December 4 2023

KHEM N. THADANI,

Structuring EPC contracts J A S P R IT K A U R I N D E R J IT

SINGH

Adnan Sundra & Low | Energy & Natural Resources -

Malaysia

 Introduction

 Industry specifics

 Risk allocation

 Tax aspects

 Comment

Introduction

The structuring of engineering, procurement and construction (EPC)

contracts in the energy sector, comprising oil and gas, power or
electricity and district cooling (in warmer climates) is a holistic task.

This is due to some challenging considerations including:

industry specifics;

risk allocation;

tax aspects;

onshore or offshore portions;

regulatory regime;

change in-law; and

commencement to completion issues.

A new conundrum to this challenge is the energy transition due to

climate change necessitating a huge shift to renewable energy for
which multiple other factors come into play – in particular, the
environmental, social and governance (ESG) aspects.
For the sake of clarity, the concept of EPC is intended to be universal (ie,
to cover the variety of design and construction contract permutations in
the energy sector). It includes, under both bespoke and the various
International Federation of Consulting Engineers books (ie, silver, red,
yellow, blue and orange):

drilling and completions;

engineering, procurement, construction and commissioning;

engineering, procurement, construction, installation and

commissioning;

floating, production, storage and offloading; and

engineering, procurement, construction, hook-up and

commissioning.

The points deliberated below, apply invariably to the variety of contracts

for the energy sector.

Industry specifics

The specifics of each industry need to be clearly understood as they

constitute the brief of the client or employer to both the contractor and
the myriad team of consultants who each need to collectively integrate
their respective disciplines to achieve the deliverable, be it a power
plant, petrochemical complex or district cooling plant.

In the instance of a gas fired power plant, the performance guarantee is

on emissions, heat rate and output.

In the case of solar power plants, it is the guaranteed ratio which, by

itself, has interpretation issues arising from the measurement period.

Accordingly, the deliverables required for demonstrating performance

and for power plants (eg, solar, biomass, gas or nuclear) each have their
own technical perspectives which need to be achieved based on the
lifecycle of the plant to make the project economics viable and
bankable.

The consequence of failure to achieve the performance guarantee is

typically liquidated damages for a below-par or substandard plant. Its
legal basis, the quantum of which is challengeable in some jurisdictions
(eg, Malaysia or on a strict liability application as in England) needs to
be addressed carefully in the EPC contract.

Risk allocation
An employer often prefers to engage a contractor on a turnkey basis
due mainly to the single point of responsibility. This is quite prevalent in
the energy sector.

The contractor then sub-contracts the works to the suppliers, service

providers and sub-contractors based on their respective disciplines
required for the project.

For instance, the scope of a project for an offshore wellhead platform

will cover a wellhead platform at sea, a pipeline to transport the oil or
gas to land and delivery to refinery or tankers (both at sea or landed).

The allocation or breakup of the works has its risks in terms of timely
completion or delay, defects and application of the warranty obligations
with its consequent rectification.

The turnkey contractor must ensure that the various suppliers and sub-
contractors deliver timeously to enable integration and sequential
completion of the interdependent components, so that the critical path
is not jeopardised.

This task of managing multiple sub-contractors (due to the diverse

skills set required) is a huge challenge in today's environment for a
turnkey contractor. Timely delivery, work in accordance to specifications
and variations (both to design and construction) require proper drafting
to provide for elasticity without risking the contractor's obligations to
the employer with any added exposure, notwithstanding the turnkey
contractor having structured the subcontracts diligently.

Tax aspects

These comprise both direct and indirect taxes together with payments
of similar effect (eg, import duties, levies and stamp duty).

Where goods, equipment or components are imported for permanent

incorporation into the works, import duty (unless granted waiver)
applies. Likewise for imported services, a withholding tax is often
payable.

In countries with a consumption tax, either in the form of goods and

service tax or value added tax, this is priced in. Alternatively, there may
be a separate sale and/or service tax, as in Malaysia, which is payable
for both the local goods and services sourced.
It is quite common for tax structuring purposes to split a turnkey EPC
contract into separate supply and service contracts to minimise or
properly segregate the tax payable for the relevant aspect, especially if
savings can accrue.

Related taxes (eg, levies and stamp duty payable on a contract) need to
be properly ascertained and structured to accrue savings. In addition,
taxes at federal, state and local government levels need to be
considered and priced in or provided as a reimbursable item.

It is prudent to obtain tax advice if an EPC contract can allow for useful
savings in structuring the contract. Simultaneously a check list of all
taxes applicable under the EPC contract should be finalised. At the
same time the single point of responsibility should not be compromised
or reduced if an EPC contract is split for tax purposes.

Onshore or offshore portions

It is not uncommon to have EPC contracts split into the onshore, being
the local portion and offshore, being the imported portion of the works.

This is done for the following reasons:

complying with host country policies to enable work to be given to

local companies;

managing foreign exchange considerations;

price competitiveness; and

tax including stamp duty considerations.

The onshore portion will typically cover locally available skills (eg, for
civil works and locally sourced materials, parts and transportation). The
offshore portion comprises imported equipment, goods and services
that are intended for permanent incorporation. In structuring
onshore/offshore contracts it is necessary to have a "wrap or umbrella"
agreement to ensure that the single point responsibility,
notwithstanding the split, is not compromised.

Regulatory regime
The regulatory regime, at all levels, applicable to the energy sector can
be daunting and detailed.

