EPCM contracts

Key issues for junior mining companies
October 30, 2015

Summary

This document provides a description of the EPCM procurement structure and some of the key issues that should be considered by any junior miner contemplating its use for mining infrastructure delivery.

Contract for professional services, not works

An EPCM contractor will not carry out construction works. The EPCM contract is essentially a professional services appointment under which the EPCM contractor’s services will usually be limited to the production of detailed design and the procurement, construction management and coordination of the works necessary to deliver the project.

Whilst often confused with the EPC contracting solution, the EPCM and EPC contracting solutions are very different in terms of the nature of the obligations undertaken and the risk allocation assumed by the respective contractors.

An important difference between the two is that an EPCM contractor will not accept cost and/or time risk for the delivery of the project, this is a risk retained by the employer. The employer will therefore need to manage these risks with the professional assistance and support of the EPCM contractor through the construction and equipment/plant supply chain.

Save as highlighted in this document, the quality of the EPCM contractor’s performance will generally be determined by reference to the extent to which it has performed its services in accordance with the level of skill and care required by the EPCM contract, rather than by reference to the achievement of overall project budgetary or scheduling targets.

Historically, the mining sector has tended to see quite an unsophisticated approach to EPCM contracting when compared to other sectors where the model is commonly used (for instance, in the petrochemicals industries).

Well advised employers in the mining sector are however seeing that contractors undertaking EPCM services are increasingly willing to accommodate a more onerous risk profile under which the EPCM contractor may be more effectively incentivised to manage time and cost overrun exposure for employers (see ‘Incentives’ below). The drivers for this development are numerous but clearly economic pressure during a downturn, and so competition for work, is key.

Advantages to EPCM contracting

The EPCM solution is the preferred procurement structure for junior miners, since it can offer significant advantages if properly managed.

Initial capital estimates for completion of the works can be significantly lower under the EPCM solution when compared with EPC fixed price ‘turn-key’ solutions

This is because EPC turn-key solutions will tend to include significant levels of contingent pricing introduced to manage overall project delivery risk. The EPCM solution may therefore assist with project economics and so help to attract debt and equity funding.

The EPCM solution will allow employers to retain ultimate control over design development throughout construction

This will provide flexibility to allow employers to adapt design to suit precise (and sometimes changing) requirements and to allow optimisation and value engineering where relevant to control capital costs. Such flexibility is not possible under an EPC solution (at least not without significant price consequences) since design development will be controlled by the EPC contractor.

The EPCM solution will allow flexibility in the procurement process

This is particularly important where there is an extended build period with a multi-phase construction programme with many distinct and separate packages for overall infrastructure delivery (eg, process plant, road, rail and port infrastructure etc.).

But the advantage of lower costs and increased flexibility under an EPCM solution should always be balanced against the significant additional risks being retained by the employer in project delivery. As mentioned above, the employer under an EPCM solution will not be insulated from cost overrun risk in the same way as they would be under a fixed price EPC solution.

The employer’s role in the management of the works in parallel with the EPCM contractor is therefore paramount. For successful project implementation, the EPCM solution requires a well-equipped and mobilised employer’s team to take a hands-on and intrusive role in the management and administration of the works.

Form of contract – what should be the starting point?

There is no international standard form template contract for the EPCM contracting solution, unlike for EPC turnkey or traditional build contracts.

Is use of standardised forms of contract appropriate?

EPCM contracting is essentially contracting for the delivery of professional services. There are numerous published standard forms of contract (the most popular being the FIDIC White Book) that could be adopted for these purposes. It is important however for employers to recognise that:

  • the published standardised contract forms are typically developed to be consultant/contractor friendly
  • simple professional services appointments will tend to lack the sophistication necessary to readily address many of the issues that arise in a mining project.

In our experience:

  • significant amendment will be required to standardised forms of professional services appointment to generate a form of EPCM contract that could be reasonably acceptable to well advised employers in the mining sector
  • licences to amend such forms are not easily obtained
  • difficulties may be encountered from a negotiating perspective when attempting to justify to the EPCM contractor (and its board of directors) the reasons for a move away from what are ‘internationally accepted contracting principles’, ignoring, of course, that the terms were not appropriate for the employer in the first place.
Suggested approach to contract form selection

The format should always be driven by the requirements of the employer and his backers and not by a format that the contractor has delivered services on in the past. The fact that the contractor has used a particular form previously says nothing of the appropriateness of the form proposed.

In our experience, significant time and cost can be saved by the employer taking the initiative in this regard and delivering terms to the EPCM contractor which represent those on which it is prepared to negotiate.

