Project Agreements, Risk Management and Litigation Risk Sean Ralph, General Counsel, Sasol Canada Phil Scheibel, Partner, Rose LLP Canadian Energy Law Foundation March 1, 2013 11:00 a.m. 12:00 p.m.
Introduction Purpose of presentation is to provide a high-level review of common project delivery methods / contracting strategies used in Canada. Three major concerns in any Owner/Contractor negotiation: 1. Schedule 2. Cost 3. Quality (or Completion Risk) Presentation does not discuss: 1. Tax considerations 2. Corporate structure to mitigate liability (e.g. Joint Ventures / Incorporation of Project corporation) 3. Financing of Project 1
Market Trends *Information on this slide was taken from albertacanada.com In June 2012 the value of the Inventory of Major Alberta Projects was $193.5 billion, up from $188.2 billion in June 2011. The current Inventory is comprised of 874 projects with the infrastructure sector having the largest number of projects. Pipelines accounted for 4% of the new projects (projects added between April 1 and June 1 2012) with a value of almost $1.2 billion. Alberta's engineering and construction sector generates annual revenues of $56.5 billion. 2
Scale of Projects Most of the construction projects in the Oils Sands are, by their nature, large Capital budgets for such projects range from $250 million to $7+ billion Design and construction of a $3 billion dollar Oil Sands project can involve: Engineering Effort 3.5 million work hours at a cost of $100/h 40,000 to 50,000 design drawings 10,000 to 20,000 vendor and shop drawings Construction Effort 15 million man-hours at a cost of $85-100 per hour Labour force of 10,000 workers with a turnover of 30,000 people Supported by 500-800 staff personnel Organize, store and retrieve 80,000,000 material items Source: Jergeas, G.F., & Ruwanpura, J. (2010). Why Cost and Schedule Overruns on Mega Oil Sands Projects? Practice Periodical on Structural Design and Construction, 15(1),10. 3
Scale of Projects Recent examples of major cost and schedule overruns include: Suncor Millennium Project (2002) months behind schedule, at a cost of $3.4 billion, about 70% percent over the original budget of $2 billion Shell Canada Athabasca (Muskeg River) Project (2003), months behind schedule, at a cost of $5.7 billion, roughly 50% more than the original $3.8 billion estimate The Syncrude Upgrader Expansion 1 Project (2006), roughly two years behind schedule, at a cost of $7.8 billion, about 90% over the original budget of $4.1 billion Phase 1 of the CNRL Horizon Project (2009), months behind schedule, at a cost of $9.7 billion, 43% above the original budget of $6.8 billion first set in 2004 Imperial Oil recently announced that Phase 1 of the Kearl Oil Sands mine will cost $12.9 billion, $2 billion higher than a revised estimate released just 21 months ago, and roughly $5 billion higher than initial estimates 4
Understanding Risks With a clear understanding of the desired business deal, the Owner will be in a better position to identify, evaluate and assign associated risks in its contracts. Risk is contractually managed by drafting appropriate: 1. Legal terms (allocate risks between parties) 2. Insurance provisions (pass certain risks to insurance company) 3. Performance Security provisions (pass certain risks to surety, parent company or financial institution) Party best able to manage and mitigate the risk should bear it. 5
Overview of Project Delivery Methods Common contract forms include: 1. Design Bid Build Contracts 2. Design Build Contracts 3. Engineering, Procurement, and Construction Management ("EPCM") Agreements 4. Engineering, Procurement, and Construction ("EPC") Agreements 6
Design Bid Build Contracts Owner Vendors Engineering Design Trade Contractors Subcontractor Sub-Vendor Owner is the project manager. Owner retains an architect or engineer to design the project and, usually through a tender process, will then hire a Contractor to build the project as designed. 7
Design Build Contracts Owner Design/Contractor Design Professional Owner deals with a single entity for both design and construction. Design builder is typically a contractor who sub-contracts the design. Primarily intended to save time. Unlike the Design Bid Build method, the design does not need to be complete prior to tender or construction. 8
EPCM Agreements Owner Owner Specialized Process Vendors EPCM Work Contractors EPCM Subcontractors Subvendors as agent for Owner Works Contractor Specialized Process Vendors Pros Owner gets the benefit of independent expertise regarding construction management. Potential to match the best EPCM with the best Construction Contractor. Breaks up the project into smaller, more manageable pieces, wider potential field of RFP applicants to choose from than perhaps would be the case if a single EPC structure was employed. By breaking up the project into smaller pieces, there is the potential to reduce the "risk premiums" often seen when a single entity takes responsibility for the entire management. Cons No single point of contact on disputes relating to risk and commercial matters. Potential for disputes if scopes of work for EPCM and Construction Contractor are not concise (i.e. work that is not clearly allocated to one scope of work or another, referred to as the "gap" problem). Potential for duplication and inefficiencies (duplication in QA/QC across construction Contractor / EPCM) - counter this by having concise scopes of work. 9