Typically, it starts with statutes, followed by regulations. These are

augmented by by-laws and guidelines. Further, there are codes and
standards and finally benchmarks, both local and international.
There are two key aspects of the regulatory regime to consider:

First, those that are obligatory and must be complied. These

usually comprise statutes, regulations and by-laws and the
applicable case law.

Second, those that are discretionary or at best persuasive.

Guidelines fall under this category and although they are intended
to be complied, it may not necessarily be obligatory. This is often
a question of interpretation.

On the other hand, codes (eg, the grid code for electricity and
standards), although couched as benchmarks, are intended to be
followed quite rigorously at times.

In any event, most matters under the regulatory regime tend to be

technical and it is often prudent to simply comply so that the necessary
sign-off by the technical professional can be obtained to achieve a
successful passing of the factory acceptance tests, testing and
commissioning requirements and ultimately the performance and
acceptance tests.

A key challenge is the issuance of a government directive. Most EPC

contracts will provide a clause stating the works shall be carried out in
accordance with the laws of the applicable country. As such, any
government directive issued (eg, a stop-work order for a mishap at site
must be complied with). What if the directive interferes with the
performance of the works-can or should it be challenged or followed
and if it is the latter who bears the cost and time consequences? These
aspects need to be properly captured.

Change in law provisions

Law is not static. It evolves and over the last 20 years or so, its pace of
change is more frequent.

Change-in-law provisions deal with a change to the law after a contract

is signed. Its impact under an EPC contract is to time, cost and risk
during implementation.

Recent examples include introduction of levies to the construction

sector payable to a statutory body. It's an immediate additional cost and
the logical argument is for the employer to bear this as an additional
cost, as the contractor would not have priced it as it was not known at
the time of pricing.
Where a law is changed and imposes stringent compliance obligations,
there may be both time impact and additional cost. This can affect the
budget, cash-flow, completion date, payment of liquidated damages,
commencement of revenue and various consequential obligations.

Where the EPC is three years or more to complete the facility, it is

advisable to be realistic of potential changes-in-law occurring and to
cover this aspect properly.

With increasing ESG considerations it might be useful to provision a

certain budget (by way of a contingency sum or prime cost) for
compliance by the employer, as the employer will be the owner of the
product.

Considerations from commencement to completion

The execution of works under an EPC contract typically commences
with the issuance of a notice to proceed by the employer and the works
are considered to be completed upon the issuance of a completion
certificate by the contractor.

The notice to proceed will coincide with the date on which possession
to the site is handed over to the contractor. The completion certificate
will coincide with the taking over of the completed structure or facility
by the employer.

Between notice to proceed and the issuance of the completion

certificate, both the employer and contractor have multiple roles, rights
and responsibilities or obligations.

For site possession, it can be handing over of the entire site on a single
date or progressively of various parcels. If it is the latter, which is
common for highways and train systems, then it is common to have
completion and the take-over in stages but on a single date for final
completion.

For power plants with various blocks, the site possession is given all at
the same time but the takeover can be staggered over three, six or more
months. Hence, the effects of the following will each have to be
properly considered, structured and drafted accordingly:

transfer of title;

insurances (ie, construction all risk and business interruption);

return of performance bonds;

 issuance of retention bonds;

payment of liquidated damages;

start of revenue service;

start of defects liability period or warranty period;

final payment; and

issuance of final certificate.

Typically, the works will be carried out in accordance with the:

programme;

payments made progressively subject to proper documentation;

and

certification, including by independent checking engineers in a

project finance transaction.

Recent experience has suggested that upon completion of the facility,

fine tuning is required as to what constitutes "completion". There are
various key elements.

Usually, the owner would need to obtain all relevant approvals to

conduct the business operations (eg, a licence from the relevant
authority, to generate and sell electricity, gas or cooling energy in the
energy sector) which may have to be issued prior to commencement of
the testing and commissioning of the plant. The contractor would need
to obtain all approvals pertaining to completion before hand-over of the
plant is given to the owner.

Then there is the technical aspect. This would include having the
various tests being successfully conducted and ready for processes
such as acceptance procedures, performance tests, acceptance tests,
and reliability runs. In this regard the certificate issued by the
independent checking engineer is critical as it is usually conclusive
evidence of satisfactory completion or otherwise. If otherwise, the
process for rectification and repetition to demonstrate completion
needs to be explicit.

The third aspect is the documentation to be handed over at the time of

completion. There are two key documents – the operation and
maintenance manuals and the as-built drawings.
It is common for both these documents to be given as draft or
preliminary versions at the hand-over stage, since there is a warranty
period to be fulfilled. During the warranty period, there may be
adjustments made to the operation and maintenance manuals arising
perhaps from operational challenges.

As for as-built drawings, if there are changes to design, variations or

other material adjustments (both during construction and operation) the
as-built drawings will take time to be finalised to ensure each of these
changes are properly captured.

As such, it may be prudent to provide for a draft or preliminary version

of the operation and maintenance manuals and as-built drawings to be
provided at hand-over, but the finalised versions must be issued as part
of the contractor's obligation to achieve final completion to bring a total
closure of the transaction.

Comment

It is evident that structuring and drafting EPC contracts is a formidable

task. Each point needs to be clearly ventilated, decided and then
properly drafted. This will help to minimise controversies and
interpretations. The intent ought to be clear at all times.

For further information on this topic please contact Khem N Thadani or

Jasprit Kaur at Adnan Sundra & Low by telephone (+603 2279 3288) or
email ([email protected] or [email protected]). The
Adnan Sundra & Low website can be accessed at asl.com.my.