[co-author: Roshni Mali, Director, Karbone*]

Introduction

Large-scale solar development is big business, and solar EPC Contracts are big business by association.  In Q2 2017, the U.S. solar market installed 2,387 MWdc, an 8% increase year-over-year, and the largest second quarter everⁱ.  Utility PV accounted for 58% of those installations, making that the seventh consecutive quarter that the utility-scale space added more than 1 GWdcⁱⁱ.  In today’s solar market, there is significant competition among project developers in search of debt lending and equity investment partners.  This means that in order to develop a competitive edge, developers need to prepare a solar project with the strongest level of guaranteed revenue in order to increase the likelihood of selling the project to such potential debt and equity companies.  Given that the majority of a solar project’s capital expenditure is EPC costs (approximately 70%-90%)ⁱⁱⁱ, the cornerstone of any bankable solar project is a properly negotiated EPC Contract.  As such, developers must offer lenders and investment partners bankable EPC Contracts that centralize the responsibility for meeting many of the perceived challenges associated with a big solar project and make the risk profile of the entire solar project more attractive to such potential partners.  This article identifies the five fundamental risks facing any project developer in an EPC Contract and lays out an easy to use checklist of legal and commercial tools to mitigate them and to ensure the developer is able to present debt lenders and equity investors with the most bankable EPC Contract possible - one that is the most likely to deliver a well-performing solar project on time and on budget.

Bankability

A “bankable” EPC Contract is an agreement between the EPC contractor and the developer that establishes a risk allocation profile for the construction of a project that satisfies the requirements of lender or equity provider^iv.  As discussed below, lenders and equity investors are primarily concerned with whether or not the EPC contractor can claim additional costs or extensions of time under the EPC Contract.  Additionally, they are concerned with the EPC Contractor’s ability to perform its obligations under the EPC Contract and the security provided by the EPC contractor or its parent company to secure its performance^v.  These elements should be top of mind for every developer because, the further the terms of the EPC Contract are from the requirements of the lenders or investors, the greater amount of equity support the developer will have to provide for its project^vi.

In assessing the bankability of an EPC Contract, lenders and investors will look at a range of factors and assess a contract as a whole.  Generally speaking they will require the following:

• Fixed completion price;
• Restrictions on the ability of the EPC contractor to claim extensions of time and additional cost; Output and performance guarantees;
• Limited to no technology risk;
• Fixed completion date;
• Liquidated damages for both delay and performance;
• Security and guarantees from the EPC contractor (or its parent company); and
• Single point of responsibility resting with the EPC contractor^vii.

At a minimum, an EPC Contract delivers each of the requirements listed above, making it the predominant form of construction contract used on large-scale project-financed infrastructure projects^viii.  A properly negotiated EPC Contract, however, provides both the aforementioned requirements as well as incentives and management tools for the developer to manage the EPC contractor over the course of the construction of the project.

The Checklist below addresses each of the items listed above from both a legal and a commercial perspective by grouping them into five fundamental risk categories and providing a checklist of items and questions to ask internally when negotiating the EPC Contract.

Price Risk

Lenders and investors will not generally take construction cost risk and will instead require that the EPC Contract be a fixed price lump sum turnkey contract.  As such, a well-constructed EPC Contract should be fixed price, with only limited, customary exclusions that permit price increases.  A few of the developer’s tools for mitigating price risk are:

• Change Orders: The EPC Contract should limit the grounds on which the EPC contractor can ask for additional compensation to a very narrow, well-defined subset of excusable events and a very clear change order process for addressing such events.  In addition, the parties may negotiate whether certain events like force majeure or change in law, which are commonly accepted excusable events, warrant an adjustment to the contract price or only an extension in the completion schedule.
• Invoice Approval Process: The EPC Contract should clearly define the procedural and documentation requirements with which the EPC contractor must comply when submitting its requests for payment.  Minimum criteria should include supporting documentation for all invoicing and an adequate period allowed for developer to review invoices before being obligated to make payment.
• Right to Dispute in Good Faith: The EPC Contract should allow for the developer to dispute those invoices or items in an invoice that it believes are inaccurate or not due and owing.  In order for both parties to keep the project moving, it makes sense for the developer to be obligated to make full payment for those undisputed items in the invoice, but to withhold payment on the disputed portions until the parties can agree on such items or such items are resolved via the EPC Contract’s dispute resolution mechanism.

