until the latter date, when there is assurance that the financing is available. The
Construction Contract therefore often provides for a Notice to Proceed (NTP), i.e., a formal
notice to begin the works, which can be issued by the Project Company at Financial Close. In
such cases the required Project Completion date is calculated as a date that is a period of time
after the NTP is issued, rather than a fixed date.
A delay in reaching Financial Close may affect the Construction Contract pricethere is
likely to be a final date for NTP, after which the Construction Contractor may increase the
price (or there is an automatic increase based on an inflation index) or is no longer bound to
undertake the works. Similarly, a delay in starting the work will lead to a delay in Project
Completion, which could jeopardize the project as a whole. In such cases, the Sponsors may
be willing to take the risk of asking the Construction Contractor to begin work under their
6 C.G. Hammond, Dealing with Defects: Defective Owner Provided Preliminary Design in
Design-Build Contracting, 15 I.C.L.R. 193 (1998), 196.

9|Page

guarantee, based on the assumption that Financial Close will catch up with events, enabling
the guarantee to be cancelled at that point. For this purpose, an optional procedure for preNTP works may be included in the Construction Contract: this work may cover just the
(relatively low cost) preliminary design work, or allow the Construction Contractor to place
orders for (high-cost) long lead-time equipment.7
The Project Company should have the right to terminate the Construction Contract if at any
time a decision is taken not to proceed further with the project (this is known as a
termination for convenience), against an agreed formula for paying compensation to the
Construction Contractor.
CONTRACT PRICE, PAYMENTS, AND VARIATIONS
Payment of the contract price is normally made in stages: after an initial deposit, payments
are made against the Construction Contractor reaching pre-agreed milestones, relating to
items such as completing a major stage of the works or delivery of a major piece of
equipment, or alternatively against the overall value of the work performed as a proportion of
the total contract value.8 Payments may be made directly by the lenders to the Construction
Contractor, rather than passing the funds through the Project Companys bank account.9
If export credits or other tied funding are being used, the Construction Contractor cannot
change the arrangements for sourcing of equipment or services (as otherwise the Project
Company may not have enough finance available).
Although in principle the Construction Contract price is fixed, there are some exceptions to
this that usually allow the Construction Contractor to increase the price, e.g. : if the Project
7 J. DAVIDSON FRAME, PROJECT FINANCE: TOOLS

AND

PRACTICE, 68 (University of

Management and Technology, 2003).

8 Huse Kirkland, Shumway, The Use of the Target Concept for Tunnelling Projects in Light
of the Eurotunnel Experience, OPTIONS

FOR

TUNNELLING CONFERENCE

OF

THE

INTERNATIONAL TUNNELLING ASSOCIATION, Amsterdam, the Netherlands (Apr. 19-22, 1993)

at 6.
9 M.L. McAlpine, Construction Law: Will DesignBuild Contracting Really Solve All of the
Problems? (1997) 76 MI BAR JNL. 522, at 533.

10 | P a g e

Company changes the required design or performance of the plant, or adds other new
elements to the contract; if Owners Risks cause additional costs, including the cost of delays
to the construction program; if changes in law require the design or construction of the
project to be changed.
The Construction Contractor normally remains responsible for any problems with the
geology of the site that cause extra costs, although the Construction Contractor may not
accept liability for problems with projects being built in locations where mining has taken
place and underground site conditions are uncertain. The way in which the Construction
Contract price is made up has in principle nothing to do with the Project Company, which is
just paying a lump-sum price; however, it is sometimes necessary for the price to be broken
up by the Construction Contractor for the Project Companys tax purposes.

