EPC: Who should be responsible for our projects?

Although, arguably, the best method for an infrastructure project, Engineering Procurement and Contract (EPC) is still being debated for loopholes in accountability. While the government revised its norms in 2008 to tighten the accountability on the contractors, contractors believe that unless maintenance is a part of their contract, and they can only be held that much accountable, as Shashidhar Nanjundaiah finds out.

The Public-Private Partnership Appraisal Committee (PPPAC) feels that in most cases, projects should be taken on EPC basis rather than BOT (annuity). The Planning Commission is reviewing the Build, Operate and Transfer (annuity) model of building roads to see why it is not finding acceptability in large sections of the government. The Commission believes that EPC saves on costs and increases accountability on the contractor. Project finance lenders, too, usually prefer EPC in which a contractor is engaged to design and construct a facility in a turnkey fashion.

EPC contracts are turnkey contracts with a fixed time for completion at a fixed cost. All these are attractive elements to a lender. It would make sense if EPC contractors in infrastructure projects also take on the responsibility of maintenance, much like a software program. A solution that has emerged from debate is the cascade method, whereby the contractor could be a partner to begin with, and once both parties have a reasonable handle on the project costs and schedule, the contractor offers a fixed price to finish the work on a turnkey basis. If the price proves unpalatable, the EPC side of the work can be tendered. An analogous approach, favoured by a number of contractors, is to operate EPC contracts on an open-book basis up to an agreed point. In the roads sector, the National Highways Authority of India (NHAI) follows a waterfall model where the project is tried on toll, then on annuity and finally on EPC, to achieve the award.

Under current government contracts, the EPC contractor assumes most responsibilities in a contract, and absorbs any increased costs between bidding and operational phases. A Planning Commission RFQ document states, “This system helps the government avoid risks from increase of costs arising from inflation, changes in bill of quantities during construction, compensation events due to delays and arbitration claims on myriad issues. The contractor accepts all these risks, and bids a lump sum amount for the entire work, with inflation proofing in specific situations,” says the document.”

Unlike in BOT projects, EPC has no blanket set of norms, and most contractors will swear by the current system of bilateral agreement rather than something that can override it. While the Planning Commission revised EPC norms in order to make EPC more “output-based than input-based”, the idea was aimed at eliminating the practice of “contractors claiming higher-than-necessary input costs to make profits”. That document, prepared by the Commission back in 2008, recommends that government agencies, NHAI in particular, award maintenance to the same EPC company rather than the extant, potentially corrupt system of awarding separate yearly road repair contracts.

We asked a few major EPC contractors and developers how they see the debate on accountability:

Do you believe EPC contractors should be responsible for work beyond the completion, and if so, should O&M be a necessary part of the arrangement?

Menon
If O&M is made a part of the EPC arrangement, then it would resemble the annuity mode with the only difference that they get upfront payment for the work executed.

It is a general misconception that annuity increases costs, because the annuity model is based purely on EPC costs and O&M costs with fixed six monthly instalments up to the end of the concession period, which is also fixed. These instalments begin after the road asset is created and covers the EPC costs, the accrued interests and the O&M costs, for operating and maintaining the asset. The only difference is that the concessionaire does not get the licence to collect toll from road users. This mode is much better than EPC mode as far as accountability is concerned because in India, EPC contractors are responsible for maintaining the asset only for one year whereas in the annuity mode, the concessionaire maintains the asset for the entire concession period.

Parakh
EPC contractors, by definition, cannot be and should not be held responsible for post-construction maintenance. It would be ideal if O&M is contractually awarded to the EPC contractor and should form part of the EPC Contract document.

Many road projects are not viable as they do not yield sufficient toll revenues, attracting Viability Gap Funding (VGF). Given the resources constraints faced by the national exchequer, annuity based projects will continue to be awarded. The remedy lies in a mix of EPC, annuity and BOT modes to address the ever increasing need for rapid development of infrastructure in the country.

Subrahmanian
O&M is a specialised business, and can be given as a separate contract to a more specialised agency experienced in the respective field or can be taken by the client itself to minimise cost.