Commercially, developers can protect themselves from price increases by ensuring that the work they perform on their end, such as subsurface investigations, is done thoroughly.  In addition, developers should also have a firm grasp of the local labor and transportation issues that may face the project.

• Subsurface Investigations: Subsurface soil conditions are one of the larger design and cost risks associated with large-scale solar projects. Developers can keep risk premiums to a minimum by doing a professional and thorough soils investigation, including driven pile load testing^ix.
• Extensive Knowledge of Local Labor and Transportation: Large-scale solar projects require significant man-hours to fabricate and install. To keep costs and risks to a minimum, the EPC contractor needs to have a thorough understanding of the local labor rates and rules.  Additionally, the EPC contractor should have experience mobilizing large labor forces to remote areas, including a plan for how to deal with transportation, housing and labor rates to get the crews to the site^x.

Performance Risk

At the most fundamental level, a project’s revenue will be earned by the operation and performance of the facility.  Therefore, it is imperative that lenders and investors are entirely satisfied with the technical risk of the project and that the facility will perform properly in terms of reliability, efficiency and output.  In order to get comfortable with the performance risk of the project in order to finance a large-scale solar project, lenders and investors will require a risk-mitigating mechanism in place to ensure that the facility will perform in line with how it was presented for investment.  As such, EPC Contracts contain performance guarantees (one of the distinguishing characteristics of EPC Contracts) that place the EPC contractor “on the hook” for performance liquidated damages if the EPC contractor fails to meet the performance guarantees.  The end result is that, upon completion of the project, the EPC contractor is responsible to deliver a facility that actually meets all pre-agreed performance criteria by a specified date.  A few of the developer’s tools for mitigating performance risk are:

• Minimum Guaranteed Capacity: The EPC contractor should incur delay liquidated damages in the event the project fails to meet the minimum guaranteed capacity (and which should be a condition to substantial completion) by a date certain.  The minimum guaranteed capacity should be set at the level at which the project must operate to support the developer’s capacity requirements under the Power Purchase Agreement.
• Guaranteed Capacity: The EPC contractor should also incur liquidated damages for any failure to achieve the guaranteed capacity for the project.  The guaranteed capacity should be set at the level higher than the minimum guaranteed capacity and at a level at which the project must operate to support the developer’s capacity requirements under the Power Purchase Agreement, its debt repayment obligations and revenues forecasted in the developer’s model.
• Performance Liquidated Damages: In a perfect world, liquidated damages would cover the developer’s lost revenue and inability to meet its debt payment obligations as a result of such failure.  In practice, however, the EPC contractor will often limit its liability under the EPC Contract to a certain percentage of the EPC Contract price, and the developer will bear the risk of any shortfalls.

Commercially, the developer can make sure that the EPC contractor takes certain steps to ensure that the system performs to its highest potential.

• Equipment Procurement: The EPC contractor should be procuring Tier 1 equipment and double-checking that the manufacturers are in good financial standing.  Often times, switching out equipment for a cheaper model results in incompatibility with other parts of the overall system.  Additionally, foreign parts will need to undergo a certification process before being accepted by wiring and electrical inspectors.  Throughout the construction process, the developer should verify that the equipment models being procured by the EPC contractor are in line with the construction drawings.
• Inventory: Every EPC Contract should include a provision dedicated to the EPC contractor’s obligation to provide an inventory of spare parts.  It is extremely beneficial for the developer to have the EPC contractor order extra equipment so that there are spare modules, inverters, bushing wells, buss bars, fuses, fuse holders, insulators, clamps quickly and easily accessible.
• Warranty: Understand your EPC contractor’s warranty. Some EPC Contracts provide the installation labor for any damaged equipment while others only serve as a pass-through entity for filing a manufacturer's claim.