11 | P a g e

TYPES OF TURNKEY CONTRACTS

In a number of projects, completion risk is allocated to a contractor through a turnkey
construction contract. In such an agreement, the contractor undertakes to build a fully
operational facility for a fixed (subject to limited exceptions) price by a specified date certain.
Where the market for construction work is competitive, with enormous costs and great
attention to bidding detail, when tenders are called for projects, a pre-committed project
financing package will often be required by the relevant procuring authority. In many sectors
a turnkey construction contract by itself will be accepted by banks for known sponsors,
familiar equipment and systems, and safe locations without further sponsor support for delay
or cost overruns.2 These structures are commonly seen in the context of independent power
projects (IPPs) and a number of public private partnerships (PPPs).
LUMP-SUM TURNKEY PROJECTS
In this type of project, which is also called an engineering procurement and construction
contract (EPC) contract, the owner develops a conceptual design specification and issues
requests for proposal and engages an engineering company as the contractor. The contractor
is required to deliver the project on a particular date for a fixed price, hence the term lump
sum. The contractor also needs to guarantee the performance, quality and efficiency of the
operations, hence the name turnkey, which suggests that all the owner has to do is turn the
key for operations to commence without any problem. 3 In the building and construction
industry, this form of contract is known as design-build contract. The contractor provides
architectural design, engineering, and construction to the owner for an agreed price.
The risk is mostly transferred from the owner, who responsible for setting only the conceptual
specifications, to the EPC contractor, who is responsible for delivering the project for the
agreed price. As a result, owners view EPC contracts favourably. The disadvantage is that the
project may cost more because the con tractor will include a charge for risk in the price.
Governments preclude this type in a bid to ensure the lowest price for infrastructure

2 I.N.D. Wallace, Design-and-Build: a No-No for Owners, (1999) 4 CONST. & ENG. L. 7 at 8.
3 G. Westring, Turnkey Heavy Plant Contracts from the Owners Point of View, (1990) 7
I.C.L.R. 234, at 235.

12 | P a g e

development. The acceptance of publicprivate partnerships and project finance means that
EPC contracts have become more common in the development of public infrastructure.
ENGINEERING PROCUREMENT AND CONSTRUCTION MANAGEMENT PROJECTS (EPCM)
In the engineering procurement and construction management (EPCM) contract, the owner of
the project appoints a contractor to manage the engineering design, the procurement of the
equipment and materials, and the management of the construction phase. Construction
contractors and equipment suppliers perform the work required to build the project under
supervisory management of the EPCM contractor. The EPCM contractor, who is paid on a
cost reimbursable basis, acts on behalf of the owner, who retains responsibility for the
project. (An EPCM contract should not be confused with an EPC contract. The EPC contract
is to deliver the entire project, generally for a lump-sum price, while the EPCM contract is a
design and management function, generally rewarded on a cost reimbursable basis.)
A major difference between these contracts is the manner in which the risk is shared between
the owner and the contractor. The three main forms of engineering contract share the
construction and completion risk between parties differently. The owner retains most of the
risk if it decides to manage the project itself or to appoint an EPCM contractor. The
contractor accepts most of the risk in an EPC contract.
Table 1: Sharing of risks between contractor and owner in a capital project4
RISK SHARING
RISKS RETAINED

BY

PROJECT OWNER

RISKS

SHARED

WITH

CONTRACTOR

RISKS

ACCEPTED

CONTRACTOR

BY

TYPES OF CONTRACT
Engineering, procurement, and construction management
(EPCM)
Cost reimbursable
Project management
Fee for service
Alliance
Performance incentive
Construction management
Lump-sum turnkey
Fixed price
Guaranteed maximum price
Engineering, procurement and construction (EPC)

4 F.K. CRUNDWELL, FINANCE

FOR

ENGINEERS: EVALUATION

AND

FUNDING

OF

CAPITAL

PROJECTS, 533 (Springer Publications, London, 2008).

13 | P a g e

An EPC contractor is unlikely to accept responsibility for the engineering design package that
has been prepared by the owner or on behalf of the owner by another contractor. The
providers of such front-end engineering services will limit their liability to a percentage of
fees.5 If it is suspected that there is a fault in the design, it is difficult to determine which of
the parties is at fault. As a result, the owner does not divest himself of all risks through a
lump-sum turnkey or EPC contract.

5 P.O. MARSH, CONTRACTING

FOR

ENGINEERING

AND

CONSTRUCTION PROJECTS , 252

(Institute of Purchasing & Supply, 1988).