EPCM services

EPCM services typically fall into the following categories:

‘E’ – Engineering services

This is the design of the process plant, the buildings housing the process plant and any associated infrastructure. The EPCM contractor may or may not have been involved in producing the basic design and/or the ‘process flow design’ at feasibility stage.

Where the EPCM contractor has not produced basic design, the EPCM contractor should accept the risk of the accuracy and completeness of the basic design or at least verifying the same to the employer.

The EPCM contractor should be allocated responsibility for overall co-ordination of design for the project to ensure that the completed works meet the required technical and performance specification (but note ‘Price certainty on the cost of the works’ and ‘Incentives’ below describing the limited liability typically accepted by EPCM contractors in this regard).

‘P’ – Procurement services

The EPCM contractor should be allocated responsibility for the overall procurement strategy. He will also source contractors, consultants and the necessary plant and equipment in consultation with the employer and in accordance with the employer’s requirements and the assumptions established at feasibility stage.

The EPCM will advise on the timing of the letting of the relevant packages and will advise the employer on the terms available and will typically negotiate the contract packages on the employer’s behalf.

It is usual for the employer to enter into the works and supply contracts directly but we have seen exceptions to this approach under which the EPCM contractor enters into contracts as the employer’s agent.

‘CM’ – Construction Management services

The EPCM contractor should be allocated responsibility for overall management of the carrying out and completion of the works. This will include the co-ordination of the works and services being procured on the employer’s behalf to achieve completion of the works in accordance with the project schedule, the project budget and to meet the required technical and performance specification (but, again, note ‘Price certainty on the cost of the works’ and ‘Incentives’ below and the limited liability typically accepted by EPCM contractors in this regard).

The construction management services will also typically include the management of health and safety at the site, the management of disputes between the employer, the works contractors and/or the suppliers, the establishment of quality assurance systems and the management of the remedying of defective works and/or services provided by other parties.

In all cases, it is important that the nature and extent of the services being provided are well defined and that appropriate levels of contractual flexibility are created to allow the scope of services to be adapted through the execution of the project in a manner which does not expose the employer to de-scoping ‘penalties’ or inflated pricing for enhanced services.

The above allocation of responsibility is not the only solution. Hybrid solutions have also become more common, for instance where employers wholly retain the management function through the owner’s team to create an EP/CM split. The appropriateness of the structure proposed will always be something that the employer should consider with its technical, commercial and legal advisers on a case-by-case basis.

Price certainty on the cost of the works

Whilst an EPCM contractor may accept some limited risk in delivering a project on-time and on-budget (see ‘Incentives’ below), EPCM contracting does not offer a fixed price solution.

Cost control must ultimately be achieved through the implementation of a robust procurement strategy, typically developed and managed by the EPCM Contractor in consultation with the employer, as outlined above.

Key to this will be the separation of the works into appropriate works and supply packages which should each be procured on robust terms which seek to insulate the employer from time and cost overrun risk. The procurement strategy should seek to avoid where possible the creation of time, design and works interfaces and where the creation of such interfaces is unavoidable, a clear strategy for the management of them should be established by the EPCM contractor (and indeed this should be a contractual requirement).

The role of the employer’s team in monitoring, supporting and supplementing the services of the EPCM contractor is extremely important to achieve successful project execution and delivery within project budgetary constraints.

Payment

The usual basis of payment for EPCM contractors is as follows:

  • payment on a cost reimbursable basis for the man hours expended at agreed rates (rates should reflect the actual and verifiable cost and the contract should expressly provide that these rates should usually NOT include profit) plus
  • overhead payments that will be charged at a fixed percentage of the reimbursable rate plus
  • a fixed fee element representing the EPCM contractor’s profit. Employer’s should seek to agree to fix this amount at day 1 and not permit any increase in the event of project cost and/or time overruns (ie, to avoid any indirect disincentive to the control of overruns).

The EPCM contractor should warrant that the agreed rates in that the agreed rates in the first two bullet points above do not contain any profit element, and the employer should have the right to claw-back any profit element subsequently identified through agreed audit rights or as disclosed by the EPCM contractor.

The value of the hours expended by the EPCM contractor in providing the required services are not typically subject to an overall cap or limit, although employers sometimes offer incentive payment for the achievement of budgeted man hours.

However, with a competitive market, there are contractors who may be willing to accept delivery of all the EPCM services for a fixed amount. The only exceptions to this would be subject to negotiation but might include: variations to the EPCM or trade contracts; breach by the Employer of the EPCM contract or trade contracts and possibly ‘force majeure’ type events.

