In the first of three articles looking at key risks for contractors on energy projects, we examine a typical contract structure for a power station build
Energy is one of the few areas where new build activity is set to increase in the coming years. For contractors the structure behind such projects can be unfamiliar and daunting where the pass through of risk is concerned. Although nuclear new build and its contracts have been the focus of much attention, there are many other types of energy projects out there, including waste to energy, gas storage, wind, biomass and hydro.
Central to it all is the company that will own or is procuring the project. Developers of the project may include large utilities, landowners, specialist project development companies and large equipment suppliers. They will usually want to set up a separate legal entity to hold all the necessary legal rights and authorisations needed for the project - known as the project company.
This is a single project vehicle. Alternatively, the developer may be a contractual joint venture or, more recently, a Limited Liability Partnerships. If more than one developer is to have
an “equity” stake in the project then they will need to conclude some form of agreement between themselves to govern how the project will be developed, funded and operated and how the risks and responsibilities will be shared amongst the different parties. If the project starts losing money all members or shareholders need to know where they stand relative to one another. The agreement that deals with this will, in the case of a project company,
be a shareholders agreement and for an unincorporated body, such as those referred to above, a Joint Operating Agreement or Limited Liability Partnership Agreement. They all serve the same purpose. Bank funding may be required for the project unless it is to be done “on balance sheet” by the parties that make up the project company, funding it from their own resources. Where the project company needs funding, a facility agreement - namely the funding agreement - will be needed. The funders will take a keen interest in the pricing arrangements and allocation of risk to contractors and others so the extent of their exposure is fully understood - in the same way as they will look at revenue generation of the plant and the risks associated with that.
The other agreements that will be needed include a construction agreement - usually a turnkey contract where the contractor delivers a fully operational plant. However, developers used to operating in this market may prefer a multi-contract approach rather than turnkey, on the basis that they don’t want to pay a premium for a turnkey service and they have the resources and skills to manage the risks inherent in a multi-contract structure.
The operator will take over the plant on the passing of certain tests. These can be acceptance tests, handover and/or performance tests or any variation of the three. The operator will have stringent requirements before it will take over the plant, and then going forward regarding its performance. These requirements and the risk of the plant not being able to meet them, as a result of its design and/or construction, will be passed through to the contractor There will also be some form of fuel supply agreement around what will be driving the plant. The specification of the plant and its output will be dependent on the quality and nature of the fuel supply. For example, waste to energy and biomass plants will have specific requirements or parameters around the waste and input fuel to be used. Where these parameters are not met, there may be relief from non-performance of the plant.
The project company will also enter into agreements regarding the output from the plant, for example, power purchase agreements with those purchasing the power (and in the case of renewables all the green benefits associated with power generation). Separate from that there may be contracts required, either to allow the project company to connect to the gas transmission system or the electricity grids. This may require construction of the necessary physical assets to enable the connection to take place.
Normally the project company and its shareholders will bear the development period costs, which may well be substantial due to planning consents and other necessary permits and licences having to be obtained. There is every potential for significant delay in this development period but power purchasers may not agree to open-ended delays and so seek a backstop date after which they can walk away from their agreement.
As well as risks in the development period there are other risks that the project company will find hard to pass through. These are typically the possibility of changes in the law that increase the project company’s costs.
For example, a change in environmental requirements might result in a project company needing to make expensive modifications to the plant. Force majeure risk may also remain in whole or in part with the project company backed off with insurance cover to the extent available.
The main factors for contractors to consider then is how and to what extent the contract structure that they tie themselves to exposes them to the risks associated with the fuel supply, power purchase agreement and operator’s requirements to them.
Lindy Patterson QC is a partner at Dundas & Wilson