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FIDIC AND TURNKEY CONTRACTS

BALANCING OF RISK BETWEEN EMPLOYER AND CONTRACTOR
FIDICs Red and Yellow Books (i.e. standard forms of contract for works of civil engineering
construction and for electrical and mechanical works) have been in widespread use for
several decades, and have been recognised among other things for their principles of
balanced risk sharing between the Employer and the Contractor.2 These risk sharing
principles have been beneficial for both parties, the Employer signing a contract at a lower
price and only having further costs when particular unusual risks actually eventuate, and the
Contractor avoiding pricing such risks which are not easy to evaluate. The principles of
balanced risk sharing are continued in the new Construction and Plant and Design-Build
Books.
During recent years it has been noticed that much of the construction market requires a form
of contract where certainty of final price, and often of completion date, are of extreme
importance.3 Employers on such turnkey projects are willing to pay more sometimes
considerably more for their project if they can be more certain that the agreed final price
will not be exceeded. Among such projects can be found many projects financed by private
funds, where the lenders require greater certainty about a projects costs to the Employer than
is allowed for under the allocation of risks provided for by FIDICs traditional forms of
contracts.
Often the construction project (the EPC Contract) is only one part of a complicated
commercial venture, and financial or other failure of this construction project will jeopardize
the whole venture. For such projects it is necessary for the Contractor to assume
responsibility for a wider range of risks than under the traditional Red and Yellow Books. 4 To
obtain increased certainty of the final price, the Contractor is often asked to cover such risks
2 Joseph A. Huse, Jonathan Kay Hoyle, FIDIC Design-Build, Turnkey and EPC Contracts,
(1999) I.C.L.R. 27.
3 Christopher Wade, The Silver Book: The Reality, 18 (3) I.C.L.R. 497 (2001).
4 1 ATKIN CHAMBERS, HUDSONS BUILDING AND ENGINEERING CONTRACTS, 3.026, 426428 (Sweet and Maxwell, 11th ed., 1995).

15 | P a g e

as the occurrence of poor or unexpected ground conditions, and that what is set out in the
requirements prepared by the Employer actually will result in the desired objective. 5 If the
Contractor is to carry such risks, the Employer obviously must give him the time and
opportunity to obtain and consider all relevant information before the Contractor is asked to
sign on a fixed contract price.
EMPLOYERS VIEW
The Employer must also realize that asking responsible contractors to price such risks will
increase the construction cost and result in some projects not being commercially viable.
Even under such contracts the Employer does carry certain risks such as the risks of war,
terrorism and the like and the other risks of Force Majeure, and it is always possible, and
sometimes advisable, for the Parties to discuss other risk sharing arrangements before
entering into the Contract.6
In the case of BOT (Build-Operate-Transfer) type projects, which are normally negotiated as
a package, the allocation of risk provided for in the turnkey construction Contract negotiated
initially between the Sponsors and the EPC Contractor may need to be adjusted in order to
take into account the final allocation of all risks between the various contracts forming the
total package.7 Apart from the more recent and rapid development of privately financed
projects demanding contract terms ensuring increased certainty of price, time and
performance, it has long been apparent that many employers, particularly in the public sector,
in a wide range of countries have demanded similar contract terms, at least for turnkey
contracts.8 They have often irreverently taken the FIDIC Red or Yellow Books and altered the
terms so that risks placed on the Employer in the FIDIC Books have been transferred to the
Contractor, thus effectively removing FIDICs traditional principles of balanced risk sharing.
This need of many employers has not gone unnoticed, and FIDIC has considered it better for
all parties for this need to be openly recognised and regularised. By providing a standard
5 Supra n. 15, at 37.
6 Supra n. 25, at 500.
7 Supra n.24, at 30.
8 Supra n. 17, at 223.