On the face of it, capping the amounts payable to the EPCM contractor appears commercially sensible but employers need to be aware that where matters have
taken a turn for the worse – for instance where the project has fallen into delay (which may be for reasons beyond the reasonable control of the EPCM contractor), employers will want to avoid effectively putting a halt to the services or disincentivising the EPCM contractor from applying appropriate resource to the project to assist in rectifying the relevant issues.

Incentives

The EPCM contractor will not backstop project delivery risk and, importantly, the achievement of key project targets. The EPCM contractor will however be responsible for managing the same on behalf of the employer.

The challenge for employers will be to incentivise the EPCM contractor to effectively and proactively manage project delivery and the achievement of key project targets.

The approach typically adopted relies on an incentive structure which provides positive (and sometimes negative) incentives to the achievement of key project targets. These provisions are generally bespoke and may be underpinned by fairly complex calculations but equally can be fairly straight forward depending on the approach preferred by employers.

Typically, incentive regimes cover the following:

  • bonus payments for the works being completed on time or within a fixed period following the scheduled completion date
  • bonus payments for the works being completed for an overall outturn cost below or within a fixed amount over the outturn cost budget
  • bonus payments based on the health and safety record at the site
  • bonus payments for completing the required EPCM services within the projected budget for such services (based on projected man hours at the agreed rates)

but there will always be variations on the approaches outlined above and the proposed approach will tend to be shaped by the concerns the employer may have in respect of key aspects of project delivery.

It will be a matter for the employer to consider commercially whether the incentives should remain payable where extraneous circumstances outside of the control of the EPCM contractor have undermined the achievement of the relevant project targets. We have seen varying approaches in this regard.

Since the EPCM contractor will typically set key project targets (eg, the project budget and the project programme), appropriate due diligence will need to be undertaken by the employer to establish that the project targets are sensible in the context of the project proposed.

More recently, we have seen EPCM contractors willing to accept negative incentives around the achievement of the key project targets, such that they are prepared to place an element of their profit at risk. This approach has been commonplace in other sectors using the EPCM model for some time but it is now becoming more common now in the mining sector.

Limitations on liability

All EPCM Contractors will expect to cap their liability under the terms of the EPCM contract.

The liability accepted by the EPCM contractor must be appropriately sized but the ethos of EPCM contracting is that the EPCM contractor is providing consultancy services only and is not underwriting project risk. The size of the liability caps under the EPCM contract (compared to the overall project cost) and security package (if any) supporting the EPCM contract will be reflective of this.

Sizing of the liability cap

It would be usual for EPCM contractor’s to limit their liability to a percentage of the budgeted fees or an amount equal to their profit at the date of contracting. The approach taken differs from one contract to the next but our experience is that liability tends to be limited to an amount equal to 10-20 per cent of the budgeted cost reimbursable element of the EPCM payment (which broadly equates the level of profit expected by EPCM contractors).

Exclusions from the liability cap

Certain defined liabilities must be uncapped and so excluded from any limitation on liability. These liabilities should include those which can not be limited at law (eg, fraud, death and personal injury etc.).

In addition, there is usually an agreed list of further liabilities that will not count towards the liability limit. This is usually a matter for commercial negotiation and will, to a certain extent, be driven by project specific concerns.

Consequential losses

Liability for consequential losses (ie, the losses that arise indirectly from the failure,
act or omission of the EPCM contractor) is a key issue:

  • employers will be concerned about the cost of its ‘trade’ contractors having to re-perform works as a result of defective services or design by the EPCM contractor
  • the extent of liability typically accepted by EPCM contractors will leave the employer exposed given the likely quantum of these liabilities
  • professional indemnity insurance should therefore be arranged to cover these types of losses (either procured by the EPCM contractor or by the employer as part of the wider project insurances)
  • where professional indemnity insurances is available, such liability should be uncapped to the extent it is recoverable under the relevant policy. This would permit full recovery by the employer (subject to the extent of the insurance cover)
  • the allocation of insurance deductible risk will be a matter for commercial negotiation.
Re-performance of defective services

Many EPCM contractors look to limit their liability to ‘re-performance’ of defective services only:

  • this is a difficult concept for an employer to accept particularly given the above described trade contractor losses
  • employers should resist this since any such re-performance should be treated as a cost of performing the services and is not a liability as such
  • many liabilities that should be captured by the EPCM contract liability regime may not be remediable through re-performance of defective services alone, so this approach will not provide for an appropriate remedy in many circumstances
  • it ignores the purposes of professional indemnity insurance cover.

