After a long period of relative stability, we’re seeing market conditions — in all industries — that are more volatile than any experienced in decades. Commodities and materials are in short supply, causing prices to fluctuate by 40% or more. Fuel prices are skyrocketing, and we’re seeing continued shortages of craft and trades needed on construction sites.
These conditions are resulting in escalation clauses in equipment manufacturer pricing, and validity dates for bids are growing shorter than anticipated.
For owners in the electric power industry, these market conditions make it more important than ever to choose the right contracting strategy and delivery method. Cost, schedule and owner participation are only a few of the factors that must be weighed. Fortunately, there are several contracting options that can help owners address novel market forces in play today.
Allocating Risk and Defining Success
Selecting the right contracting strategy is always a matter of evaluating risk in the context of who does what and when. When thinking about risk management, one must always revert to a core principle: Risk should be allocated to the contracting party most able to handle that risk.
The owner always has the final call in selecting a contracting approach that offers the most appropriate risk profile, given the goals and objectives of the project. Successful project outcomes are more likely if risk is properly allocated and assigned to the entity most able to control that risk, again keeping the core principle of risk management at the forefront.
While risk is top of mind for both owners and contractors, it is equally important to properly define what makes for a successful project. A few key questions must be weighed:
- Are cost control and budget certainty the biggest drivers of project success? This may be the case if there are constraints on cash flow, fixed price offtake agreement or stringent financing requirements.
- Is schedule the most important criteria? Does the power plant or facility upgrade need to be completed by a certain date to meet an urgent business need?
- What about quality? Is it worth adding a little extra to the budget or taking more time to be sure all equipment and systems perform correctly during commissioning and startup? Quality control is like an insurance policy, guarding against the need to fix issues on the back end that should have been detected earlier.
In these volatile conditions, defining success and assessing risk are more important than ever. Given these questions it may be helpful to review the relative merits of traditional contracting approaches, like design-bid-build (DBB) and lump sum versus newer alternative contracting methods like open-book engineer-procure-construct (EPC).
DBB Delivers Some Advantages
DBB has traditionally been considered the primary method if the project goals are focused on providing the most defined bid specifications and drawings to the contractors and selecting the lowest bids for contractors, materials and equipment. However, this method often involves a protracted bidding process that results in longer schedules.
Under DBB, engineering design must be substantially complete before drawings go to the construction contractor, who only then is able to develop an estimate of pricing for materials, commodities and equipment. With both engineering and construction teams working in a vacuum with little interaction, the process creates risks of not meeting budgetary constraints set by the owner. In addition, there may be potential scope gaps between the various entities while opportunities for early cost certainty may be reduced. Delays also are common if redesign and rebidding are required. In summary, owners hold the largest share of budget, schedule and interface risk under the DBB method as allocating risk to third parties can be difficult because only the owner can see or control the entire project process.
Lump Sum Contracting Addresses Some Owner Risk
Lump sum contracting has gained some traction because the schedule, budget and interface risks are shifted to the contractor, in return for the potential to pocket any savings for a final project cost that comes in below the contractual lump sum price.
Owners have the least control and influence over design and execution under the lump sum method. Additionally, this method results in a longer schedule from project inception to substantial completion because of the time required to define scope. But this may be the correct approach if the project is well-defined and the schedule can be executed comfortably within target deadlines.
Since contractors shoulder a larger share of risk under the lump sum method, today’s volatile conditions can create uncertainty and hesitation to agree to work under these terms. Subcontractors — who tend to be cashflow limited — are mostly unwilling under current conditions to provide long validity periods in which they will stand behind bids. Similarly, equipment manufacturers are less willing or even unable to provide guarantees on equipment pricing and lead times for delivery. Combine these factors with a tight labor market, and it can become problematic for contractors to work under the parameters of a lump sum contract. In some cases, it may result in risk money being added, making the project uneconomical for the owner.
A Collaborative EPC Approach Addresses Volatility and Uncertainty
Whether you call it open-book EPC, collaborative EPC, progressive EPC or something else entirely, EPC contracts emphasize close collaboration between owners, contractors and subcontractors as a means of risk sharing, cost savings and schedule certainty. This can be particularly advantageous when the owner has strict budget or schedule constraints.
Unlike the lump sum method, in which project cost savings only flow to the EPC contractor, the open-book process emphasizes shared cost savings that benefit all parties.
Under this method, a primary contractor is selected, but the owner then remains closely involved in scoping and all decisions related to the project. It is a partnership defined by transparency as the owner and contractor jointly develop an execution approach; engage in constructability reviews; select materials, equipment and subcontractors; and collaborate on all other aspects of project management. The owner can view line-item pricing as it is firmed and realize the potential cost savings immediately.
Additionally, there are schedule benefits to this approach as the EPC contractor starts immediately after selection to develop engineering needed to clearly define the project. This eliminates the need for lengthy requests for proposals (RFPs) from subcontractors or original equipment manufacturers (OEMs). The owner will see in real time the cost of the scope decisions that are made, creating more flexibility to make decisions quickly based on accurate assessments of whether the cost of a particular design element is justified by the scope of the overall project.
Keeping risk management at the forefront, this process allows for risks to be allocated as the project progresses and not at the beginning before the project is well defined. For example, in this approach the owner can take on procurement of certain items or ask an integrated EPC contractor to take on those responsibilities, based on the real-time needs of the project and not an assumed risk profile that could cause additional contingency to be added to a job.
While this approach may ultimately place some of the risk back on the owner, regardless of scope definition, it is commonly the case that price competitiveness still is achieved when subcontractor or OEM bids are compared with estimates derived under this collaborative process. With this approach, unlike in a lump sum agreement, the owner retains the potential of recouping some of the contingency not spent on the project, resulting in an economically efficient delivery method for all parties.
Reciprocating engine projects can be surprisingly complex. An EPC contracting framework can help minimize potential risks by leveraging preliminary engineering to refine scope and zero in on costs and specifications.