Permitting and Approvals Risk

The construction of a large-scale solar plant requires a myriad of permits and approvals from governmental authorities and regulatory bodies, including land use and zoning, building permits, federal and state authorizations, and environmental permits.  The EPC contractor should remain responsible for obtaining and maintaining the vast majority, if not all, of all such required permits and approvals.  The EPC contractor should be required to obtain not only those permits and approvals in its own name but also those needed in the name of the project company.  A few of the developer’s tools for mitigating permitting and approvals risk are:

• Project Permits: While the permits for the project are obtained in the project company’s name, the EPC contractor is typically responsible for applying for and pursuing all applicable permits necessary for the construction of the project (with the developer’s cooperation).
• Contractor Obligations: Since the permits for the project also typically contain a number of conditions to be met prior to construction, the EPC contractor should be directly responsible for satisfying any such permit conditions.
• Contractor Permits: Aside from the permits required for the project, the construction of the project will also require the EPC contractor to have and maintain certain permits in its own name.  The EPC contractor should be responsible for all permits applicable to the EPC contractor’s tools, equipment, personnel and operations.

Commercially, choosing a well-known EPC contractor that has strong relationships within your area of construction can help mitigate approval and meet constrained deadlines.

• Relationships with the Utility and Others: Constructing a large-scale solar project involves meeting numerous deadlines, whether SRECs, or COD and often times both the developer and the EPC contractor can be thrown off track to meeting them.  When tweaks and adjustments are required, having a positive rapport with the utility, local wiring inspector, building inspector and engineer of record can help ensure those deadlines are met.  That way you can expedite the turnaround time of any fixes and get back on track to COD.

Completion Risk

In order to protect its own interests and to ensure it will receive the supply of power as agreed, the offtaker under a Power Purchase Agreement will require that the project complete construction by a certain outside date.  In the event the project fails to be constructed by the outside date, the offtaker will enforce this deadline by requiring the developer to pay delay liquidated damages.  If the delay in completion is long enough, however, the offtaker will typically have the right to terminate the Power Purchase Agreement at some point.  While lenders and investors are concerned with liquidated damages under a Power Purchase Agreement to a certain extent, their primary concern with a delay in construction is that it does not result in the Power Purchase Agreement being terminated and the project losing its source of revenue entirely.  A few of the developer’s tools for mitigating completion risk are:

• Guaranteed Milestones: In every EPC Contract, the parties will negotiate the substantial completion date, the most important project milestone.  The substantial completion date is the date the solar plant is complete and functional (capable of generating electricity) except for punch list items and interconnection.  In many EPC Contracts, the developer will also negotiate a series of interim milestones that are on the critical path to achieving substantial completion in the hopes of keeping the contractor’s “feet to the fire” each step of the way as opposed to simply waiting for the project come together for one critical milestone at substantial completion.  In each of these cases, if the EPC contractor fails to achieve any guaranteed milestone date, the EPC contractor is obligated to pay the developer liquidated damages for each day of delay until such milestone is achieved.
• Delay Liquidated Damages: From the developer’s perspective, it will be incurring delay damages under the Power Purchase Agreement, interest under any financings during the construction period and certain other fixed costs in the event of a construction delay. The developer is also losing revenue from the sale of power for every day the project is delayed.  The EPC Contract should ensure that the EPC contractor is obligated to pay liquidated damages in an amount equal to all such costs for each day that it is delayed in meeting the guaranteed milestone.
• Termination: The EPC Contract should also state that if the EPC contractor is too delayed, and misses the outside date, the developer has the right to declare a default and terminate the EPC Contract. A more protective approach is to establish a right for the developer to declare a default and terminate the EPC Contract prior to the outside date if the EPC contractor could reasonably be expected to miss an outside date.  In this second approach, the developer does not have to wait for the actual Power Purchase Agreement outside date to be missed and for the fallout to come from the default under the Power Purchase Agreement.  Instead, while not desirable, the developer can terminate the EPC Contract prior to any default under the Power Purchase Agreement, hire another contractor to take over the project, and hopefully salvage the project and the Power Purchase Agreement on an accelerated basis.

Commercially, it is imperative to review the final completed system before the substantial completion is declared in order to ensure that everything is squared away before the EPC contractor can leave the site.  Additionally, the developer can hedge completion risk by not relying solely on the utility providing test power before the witness test and instead penciling in as many tests as possible before the witness test in order to guarantee a smooth process on the day of testing.

