Some thoughts on engineering project contracting strategy and risk

A few years ago I consulted with a client who was asking for help in developing their next big engineering project. Their previous project had not gone so well, owing largely to the EPC Contract having been poorly structured and with a technical specification that had not been clearly defined. Sounds familiar? The client’s idea for the next project was to specify the plant in great detail and to force the EPC contractor to take on the equipment suppliers the client had identified. Does anyone else see a problem here?

Engineering project development requires a well thought through strategy of which good contracting structure and appropriate risk allocation is essential. In the early 1980s, international construction lawyer Max Abrahamson proposed principles (known widely in construction law as the ‘Abrahamson Principles’) to achieve fair risk allocation between the competing commercial interests of a principal and a contractor. The essence of these is that a risk should lie with the contract party who is best placed to either control or accept it. Having an EPC contractor take on a risk they cannot control or that would bankrupt them for example is only likely to end in tears for the principal/owner.

In 2014, Melbourne Law School and the Society of Construction Law (Australia) conducted research into Australian Standard Forms of Contract (e.g.: AS4300, AS4000, AS 2124 and AS4902). The results showed that 68% of construction contracts are based on Australian standard forms but that 84% were amended, the main reason for doing so being to ‘shift the risk’.  Various commentators have noted the strong tendency towards more one-sided contracts in favour of the principal in recent times.

Forcing an EPC contractor to take on suppliers and subcontractors it has no relationships and experience with is fraught with danger. One of the greatest advantages of the EPC contract/subcontract structure is the alignment of culture, strategy and systems between businesses which evolves from close working relationships on numerous projects. The resultant integration of overall design, procurement from a range of equipment suppliers (sometimes part of the same group) and the coordination of the various construction subcontractors is what made EPC contracts for the big power plant equipment suppliers (e.g.: Siemens, Alstom, GE) popular and generally successful in the 1990s and early 2000s.

A key focus of risk for engineering projects is regarding who takes the responsibility for design. If there are real reasons for the principal to specify a particular design (e.g.: for commonality of proven equipment), then that is fine. If however you are engaging a competent EPC contractor, with the experience of building similar projects why wouldn’t you leave the detail design to it? If you don’t trust it with the design, then why are you using an EPC contract? Instead, it would be better to contract that company for its speciality (construction for example) and contract separately for the other elements such as design and procurement. This approach is known as EPCM contracting, and whilst requires an increase in your own project team staff for the additional contracts management, you are actively taking control over the real risk of poor contract structure.

A particular issue with a principal/owner specifying particular elements of the design, is that when a problem arises in anything that has an interface or any relationship with that equipment, you can guess who the contractor is going to blame. And therein starts the technical and legal battle of trying to prove who is really at fault. For the client I consulted with, the draft specification for the industrial plant included such specified gems as; the required mixing times for concrete, the allowable design strains for various piping  materials and my favourite - the make and model number of the toilet pan to be installed!

An EPC contract is not a panacea for lazy project development and management by a principal. Engaging an inexperienced EPC contractor and allocating it risks it does not have the skills or interest in managing is not likely to end well for the principal.  Sure, the alternative means that your project needs more front end development time and perhaps resources, but that will be more than made up for when the schedule delays and poor quality outcomes begin during execution. Who really pays for the delay in production start-up after contract Liquidated Damages cap out at 10 percent? - The principal/owner does!

A good way to start your engineering project off on the right foot with good contracting structure and appropriate risk allocation is to get an owner’s engineer on board early to assist in the development of the technical specification – one thing the client above was on the right pathway of doing.