EPC Turnkey Contracts – Risk or Risk Avoidance?

The correct and official name of the FIDIC Silver Book is „Conditions of Contract for EPC/Turnkey Projects“. This suggests that this is the only and appropriate standard form of contract for EPC/T projects.

However, the abbreviation EPC/T merely connotes that this document is a suitable standard form of contract for such purposes. But it is far away from meaning that it is the only one. In fact also the FIDIC Yellow Book (Conditions of Contract for Design & Build) may perfectly serve as EPC/T contract. Why?

1. The Term “Turnkey”

In former times the term turnkey was conceived as meaningless. In Cable (1956) Ltd v. Hutcherson Bros Ltd [1969] HCA 37; (1969) 123 CLR 143 his Honour Barwick CJ said on behlaf of the High Court of Australia as to the expression “ turnkey ”:

Nothing can be made, in my opinion, off the use of the word “ turnkey ”. It is not a term of art and, even if it could be taken to mean that the works must be handed over as a going concern, I would not have thought that in the context of these articles the word or expression meant that the builder warranted the efficacy of the works he had agreed to erect.

As observed much later by the HHJ Bleby on behalf of the Supreme Court of South Australia in ALSTOM LTD v. YOKOGAWA AUSTRALIA PTY LTD & ANOR (No 7) [2012] SASC 49 design and build contracts have become increasingly common in the last few decades, before which they were comparatively rarely used for building or traditional civil engineering projects in the UK and Commonwealth. Their earliest use was for contracts with a high mechanical content, such as industrial plant and machinery contracts. They appear to have emerged rather earlier in the construction field in the US. In the 10th edn of Hudson in 1970, they were referred to in the traditional construction context as “package deal” contracts, … The more modern UK description “design-and-build” is in fact the most useful and least misleading description, but the American oil industry description “ turnkey ”, originally used for industrial plant projects such as refineries, is still widely used at the present day, particularly in the international field. The expressions “ turnkey ” and “design-and-build” can now be said to be synonymous, while the expression “package deal” has largely disappeared. …

In these contracts the essential feature is that the Employer does not employ their own professional advisers to produce the complete or final design of the building or project which they require. Either by negotiation, or by outline specification to tendering contractors, the Employer makes known their requirements and the Contractor then produces the design, in the form of drawings, a specification and sometimes schedules of rates to cover possible variations.

It can also be said that EPCT means or includes the supply and installation of equipment to the point where the customer could use it by the turn of a key (as confirmd by HHJ R. Foster in the English case Whitecap Leisure Ltd v. John H Rundle Ltd & Anor [2007] EWHC 1352 (QB) (13 June 2007). Such a contract would for example be for the Design, Procurement, Management and Execution of the works on a  turnkey  basis incorporating a total responsibility for all aspects of the function of the completed buildings …. for a … Price.

2. The FIDIC Approach

The FIDIC Yellow Book is the natural born design & build contract. The concept of engineering, procurement, construction and supply of a plant ready for operation (turn key) can be easily and properly achieved through a Yellow Book contract or other balanced design & build contract like the former FIDIC Conditions of Contract for Electrical and Mechanical Woks (3rd Edition) 1987 (see Rolls-Royce New Zealand Ltd v. Carter Holt Harvey Ltd [2004] NZCA 97; [2005] 1 NZLR 324 (23 June 2004), since a design & build contract obtains the nature of an EPC/T contract not by reference to general conditions of contract rather through an extended and broader scope of the Works which includes for instance the supply of equipment, staff and personnel and consumables. Under FIDIC 1999 the appropriate document for the definition of that objective are the Employer´s Requirements which under both contract forms are aimed at the definition of the Works. However, if the Employer and the Contractor intend to agree on a more (in general terms) one sided risk allocation they may do so by using the FIDIC Silver Book. Whether it is wise to do so may depend on a variety of things.

The following test may help:

1. Is the Contractor going to do most of the design? if yes, it is appropriate to use a design & build contract form.
2. Are funds from a bank or funding institution involved? If so, they may require more price certainty.
3. Are Works involved where the Employer wishes to implement the project on more or less fixed price basis? If so, then the FIDIC Silver Book may be suitable, regardless of whether a power plant, a process plant, infrastrcure works or buildings works are involved.

However, albeit FIDIC recommends the aformentioned test in order to facilitate the selection of the appropriate FIDIC Book (see FIDIC Contracts Guide, 6 et seq.), Employers should be reluctant to  make a premature decision in favour of the FIDIC Silver Book. FIDIC also expressly warns Employers that the FIDIC Silver Book should not be used (1) by unexperienced employers, (2) if there is insufficient time for the preparation of the tender documents, and (3) if the project involves major unforeseen risk.

