What is an EPC Contract?
First things first, I should clarify that here we will refer to a particular field: engineering and construction projects in heavy industries such as mining, oil & gas, energy, etc.
Let us start from the beginning: what is an EPC contract? EPC stands for Engineering, Procurement and Construction. This means that an EPC contract is no different than any other contract, under whatever terms of payment and risk distribution client and contractor might want to agree upon, but it includes the design, purchases and construction of a specific project in the scope of work.
EPC contract must not be mistaken as the EPCM contract, where the CM stands for Construction Management, meaning that the contractor does not perform the construction by itself, but manages it through one or several contractors for construction. The CM contractor becomes the client´s “project construction management team”.
How come a client sees the Lump Sum EPC Contract as a guide?
EPC Contracting systems
In our market it is typical to think of a specific EPC Contract type: Lump Sum. Just to be in the same page, what is the definition of Lump Sum? Once I had a disagreement with a client (a friend and engineer, like me) and, since the answer involved a nice amount of money, the fair thing to do was to look for a neutral, technical and somehow “close-to-official” source for the private sector: the Public Contracting Law. (I am based in Peru) The Peruvian Public Contracting Law states:
“Contracts use the following contracting systems:
- Lump Sum, applicable when quantities, magnitudes and qualities are defined in the
technical specifications, reference terms or, in the case of construction works, in the
corresponding drawings, technical specifications, descriptive report and construction budget.
The bidder shall present its offer for a fixed amount and a defined execution term, to fulfill the
requirement. (…)”
The most common situation is that everybody has in mind something like “The bidder shall present its offer for a fixed amount and a defined execution term, to fulfill the requirement” and not necessarily the concept of “…applicable when quantities, magnitudes and qualities are defined in the technical specifications, reference terms or, in the case of construction works, in the corresponding drawings, technical specifications, descriptive report and construction budget”.
Wait a moment! Defined quantities, magnitudes and qualities? But, if we are talking about an EPC, which means that the contractor shall take care of the engineering, how could we have defined quantities, magnitudes and qualities? Exactly, …we do not have them.
Before going deeper into the problems this incongruence brings, it is good to know that there is no obstacle to use an EPC contract with some of the other existing contracting types such as Unit Prices, a mix between Lump Sum and Unit Prices or, even some open book cost-reimbursable agreement, meaning that real costs are shown, and a fee is paid to the contractor.
We should also say that clients (clients are usually the most enthusiastic about Lump Sum EPC contracts) have in mind that EPC implies “turnkey”, which means that “…the bidder’s proposal includes the construction, equipment and erection up to commissioning and, if necessary, technical dossier and/or assisted operation of the project.”
As a summary, in our market the EPC Contract has the marketing position of a Turnkey-Lump Sum Contract, despite that is only one of several options.
Risks of a Lump Sum EPC Contract
So far, we have seen that a Lump Sum contract is applicable when the engineering of a project is essentially ready: it has drawings, specifications, descriptive report, etc., therefore quantities and qualities are already defined.
This happens because, when a project is well developed and its engineering is essentially complete, the risk of errors in a bidder’s proposal is low. It is expected that the proposals are complete, and the price and delivery term are appropriate.
But what happens when a client asks for Lump Sum EPC proposals? Obviously, the client should have a minimum design for its project, a basic engineering development able to provide the bidders enough information in order the proposals to fit the client’s expectations.
If we were talking about a house, the client should be clear in its needs and expectations: how many bedrooms, bathrooms, which bedroom should have incorporated a bathroom, if a parking garage is needed and, if so, for how many vehicles, etc.
In our case, EPC contracts in heavy industry markets, the issue is a bit more complicated, but the concept is quite similar.
When a bidder faces a Lump Sum EPC bid, immediately realizes its high-risk exposure and the need to take precautions. We are here considering experienced and diligent bidders.
As a first step, it assembles an engineering team to develop a pre-design that allows to estimate quantities and qualities for a substantial part of the most important works, and their impact in cost and delivery term. It is even possible that the bidder engages an engineering firm for this pre-design.
In addition to that, since the bidder knows that the quantities it may estimate might not be accurate enough, it will probably add some “reserves”, as a contingency, to its estimation of quantities, costs and delivery term; as well as a general contingency according to the risk taken. As it is to be expected, the bidder’s cost and delivery term will also include a specific task for the ready-for-construction detailed engineering development.
