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Project finance, EPC contracts and the brave new world for Chinese contractors

Even as the world watches China, Chinese companies are starting to look towards business opportunities beyond Chinese borders. Outbound foreign direct investment from China in 2008 was a record US$ 52 billion and outflows could reach US$ 100-150 billion a year as soon as 2012.

International demand for new and renewed infrastructure presents enormous opportunities for Chinese companies and government pledges to combat recession by investing in infrastructure means that the demand for large-scale construction services will continue into the foreseeable future.

Much of the world's infrastructure development outside China is financed using project finance models which are often unfamiliar to Chinese contractors. Project finance structures put particular risk pressures on contractors, but they also offer especially lucrative opportunities to contractors who understand, price and manage the risks. Chinese contractors who want to compete in international markets should be aware of the impact of construction project finance on contractors.

In this article we explain the mechanics of project financing, how and why it is used in infrastructure projects, and outline the implications for contractors.

An overview of corporate finance

Most large-scale lending in China is 'corporate', meaning that a company that has several sources of income from different projects borrows or guarantees the loan. In corporate lending, even though a loan may be used to finance a particular project, the company that borrows or guarantees the loan has sources of revenue other than the target project, so it will be able to repay the loan even if the target project fails or makes a loss. Corporate lending is sometimes referred to as 'on-balance-sheet' lending because the borrower or guarantor is putting its entire net worth behind the loan.

Project financing differs from corporate financing in that the banks take the risk on a single project. They lend to a shell company that is established exclusively to develop that single project, such as a power plant or toll tunnel; and project revenues constitute the sole source of repayment to the banks. It is generally not relationship-based lending, as neither the project's equity investors (called 'sponsors'), nor anybody else guarantees the debt: if the project fails there is no recourse to other projects the sponsors may be involved in. The banks can only take over the project (to sell or operate it themselves) as a means to get repaid. This remedy is often highly unsatisfactory as a failed project is unlikely to be attractive collateral, and the operation would be fraught with difficulties.

Project financing for the development and construction of a project is therefore considered high risk, even though the lenders will typically seek to syndicate the loan to spread the risk. Commercial bank lending for project finance is relatively expensive because the amounts involved are very large, the payback period is long (10 years or more) and the loans may be made two to four years before a project is expected to see its first dollar of revenue.

Since the start of the financial crisis in mid -2008 this type of lending has been in short supply, with some projects placed indefinitely on hold, substantially reduced or cancelled altogether. Multilateral agencies, the capital markets, highly capitalised Chinese commercial banks or direct government funding are other funding alternatives, but each with their own limitations. Where a project is project financed after it is built and operating, the risk is much less, and this has been an alternative strategy for some governments and developers that have sufficient funds for construction.

The benefit of project finance loans to the project's sponsors, sufficient to make project finance worth persevering with, is that as these loans are off-balance-sheet the sponsors have limited their equity at risk. If the project fails and is unable to pay its debts, the sponsors have no obligation to invest more money to make the project work or to pay the lenders back so their risk is capped.

Managing project finance risks for contractors

Because construction project finance is so high risk for lenders, the banks and the sponsors work together to ensure that the borrower does not take on more risk than is necessary. They expect the project's suppliers and contractors to take on greater risks than contractors might accept in other kinds of jobs.

Contractors are willing to do so because project financed projects tend to be big-money transactions and because the contractors can charge a premium for accepting the higher risks. Some contractors also invest in the projects they are building, usually as minority investors, and some are allied with large equipment suppliers who sell equipment to the project. This way the contractors may earn a return on the project from sources other than their construction services. With access to low labour rates, advancing technology and readily available finance, Chinese contractors can compete with more established international rivals.

The biggest risks to equity investing sponsors in construction infrastructure projects are that the project:

• will not be built properly and/or
• will not be able to sell its output for enough money to repay its loans and pay out its equity investors.

The first of these risks is known as 'construction risk'.

Key elements of construction risk

The risk that:

• the project will not be designed to meet the specifications in the concession agreement
• the project will not be built according to the design/specifications
• the engineer/architect and contractor will dispute responsibility for any delays or performance problems
• major equipment failure (especially in power plants, for example)
• the site is not suitable for the project
• different pieces of equipment do not work together as intended
• the designer, contractor and equipment suppliers will dispute responsibility for delays or performance problems
• constructing the project to the required standard, or ensuring that it performs properly, will cost more than expected so that there is not enough money to complete it
• the project will not be built on time, including due to force majeure (i.e., an exceptional event beyond a party's control such as natural disasters, war, some labour problems, public protests or political problems) affecting either the contractor or one of its suppliers.

Construction risk is high, in part, because infrastructure projects are often built in accordance with a government 'concession' agreement, where the local government or a utility company agrees that if a project, say a power plant, is built in a certain place, to certain specifications within a certain time period the government or utility will guarantee that it will buy a certain amount of the project's output. If the project is not built on time or does not comply with performance requirements, the government or utility may be excused from buying the project's output or may be in a position to renegotiate price or volume, rendering the project uneconomic or even entirely worthless.