Bowden
There have been differing opinions expressed from the Planning Commission, PPPAC and the National Highways Authority of India (NHAI). However, NHAI does not appear to have any fundamental concerns regarding the existing BOT (annuity) model and, as they follow a waterfall model wherein the project is tried first on toll, then on annuity and finally on EPC to achieve the award, then annuity would appear to be a reasonable step in assuring that as many projects as possible are able to be financed and reach a conclusion.

Road construction and O&M are two different functions and require altogether different skill sets, capability and financial management. From recent modifications made by ‘BK Chaturvedi Committee Report-1’, the government has recognised this fact and therefore permits exit of the project developer two years after COD to facilitate entry of an O&M company at the appropriate time.

The EPC contractor’s liability should be limited to the Defect Liability Period (DLP), however DLP time can be suitably adjusted to verify the quality of construction.

George
It depends on the point of view. Post completion, there is a warranty, typically a period of 12-18 months depending upon how you negotiate, but beyond that period, everything comes with a price. As far as accountability for design defect or any sort of defects in workmanship for the work carried out, a contractor should be responsible for a period of five years after completion.

As a developer, we have evolved over a period of time in contracting out. Every contract is negotiated. However, we do have a sort of a benchmark contract from the past that was a no-problem document with no execution problems. We will negotiate every line in the contract. When we negotiate with the EPC contractor, we figure out what is the optimum warranty we would look for without an exorbitant increase in prices. We also believe that if our plant operates for a year without any problems, it will continue to do so.

Nath
Yes. O&M should be a necessary part of the agreement. In fact, in case of a number of highway contracts, the case is already so.

Roy
You just can’t claim to be a complete EPC company unless you also extend your responsibility of the O&M. If you look at all the top world class EPC companies carefully, you will find that the O&M is also a part of the contract. This is what I have been watching for quite sometime because you have got a single responsibility but as soon as the contract part is over and the O&M takes over it is also important that EPC also extend their services to O&M to ensure complete stability and at the same time and all that they have promised in the guarantee is sustainable.

I think that EPC contracts themselves should include the O&M part from the beginning, especially if it is external (as opposed to some contracts we take on within our company, (since we are also a developer). It is important that we extend the O&M part.

Is the current single-point project accountability in EPC contracts (on the contractor) desirable, or should that clause be tweaked?

Bowden
Placing the entire accountability for risk on EPC contractors is not desirable. The project risks should be allocated to those who have the best expertise to carry that risk.

Issues related to price escalation of the construction materials, delays in obtaining land, right of way, villager issues, various statutory and regulatory approvals, utility shifting, and so on, are often beyond the control of the contractors and impact their ability to deliver. There may be an argument that if the initial actions are in place then the contractor can be left to follow through, but it is difficult to set the boundary and tweaking accountability after entering into a contract.

Menon
Accountability should lie with the EPC contractor for better asset management.

Nath
It is desirable and should not be tweaked.

Parakh
It is unjust and not desirable to continue the single-point project accountability on the contractor since timely implementation depends largely on external factors, beyond the control of a contractor. Examples are utility shifting, land acquisition, forest clearances, environmental issues and R&R. Instead, there is need for re-assessing existing arrangements to make them more practical and for addressing the numerous difficulties that crop up along the way in project execution.

Subrahmanian
Yes, it is required to have single-point accountability on the contractor, as this will help the client keep track of progress, quality and ensure that the work is carried out in time to utmost satisfaction. It is easier to monitor and coordinate.

Does EPC contracting need better risk management? How would you go about it?

George
Insurance policies are well structured to take into account all kinds of construction and to cover erection and construction risks completely. The policy structure can be built to take care of even time overruns. So most of the risks during construction are insurable risks, which are taken care of through good insurance management.

Bowden
Inappropriate allocation of risk should be curbed and it should be the responsibility of the government and the financial institutions to take the lead in establishing a more inclusive approach to such issues. Notwithstanding this, there is little doubt that the EPC firms need better risk management and the best way to achieve this is to start by building in risk identification, assessment and mitigation as part of everyday thinking, spanning all activities from early planning and tender stages, right through to closing out all obligations with the client.

Menon
Non-engineering risks are dangerous. In a complex country like ours, there can be no national-level solutions to these kind of risks. Each state, even each region has its own diverse issues.

