By Brad Price – Managing Director of Technical Due Diligence

New Energy Risk helps accelerate the commercialization of industrial technologies that are solving global challenges. We routinely see that one of the biggest challenges to developing a bankable project is the contracting structure for engineering, procurement and construction. Conventional wisdom holds that a lump-sum EPC contract is superior, but the data presents a challenge to this assumption.

This blog post comes with a book recommendation – Ed Merrow, the Founder and President of Independent Project Analysis (IPA), recently published a great book called “Contract Strategies for Major Projects: Mastering the Most Difficult Element of Project Management.” I highly recommend this book to anyone interested in gaining new-found, evidence-based understanding of contract strategies for industrial projects that challenges conventional wisdom.

What is split-form contracting?

Ed defines split-form contracting as a structure that separates the construction activities (the C of an EPC contract) from the engineering and procurement activities (the E and the P) by using separate firms and contracts [i]. Under this structure, the EP firm has no role in construction, other than to field design clarifications, and performs no construction management activities. In nearly all case, EP activities are undertaken by the same firm as the Front-End Engineering Design (FEED) performed during project development, prior to the execution of the EP contract. According to Ed, the split form approach accounts for almost 30% of industrial projects [ii].

Split-form contracting can be performed on a lump-sum basis for each contract (lump-sum EP and lump-sum C), which has the potential to provide the contractual cost certainty that project finance transactions require – which is of great interest to NER and anyone aiming to conduct a project financing.

The Strengths of Split-Form Contracting

Ed uses the extensive IPA project database to compare the many different forms of contracting, such as lump sum EPC; engineering, procurement, and construction management (EPCM); reimbursable EPC (an EPC contract reimbursed on a time and materials basis); and split-form contracting. What stands out from the data is the cost competitiveness of the split-form contracting method. While lump-sum EPC contracts are generally lauded as the gold standard in the finance community, in fact a properly executed split-form contracting structure can deliver significant advantages [iii]:

• Split-form contracting is on average approximately 7% less costly compared to a lump-sum EPC contract. Reimbursable EPC and EPCM contracts are more costly than the lump-sum EPC approach, by approximately 13% and 7%, respectively.
• Split-form has less cost variability, with a standard deviation of approximately ±13% compared to lump-sum EPC (±25%), reimbursable EPC (±30%) and EPCM (±25%).

Split-form contracts do demonstrate slightly higher final cost growth compared to the original estimate compared to lump-sum EPC contract (4% vs. 1%) but the original cost estimate is on average so much lower that the overall 7% cost advantage mentioned is maintained. This cost growth should be handled with a slightly larger project contingency. For reference, the average cost growth for reimbursable EPC and EPCM structures are 7% and 6% respectively.

Regarding schedule, lump-sum EPC and split-form with lump-sum EP with lump-sum C take about 4% longer than reimbursable EPC and EPCM [iv].

Ed cites many reasons for the advantages of split-form contracting. One is that it prevents construction from starting before the engineering is completed. When engineering is late under a lump-sum EPC structure, the firm is highly incentivized to start construction despite not being ready [v]. This is because there is oftentimes a milestone payment associated with the start of construction. The result is extremely poor labor productivity for a variety of reasons, such as poorly ordered work and re-work.

IPA’s research uncovered another interesting advantage of split-form: projects that make extensive use of modularization exhibit even more pronounced cost advantages. This observation was significant because prior IPA studies had not indicated cost benefits for modularization under any other contracting approaches. Ed concludes that the savings associated with modularization must end up with the contractor under lump-sum or EPCM arrangement, whereas the split form allows the savings to benefit the owner [vi].

Why utilize split-form when lump-sum EPC is readily accepted by financiers?

It is NER’s experience that industrial projects comprising new technologies struggle to find a willing counterparty for a lump-sum EPC contract. The key concern we hear about is that the contractor is reluctant to take on the lump-sum construction cost risk. Many contractors are more willing to agree to a lump-sum contract for the engineering and procurement only. Essentially, there are very few firms willing to work on a lump-sum EPC basis, and even fewer where a new technology is involved. The split-form approach opens the doors to more counterparties willing to contract on a lump-sum basis for a partitioned scope and, furthermore, can actually deliver better results overall as demonstrated by the IPA dataset – it can provide more cost certainty than a EPCM or a reimbursable EPC contract structure and may realistically be the only way for some projects to move forward.

