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EPC’s short term quality makes it attractive

EPC’s short term quality makes it attractive

Whether the defect liability clause is faulty or not, whether L-1 continues to be debated as the sole criterion in government awards, EPC remains a coveted model for implementers. As it gains renewed support from the highways sector, developers seem to value a prudent balance between EPC and investment (BOT) projects.

Experts

Abhijit Avarsekar, Vice Chairman & Managing Director, Unity Infrastructure
BK Batra, Deputy Managing Director, IDBI Bank
Vinayak Deshpande, Managing Director, Tata Projects
Divakar Marri, Head – PMO, Ramky Infrastructure

Industry sources say the developer’s micromanagement results in inadequate operational independence to the EPC contractor. What has been your experience?

Batra
Of the several contract design methods, the structure of Engineering, Procurement, Construction (EPC) is preferred by project developers and their lenders as the EPC contractor’s "single point responsibility", offers a better project risk management configuration. However, the Indian experience of project implementation through EPC contract methodology has thrown up certain issues:

  • Developers, who play a key role in project planning and conducting the bid process, do not always have adequate expertise or even complete information about an infrastructure project. As a result, during scoping and early design phases as more information about the project becomes available, it becomes clear that some elements of the project might require change in scope. This impacts the efficacy of execution. Several road projects have been affected by this inadequacy.
  • Large developers often retain the EPC contract within the group. This makes contractual separation of functions between the developer and the EPC contractor less formal in practice, and this may not be appreciated by an external EPC contractor.
  • The developer’s and contractor’s roles tend to
  • over¡lap during Project Management, potentially resulting in disagreement when new risks surface during execution.
  • Procurement strategy and sub-contracting functions of the EPC contractor are another area where developer influence could be perceived as an avoid¡able interference in the domain of the EPC contractor.
  • In our experience, value of innovation by EPC con¡tractor is not captured in EPC structure and a quality conscious contractor might see this as a limitation.
  • Commissioning and performance testing regimes are other areas where EPC contractor and developer often face issues. The gap arises due to unallocated risks, in regard to compliance to performance and technical standards, which are not adequately captured in EPC contracts on a back to back basis. 

Most of the above issues relate to inadequate risk identification and risk based cost provision at the time of award of contract. Therefore, adequate project planning and meticulousness in developing a sound risk break down and allocation structure as also its incorporation in the contract document are essential for successful execution of a project through EPC route. Also, the bid design needs to have ingredients to incentivise con¡tractors to adopt international best practices in procurement and project execution that deli¡vers value for money in a construction contract.

Deshpande
Any project will succeed and create valuable financial gain only when constituent parties participate by fully leveraging their areas of expertise. Having said that, it is essential to understand that a developer will seek to put his imprint upon the project as he is a prime risk taker during the upfront investment. This may extend to master plans, design reviews, lay¡outs, general arrangements, etc. That is good for the project because it means that there is a larger common understanding towards the project, essential to discover new areas of potential benefits. Micromanagement typically arising out of undermining expertise of other parties starts in the form of devising or interfering work methods is likely to deter progress and may even lead to project failure.

Marri
Most current developers are primarily EPC contractors and since they are completely aware of the nuances (in and out) of EPC projects. It’s not difficult for them to micromanage EPC projects. Our own developer business is a confluence of its competences developed with areas of construction business.

Avarsekar
Our experience is slightly different. We believe concessionaires-even those coming from contracting background-don’t put in enough efforts to take care of local issues, land acquisition and govt interface. We wish they could really micromanage these things so that speed of work gets improved and everyone including EPC agency is benefitted.

How is government ownership of project different, in your observation and experience, from private ownership?

Avarsekar
Working with government is mostly beneficial in terms of payment security and sanctity of contract. However, most of them are still bound by L-1 concept owing to audit and vigilance constraints. Very few of them have started practising concept of "Weightage to Technical Score and Presentation". However, unfortunately in a few instances this deviation from L-1 concept has harmed us as it opens doors for discretionary marking system during presentation. So L-1 alone should not be the yardstick but at the same time concept of evaluating technical score should be a scientific process without any scope for subjective evaluation.

Batra
Private sector participation in:

  • developing infrastructure projects brings in several key benefits as under:
  • Speed up investment in infrastructure projects
  • Improvement in project selection
  • Integrated approach reduces life cycle cost of project
  • Asset creation and management efficiency through innovation
  • Shifting of fiscal commitment of government to private sector.

Deshpande
Both forms of ownership, government and private, are good so long the expertise or knowledge of all constituent participants is gainfully leveraged. The government as owner has not only financial objective but also social objectives while building the infrastructure whereas private owner may appear to be driven solely by financial goals. Mature private owners are often self-actualise by their inner voice towards social responsibility and passion to create marvelous infra¡structure that embodies their personality and brand. So in our view, the ownership is not an issue. Wrong practice of procurement, disrespect to other experienced partners and micro¡management are the unfortunate value destroyers.

Marri
Private versus host government ownership is an important reflection of the relative control and influence exercised by government agencies and private investors in the development and management of infrastructure projects. The objective of government projects are more focused on the infrastructure development, economic development, building the nation rather privately owned projects are more towards making business and giving decent returns to its stake¡holders. In addition, private sector involvement can bring increased efficiency in investment, management, technology adoption and operation.

Is bankability better in EPC than in BOT projects? Does BOT have a honeymoon period after which it must make way for EPC?

Avarsekar
Typically EPC is a maximum three years’ game and once can easily visualise risks that need to be factored in. BOT is a much longer game (at least 20 years) and many things can change in that time-frame. We feel comfortable with EPC and even NHAI/MoRTH have now moved back to EPC mode in a big way.

