When passing risk through to various sub-contractors to a PPP or energy infrastructure project, it is important to ensure that the core sub-contracts are drafted on a ‘back-to-back’ basis with the project agreement. This method will ensure that construction, operation, and maintenance risks have been allocated and passed through correctly from the project company to the relevant sub-contractor. At the construction level, the correct allocation of risk will also be one of the key factors for lenders in deciding whether the project is ‘bankable’.
This article explores the pass through or ‘back-to-back’ arrangements that are made at the construction level for an energy infrastructure project. For the purposes of this article, the relevant parties are: (i) the owner of a project (the Owner); (ii) a special purpose vehicle set up to deliver a project (the project company); and (iii) the construction sub-contractor of a project company (the EPC contractor).
The Owner will enter into a project agreement with the project company setting out the scope of the project: for example, an exclusive right to design, procure, construct, operate, maintain, and finance an energy producing facility for an agreed period in return for agreed payments from the Owner, or in return for the right to receive third-party revenues from the project.
The project company will sub-contract its design, procurement, construction, testing and commissioning obligations to an EPC Contractor under an engineering, procurement, and construction contract (EPC contract). In doing so, the project company will generally look to pass much of its development responsibility under the project agreement to the EPC contractor. The project company will seek to ensure that key development obligations under the project agreement are consistent (back-to-back) with the EPC contract. This is to ensure that, under the EPC contract, the EPC contractor will essentially perform the project company’s development obligations under the project agreement.
Generally, the following key concepts must be taken into consideration when drafting the EPC contract:
Scope of work. The specification for the scope of work in both the project agreement and the EPC contract should be identical. Often the same document is included as an annexure to each agreement.
Extensions of time. The grounds for the EPC contractor to be able to claim an extension of time under the EPC contract should mirror the grounds for the project company to be able to claim an extension under the project agreement.
Completion. The project company should take over the works once they are certified as complete in accordance with the project agreement, not the EPC contract. An independent certifier will often be appointed to perform the certification role.
Liquidated damages. The quantum of liquidated damages for late completion under the project agreement should be no less than the quantum of liquidated damages under the EPC contract.
Force majeure. The force majeure provisions should be identical in both agreements so that any claim by the EPC contractor for force majeure relief will also be permitted at the project agreement level.
Corresponding entitlements. Any claim brought by the EPC contractor under the EPC contract that relates to the same subject matter under the project agreement should be suspended whilst the project company pursues the same claim under the project agreement. The EPC contractor’s entitlement should then correspond to the project company’s entitlement. The same principle applies for claims initiated by the Owner against the project company.
Dispute resolution. The dispute resolution regimes in both agreements should be identical to ensure consistency in the treatment of corresponding entitlements and all other claims.
Governing law. In some jurisdictions, agreements that touch and concern real estate must be governed by local laws. Lenders, however, often request English law for the financing agreements, so there can be a mismatch of laws applying. The preference is to have consistency in governing laws across all project documents.
Once the relevant ‘risk’ provisions have been identified, where possible, a bespoke EPC contract should be drafted that captures all of the development provisions in the project agreement. It is also useful to prepare ‘delta compares’ and a risk matrix showing the differences (and similarities) between the two contracts on key risk issues.
Another factor to bear in mind is that in emerging project markets, EPC contractors may not be overly familiar with the above pass-through regime, nor fully understand the rationale for applying back-to-back principles and may therefore price their bids higher than normal.
Correct risk allocation is critical in all infrastructure projects. In PPPs or energy infrastructure projects, which are project financed, the project company will wish to allocate as many development risks through to the EPC Contractor as it can, if such risks cannot otherwise be managed or mitigated. Developing a ‘back-to-back’ EPC contract is one way to achieve such risk allocation.