EPC Agreements 1(a) or 1(b) Owner Owner EPC Contractor EPC EPC EPC Subs Subs Subs Subs Subs Subs Pros Cons 1(a) & (b) Administratively simple (1 point of contact). Less Owner involvement/use of resources by Owner, as opposed to other structures. More potential to shift risk from Owner to EPC Contractor if it is a "turn-key" contract. More potential to avoid labour problems associated with unions (at least from the Owner s perspective) as EPC Contractor usually has pre-existing relationships with multiple unions. 1(a) Avoids integration problems such as gaps in scope of work. 1(a) 1(b) Less control and further reliance on EPC Contractor. Having a single EPC Contractor take responsibility for entire project may result in a narrowing of the field of potential successful EPC bidders (for large projects) which may contribute to higher initial bids. May require some oversight/coordination of multiple EPC Contractors by the Owner (or possibly a Project Management Contractor. May give rise to problems regarding integration of the project gap problem. 10
Variations in EPC and EPCM Structures Owner Construction Only Engineering or Engineering and Procurment Procurement only Construction only or Construction and Construction Management Pros Potential to continuously evaluate performance and add or subtract responsibility. More significant control in hands of Owner. Can match specific expertise of contractors to specific task. Flexibility in changing market (Owner hasn t committed to everything up front). Cons Requires more front-end planning and strategy than pure EPC / EPCM structures. Requires increased Owner resources and involvement, organization, follow-up (directly or through Project Manager) in all phases of the project. Multiple interfaces has potential to increase the gap problem. Increased potential for duplication / repetition among Contractors. 11
Which Contract to Use? Design Bid Build Contract: If the Owner wants a significant amount of control over the end product and is comfortable with the traditional method of project construction. Design Build Contract: By a sophisticated Owner who wants to save time and have construction begin before design is completed. EPC Agreement: Where Owner wants minimal risk, minimal control and the costs of the final project to be relatively certain. EPCM Agreement: In large and complex projects where the Owner wants to supplement the experience of its project management staff, and the Owner wants control over the design and construction process. 12
PAYMENT / COMPENSATION: Fitting the Compensation Regime with the Risk Profile Who Bears the Price Risk? Contractor s Risk Owner s Risk Lump Sum Unit Price Cost Reimbursable ("Cost Plus") *Target Price (can apply to all 3) 13
Pricing Scheme: Lump-Sum Owner pays a specified fixed price for all goods and services related to the work - subject to amendment only by Change Order/Change Directive. Contractor bears risk of all out-of-pocket costs. Contractor takes risk/reward of future cost deviation in performing the Work. Higher obligation on Contractor to deliver the work at agreed price. Risk of Contractor attempting to minimize costs vs. quality Owner requires (increased importance of properly negotiated warranty). 14
Pricing Scheme: Unit Rate Used when there are quantifiable, well-defined "units", priced on a per-unit basis (similar to a basket of lump-sum prices). Contractor bears risk of delivering particular quantum of units at the agreed price (and often also schedule). Contractor takes risk/reward of future cost deviation of materials required for each unit. If schedule not agreed, Owner takes risk of Contractor productivity. 15
Pricing Scheme: Reimbursable Used mainly when scope-of-work or deliverables are not known as of time of Contract award. Owner bears cost-risk (and risk of marketplace supply of materials, equipment and labour). Perception in industry is that there is less impact on Contractor quality as Contractor has no incentive to keep costs down. Audit rights of Owner become key in this type of contract. More administration required of Owner. 16
Pricing Scheme: Target Price Used most often with reimbursable pricing but can be applied to all three pricing mechanisms. Target-incentive pricing can be based on a number of factors (e.g. quality, safety, etc.) but is most often based on predetermined target cost or schedule, or both. Risk of controlling costs and schedules shared by Owner and Contractor (usually not shared equally deal specific). 17
Project Risks Schedule Delay Delay on a construction project occurs when: the construction of a project or a part of the project is not completed within the time period originally intended and as specified in the contract; or the scope of the work as contemplated in the contract increases to the extent that more work is required to be performed within the original contract time. Options in dealing with delay risk include: Linking compensation to schedule Acceleration clauses The Float Liquidated damages Consequential damages 18
