Q&A: Managing risk in cutting-edge Net Zero projects
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The shift to Net Zero will require the transition to cutting-edge technologies. In this environment, traditional contracting models – for example engineering, procurement and construction (EPC) – may not be tailored to the risks involved.
How do infrastructure contracts typically work?
The starting point to any consideration of these issues is to remind ourselves that, at their core, contracts are all about the allocation of risk.
To take a well-known example, any mention of an “EPC contract” means market participants familiar with construction and infrastructure projects have certain expectations about how they will operate. For example, there is likely to be:
- A Principal, who will be the ultimate owner of the project.
- An EPC Contractor, who is obliged to deliver the complete project to the Principal, usually on a guaranteed date, with a guaranteed performance of the project, and for a guaranteed price. If the EPC contractor fails to comply with these obligations – particularly around time and performance – then they are liable for liquidated damages.
The EPC Contractor rarely performs all of the actual “on the tools” work itself, which will typically be subcontracted to other specialists.
However, the EPC contractor retains a single point of responsibility to the Principal – “wrapping” the risk associated with the design, engineering, procurement, construction and testing of the facility. From the perspective of the Principal, this is a key feature and benefit of this contractual regime.
How do standard infrastructure projects work?
Traditional energy infrastructure projects (i.e. those producing or using oil and gas) operate in a reasonably predictable fashion that has been honed over decades of use.
Very experienced parties typically act as Principals or EPC Contractors; they know the underlying processes and technology and have an appreciation for the risks and how they might be allocated.
Further, the regulatory framework is reasonably settled and the parties usually have relationships with the regulators, so again there is a level of certainty about the likely outcomes.
In this context, both the Principal and the EPC Contractor (and, for that matter, the downstream contractors) can engage with the EPC contract in a manner consistent with these expectations, with a fair amount of certainty.
They are dealing with known quantities, both in terms of the work scope and the market participants. Importantly, they are in a position to anticipate, manage, and price risk.
What’s different in a low-carbon project?
Renewables projects, and particularly those using cutting edge, speculative, or otherwise novel technologies, can turn a lot of this on its head.
Firstly, there are the risks of the technologies themselves. Second, you often have less experienced contractors involved, particularly at a subcontractor level. And third, you have an ever-changing regulatory landscape in which they are deployed.
Many traditional features of an EPC contract are under significant strain. This requires a critical assessment of whether the traditional allocation of risk remains relevant.
What that means is that many of the traditional features of an EPC contract are put under significant strain. This requires a critical assessment as to whether the traditional allocation of risk remains relevant.
As explained above, a key facet of an EPC contract is that the EPC Contractor normally “wraps” the risk – i.e. they are the single point of contact to the Principal.
If anything goes wrong, it is the EPC Contractor that is liable to the Principal. The EPC Contractor then normally “back-to-backs” that risk to its subcontractors.
However, in the context of a renewable project:
- The parties are often dealing with new or unproven technologies, which come with unknown risks. As a result there needs to be a detailed consideration as to whether the EPC Contractor is in a position to “wrap” the design and performance risk.
In other words, is the EPC Contractor able to reliably identify, and price, the types of risks that might arise? And even if it can, are its traditional back-to-back arrangements with subcontractors feasible?
Many of the contractors involved in developing edge technologies are often of a smaller (or even start-up) scale and may be financially vulnerable. This increases the focus on where the risks might otherwise be allocated, including to insurance.
- Assessing performance can also be challenging. For example, the output of a previously untested solar farm technology can be uncertain, leaving aside the fact that it might be affected by unknown environmental conditions (i.e. the amount of sun over a designated period) in ways that traditional coal- or gas-fired power stations are simply not.
As a result, existing clauses around (for example) performance liquidated damages need to be re-assessed to determine whether they remain appropriate for those new technologies.
This re-assessment is challenging given those parameters need to be set at the date of the contract, well in advance of when they might actually be tested.
- Another ever-present issue is the constantly changing regulatory landscape that is seeking to “keep up” with the new wave of technologies. For example, it’s possible that the EPC Contractor could build a “perfect” windfarm, but that is only relevant if it can be connected immediately to the electricity grid by the appropriate regulator.
As regulators are assessing these new technologies, their requirements are in flux. There is therefore a need to assess who bears the responsibility for any changes to these requirements (which may cause delays to the commencement or operation of the project), as this can have implications not only for liabilities between Principal and EPC Contractor, but also the interface with other offtake and maintenance contracts.
How can these risks be mitigated?
All of these challenges arise from the tension between allocating all of the risks to the EPC Contractor as a single point of responsibility (which is the whole point of an EPC contract for the Principal) and those risks being unknown, or at least difficult to anticipate or price.
In our experience, it can be challenging to determine exactly how issues are to be treated under a contract, simply because they were not anticipated at the outset and therefore not expressly allocated.
Managing risk in cutting-edge infrastructure projects requires very careful engagement with the technical teams who will be responsible for delivering the project. There is a real need to break down into components every step of the construction and testing/performance regime, critically assess each step, and hold point to ensure it has been considered and addressed.
In this way, even if the position is that the risk still ends up being allocated to the EPC Contractor, the potential issues will be highlighted to all parties and provision will be made to ameliorate them, whether through contractual mechanisms such as “change in law” clauses, or the involvement of third parties.