Batra
Although the financing risks of BOT and EPC business are different, the cardinal principles of assessing bankability of a project remain unchanged [that the project cash flow must be assessed in a conservative basis, which should then yield a satisfactory debt service coverage]. In an EPC project, the project cycle stays up to the end of defect liability period after construction and delivery of the facility to the project owner. The risk of the EPC contractor is therefore limited to construction of the facility within the budgeted cost and time and the facility meeting the contractual performance parameter. An EPC contractor at a given time manages a portfolio of projects and therefore is exposed to liquidity risk. Whereas, a BOT project is additionally exposed to several risks such as delay in project completion, financing risks and operating period risks.

Deshpande
Usually an EPC contract is not about bankability.

It is more about the availability of working capital sufficient to execute the project and manage the cash flows. While the EPC contractor needs to do his risk analysis on the project and its developers, it does not, expect under very special circumstances, need to go to the bank to prove project viability.

BOT projects which need financing of the project perse are the ones that need to prove their financial viability to the banks (in short, called "bankability"). Projects, in their initial stage, have no asset cover to offer to the lenders. Lenders look at the future cash flows of the project and their timing and certainty to decide whether to lend or not. A bankable project is one where there is clear visibility on the availability of cash flows in the future and their certainty.

These are different issues. One is about developing a project and bringing it to fruition; the other is an execution or implementation philosophy. In the entire value chain of infrastructure industry, both are very important spaces and maturity in these two segments and is very fundamental to the growth of the industry. Good EPC expertise is necessary for BOT success as a business model. The financial failure experienced recently in some BOT projects resulting in lack of confidence is truly worrisome.

Marri
EPC projects reflect low risk and low returns com¡pared to BOT projects which are long term with high risk and high returns. As the EPC projects are more visible due to short term in nature, these projects are more bankable than the BOT projects. The present scenario of high interest rates, liquidity crisis, non-availability of long term funding, execution delays is misinterpreted that the BOT projects have a honey¡moon period but due to investment constraints on government side the private participation is must for infra and economic development of the country and it can be achieved only through Public PPP route.

Is the bidding process in EPC undergoing improvement? What are the remaining areas of improvement?

Avarsekar
New EPC eligibility conditions framed by NHAI/MoRTH seem to be much better than the ones framed about a year ago (and were subsequently rolled back).

Deshpande
EPC is a fairly matured industry in India especially in the area of oil, gas and hydrocarbon, power generation and other industrial infrastructure. While so, implementation of projects on EPC basis is proving to be challenging due to issues like improper survey of terrain and geography and some of the issues related to acquisition of land, etc. Improvements are needed in terms of reforms through the government policies and also in the area of skill development. Availability of good quality engineers, foremen and workmen is critical in implementation of EPC projects. India currently is lacking in both capacity as well competency for these skills.

Marri
The bidding process is evolving, but most of the contracts are still beneficial to the seller rather than the buyer. We need to focus on quality/capability based bidding rather than awarding the contract on L-1 scenario. This would enable the projects to be completed within the stipulated time, cost and acceptable quality.

How are contractors who have become developers managing their portfolio of BOT and EPC projects? What would be a good mix?

Avarsekar
We already have exposure of Rs 1,000 crore in BOT and so far we are managing well. For a company of our size, we have decided to take a "BOT Holiday" for at least next six months.

Batra
In most cases developers set up special purpose vehicles (SPVs) to implement BOT projects. The SPV structure facilitates ring fencing the risk and returns of the project and helps the developer in adopting an appropriate financing structure. On the other hand, EPC contracts are either taken up through a separate vertical structure at the parent company level (or through a sister concern). The mix of EPC and BOT business would, interalia, depend on (i) the corporate strategy of the group, (ii) resource¡fulness and ability to meet equity commitment in BOT projects, maintain desired net working capital to sustain EPC business growth and manage contingent liability and volatility in free-cash flow from existing operation, (iii) technical and project management bandwidth [to deal with complex project development and/or construction activities which are located at multiple locations and need sector specific professional project management skills]. Most Indian contractors are at varying stages of the learning curve and in the process of concretising their respective business models.

Deshpande
Contracting requires a mix of competencies that are completely different than those required by a developer. For contractors to become developers, they need to orient their skills towards project structuring, financing, etc. The revenue mindsets are also quite different. While a contractor seeks to make his money out of construction, a developer looks at the upsides provided by future maturing cash flows. We continue to evaluate these two businesses independently.

Marri
PPP projects are the future need and with a balanced portfolio of EPC projects and investments in BOT oriented infrastructure projects; the contractors should be well positioned to leverage the opportunities in the infrastructure sector.

Does Defect Liability Clause in EPC contracts need an overhaul or revision? If so, how? If not, how do you believe it has been effective?

Avarsekar
The defect liability period should be replaced with a 3-5 years payable maintenance period (with an inbuilt defect liability) which will make the whole thing really meaningful.

Deshpande
In industrial systems, defect liability is usually asked for two years. However, this could be for one year. In heavy civil infrastructure, defect liability period extended to 60 months or some times to even 10 years. This may be very long and should be reviewed upto three years. However, the defect liability period should be according to the nature of infrastructure being built and also ensuring that the appropriate entity is being held responsible for defect liability.

Marri
The wording of the defects liability clause could create liability to repair any and all damage occurring to the works for any cause whatsoever. One effect of this is that if the employer does not give the contractor due timely notice to return and make good defects, the amount which the employer can recover from the contractor for putting right such defects is limited to the cost at which the original contractor could have done the work and not the price of a new contractor on a "learning curve".

The defects liability period is not an exclusion clause, so defects appearing after the defects liability period are still breaches to be remedied by the contractor in the absence of a binding and conclusive final certificate which removes further responsibility for defects.

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