Understanding The EPC Contract: Pricing
As an infrastructure investor, you are responsible for putting capital to work with as much downside risk protection as possible (within the boundaries of the expected return profile). This means you spend much, if not most, of your time assessing risk. My guess is that you have personally experienced the pains of cost overruns and schedule delays resulting from EPC performance.
The hard truth is that a project that runs significantly over budget and behind schedule is far worse for the sponsors and investors than it is for the EPC. EPC liabilities are typically capped at a modest percent of the contract value (often 20%). The sponsor liability is the balance of the investment (the other 80%) plus any additional overruns or follow-on capital required.
There are four influential components of the EPC contract.
How EPC Contracts Are Priced
To understand cost risk, you must first understand how an EPC contract is priced (when done correctly):
1. A Front-End Engineering & Design (FEED) package is completed, often utilizing the Front-End Loading (FEL) process. This process leverages a phase-gated approach to maturing project definition (often ~30% design complete) allowing for the ability to cut off development capital spending if it looks unlikely to reach technical or economic viability.
2. During the progression of the FEL process, equipment package specifications are being defined and drafted to use as the basis to obtain pricing from equipment and technology vendors. Detail-oriented communication with such vendors is critical, regardless if sole-sourced or awarded via a bid process. Equipment costs typically make up 30-45% of total project cost. Equipment costs before contract signing should be very accurate.
3. At the completion of FEL 3, we typically say we have completed “Basic Engineering.” This means there is still lots of detailed engineering remaining to be ready for construction and have firm quantity take-offs, but there is enough work complete to determine if the project remains viable. The engineering package typically has enough definition to complete some level of material quantity takeoffs (remaining will typically be factored) and a reasonable assumption can be made for standard plant equipment such as electrical MCCs and standard pumps which will be finalized during the detailed engineering process.
Performing quantity takeoffs is the process of “measuring” the number of bulk commodities that must be installed. For example, measuring the number of cubic yards of concrete that need to be poured based on foundation design. Or the length of small-bore carbon steel pipe that must be installed. By measuring quantities as accurately as one can at this phase, you establish in reasonable detail the amount of material you need to install in order to complete the project. Once you know how much you must install, you can calculate the cost to purchase the material and the amount of labor that will be needed to install it. Material costs typically make up 25-35% of the total project cost. Material costs before contract signing should be modestly accurate, but where large assumptions are made, the appropriate amount of contingency should correlate.
4. Once you have the quantity of pipe, cable, concrete, instruments, and other material, you can estimate labor costs. There are several ways in which this is done, but the most common is by applying install unit rates. EPCs maintain and retain access to a large amount of data. They know exactly how much time it takes a pipefitter to install (run) 2-inch small-bore carbon steel pipe by the linear foot. Thus, the only missing part of the equation is how much footage is there to install. Multiply the two and you get the number of man-hours required to do so. Assign a labor rate and you have the number of dollars required to do so. It all comes back to the ability to estimate quantities as accurately as possible. Labor costs typically make up 20-35% of the total project cost. Labor cost risk is like material cost risk as both are heavily driven by the accuracy of the quantity and equipment install calculations and regional trade agreements. Labor unit rates are typically well known by the contractor, and when allowing for necessary escalation, can be reasonably accurate.
5. You also have subcontract considerations. Most EPCs subcontract out a portion of their work. Many of them subcontract most if not all. The most common subcontracts are specialty trades or supply install equipment packages (vendor installed). An EPC can execute entirely as a General Contractor (GC), but the ability to self-perform is typically advantageous. Self-performed work is often completed by craft labor that maintains a history of working together which impacts performance.
6. Last, but certainly not least, you have commissioning and startup considerations. This one is always a hot topic.
From the above, it is obvious to see that the amount of engineering definition, equipment vendor engagement, and effort put into generating material takeoffs drives estimate accuracy. If satisfactory engineering and project execution definition does not exist, capital cost estimate accuracy is inherently decreased which should serve as a major red flag. When done properly, an EPC pricing effort is an aggregate of producing material takeoffs (MTO’s), completing labor studies, adequately negotiating major equipment packages, and defining the balance of plant cost risk. In other words, data-driven analysis, and assumptions.
The following table depicts the various classes of estimate and expected accuracy driven by the maturity of deliverables.
If you properly evaluate the process in which an EPC price was established, you can begin to understand how accurate the price likely is. That comfort level should significantly influence the decision-making regarding which commercial cost structure is preferred. If a rigorous pricing exercise is completed as described, is it fitting to execute a fixed price agreement that increases capital costs (EPCs incorporate their own contingency) and assume all the noted downsides created by an inherently self-serving environment?
This article contains excerpts from our whitepaper, Establishing EPC Contracts Suitable for Sustainable Infrastructure Projects. Download your free copy here.
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