Investors are always pressing for the lowest capital construction cost with the least amount of contractual risk exposure. It drives up returns. At the same time, EPC’s are pressing for the highest capital construction cost with the least amount of contractual risk exposure. It drives up returns. Therein lies your inherent tug-of-war. At 5-7%, EPC profit margins are at historic lows. Investors are winning. Or are they?
Infrastructure investors exist to put money to work and generate returns for their stakeholders. Unlike consumers, they can’t afford not to spend money. Yet, there is a significant supply and demand imbalance between available capital and worthy projects to be financed. Thus, investors are increasingly feeling the pressure to find ways to allocate their capital. They must take on more risk, or risk holding cash.
Conversely, EPC’s are struggling. Profit margins are extremely low and project backlogs are shrinking. This has resulted in a flurry of bankruptcies, mergers and acquisitions, and rebranding efforts. EPC’s find themselves in the tough position of taking on more challenging projects with increased risk profiles or being selective at the expense of profit (potential) and size.
So, what happens when you have an environment where both sides badly need projects to go forward driven by differing needs? Fixed price EPC contract structures with weak foundations and unrealistic expectations that lead to contractors and owners working against one another to the detriment of the project. Fixed price works when things go right. But projects are more complex, so how often does that happen? This is the paradox that investors face; to de-risk the project on paper or de-risk the project in its practical sense.
Let’s explore further.
In the ESG and waste-to-value sectors, there is a status quo belief amongst the investment community that a turn-key EPC contract with liquidated damages and performance guarantees is the default gold standard. Consequently, most of these projects are funded as such. Although it can often be the appropriate contract structure, for many investors, it is the only commercial arrangement they can (or will) underwrite. In addition to constraints regularly imposed by their Limited Partners (LP’s), this is due to the common notion that it maximizes downside risk protection by transferring much of the risk to the EPC. The guarantees and damages are expected to motivate the EPC to meet the committed schedule milestones and stay within budget to protect their margins.
Let’s take the very common example of a $150M project that starts to considerably deviate from the original plan. The EPC recognizes they are highly likely to reach maximum liquidated damages and enter cost-savings mode. They don’t necessarily want to harm the project, but they must protect themselves. This typically means reducing man-power exposure, limiting OT or night shift work, cutting back on indirect expenses, etc. This directly conflicts with the owner's need to accelerate. At the same time, EPC contractors are smart. They know that the resulting liquidated damages for being late are far less painful to them than the lost revenue and offtake contract risk is for the investor. The owner is faced with a decision to remove the contractor and bring someone else in to finish the job or suck it up and find a way to resolve the issue.
Because it is rare a contractor is removed (the pain is even worse), the owner ends up using contingency or an additional capital raise to pay the EPC to accelerate. Or, liquidated damages are waved. The original fixed-price nature of the contract is essentially nullified and relationships all around are soured.
To be clear, EPC contractors do not want this. They prefer to get projects completed on time and on budget in a cooperative environment that incentivizes everyone to do so. Unfortunately, few projects go exactly as planned and these imposed contract structures naturally lead this scenario.
Depending on the nature of the project, a cost-plus or target price contract exclusive of performance guarantees is a much more practical way to de-risk project execution. Yes, no performance guarantees. Although they can be a good tool for accountability and financial protection, practically, if performance guarantees are being called upon it typically means the project is in bad shape and litigation is inevitable. Performance guarantee money is intended to be used in the event a new contractor or advisor is required to fix issues at hand, but it is often too late. Wouldn’t it be better to have greater control over the outcome of the project throughout its entire life?
Using the previous example, if we were to assume a cost-plus contract without performance guarantees, the project would likely be pegged at $130M. This would allow the owner to maintain the additional owner’s contingency when compared to the turn-key model. As all costs and project information is exposed, there is no real reason for the EPC to play any games, particularly if there is an incentive in place to bring in the project below a target budget. Everyone is on the same side of the table. The extra contingency can now be spent at the owner team’s discretion which is much more powerful. You can add manpower on demand, layer in a night shift, bring on a specialist contractor or advisor, or sign a JV with a supplier to provide commissioning oversight all while maintaining the budget.
I challenge investors to re-think EPC contracting underwriting requirements. It may require educating Limited Partners, or thinking outside the box, but that is what is needed to see more projects be successful.