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FIDIC form for use in such contracts, the Employer does not have to attempt to alter a
standard form intended for another risk arrangement, and the Contractor is fully aware of the
increased risks he must bear. Clearly the Contractor will rightly increase his tender price to
account for such extra risks. This form for EPC/Turnkey Projects is thus intended to be
suitable, not only for EPC Contracts within a BOT or similar type venture, but also for all the
many projects, both large and smaller, particularly E & M (Electrical and Mechanical) and
other process plant projects, being carried out around the world by all types of employers,
often in a civil law environment, where the government departments or private developers
wish to implement their project on a fixed-price turnkey basis and with a strictly two party
approach.
CONTRACTORS VIEW
Employers using this form must realise that the Employers Requirements which they
prepare should describe the principle and basic design of the plant on a functional basis. The
Tenderer should then be permitted and required to verify all relevant information and data
and make any necessary investigations.9 The Tenderer shall also carry out any necessary
design and detailing of the specific equipment and plant he is offering, allowing him to offer
solutions best suited to his equipment and experience. 10 Therefore, the tendering procedure
has to permit discussions between the Tenderer and the Employer about technical matters and
commercial conditions.
All such matters, when agreed, shall then form part of the signed Contract. Thereafter the
Contractor should be given freedom to carry out the work in his chosen manner, provided the
end result meets the performance criteria11 specified by the Employer. Consequently, the
Employer should only exercise limited control over and should in general not interfere with
the Contractors work. Clearly the Employer will wish to know and follow progress of the
work and be assured that the time programme is being followed. He will also wish to know
that the work quality is as specified, that third parties are not being disturbed, that
performance tests are met, and otherwise that the Employers Requirements are being
9 Supra n. 20, 11.
10 Supra n. 21, 237.
11 Supra n.15, 38.

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complied with. A feature of this type of contract is that the Contractor has to prove the
reliability and performance of his plant and equipment. Therefore special attention is given to
the Tests on Completion, which often take place over a considerable time period, and
Taking Over shall take place only after successful completion of these tests.12
EPC AND PPP
FIDIC recognizes that privatelyfinanced projects are usually subject to more negotiation
than publicly-financed ones and that therefore changes are likely to have to be made in any
standard form of contract proposed for projects within a BOT or similar type venture. 13
Among other things, such form may need to be adapted to take account of the special, if not
unique, characteristics of each project, as well as the requirements of lenders and others
providing financing. Nevertheless, such changes do not do away with the need for a standard
form.
These Conditions of Contract for EPC/Turnkey Projects are not suitable for use in the
following circumstances:
i.

If there is insufficient time or information for tenderers to scrutinise and check the
Employers Requirements or for them to carry out their designs, risk assessment
studies and estimating (taking particular account of Sub-Clauses 4.12 and 5.1 of the

ii.

Silver Book).
If construction will involve substantial work underground or work in other areas

iii.

which tenderers cannot inspect.

If the Employer intends to supervise closely or control the Contractors work, or to

iv.

review most of the construction drawings.

If the amount of each interim payment is to be determined by an official or other
intermediary.

FIDIC recommendations are that the Conditions of Contract for Plant and Design-Build be
used in the above circumstances for Works designed by (or on behalf of) the Contractor.

12 Supra n. 25, 503.

13 n. 7, 273.

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ATHENS GENERATING CO. V. BECHTEL POWER CORP.