Key challenges when utilizing split-form contracting

There are challenges associated with the split-form method that may represent significant roadblocks for unsophisticated developers. Foremost among them is that the project developer needs to understand construction management and select the construction company. For many technology developers, their first commercial scale plant may be their first experience of managing the construction of a large industrial site. This will require the owner team to hire employees with these necessary skills and put in place the necessary management systems. The construction management does not need to be performed by the owner, but they will need to be more involved than they would with a lump-sum EPC contract and will need to staff the project appropriately. A general contractor can be hired to perform the day-to-day construction management for the owner organization but will require close involvement of the owner’s project managers.

Structuring the contracts in a split-form is not trivial. There needs to be a well-defined division of responsibilities between the firms related to commissioning, startup, and performance testing. The schedules and associated guarantees need to be carefully coordinated to ensure the engineering and procurement deliverables are available when needed for the construction contractor. The liabilities need to also be coordinated in a way that covers all the risks effectively and places the responsibility on the correct counterparty. Both the EP firm and the C firm need to offer liquidated damages related to hydraulic performance. Thermal performance guarantees need to be offered by the EP firm at least, and maybe the construction firm as well. Any construction problems discovered during commissioning (after Mechanical Completion) need to be the responsibility of the construction firm and should be linked to their schedule guarantees. Chemistry guarantees may be picked up by the EP firm, but it is more likely that the chemistry guarantees will only be forthcoming from the technology licensor and be passed directly to the owner. As a result, the penalties from the technology licensor will be small compared to the overall project value.

The way the performance guarantees are split and shared between multiple parties will give pause to many financers. The splitting of these guarantees will also reduce the liquidated damages available for any underperformance. A performance insurance product from New Energy Risk can be used to effectively “wrap” all these performance guarantees and provide the performance certainty needed by many capital sources.

An experienced perspective on split-form project execution

To gain an experienced perspective on how to execute on a split-form contract in a project finance transaction, I reached out to Antoine Schellinger, Executive Vice President of Project Operations & EPC at Citroniq. Antoine agreed that a correctly executed split-form project would “materially reduce the cost of project implementation,” but added that there are many challenges that need to be carefully managed to make it possible (many of those are mentioned in the previous section). He suggested the following example of how to execute a project by implementing the following split-form structure in place prior to a final investment decision (FID):

1. Execute a lump sum EPF (engineering, procurement, and module fabrication) contract. The fabrication contract can be separated from the EP contract, and according to Ed’s book there are significant cost advantages for doing so.
2. Execute a ‘good faith’ construction contract with an estimated cost based on estimated quantities, but with all commercial terms and conditions firm.
3. Convert the construction contract to lump-sum when drawings are ‘Issued for Construction’ based on actual quantities.
4. Hold a calculated equity reserve to account for growth in the construction contract that accounts for every reasonably foreseeable growth allowance (there are excellent historic metrics available).

The reason to delay the finalization of the lump-sum price on the construction contract is that final engineering drawings and accurate material costs are not available for the construction contractor at FID. As a result, the construction contractor will need to include a significant “risk premium” on the price if the lump-sum price is finalized at FID. Waiting to finalize this price can significantly reduce the risk premium and reduce the overall cost to the project.

Making split-form contracting ‘bankable’ for project financing

An important question for the energy transition and project finance ecosystem is whether the advantages of a split-form contracting approach can be adopted into project finance transactions. A key component to project finance is contracted cost certainty, which is why the lump-sum EPC contracting method is preferred (despite a high frequency of cost overruns, especially in poorly defined projects). While split-form contracting may be effective in reducing costs, it must be done in a way that also provide project financers with confidence that complete project scope is contracted at a fixed price. There must be complete confidence that these contracts, when combined with the owner’s contingency, enable the project to be completed within the project budget.

In NER’s view, financial institutions should consider a carefully structured split-form project as an alternative to lump-sum EPC, especially considering all the advantages it offers. Despite the multitude of benefits, there may be unsophisticated, or “check the box,” financers that are unwilling to invest in a split-form contracting project. To move the many projects forward that are needed to transition our economy to a more sustainable one, financers will need to learn more about split-form contracting and how it is executed effectively. Project developers will carry the same burden, carefully developing projects in a way that lowers capital costs while also providing the cost certainty that the finance markets require. In support of split-form contracting, NER is well positioned to help overcome the performance guarantee challenges that are unique to this contracting structure and is one of the many ways that we are Underwriting a Greener Future^®.

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Works Cited

[i] Merrow, pg. 56

[ii] Merrow, pg. 75

[iii] Merrow, pg. 65

[iv] Merrow, pg. 68

[v] Merrow, pg. 106-107

[vi] Merrow, pg. 107-108