Understanding the EPC Contract: Contingency Basics & Beyond
A cost contingency budget exists to cover uncertainty during project development. To be clear, there will always be uncertainty and execution risk no matter the contract structure. The key is to use best practice techniques to capture and quantify that uncertainty to establish the appropriate contingency budget.
There are two predominant forms of contingency.
Contingency that is established by the amount of measured uncertainty within the detailed capital cost estimate. Were widely variable assumptions made to calculate electrical equipment costs? Was there a specific equipment package that was not quoted but rather taken from a similar project? Estimate contingency is often referred to as the “known unknowns”.
Often referred to as “unknown unknowns”, event contingency captures external influenced events. What happens if a selected equipment vendor goes bankrupt and the process to award a contract to an alternative vendor delays schedule? What if a pandemic occurs? Are you building in a union labor environment with a history of strikes?
How to Assess Contingency Requirements
There are several methods to assessing contingency requirements. Unfortunately, the most common method is selecting a percent of total cost based on similar projects or the estimate class. That can work in industries that are mature and where hundreds of similar facilities have been constructed (compressor stations, simple cycle power stations, solar farms). Even then, every project has its own risk profile. In sustainable infrastructure, that method is not suitable.
Arguably, the industry standard method is to utilize a combination of quantitative and qualitative assessments.
A quantitative assessment makes use of probabilistic analysis techniques such as the Monte Carlo simulation method. The process requires building a logical model where risks are identified from a variety of sources, including the qualitative assessment. The model is subject to simulation through multiple iterations performed with a random activity duration selected from a predefined distribution.
A qualitative assessment is an evaluation that relies on the experience and knowledge of key project stakeholders to identify items that have the potential to impact the schedule and cost. This type of assessment is typically managed via the project risk management plan and risk register.
A risk register is exactly what it sounds like. It is a register of identified known unknowns and unknown unknowns. It comprises of the following key components:
- Risk item
- Likely risk trigger
- Risk response plan
- Risk owner
- Estimated impact (cost & schedule)
- Probability of occurrence
Not only is this an extremely valuable tool to manage risk throughout the life of the project, but the information can be used to calculate contingency requirements.
By assigning a potential impact value and probability of occurrence, you can identify the potential cost and schedule impacts to a project.
Monte Carlo Simulation
Below is an example of Monte-Carlo driven contingency analysis that measures contingency requirements at confidence levels in increments of 5%. For example, a P80% means that if you were to proceed with the amount of contingency recommended at that level, you have an 80% of completing the project with enough money. This makes logical sense if you presume that the more contingency you carry, the better chance you have of finishing the project without requiring more capital.
It should be noted that in a fixed price contract environment, EPC’s add their own (hopefully calculated) contingency into their price to cover their “known unknowns”. They own it. We often see a 10-15% increase in price (as compared to non-fixed price contract structures) due to EPC contingency. On top of that you must add your assessed owner’s contingency which typically ranges between 5-15% regardless of contract structure to cover unknown-unknowns.
A New Contingency Plan
“But what happens if the desired estimate accuracy proves to be not so accurate?” This is a question posed to me often by investors. The fear of overrunning budgets by 30%+ is crippling. Financial models cannot stand that level of capital cost sensitivity, so a 10-15% higher price that is fixed provides more comfort and perceived certainty. But what if you took that 10-15% and added it to the owner’s contingency budget and absorbed the cost-risk with a strong Owner’s Engineer at the helm?
You would have 15-30% total contingency to manage together with the EPC. Information would flow and change approvals would move quickly. Commercial disputes will be minimal. Influential response plans would be deployed collaboratively. Proactive project management and decision making will govern.
This article contains excerpts from our soon-to-be-released whitepaper, Establishing EPC Contracts that Actually Work for Sustainable Infrastructure Projects. Subscribe to our newsletter to get first access.