A utility company has recovered liquidated damages from a contractor at the stipulated rate of
$49,000 per day for each of three gas turbines. Although liquidated damages totalled
$26,950,000, the daily rate was a reasonable forecast of the damages the project owner might
incur as a result of late substantial completion of the generating units. Lower actual damages,
calculated in hindsight, were of no consequence.
BACKGROUND
Athens Generating Company LL.P., was awarded a $522 million contract to Bechtel Power
Corporation for engineering, procurement and construction (EPC) Contract of a 1080megawatt merchant power plant in Athens, New York, on the upper Hudson River. The plant
included three gas turbines to be manufactured by Siemens Westinghouse Power Corporation.
The contract called for substantial completion of the project by no later than August 12, 2003
with liquidated damages of $49,000 per day for late completion of each of the three gas
turbines. Bechtel did not achieve substantial completion until March 18, 2004. Athens refused
to release the contract balance, assessing liquidated damages at the stipulated daily rate.
Bechtel argued that it was not responsible for the late completion. Athens directed a number
of product modifications and project betterments. Work was also delayed by a tornado and a
regional power outage. And. Athens suspended the use of fuel gas for 35 days because of a
spike in price.
Bechtel also challenged the enforceability of the liquidated damages clause. The contractor
said the daily rate of $49.000 per turbine constituted an impermissible penalty. The actual
cost incurred by Athens because of the late completion was far less, so recovery at the
stipulated rate would produce a windfall for the project owner. The entire dispute was
submitted to arbitration, as called for in the terms of the contract.
THE RULING
The panel of arbitrators found that the product modifications and project betterments alleged
by Bechtel were within the scope of Bechtels contract. The Siemens technology for the gas
turbines was considered Immature and not yet proven in extensive commercial use. Bechtel
was aware of this and assumed technology risk under the terms of the contract. This
technology risk included the time and cost of implementing numerous product modifications

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during the course of Bechtels performance of its obligations under the EPC contract. To the
extent that time delays and costs were caused by the implementation of these product
modifications, such cost and time should be borne by Bechtel.
The arbitrators addressed Bechtels complaint that sonic of the modifications were not
necessary to achieve substantial completion. Yet the contractor was forced to proceed with
the modifications, which further delayed completion. These were decisions that Siemens and
Bechtel made for their own convenience. There was no directive from the project owner. And
in any event, the activities were not on the critical path of the work.
Bechtel fared better with its other excusable delay allegations. The tornado affected
temporary power. Bechtel was entitled to a one-day extension on two of the three turbines.
The regional blackout also shut down temporary power at the site. Bechtel was entitled to a
two-day extension on all three turbines. And, the fuel gas suspension ordered by Athens
delayed Bechtels work on all three turbines by 35 days. The Panel found that winter weather
in 2002 constituted a Force Majeure event, under the EPC contract. However, with regard to
Bechtels $9 million weather Force Majeure claim, it rejected the vast majority.
Even after accounting for excusable delay, the arbitrators said Bechtel was responsible for
208 days of late completion on unit-1, 179 days on unit-2, and 148 days on unit-3. When the
daily rate of $49,000 per turbine was applied, Bechtel was liable for liquidated damages of
$26,950,000. The arbitrators discussed in detail Bechtels contention that the liquidated
damages clause of the contract was an unenforceable penalty. The arbitrators noted that the
contract was negotiated at arms length between two very experienced, sophisticated business
entities. These clauses are enforceable if the daily rate represents a reasonable forecast, at the
time of contract formation, of the actual damages the project owner might incur as a result of
late completions.
Bechtel presented an expert witness, Laurie Oppel, who testified regarding the economics of
operating the generating plant at the time Bechtel claimed. But Athens disagreed, that the
plant was substantially complete. The arbitrators described Oppel as a very qualified and
candid witness. But said her opinion addressed the actual damages Athens incurred as a
result of late completion rather than the estimate used at the time of contract formation. The
fact that the quantum [of stipulated liquidated damages] may with the benefit of hindsight, be
higher than the other party actually suffered is of no consequence.

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In contrast, Athens expert witness, Michael J. King, addressed the estimates used in arriving
at the daily rate of $49.000 per turbine. King testified that this had been a reasonable
forecast, at the time of contract formation, of the actual damages Athens might incur as a
result of late completion. The arbitrators found this testimony credible and ruled that the
liquidated damages clause in the contract was enforceable.
The arbitrators said the contract balance was $28,303,747. When the liquidated damages of
$26,950,000 were deducted, Bechtel was awarded $1,353,747 as force majeure damages from
the tornedo. Athens submitted the final arbitration award to the Superior Court for the District
of Columbia for confirmation.
CONCLUSION
An authoritative and persuasive expert opinion is not effective if it does not address the
necessary elements of recovery. In this case, an element as the reasonableness of the
estimated actual damages was beyond the liquidated damages claimed by the owner, but such
estimation was seen to be reasonable at the time of contract formation, neither parties can
argue the claim of a clauses reasonability after the occurrence of the event.

