A risky business13 February 2001
Recent trends in privately financed hydro power projects have witnessed the growing popularity of EPC contracts for project implementation. But is this still the most effective way forward for hydroelectric development? Suzanne Pritchard reports
Ask any member of the hydro power industry if they would like to see more hydroelectric development, and the answer will undoubtedly be yes. Hydro opponents will say that this is just the blinkered view of those who seek to secure more contracts and generate more business, but its valuable attributes do make hydro power one of the best energy resources in the world. However, as Bjorn Blaker, executive vice president of Statkraft in Norway, says: ‘The fact is not many new projects are being started. Host countries, plant owners, sponsors and investors would like to see good, high quality hydroelectric development at a reasonable cost. And when this does not happen, we have to start asking why.’
Kim Knightstep Monk is the manager of renewable energy at Enron International. ‘From an owner’s perspective our goal is to maximise returns and minimise and manage risks,’ she says. ‘So when we say that not enough projects are getting done it is probably because the returns are not high enough. Our goal is to figure out how to reduce costs.’
The EPC approach
Reducing project costs is inextricably linked with reducing the risks associated with hydro power development. And this subject was discussed in detail at HydroVision 2000, when delegates looked at project finance and the role of engineering, procurement and construction (EPC) contracts.
‘Construction is one of the key aspects of project finance,’ says Walid Musallam, managing director of the Infrastructure Finance Group, ‘and this can be modelled on an EPC basis where lenders and investors seek a construction contract which is single, turnkey and of a fixed price.’
Musallam believes that this model has worked very well in different aspects of project finance but hydro power projects put significant pressure on the contractors. ‘The construction risks are significant,’ he says, ‘and when these become attached to financial risks the contractor has to undertake to deliver obligations, and it all becomes quite a formidable task.’
‘The EPC contract is all part of the puzzle,’ Monk believes. ‘Don’t just look at it by itself. You need to fit all the pieces of the puzzle about the project and financing agreements together. This is what you need to make the project reach financial closure. No matter how good the project is from a feasibility perspective, or how bad the government needs that power, if the project can’t be financed and paid for it will not get built.’
World bank discussions
According to the World Bank’s discussion paper on Financing Private Hydropower Projects (no 420) there has been a strong move towards EPC contracts in private financing. This contrasts with traditional arrangements where the owner retains control of the design and the project is managed as a series of single-discipline contracts. The paper states: ‘Whereas this makes little difference in the context of an equipment supplier, it has a big impact on the civil works, on the bidding process and on the overall cost of the project, which is generally accepted to be higher under EPC arrangements.’
Patricia Jungreis Sulser from the International Finance Corporation gives a lender’s perspective on hydro power development. ‘Hydro is more complex and capital intensive, particularly the civil works,’ she says. ‘It has a longer construction period which lenders view as the most risky period, and projects need a large number of experts. Hydro is also prone to cost overruns, delays, contractual disputes (mainly due to the sheer number of people involved), and also environmental problems.’
When stepping into a lender’s shoes it becomes clearer that cost overruns and delays trouble them. ‘A lender’s principle security is the power purchase agreement (PPA) which itself has completion deadlines and tariffs which take into account the debt raised and cost of the debt,’ Sulser said. ‘When institutions, like the IFC, get board approval for a project they have a set date when interest payments start and when principle payments start. These dates do not shift. So if there are cost overruns because of delay or performance deficiencies, it is a direct hit to the lender and the equity as well.’
An EPC contract is the preferred model for lenders in the hydro area as it has a single point of liability [the EPC contractor]. Sulser says that should delays arise it eliminates arguments about who caused them. Having a single party co-ordinate the project through a fixed price, turnkey contract is viewed as advantageous by the lenders.
Generally, lenders believe that an EPC contract protects the owner, and thus themselves, from risk. But, as the World Bank discussion paper states: ‘this may not be the case and serious contractual difficulties are occurring with increasing frequency on EPC hydro projects.’
Chris Head from Knight Piesold in the UK believes that the present arrangements for fixed price contracts do not work and are not suitable for most hydro power projects. He said that the industry has to be realistic about such contracts, and the question of design responsibility must be considered seriously.
Head said: ‘If we give the contractor design responsibility against an imprecise project definition with an obligation to design down to a fixed price, then there is the risk that the owner will not get a project which, in the long term, provides high reliability with low maintenance costs.’
International competitive bidding (ICB) can also have a knock-on effect on the EPC contract. If ICB is difficult then it is even more difficult for EPC contracts.