The time needed for the detailed engineering development also affects the costs, since it can delay the start of the purchases beyond the validity time frame of the quotations the bidder obtained for its proposal, so it is common to include also allowances for price escalation.
In short, this type of bid generates proposals with longer delivery term and higher prices than the proposals from “classic” bids with well-defined and complete engineering or any of the other EPC contract types using Unit Prices or some cost-reimbursable contract. This is the direct consequence of the high risk of the operation.
From the client’s point of view, why ask for a type of bid which, quite certainly, will offer higher prices and a longer delivery term? How come a client sees the Lump Sum EPC Contract as a guide?
Primarily, due to the certainty about the delivery term and the cost that a Lump Sum EPC contract can provide. The over-price paid by the client is like an insurance against additional costs and time extensions. It is the cost of transferring the risk to the contractor.
Certainly, the risk balance leans strongly to the contractor’s side - more than what is reasonable, if I may say - and this brings some problems.
The first of them is that a wrong estimation can cause losing the bid, in case of an over-estimation or, much more serious, the case of an under-estimation that ends in the award of a proposal which will generate the loss of money to the lucky winner bidder. A loss means that the contractor ends with less money than in the case of not executing the project. In short, not being awarded would have been a better situation.
We could call this last situation a Pyrrhic victory, named after King Pyrrhus of Epirus, whose army suffered so many casualties in defeating the Romans, that it is said he exclaimed: “If I achieve such a victory again, I shall return to Epirus without any soldier”.
The case is, this kind of Pyrrhic victories are quite common in the world of Lump Sum EPC contracts due to the high complexity of the projects, so the chances of errors are high. In a typical bidding process, someone over-estimates, so it loses the bid; a group of bidders’ proposals go aligned inside a “reasonable range“ of prices; while is highly possible that one bidder, at least one, under-estimates. If the bidders are financially strong companies, we have our happy winner, our own King Pyrrhus.
It is obvious that, sooner or later, the awarded contractor will realize that it is going to lose money, usually a big amount, so it will be tempted to look for any chance of recovering money or saving it.
Some strategies to achieve this will be quite valid and acceptable: having the engineering of the project as part of its scope of work, the contractor can analyze changes, reductions and any type of adjustments intended to save cost or time. As long as the client’s acceptance criteria are met, meaning that the contract is fulfilled, the client has no reason to complain.
The real problem arises because it is possible that the contractor, already deep in the problem of an important loss of money, might be tempted to use unacceptable or unethical strategies.
It is then that we run into an undesirable situation.
Equally undesirable, although morally acceptable, is if the contractor explains the situation and asks for a termination of the contract; if such an action, with all the punishing costs usually associated, is for the contractor less harmful that finishing the project.
When to use an EPC Contract?
From my point of view, the EPC contract, with all its variations, is just a tools box, but as such, each tool will be useful as far as the selected tool is fit to the job.
In the case of the Lump Sum EPC, it can be used for specific scopes of work for which a highly specialized supplier is required and, therefore, such supplier already has of-the-shelf designs ready and needing only minor adjustments to fit the project: office containers, frigorific chambers in a client’s specific room, etc.
On the contrary, a Lump Sum EPC contract is not recommendable for large and complex projects with the integration of several disciplines and highly technical supplies from diverse vendors. Classic case: a mining concentration plant. For such cases, if in order to shorten the delivery term, the decision is to use an EPC contract, it is better to use Unit Prices or some cost-reimbursable agreement.
This last few years collaborative contracts are being introduced. The concept is simple, but very interesting: the client pays all costs, and the contractor earns a fee. Any bonus or penalty goes against its fee, but penalties never can exceed it, so, even in the worst-case scenario, the contractor earns nothing but is in no risk of paying costs that would not be recovered. This system involves additional tenets such as sharing the management and outcome of risks, collaboration instead of confrontation, unanimous decisions, focus on results and solutions not in assigning responsibilities, and full costs transparency.
I firmly believe that is the way to go.
In times of change, when agility and economy are needed at all levels, the use of specialized services provides that precise mix of capacity, effectiveness and efficiency that organizations need to succeed.
At DC&R we are able to meet these requirements with professional solvency and the experience of more than 25 years in complex engineering and construction environments for heavy industrial markets of high demand such as mining, gas & oil, or energy, as well as for infrastructure and commerce.
DC&R also offers technical assistance services to businesses that need to interact with engineering and construction companies, from tender and project management to contract administration.