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China Infrastructure Projects – Choosing The Right Contracting Structure

China’s phenomenal economic growth in the last decade has put tremendous pressure on the country’s infrastructure today, particularly water, waste, transportation, power and telecommunications. To finance the country’s mega infrastructure needs, the Chinese government has turned to Public-Private Partnerships (PPP) - joint venture efforts between a government and the private sector. PPPs are becoming increasingly popular today amongst developing nations as a means of securing financing for national development.

A key issue for foreign investors in infrastructure projects is risk management. Lenders to such projects are also concerned with this issue, particularly if the projects are financed off the balance sheet. It is therefore important to structure contracts so as to manage risks optimally.

A major infrastructure project involves numerous contracts, including concession agreement, offtake agreement, construction contract, consultancy agreement, sponsors’ agreement, lenders’ agreement, security agreement, operation and maintenance agreement, and feedstock agreement.

There are different ways of structuring the construction contract. Whether they are suitable depends on the nature of the project, parties involved, commercial, practical and financing considerations, as well as constraints imposed by Chinese law.

EPC Contract Structure

One of the features of a PPP project is that sponsors are responsible for securing financing for the project. Lenders usually finance a substantial portion of the project.

There are several approaches to structuring a contract for an infrastructure construction. Whichever contractual structure is chosen, however, it must be bankable. In a project financed project, the repayment of loan comes from revenue generated from operations during a fixed period of time. The loan may be on a non- or limited recourse basis, i.e. lenders have very limited rights to look to sponsors for loan repayment. Project finance lenders usually prefer the Engineering, Procurement and Construction (EPC) Contract in which a contractor is engaged to design and construct a facility. EPC contracts are turnkey contracts with a fixed time for completion at a fixed cost. All these are attractive elements to a lender.

In an EPC contract structure, the contractor is responsible for both design and construction of a facility. This creates a single-point accountability: if a problem arises in the works, the project company looks to a single party, namely the contractor, for accountability.

The contractor may do all the design and construction works on its own, or it may subcontract the design works to a specialist design contractor and some construction works to other parties. In China, however, there are legal constraints to subcontracting. It is common for a contractor in a major infrastructure project to be a consortium of local and foreign contractors, designers and suppliers.

An EPC contract is also called a “turnkey” contract because the EPC contractor is responsible for designing, completing and delivering a facility that meets the requirements of the project company. In other words, the project company needs only to “turn a key” to start the facility.

One of the first tasks for a project company is to engage consultants for feasibility studies, initial engineering to define the scope of work, and tendering. It is imperative that the consultants do a careful job of preparing the tender documents, spelling out precise requirements on performance.

It is common for a project company to engage a specialist design checker to review designs provided by an EPC contractor or its design contractor. Lenders are likely also to engage their own independent consultants.

A project company may engage a contractor which has qualifications in engineering design and construction as the EPC contractor for the entire project. For major projects in China, foreign design consultants are often engaged with the participation of locally qualified consultants. Moreover, Chinese law requires locally registered design institutes to take on detailed design works. Engineering companies which have the relevant engineering design qualifications but lack qualifications to carry out construction works, can still be engaged as an EPC contractor; they simply subcontract the physical construction works to a local contractor. Thus, the EPC contractor carries out the design work, offshore procurement and project management which are within its sphere of expertise, while retaining the liabilities for the performance of the entire EPC contract, including those of the local contractor for the physical construction work.

In China, the EPC contract structure is used mainly in large scale infrastructure projects such as transportation, power, and oil and gas projects.

Advantages and Disadvantages of EPC Contract Structure

Advantages

• Single-point accountability
• Fixed contract price – a contractor’s right to claim for additional money is usually very limited.
• Guaranteed completion date – the contractor guarantees a completion date, and pays delay liquidated damages if it fails to meet the deadline.
• Bankability – lenders are familiar with the contract structure.
• Increased efficiency – contractor and designer pool resources together.
• Less opportunity for contractor claims on directions issued by the project company.
• Higher design standards – a contractor is usually required to comply with higher “fitness for purpose” standards in design rather than the standard of care required of a design professional.

Disadvantages

• Increased cost of tendering
• Increased contract price – accounts for cost of risks.
• Limited control over design – a contractor may increase profits by under-designing or designing to just meet minimum requirements.
• Improper risk allocation – risks may not be well placed for optimal management.

Traditional Contract Structure

The traditional contract structure is most prevalent in Chinese construction contracts. A project company initially hires a designer to design a facility, and separately engages a contractor to do the construction works. This allows the project company greater control over the design. Some detailed design work may be allocated to the contractor. The project company coordinates the designer and the contractor, although the designer often represents the project company in supervising construction works.