The ideal position would be when all these issues are settled by the client before tendering, so that the contractor has nothing else to worry about except the work in hand. But this is easier said than done. Hence, the contract itself has to attend to these risks with clear and proper compensations in time and cost. There should be no room for disputes.

Nath
Yes. It needs better risk management and there are a number of ways to go about it depending upon various parameters and these would be project specific. These methods to be adopted cannot be generalised.

Subrahmanian
Yes. Managing the risk is one of the key ingredients in an EPC contract. As one may appreciate, right from engineering and methods, till the commissioning at all stages it carries risks, not confined to monetary risk alone. We have a proper risk management framework which measures risk based on which mitigation plans are prepared and executed.

Should EPC contractors carry the risk of the project, or should it be conditional? If it should be conditional, on what parameters? Can this be uniformly applied across the sectors, or are there sectors that are more ready for this model?

Menon
In any sector, contractors can carry the risk of the project if there is an anticipated return on the investment (RoI) made to mitigate the risk.

The contractor should be able to see the silver lining in the cloud. In BOT mode, the construction risks are duly covered by increase in tollable traffic. If the contract is design-and-build, the risk can and should be taken by the contractor. But other risks like land acquisition, forest approvals, etc, should be that of the client and any delay in these aspects should be duly compensated in time and cost.

Nath
No. EPC contractors should not be made to carry the project risk as they are contractors and not financiers or bankers. And this should be applied across all sectors. There are no sectors or no EPC contractors ready for this model in India.

Parakh
EPC contractor’s risk should be conditional upon occurrence of factors beyond his control. Study and research into risk assessment and mitigation should carry more weight while planning, but some risks like natural calamities are very difficult to predict.

Subrahmanian
It is preferable to have conditions to cover the risks. If the risk is on a contractor, risk cost is always included in pricing. Valuation of risk cost provides for buffers to account for unforeseen situations. If it is made conditional then the risk cost can be restricted to the actuals: for example, material, labour, fuel escalation, foreign currency fluctuation and unforeseen utility. An agreed formula can be built into the contract to cover these risks.

Roy
The EPC contract should be drawn in a detailed way so as to address all perceived risks, with responsibilities apportioned. All forms of risk can actually be the EPC contractor’s risk, including the financial risk with respect to the executions. Sometimes, with cost overruns, the normal complaints from EPC contractors is that they are being held responsible for an escalation that is from no fault of theirs. But by the same token, do they pass on profits if they make extra cash?

Are you happy with the payment methodology in EPC contracts? Should payments be based on output or on input?

Bowden
There is room for improvement in payment methodology because the employers try to backload EPC payments whereas contractors seek to frontload. There appears to be a perception that if the contractor is post-funded rather than pre-funded then the client has more control. This view, however, is short sighted and pays little heed to the true dynamics of construction. A contractor who is starved of funds will pass this pain down the chain and inevitably this will result in dispute and delays at the workface, exactly the opposite of the working environment that the client should be seeking to engender.

Today, the majority of EPC contracts are based on output rather than input. The payments are made on completing defined milestones, sections, segments, or components, and individual quantities are not as relevant. Notwithstanding this, price escalation of major input materials continues to be an issue and the majority of EPC contracts are not adequately covered. There is a strong argument that such things could be better dealt with through use of star rates rather than via links to WPI formulas, which may not adequately address the true impact.

Parakh
The existing payment methodology needs to be improved. The owner should provide bank guarantees or Letters of Credit (LCs) that can be discounted by contractors to raise funds required for timely completion of projects. That would avoid delays in payments. Delaying payments to the contractor is counter-productive, as it entails delayed payments to people who are working on the projects in far flung areas under trying living conditions. It is imperative to understand human psychology of workers on a more humanitarian basis.

Subrahmanian
In the EPC business, there is no milestone-based output; therefore payment has to be input based. In today’s contracts, other than the BOT operator, the EPC contractor cannot find funding to such a large extent to wait till the end. It has to be input based, based on shadow bill of quantities to regulate the payment.

Nath
Payments should be based on output milestones.

Menon
There can be only two systems of payments in EPC contracts—input/BOQ based or output/milestone based. A third system can be an amalgamation of these to improve the cash flow into the project. And obviously, bonus clause for early completion can be an additional sweetener.