‘I’ve been in the business long enough to come to the belief that you get what you pay for,’ says Head. ‘If we invite contractors to bid time-sure, fixed price contracts on the basis of what is usually an inadequately investigated project, the result is either a gamble or a very high price.
‘The chance of concluding a contract at a sensible price, fair to promoter and contractor, is very slight indeed. I’ve seen a number of fixed price, time-sure contracts which have satisfied neither of these criteria. We have got to be realistic.’
Blaker explained that the purpose of ICB is to minimise costs and avoid suspicion and criticism through a transparent selection process. However, he adds, ICB is not easy.
‘In my experience,’ Blaker says, ‘this can cause delays and cost money. And in some countries, particularly developing ones, this can lead to corruption and bribery.’
An appropriate tool
So when is ICB the appropriate tool to use? Blaker believes when there is an easily defined and specified commodity — but this is not characteristic of hydro. The problem, Blaker says, is that you don’t know what you’re competing with. ‘For example you can discover subsurface conditions as you go and you wouldn’t have known about them in bidding. It’s all guesswork and this is not the best starting point for ICB.’ Guesswork and an unclear hydro selection criteria may lead to the utilisation of other means. ‘And in may cases, paying your way through is often used. I’ve seen it time after time,’ says Blaker.
The bidding process can also lead to costly delays. ‘When you have all the bids you’ll look at the lowest one and probably won’t want it. The bidder may not have the capability or the financial backbone and so you start the process again to avoid him. This takes time and can take up to one year for a large hydro project,’ Blaker says. ‘But this is funny. When you start construction, penalties are there, and you have to pay for each day’s delay. No one thinks about this procedural delay of taking one year to decide who’ll be the civil contractor — but the host country should.’
Money speaks many languages and Blaker estimates that for a 1TWh project the typical cost of a year’s procedural delay amounts to US$100-150M. This is a lot of money that cannot be saved in the project thereafter.
Statkraft’s vice president says that ICB is the right thing to use at the appropriate stage, but it should not be the first thing that is thought of. ‘My view is that sponsors should be chosen by the host country based on their competence and financial strength. Then sponsors should choose the civil contractor, without ICB. And, only when the time is right, should ICB be used for electrical and mechanical equipment suppliers.’
As the World Bank’s discussion paper has stated, EPC contracts often lead to higher overall project costs. Sulser agrees that this is one disadvantage of EPC contracts for project owners. ‘There is padding added to the EPC cost structure,’ she says. ‘The project price might be higher than if you had individual contracts.’
An EPC is attractive to lenders as they want a fixed price contract to reduce risks they have to bear in renowned risky hydro projects. ‘Lenders do not handle risk, they eliminate it,’ says Blaker. ‘Eliminating risk is one of the most expensive things in the world, and risk is always over estimated when it is not known,’ he says. He also believes that the way in which lenders operate today actually leads to more expensive projects. ‘And this could be why there are not more hydro power projects built today.’
Kevin Candee, vice president of Harza Engineering, says that his company has been endeavouring to bring down the cost of projects. ‘We’ve been using a different approach to the EPC method,’ he says. ‘We’ve used second tier contractors who are national companies, less well known, generally involved in smaller projects and often less bankable.’
Candee says that there are clearly difficulties in financing hydro projects. There are admittedly high upfront capital costs and construction risks, but he also believes there is insufficient competition in the bidding process. Harza has tried to open up bidding and make it accessible to a wider selection of contractors, helping to make them more bankable and able to manage the risks they must bear.
Candee spoke about Harza’s experience of working with second tier contractors. In the Upper Bhote Koshi project in Nepal, sponsors for this 41MW project included Panda Energy and Harza of the US and HIPC in Nepal. The location and size of the project meant that it was best suited to a regional contractor. Eight contractors participated in the bidding process and a Chinese company was selected.
To ensure that the budgets were met and a quality project achieved the project sponsors provided very strong management support as the company lacked international experience and reporting skills to both the lender and project managers.
Strong project sponsors
Candee says that from this experience Harza learnt that as the contractor lacked EPC experience the contract needed to be tightened up. The contractor was not used to managing engineers and so it was necessary to specify exactly what was needed to ensure the project was on schedule.
Cultural and language issues also needed clarification and at the beginning of the project difficulties were experienced with travel visas and customs. Candee stressed the fact that the sponsors had to spend time with the contractor to ensure that they understood such issues.
‘It is very important to have strong project sponsors to give support, especially with regional contractors,’ says Candee. ‘The sponsor must understand all aspects of hydro and the contractor must possess all necessary technical skills. From our experience, I would say don’t overlook the first tier contractors but, in smaller projects, smaller contractors do have a lot of capability if you can get them financed.’
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