3.2 Risk Allocation with Contracts Stipulated by the SPV
3.2.1 Allocation of Construction Risk
The Turnkey (or Engineering, Procurement, and Construction—EPC) Agreement
A turnkey agreement—also known as EPC (engineering, procurement, and construc- tion)—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 following:
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. The completion date
. The cost of the works
. Plant performance
In addition to these guarantees, there may be coverage against technological risk.
Transferring this type of risk to third parties is always quite complex, in particular if the project’s base license is extremely innovative. In concrete terms, the options available are the following:
. To ask independent technical advisors (see Section 4.2) their opinion on the effectiveness of the technology
. To oblige the technology supplier to pay penalties either in one lump sum or proportional to the patent value of the technology
. To oblige the contractor to provide performance guarantees on the technology that are incorporated in the construction contract (wrapping or wraparound responsibility).
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 SPV’s 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.
Wrapping (or wraparound responsibility) is what provides lenders with a real guarantee. 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 know-how 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.
As far as guarantees on completion dates, when the preestablished construction time is up, one of two possible situations can occur:
1. The plant meets minimum performance standards.
2. The plant does not meet minimum performance standards.
Let’s examine the two cases separately via Figure 3-4, which shows the crucial checkpoints the plant must pass before starting operations. The first test is performed by the independent technical engineer at the commercial operating date (COD), the date originally indicated in the construction contract as the deadline for the delivery of the facilities. The contractor is considered in compliance with contract obligations (and therefore does not face additional costs for delays in delivering the structure) if the plant meets minimum performance standards (MPS) in the initial test and is given a Provisional Acceptance Certificate (PAC). In power plants, for example, MPSs are 46 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
set at 95% of the theoretical performance of the plant. These standards relate to electrical output, steam production, heat rate, and emissions.
If the plant meets the MPS but does not function at a 100% performance level as defined in the contract, the contractor is usually given two options:
. To liquidate
. To make good
In opting to liquidate, the contractor takes no steps to bring the plant up to the 100% performance level, but instead pays the SPV an amount referred to asbuydown damage,which corresponds to the difference in actual revenue as compared to 100%
yield. The buydown damage serves to ensure that the project satisfies debt service obligations, even in the event of a reduction in revenues caused by the plant’s lower performance level. With the make-good option, the contractor pays the cost of bringing the plant up to 100% output within a set period of time.
Testing continues for a certain period of time, after which the plant is issued a Final Acceptance Certificate (FAC) (see Section 4.2.3) and is turned over to the SPV.
The contractor guarantees that the facility is free of any pledges, claims, or mort- gages. In addition, the terms of the construction contract include a commitment by the contractor to repair or substitute defective materials at no cost to the SPV for a preestablished warranty period starting from the date of the FAC.
Now let us return to Figure 3-4. If the plant does not pass the MPS test, the contractor is considered in breach of contract and in theory is obliged to reimburse the SPV for all down payments received during the construction phase. In actual practice, such a radical course of action is never taken. In fact, technically the project would be in default. However, with the consensus of lending banks, the SPV always attempts to negotiate the completion of the plant with the contractor or another counterparty, who pays the SPV damages in proportion to the revenue lost due to the delay.
The contractor is not in breach of contract if plant completion is delayed due to force majeure events. What exactly constitutes such an event is the subject of very
Deadline for completion of the structure
Plant testing: verification of minimum performance
standards (MPS)
Commercial operating date (COD)
If MPS are met:
1. Liquidate 2. Make good
If MPS are not met:
Contractor in breach
Final plant testing:
Final acceptance certificate
TIME
F I G U R E 3-4 Contractor Guarantees on Project Completion Date and Performance: How They Work
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intense negotiations between contractors, sponsors, and lenders. In addition, con- tractors always attempt to negotiate the following in the construction contract:
. Bonuses in their favor if the plant is completed ahead of schedule or if it functions more efficiently than specified in the contract (for example, with a lower level of input consumption)
. Clauses that limit their responsibility for paying damages, up to a maximum percentage of the turnkey price (guaranteed by a performance bond that con- tractors post in deposit until construction is complete)