Adapting to the changing risk dynamics of energy projects

The Shasta Dam under construction in northern California, 1942 (Russell Lee/US Federal Government/Public domain)
The increasing scale and complexity of energy projects and a growing list of budget blowouts over the past decade have been reshaping the dynamic between project owners and contractors, making it more difficult for owners to convince contractors to accept the terms of traditional engineering, procurement and construction (EPC) contracts on a lump-sum turnkey basis.

The pandemic only exacerbated the issue with project delays and extra site safety constraints, with post-lockdown demand spikes causing labour shortages and driving material costs to 40‑-year highs in 2021.

As a result, project owners are starting to think laterally about how to keep contractors on board, while maintaining the financial viability of their biggest projects.

The balancing act of contractual risk

Many projects are pivoting away from traditional lump-sum EPC procurement in an effort to recognise the impact of higher risk on contractors. Creative thinking to address changing market conditions and increased risk in a fair and sensible way should be encouraged. But untethering from familiar lump-sum EPC contracts requires careful thought and planning.

There is a range of alternative contractual structures that owners and contractors can consider to navigate changing market dynamics. These structures will sit along a spectrum of risk, with a traditional EPC structure, which assigns the most risk to the contractor, at one end, and EPCM (engineering, procurement and construction management) structures, which allocate more risk to the owner, at the other.

The new “hybrid” structures often attempt to find a balance between owners and contractors by either assigning different pricing components to different phases of work or splitting out work between different contractors. For example, the engineering and procurement could be handled by the technology provider, while a regional construction specialist handles the onsite construction works.

Adapting to the new structures

As the industry transitions to more bespoke procurement structures, the need to thoroughly scope out the work required, anticipate where trouble spots could emerge, and provide processes and incentives for managing such risks, is becoming even more crucial.

For example, if the owner is taking on risks traditionally carried by the contractor and which are dependent on the conduct of the contractor, the parties should consider the following.

What other mechanisms can be included in the contract to motivate the contractor to manage the works to reduce costs and delay that may be considered at the owner’s risk? This is an issue where drafters may be able to take some inspiration from EPCM contracts. For example, by linking parts of the compensation to key performance indicators and the use of early completion bonuses and the sharing of cost savings.

What additional reporting and project controls might the contractor need to maintain to ensure the owner has the information it needs to properly manage the additional risk it has been allocated? Relatedly, the owner must be realistic about its ability to manage these risks and must ensure it structures its project team to reflect the increased management and oversight it will need to take on in respect of the relevant works.

Is it appropriate to adjust the percentage profits and overheads (P&OH) payable to the contractor for those parts of the works for which the contractor is carrying less risk? This reflects the fact that the owner will need to carry additional contingency for these parts of the works.

All projects experience unplanned events, but the parties’ reactions to those events and management of the resulting consequences is often the greater determinant of the extent of delay and cost overrun. A successful procurement structure must therefore facilitate and incentivise efficient and timely execution of the works and the mitigation of total project time and cost overrun, irrespective of which party may be allocated a particular risk.

It should also be recognised that interfaces between parts of the works being executed on different pricing arrangements can create unintended dynamics that can be prejudicial to the project. Owners will prefer that more of the costs be incurred in parts of the work priced on a lump sum basis, whereas the contractor will want the costs to fall within parts of the works priced on a time-and-materials or reimbursable basis. This may lead to more disputes relating to contractual interpretation and root cause analysis and/or increased issues with “carryover works”.

Looking ahead

There is no one-size-fits-all for energy procurement contracts. However, when developing a new procurement structure parties must carefully consider how the changes to the traditional risk allocation will affect the working relationship.

Parties should develop a new framework that facilitates a productive relationship between contractor and owner, and encourages timely and efficient execution of the works. In the words of Socrates: “The secret of change is to focus all of your energy not on fighting the old, but on building the new.”

  • Daniel Garton and David Strickland are partners at White & Case
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