Project Risks Cost Overruns Cost over-runs are the additional percentage or dollar amount by which actual costs exceed estimates for the project. This is one area where the parties can be creative in their negotiations when selecting the proper risk allocation for cost over-runs. If Owner's biggest concern is cost, it may want to consider a lump-sum contract. However, Contractor may simply inflate its lump sum price. Options in dealing with cost over-runs include: Incentives for meeting or coming under budget Owner/Contractor sharing of increased costs (e.g. Contractor forfeits its profits up to a specified maximum amount or percentage) 19
Project Risks Scope Definition Risks of inadequate scope definition include: Schedule Delays Change Orders/Cost Overruns Rework/Quality Issues 20
Project Risks Quality (Completion Risk) Quality is a primary Owner concern. Will the Plant start up and run to design capacity. Completion is a important trigger: project financing warranty periods transfer of risk Incentives/penalties 21
Project Risks - Warranty How do warranties differ from construction warranties? Construction warranties usually extend the warranty concept considerably Key Distinction construction warranties are key tools the Owner has to expressly bind the Contractor to perform the construction work, not just a boilerplate confirmation of status 22
Project Risks - Warranty What is the purpose of a Construction Warranty? To protect the Owner against defects or failures within the warranty period To provide a remedy to the Owner for defects discovered before or after completion To provide the Owner with a remedy against parties it does not have a contract with (manufacturers, subcontractors and suppliers) but who provide warranties that benefit Owner To define responsibility between the parties 23
Project Risks - Warranty Warranty Drafting Points Construction warranties typically are heavily negotiated. The relative strength of negotiating provisions and skill are therefore key Knowledge/Circumstances are also key for example, is this an area where both the Owner and Contractor have expertise? To illustrate we will examine typical components of construction warranty provisions and highlight certain key points for negotiation 24
Project Risks - Warranty Warranty Provisions 1. Contractor warrants and guarantees the work Components of this: A.Work shall comply strictly with an agreed upon standard: Owner typically want broad, general standard tied to the scope of the work Contractor typically wants narrow standard or no specified standard Issue of fit for purpose may also be addressed - Contractors increasingly resist use of this term Note: Knowledge of Owner key for example, LNG is a new industry for many Owners and therefore, relies more heavily on Contractors 25
Project Risks - Warranty B. Materials and workmanship are free from defects and new Owner wants new Contractor wants flexibility C. Design and engineering free from defects - this relates more to design defects 26
Project Risks - Warranty 2. Length of Warranty Owner wants longer term and warranty to start from commercial operations date. Owner may also try and link warranty commencement to when defect is discovered but this creeps into statutory limitation periods and the common law. Owner often seeks explicit language allowing common law and equitable remedies as well as explicit contract remedies. Contractor wants shorter term and warranty to start from installation or immediately after testing/substantial completion (especially on large, multi-faceted projects). Contractor often seeks explicit exclusion of common law and equitable remedies. 27
Project Risks - Warranty 3. Warranty Remedies In addition to usual contract remedies for material breach, construction contract warranty provisions often include rework (reperformance of work) obligations for Contractor. Owner typically wants repeated rework by Contractor until the problem fixed. This may be coupled with Owner right to retain self or third party re-works rights at Contractor expense if Contractor re-work fails to remedy defect. 28
Project Risks - Warranty 3. Warranty Remedies Contractor wants limited re-work obligations with option to pay specified liquidated damages in event Contractor can t (or if too expensive, won t) fix the problem. LD s usually sliding scale linked to contracted performance standard versus actual impaired performance. Contractor typically wants Owner to pay for in and out costs for warranty re-work. Contractor does not like Owner re-work rights because Contractor can t control quality or costs. 29
Project Risks - Insurance Insurance is one option available to ensure that financial capability exists to manage risks. An owner may also want to limit its exposure to nonperformance or defaults by the Contractor by way of: Performance Bond Parent Company Guarantee Letter of Credit 30
Project Risks Liability Caps Amount Types 31
Project Risks Additional Issues Prime Contractor HSE Technology Counterparty creditworthiness Political Labour Force Majeure Brownfield/Greenfield 32
QUESTIONS! 33