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INDIANTOWN COGENERATION FACILITY

Bechtel Power Corporation was awarded a fixed price turnkey construction contract for the
Indiantown Cogeneration facility in Florida. Cogeneration refers to the production of
electricity and steam from the same power plant. A fixed price of $438.7 million was agreed
on for a guaranteed completion date of January 21, 1996.
Three different definitions of completion were defined: (i) mechanical completion meant that
all the materials and equipment required for the operation of the facility had been installed
and operated safely; (ii) substantial completion meant that the facility met certain
environmental requirements and could be operated at 88% of the net electrical output; and
(iii) final completion meant that mechanical completion in addition to all performance tests.
Substantial completion was to be met by the completion date, and final completion within
one year of substantial completion. If final completion was not met by the guaranteed
completion date, Bechtel would pay liquidated damages. The liquidated damages were
limited to $100 million. The contract limited changes to the scope of the project.
Construction was financed from four sources: (i) a bank loan of $202.6 million; (ii) taxexempt bonds totalling $113 million; (iii) a $139 million loan from GE capital; and (iv)
$100,000 of equity capital.
The project was refinanced before completion of construction due to cost overruns during
construction that called for additional capital. Bonds, called first mortgage bonds, were issued
for the amount of $505million. In addition, new tax-exempt bonds amounting to $125million
were issued. These funds were used to repay the bank loans, the earlier tax-exempt bonds,
and the original loan from GE Capital. GE Capital was committed to funding $140 million of
the construction costs.
On completion, this loan would effectively be converted to equity, and the other partners
would pay GE Capital for their share of the equity. Thus, the total capital on completion of
the project would be $630million in debt from the mortgage bonds and the tax-exempt bonds,
and $140 million in equity

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MCDERMOTT INTERNATIONAL INC. V. BURN STANDARD CO. LTD

BACKGROUND
In this case Burn Standard Company Limited (BSCL) and McDermott International Inc.
(MII) entered into various agreements whereof, the latter undertook work in respect of
fabrication, transportation and installation of structure, modules, platforms and pipeline
components which was to be completed within 24 months. The aforesaid work was sub
contracted to MII by BSCL as part of the main contract between BSCL and Oil and Natural
Gas Commission (ONGC). BSCL was bound to MII through the terms of the agreements
and to the extent that the provisions of the respective main contracts between ONGC and
BSCL apply to the relevant sub-contract work of MII. BSCL through these agreements
assumed towards MII all the obligations and responsibilities that ONGC, by such main
contract, assumes towards BSCL insofar as applicable to the subcontract agreements.
There was a delay in performance of the contract on default of BSCL, which led to various
disputes and claim for damages by MII. The matter went in for arbitration. In its final award
the arbitral panel allowed certain amount of damages along with interests to MII based on the
evidences produced by them, which was disputed by the opposite parties, i.e, BSCL. For
computation of damages the arbitration panel relied on the Emden Formula as argued by MII.
The use of such formula was also disputed by BSCL and the award was challenged before the
SC. For the first time the SC, broadly recognized and discussed in detail various formulae
that may be used by the parties for computation of damages.
THE RULING
The SC discussed the following formulae which have been applied internationally for
computation of damages in case of EPC contracts:
1.

Hudson Formula: In Hudsons Building and Engineering Contracts, Hudson formula

is stated in the following terms
Contract Head Office overhead & profit
100

x Contract sum
x
Contract period

Period of delay

Using the Emden formula, the head office overhead percentage is arrived at by dividing
the total overhead cost and profit of the contractor's organization as a whole by the total
turnover. This formula has the advantage of using the contractors actual head office and
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profit percentage rather than those contained in the contract. This formula has been
widely applied and has received judicial support in a number of cases.
2. Emden Formula: In Emdens Building Contracts and Practice, the Emden formula is
stated in the following terms
Head office overhead percentagex contract sum x
period of delay
100
contract period
3.