The traditional contract structure is not suitable for project financed projects simply because the project company is exposed to risks due to interface between the designer and the contractor. The structure also erodes the certainty of price, completion date, and performance of the facility.

Notwithstanding the higher risks, the traditional contract structure is used commonly in Build-Operate-Transfer (BOT) projects in China. These are not typical BOT projects executed through non- or limited recourse financing since they are mainly financed by conventional bank loans. Example: the National Stadium in Beijing which is being constructed for the 2008 Olympic Games. The project company initially engaged a Sino-Swiss design consortium to do the design, and later engaged a separate main contractor to do the construction works.

Novated Design Contract Structure

The novated design contract structure is commonly adopted in international projects. A project company initially engages a designer to design a facility. Then, when the project company engages a construction contractor for the physical construction works, the project company novates or transfers the design contract in such a way that the designer is now hired by the construction contractor instead of the project company. This practically evolves into an EPC contract structure, making the designer a nominated subcontractor of the main contractor.

The novated design contract structure retains the advantages and disadvantages of an EPC contract structure. It is particularly useful if the project company wants the design done quickly due to time constraints, or if the project company wants a tighter control over the initial design.

Project companies should be aware, however, that Chinese laws effectively prohibit nominated subcontracting. Further, if the designer has subcontracted part of its work (for example feasibility study) to its subcontractors, such subcontractors will become sub-subcontractors of the project company after the novation. Current Chinese laws do not permit such sub-subcontracting. Hence there may be constraints in employing the novated design structure in China.

Work Packages Structure

In the work packages structure, a project company has separate contracts with various contractors for different types of work. For example, a project company may have one contract with a designer, and separate contracts with other contractors doing major portions of the works. The advantage is that the project company has greater control over critical packages of works.

Project companies should be aware, however, that Chinese laws prohibit an employer (project company) from splitting up construction works that should be done by one single contractor. The law stipulates that the main part of the construction works must be done by one contractor, while the survey, design, construction and procurement components can be contracted separately with other contractors. It is not clear, though, whether separate contracts can be let as specialist works. Each case is evaluated on its own merits, and enquiries should be made with the relevant local authorities.

Management Contracting Structure

If a project company does not have the resource to manage an EPC contractor (or in the case of a work packages structure, the various contractors), the project company may engage a specialist project manager. The project manager negotiates contracts for various work packages and manages the contractor works. However, the project manager merely acts as an agent for the project company and does not take responsibility for the contractors engaged by the project company.

In an EPC contract, a project company manages only the main contractor. In the work packages structure, however, a project company manages several contractors. This exposes the project company to greater risks as the project company cannot look to a single contractor for accountability. To minimise the risk factor, a project company may structure the project in such a way that the project manager is effectively a “management contractor” that takes responsibility for the contractors and ensures that the contractors complete the project on time and within budget. This is known as “management contracting” structure and is a common practice amongst international projects.

If structured properly, the management contracting structure can retain the advantages of an EPC structure of a single-point accountability as well as the advantages of a work packages structure of engaging expert contractors for different work packages.

However, the use of the management contracting structure is greatly limited by Chinese laws prohibiting subcontracting of all works, and requiring the main contractor to complete the main structure. Thus, the management contractor must carry out at least the main part of the construction works.

Split Onshore/Offshore Contract Structure

What is increasingly being adopted amongst infrastructure projects in China today is the split onshore/offshore contract structure. A modification of the contracting structures mentioned above, the split onshore/offshore contract structure is driven primarily by tax, and structured in a way that minimizes local taxes for a contractor, particularly for services and equipment purchased offshore. Tax savings may be passed on to the project company. Such a structure was used in the mammoth Nanhai Petrochemicals Project (sponsored by Royal Dutch/Shell, CNOOC and Guangdong Investment).

In this contracting structure, the works are split into separate contracts with an onshore contractor being responsible for works such as construction, testing and commissioning of onshore activities, and installation of imported equipment. The offshore contractor, on the other hand, is responsible for offshore design services and supply of imported equipment into the country.

Key Takeaway Lessons

• Contracting structure: Do consider early in the project how to structure the construction contract. Not only is this important in managing contractual risks, it also impacts the type of consultants and contractors to be hired.
• Restrictions on splitting up work into packages: key effect is that an employer (project company) of a large project has to source a general contractor which has all the necessary expertise, funding and resources to carry out the works. This is difficult, given the restrictions on foreign contractors and designers operating in China. In practice, however, major projects engage consortia which comprise key contractors and designers.
• Restriction on subcontracting: this imposes limits on the use of novated design contract structure, management contracting structure, and nominated subcontractors.
• In-depth knowledge on techniques of contractual risk management in China: The EPC contract structure provides a good framework for risk management. In future editions of this newsletter, we will discuss more techniques in contractual risk management in China.