EPC contracts in the road sector in India is based on item rates. As such, the payment is based on inputs. In the case of lumpsum turnkey projects, payments are based on outputs, or milestones. Both the modes of payments are satisfactory for the contractors if the finance planning has been effective.

Since EPC contracts pit the contractor and the owner in an “us-them” relationship, unlike in a PPP, does this result in a conflict of interest?

Nath
Yes. Most of the contracts in India are one sided and are in favour of the owner. This situation should be rectified as soon as possible, in line with international practices.

Parakh
There is no conflict of interest per se, but closer coordination and interaction is required to resolve problems which arise during construction.

Subrahmanian
Let us look at the end results: The EPC form of contract has seen more success, while PPP is still under testing and has seen more delays in implementation. In a framework that lays out a clear responsibility matrix, there will be no conflict of interest.

Can you give us examples from any other system or country that may be following a different, and more efficient, process in EPC contracting?

Bowden
A cost-plus contract, also termed a cost reimbursement contract, is a contract where a contractor is paid for all of the allowed expenses, sometimes up to a pre-set limit plus additional payment to allow for a profit. Cost-plus contracts contrast with fixed-price contract, wherein the contractor is paid a negotiated amount regardless of incurred expenses. Under cost-plus arrangements the contractor makes available his project account books for monitoring by employer to check the accuracy of costs. A cost-plus contract is appropriate when it is desirable to shift some risk of successful contract performance from the contractor to the employer. A recent example is the Delhi International Airport constructed for GMR on cost plus basis, and the outcome is a marvellous feat of engineering.

Nath
I understand ADB and WB follow a system based on output milestones and work quite efficiently.

Some countries are proposing an Engineering, Procurement and Construction Management (EPCM) model, which effectively means the contractor does not build the facility itself, but acts as an agent of the owner in the design, procurement and management of construction of the project. In this way, the profit margin is fixed and the client has control of what they want done and the amount they pay. Can this model be adopted in India?

Bowden
The EPCM model can be adopted in India and is especially suited to projects where the complexity level is high. In this contracting method, the actual construction is undertaken by separate contractors engaged by the project sponsors, who then have rights of recourse direct to those providing the work. However there is generally no complete assurance wrap from the EPCM contractor.

For its Mangalore Refinery, ONGC appointed an EPCM consultant for CDU/VDU, LPG, Kero and ATF Merox Process Units. There are many advantages to the EPCM model for the client, and lower costs should result, particularly in circumstances of uncertainty as to final scope or definition at the point of award. However, there has to be a good level of maturity in the behavioural patterns of the participants.

George
I don’t see a big difference between construction and construction management. An EPC contract is a coordinated effort between the owner and the contractor. You need a coordinator plus checks and balances from your side.

Quality becomes critical and that is what you ensure the company’s construction supervisors and also the owners’ engineer.

Menon
This is the cost-plus-profit model which some of the concessionaires and developers in airport and manufacturing sectors are adopting. Such a model becomes necessary if the actual end product is not definite or major design changes are anticipated in course of construction. In government contracts, the end product is usually definite and the DPRs are all done before putting the project to tender. In any case, in all these modes of EPC contracts, whether a definite BOQ based or cost-plus-profit mode, the main criterion is that the payments are based on costs incurred + IDC + Profits.

Parakh
EPCM model is more suited for very large highway and expressway projects, say above Rs 2,000 crore. It is good idea to introduce EPCM in India on an experimental basis.

Subrahmanian
Yes, EPCM is better than EPC for the following reasons:

a. Employer can modify project specification with little or no trouble.
b. Employer with the help of EPC contractor can negotiate with vendors and suppliers
c. Risk of contract is shared which will result in benefit of project.
d. In some companies in the private sector, this method is prevalent and quiet successful as well.
e. However, to arrive at the right mechanism for public sector or government may be difficult.

Roy
The reason that this model is still not adopted in India is that the maturity has still not come to India. In the Indian scenario, we use a large contingent of subcontractors. European and American construction companies are no longer just construction companies. They are primarily EPCMs that engage the local contractors wherever they work and engage them for construction work.

Suppose we go and do a job in another country, we can go for EPCM provided I am convinced that locally the sub contractors’ capability and skills are available. In our country, the quality of second and third levels of subcontractors is not very good.