Tax issues – on-shore/off-shore

Most developing countries have tax regimes which seek to control, through taxation, the amount of investment in a mine development that does not become directly invested in the country (so for example, professional services fees). Withholding tax is the most common form of taxation that needs to be considered when structuring the construction development stage of any mining project.

It would be unusual for any contractor to bear withholding tax risk and, if it did, then it would simply become a ‘cost’ to the project that would add to the overall project economics. It is important therefore:

  • to give proper consideration to structuring the construction contracting arrangements very early in the procurement of a mining project
  • to obtain the early buy-in by the local tax authorities (either directly or through local advisers) to those arrangements.

One of the most common means of mitigating withholding tax exposure is to adopt a split ‘on-shore’ and ‘off-shore’ contract structure. This usually means that there will be two contracts, each entered into by a different EPCM contractor entity and each containing different scope of services. For example, there will usually be:

  • one contract for those services which may take place outside of the country in which the works are being delivered, payment for which may therefore be structured to avoid withholding tax. This contract will typically be entered into by a non-local EPCM contractor entity, (the ‘off-shore contract’)
  • one contract for those services which must be performed in the country in which the works are being delivered, such as the EPCM construction management services (because there must be personnel presence on the ground in order to carry out the supervision), payment for which may be subject to the relevant local withholding tax regime. This contract will typically be entered into by a locally registered EPCM contractor entity (the ‘on-shore contract’).

The obvious risk to the employer with a split structure is that he is required to deal with two contractors each with a separate scope of work and separate rights and obligations. It is important therefore that these contracts are well drafted and dovetail together so that they include, at least, the following provisions:

  • a recognition of the joint objectives across the two contracts and a requirement for coordination
  • an acknowledgment by each entity of the scope of the services being performed by the other and an allocation of responsibility for any gaps between the two scopes
  • an obligation to not interfere with or impede the other entity
  • an acknowledgement that any act, omission or default by one entity will not give rise to any right of the other entity to relief from or a right to claim against the employer
  • default termination triggers in one contract automatically triggering termination of the other contract (so called, cross default provisions)
  • a right for the employer to consolidate any dispute against one entity with any dispute against the other.

The employer will usually look to limit its exposure to breach by the separate on-shore and off-shore contractors by putting in place further contractual arrangements which provide for the off-shore EPCM contractor entity (or a suitable parent) providing a performance and financial guarantee (backed by indemnities and, possibly, suitable financial security) in respect of discharge by both the on-shore and off-shore entities of their respective and collective obligations. This guarantee (which could be wrapped into the off-shore contract) is often referred to as an ‘umbrella agreement’.

However, in jurisdictions where the tax authorities do not recognise this ‘split’ due to the presence of the guarantee (or ‘wrap’) provided by the umbrella agreement, then further careful consideration is required in the drafting of the on-shore and off-shore contracts in order to deal specifically with the above concerns.

English law is the preferred governing law for substantial international contracts because it carries a guarantee of impartiality and integrity that is recognised worldwide and provides the ideal balance of predictability and flexibility. It is invariably the preferred choice of lenders in the EPCM market.

When things go wrong – choice of law and dispute resolution

  • The dispute resolution clause can provide for a tiered approach involving high level commercial negotiation then alternative dispute resolution (mediation usually) with arbitration only to follow after those processes are exhausted.
  • Arbitration (contrasted with court proceedings) has the advantages of easy enforcement of an award as the New York Convention is in force in 148 countries. There is no comparable treaty in place to enforce court jurisdictions which are only generally enforceable where there are reciprocal enforcement arrangements in place (for example, within the EU). Further, arbitral proceedings are confidential and any award is final and binding with limited exceptions.
  • There are well established international arbitral rules (such as the ICC, LCIA) which have dedicated resources to deal with all administrative aspects of the arbitral process including but not limited to nomination of arbitrators, advances on costs and recommended model clauses.
  • Finally the place (or seat) of arbitration needs careful consideration because:
  • it determines where the award is made (and hence whether it is an award of a party state for the New York Convention)
  • the arbitration will be subject to the procedural law of the seat
  • the courts of the seat will have a supervisory/supportive function in connection with the arbitration.

Advice should be sought on a case-by-case basis to ensure that the EPCM contract contains appropriate dispute resolution provisions which provide clear recourse for the employer and a high degree of certainty in terms of its ability to enforce any award made in its favour.