• Third Party Audit: In order to get comfortable with the electrical, and technical details of the system, lenders and investors will want to hire a third-party to conduct an audit after the system achieves mechanical completion.  This third-party engineer will compile audit results in a non-conformance report from which the developer can direct the EPC contractor to make any corrections.
• Test Before the Witness Test: A lot can be tested before the witness test. In fact, inverter commissioning and transformer commissioning will require some test power.  There are examples of certain utilities who have recently stopped providing test power before a witness test for grid-related safety reasons.  If this is the case, it is important that the EPC contractor have access to a back-up generator and a load bank at its disposal.  The EPC contractor should coordinate the engineer of record and the inverter technician to be on-site the day of inspections and the day of witness testing.  This is a simple way to ensure that any questions or necessary fixes can be performed immediately.
• Detailed Testing: Different off-takers will require different tests.  The developer should make sure all necessary testing is properly identified as a condition for substantial completion in the EPC Contract, including: PV module flash test analyses; String I-V Curve Tests; Megger tests; Continuity tests; thermal scans of main components; DAS and monitoring system tests; reliability tests, etc.
• Review Interconnection Requirements Closely: Interconnection agreements, including the footnotes, stipulate a variety of tests that can often be overlooked by the developer.  Some utilities require a single-phase islanding test, revenue meter testing for accuracy and functionality, etc.  If a developer is interconnecting to a municipal utility, the paperwork will be different in each municipality.  The developer should make sure both it and the EPC contractor communicate with the local utility to verify the project has purchased the correct revenue meter, received any necessary account numbers, paid any down payments, etc.  Often times, a local utility will require the installation of their own billing meters and check meters at the expense of the developer.  These responsibilities will be outlined in the Power Purchase Agreement, and should be passed on to the EPC contractor.

Credit Risk

While it is imperative to negotiate a well-defined contractual arrangement that clearly sets out the rights and obligations of each party, in practice, lenders and investors will be concerned not only with the written terms of the EPC Contract, but also the ability of the EPC Contractor to actually perform the terms of the EPC Contract.  As a result, lenders and investors will require an entity with an investment grade rating to guarantee both the construction of the project on time and the ultimate performance of the project.  If the EPC contractor as counterparty to the EPC Contract is not itself creditworthy, credit support from another entity will be required.  The EPC contractor’s credit support is provided in one or more of the following forms:

• Parent Guarantee: In an EPC Contract, the parent company of the EPC contractor performing the work under the EPC Contract will typically provide a parent company guarantee to enhance the financial credibility of the subsidiary company and backstop the obligations of the EPC contractor.  In the event the subsidiary performing the work cannot fulfill its obligations under the EPC Contract, the developer can look to such parent company to “step into the shoes” of the non-performing subsidiary to either make payments in the event of a financial guarantee or perform the work in the case of a performance guarantee.
• Performance Bond: In order to protect itself from non-performance by an EPC contractor with a less than acceptable credit rating, the developer may require a performance bond.  The performance bond provides a guarantee that the bonded company, the EPC contractor, will perform its obligations in good faith.  The EPC contractor’s failure to do so may trigger a requirement that the surety, the company who provided the performance bond, is obligated to the developer for the financial loss incurred.  A typical performance bond would ensure that the project was built to specification, within the contractual time allotted and for the agreed upon price.

Commercially, the developer will want to ensure that the EPC contractor is incentivized to perform.

• Offsets: Regardless of the EPC contractor’s creditworthiness, the EPC Contract should allow the developer to offset any amounts that are owed by the EPC contractor to the developer against any amounts owned by the developer to the EPC contractor.  The offset is intended to protect the developer from sending additional cash out the door to the EPC contractor while it is still waiting for the EPC contractor to make payments to the developer under the EPC Contract (delay liquidated damages owed by the EPC contractor for missing a milestone, for example).
• Retention: Regardless of the EPC contractor’s creditworthiness, the EPC Contract should provide for the developer to retain a percentage (typically between 5% and 10%) of an invoiced amount.  This retention amount is deducted from the amount due to the EPC contractor and is retained by the developer to ensure that the EPC contractor completes the remainder of its obligations under the EPC Contract before the retention amount is released to the EPC contractor.

Conclusion

The cornerstone of any bankable solar project is a properly negotiated EPC Contract.  Ideally, the Checklist above provides solar project developers with a framework for creating a bankable EPC Contract that will attract lenders and equity investment partners by mitigating the top risks found in large-scale solar projects while also centralizing the responsibility for meeting many of the perceived challenges associated with a big solar project with the EPC contractor.

* This article was produced in collaboration with Karbone Inc., a fully integrated financial services firm that specializes in renewable and traditional energy markets.