This is unlike a normal housing or commercial development where there may be financial risks related to timing or quality of the development, but it is unlikely that the development will lose all value as a result of ordinary delays or performance shortcomings.

Project lenders and sponsors look for a single reputable and financially sound construction contractor to bear all of these risks. Where a project has a firm concession agreement and a construction contractor with a good performance record who has agreed to take on the construction risks, the project is said to be 'bankable', meaning that it will be able to obtain loans on a project finance basis.

EPC contracting

The mechanism projects use to pass on all of the above risks to the construction contractor is the lump sum turnkey contract, often in the form of an Engineering, Procurement and Construction (EPC) contract.

Under an EPC contract a single construction company agrees to provide a finished project, meeting certain technical and functional specifications, by a fixed time for a fixed price. The sole contractor takes responsibility for all the risks of design, procurement, construction and commissioning with very few opportunities for time and cost variations. This includes potential design and engineering problems, gaps and mismatches among sub-contract packages, changes in material and equipment prices, permit problems, labour and safety issues at the subcontracting level and many other issues that arise in a large, complex project.

If the contractor fails to perform on time or the project does not meet all the functional specifications, the contractor will have to pay compensation to the project company. The contractor's performance and compensation undertaking is usually secured with a bond that the project company or the lenders can draw on.

The key skill of an EPC contractor is generally not its actual construction quality but its risk-management know-how and abilities. It will look to manage and lay off as much risk as possible onto its own suppliers, consultants and sub-contractors. The risk of major equipment failure, for example, can be mitigated by matching the contractor's obligations under the EPC contract to the rights the contractor can enforce against its equipment supplier. Striving for this 'back-to-back' pass through of the many potential risks on such projects is a complex administrative and management task that contractors unfamiliar with project financing may struggle with. Also, there is not much value in passing through risks as a contractual matter if the sub-contractor is not financially or physically capable of dealing with the risk should it eventuate. Potentially complex early warning and supervision mechanisms are needed as is a viable 'plan B' in case the worst happens.

If it correctly assesses the costs and risk when it makes its bid and closely manages every aspect of the project, an EPC contractor can make a large profit. But if its pricing, supervision and risk-management functions are weak it could lose out completely.

How contractors can deal with risk allocation issues:

1. Contractors must consider the feasibility of the employer's outline performance requirements (e.g. required output capacity of a power station or pollution emission targets) and may need to engage their own independent consultants to check and review such criteria, if unable to do so in-house.
2. If the contractor specifically agrees to ensure that the works are fit for their purpose as defined in the contract, it must carefully examine the stated 'purposes', so the accepted risk is no wider than necessary, has been priced appropriately and is back-to-back with the obligations it is owed by third parties.
3. The contractor will usually be deemed to have scrutinised the employer's requirements and to have taken responsibility for their accuracy. If site data provided by the project company describes site conditions that may subject the contractor to substantial liability, the contractor must verify the data and risk exposure. In many cases this may be the equivalent (in time and cost) of obtaining the site data from scratch.
4. An EPC contractor will bear almost all the risk of delay in the completion of the project. But if the project company changes the scope of the work and causes a delay, the EPC contractor must have agreed an entitlement to an extension of time. The project company should be able to obtain a back-to-back entitlement to delay under its concession agreement, if the variation was requested by the host government.
5. The project company would usually be able to obtain expense and a back-to-back extension of time from the host government under the concession agreement for delays or scope changes caused by changes in law, for example, or unjustifiable delays to the testing and commissioning regime.

Placing all risk primarily on the construction contractor, as the EPC model seeks to do, is superficially inappropriate. First, where risks do not materialise, the project company notionally would have paid too much if the contractor had provided a sensible contingency in the contract price. Secondly, if risks do materialise many contractors would not have the financial means to manage the consequences and may cut corners – or go out of business –attempting to do so. Finally, where risk is forced upon a contractor who is unwilling or unable to manage the risk it will likely provoke disputes further down the line.

Yet, as project financed projects have evolved, most problems are usually resolved by the terms of the contract between the project company and the concession grantor, by laying-off the risks onto third parties, through insurance, or by minimising the risks (e.g. through more extensive ground investigations). Where a risk is large and genuinely unquantifiable, as is often the case with subsurface conditions, the EPC tenderer may identify the part of its tender price relating to that risk, state the assumptions underpinning the tendered price, and reserve a right to adjust the price if the assumptions are not correct. Using these techniques EPC contracting has become a central plank of the project finance model.

In China the EPC contract structure is not unknown: foreign EPC contractors have operated in China to the extent permitted by domestic regulation, but many domestic contractors will be relatively inexperienced with the wider structure of project finance.

To fully seize the opportunities beyond their borders Chinese contractors must teach themselves, or otherwise acquire, the risk assessment skills needed to win project finance deals and complete them profitably. In completing large, complex projects successfully they will mark their place as a reliable new player in the market. The rewards for those bold enough to engage and able enough to deliver will be a door into the lucrative 'new' world of international project finance.