Eichleay Formula: This formula was evolved in America and derives its name from a
case heard by the Armed Services Board of Contract Appeals, Eichleay Corporation. It is
applied in the following manner
Step 1: Original delayed contract price/Total billings for the actual delayed contract
period x Indirect expenses for the actual delayed contract period = Indirect expenses
allocable to the delayed contract
Step 2: Indirect expenses allocable to the delayed contract/Actual days of delayed
contract performance = Indirect expenses allocable to the delayed contract per day
Step 3: Daily indirect rate x Number of delays = Unabsorbed Indirect expenses
This formula is used where it is not possible to prove loss of opportunity and the claim is
based on actual cost. The Eichleay formula is regarded by the Federal Circuit Courts of
America as the exclusive means for compensating a contractor for overhead expenses.

The Supreme Court of India held that the Indian law does not restrict the use of
internationally accepted formulae for computation of damages and the same is consistent with
the principle enshrined under the Contract Act. Further, the list of formulae provided for in
para 4 of the judgment were held not to be exhaustive and any other formulae can be adopted
for computation of damages, depending on the evidences produced by the claimant.
Therefore, the Supreme Court upheld the validity and use of Emden Formula by the
arbitration panel in the present case for computation of damages which was carried on by
experts in the field.
CONCLUSION
The Supreme Court for the first time in McDermotts case above acknowledged the
applicability of various internationally accepted formulae for computation of damages.
Following this decision, many courts in India have applied the formulae discussed and
considered by the Supreme Court above which were most apt as per the facts and
circumstances of the case. For example, in Chennai Container Terminal Private Limited v.

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Board of Trustees2 and National Thermal Power Corporation Ltd. v. Wig Brothers Builders
and Engineers Ltd.3, the courts upheld the applicability of one of the formulae as decided
earlier. Mostly these formulae are brought in use at the stage of dispute resolution. As the use
of a particular formula can be only ascertained taking in account the facts and circumstances
of a particular case, these are not mentioned in the contract itself. The use of these standard
formulae minimizes the scope of errors in computation of damages and instils confidence in
the contracting parties over the security of their investments due to breach. However, there is
a lot of scope for development in this field of law and its high time that proper guidelines are
framed, analyzing various facts and circumstances under which a particular formula can be
used for computation of damages in an EPC contract.

2 2009(6) CTC 887.

3 2009 (2) Arb.LR 238 (Delhi)

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CONCLUSION
The key aspects of an EPC Contract from the project-finance point of view are contract
scope; commencement of the works ; contract price, payments, and variations ; construction
supervision; Owners Risks (Compensation Events); Relief Events; definition of Project
Completion; liquidated damages and termination; security; suspension and termination by the
Construction Contractor; dispute resolution. There is no single standard form contract or set
of contracts that serve as models for international projects. Instead, the parties are best served
by identifying the array of relationships which comprise the project in its totality and seek to
tailor each agreement to protect the respective parties interests and minimize their risks. For
example BOT projects, the FIDIC Orange, Yellow, and Silver Books may all serve as a good
starting point for the agreement between the employer and the contractor.
A project finance transaction needs predictability, a hybrid construction contract has
developed which requires the contractor to provide the complete scope of construction work
for a project, for a fixed price, for completion and delivery by a date certain, which performs
at agreed-upon levels. All the project company has to do is pay the construction price and
turn the key. However, these EPC Contracts become contentious if the boiler-plate clauses
are not clear and unambiguous, it would only enhance the financial risk content for the parties
to the EPC Contract. Either party may suffer loss in the form of damages, either liquidated or
unliquidated, upon breach of the contract, due to the obligation created upon the Contractor
or the Employer. A legal advisor has to conduct proper due diligence to avoid or minimise the
risk of unliquidated damages and reasonable liquidated damages. Nonetheless, for successful
completion of a large scale EPC contract it becomes increasingly important for the
contractors to develop their bearings in all aspects of a project like design, procurement,
project management competencies, quick mobilization, construction and erection and also to
possess new machinery and adopt technological advancements without delay, as it
encourages hassle-free single point contracts.

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