3. Risk Allocation

Anyway some believe that the inimitable advantage in using the FIDIC Silver Book (EPCT) is that all risk will be borne by the Contractor in consideration of the following disadvantages:

• The Contractor will price for the assumed risk
• The Contract Price will be higher than under other FIDIC forms of contract
• Where there is a substantial amount of underground works,
  • few or no bids will be submitted and
  • bids submitted will be qualified
• Employer has little control over the quality of construction
• The risk of latent defects and escalating maintenance costs increases

These conclusions and/or observations are then used as an argument which employers are likely to overemphasize inducing them to rely on the FIDIC Silver Book (EPCT) in order to take full advantage.

However such premature observations and conclusions are suited to result in considerable losses for both contracting parties. A more sophisticated analysis shows that under the design & build contracts and in particular under EPC/T contracts incorporating the FIDIC Silver Book

• employers bear the responsibility to anticipate what they intend to have. Shortages in the definition of the Works including the definition of the project purpose, an outline design, additional functional requirements and testing specifications may result in extremely high additional costs. The reason for this is that the valuation of Variations will be done in a contractual matrix. which means that in the adjustment of the Contract Price allowance for the absorption of risk shall be made as if the Contractor had anticipated the Variation in the Accepted Contract Amount.
• the definition of the Works including the definition of the project purpose, an outline design, additional functional requirements and testing specifications must be coherent and consistent
• the definition of the purpose of the Works as such should include elements which pre-determine use, quality, maintenance and running costs of the Works which requires experienced and skilled designers
• trust in the reliability, capacities and skills of the contractor as a corner element of design & build contracts and that employers have very little control over daily activities
• suitable control over daily activities requires great skill and care of supervising staff in order to avoid accidental Variations and a negative impact on quality and the specified outcome
• a one sided risk allocation in standard terms of contract sounds good but does not at all replace an extensive and diligent risk assessment in that only by means of a project related risk assessment it is possible to allocate the risk appropriately to the parties
• the reference to the Contract Price still implies the likelihood of claims and Variations which may increase the Contract Price

Special attention requires the issue of what “substantial completion” means under a turnkey contract. The extended scope of the Works may require that:

1. the facility has achieved mechanical completion
2. the facility has achieved first industrial production
3. the contractor has completed the performance guarantee test
4. the production output is equal to or greater than 95% of the guaranteed production output
5. the facility is ready for operation (all Equipment and personnel is available

The Employer may also wish to turn its attention to the fact that the current FIDIC forms of contract assume a greenfield scenario (brand new facility or plant) rather than a brownfield scenario (refurbsuihmanet and/or enhancement of an existing faicilty or plant). Thus, particular amendments taking account of the brownfield characteristics may be required.

On the other Hand it is true that the FIDIC Silver Book allocates much more risk to contractors than the FIDIC Yellow Book does. But what does that mean?

• The Contractor is not protected against errors in the Employers Requirements of which he becomes aware of contract award (see Sub-Clauses 1.9, 5.1)
• The Contractor is not protected against Unforeseeable adverse physical conditions at the Site (see Sub-Clause 4.12)
• The Contractor is not protected against exceptional adverse climatic conditions (see Sub-Clause 8.4)
• The Contractor is not protected against Unforeseeable shortages in the availability of personnel or Goods caused by epedemic or governmental actions (see Sub-Clause 8.4)
• The Contractor bears more typical Employer´s Risk as referred to in Sub-Clause 17.3

In turn the Employer still bears all risk which is listed in Sub-Clause 5.1 Silver Book. Thus, for instance any error as to the purpose of the Works or testing requirements constitutes an Enployer´s Risk.

4. Individual Assessment Required

In any case, the above observations remain completely academic if and to the extent that risk is involved which FIDIC did not look at because it is very much project related and thus not of a type or nature suggesting that it should be dealt with in standard terms and conditions. Examples of such risk may be special weather risk in off-shore projects, untested materials and working methods in new branches of the industry, missing best practice as to new working methods, works under fire, special climatic conditions requiring to review tested and recognized practice, etc. The availability of Goods and Materials may be fundamental issue which requires specific care and additional consideration, if major items are likely to constitute a problem or if huge quantities are involved.

It is for instance defintely not the substantial amount of underground works which entails weak competition. Rather it is the missing information and Unforeseeability of the ground conditions which increases the need for risk allowance in the bids or qualifications. This clearly shows that design & build procurement is definitely not the cheapest and easiest way of procurement. Rather it may mobilize synergy and innovational powers. This may include saving of time but not necessarily.

Once the FIDIC Silver Book is in place and constitutes the law of the parties for the design and build of the Works the same applies as to all other FIDIC Books. Both parties should strictly follow all the procedures in respect of approvals, notices, certificates, determinations, etc. A good command of the contract is required and an ability and skills to apply the rules as well. Also the FIDIC Silver Book does not allow or excuse breach of contract. In most cases the contract in itself provides for remedies. The use of a standing DAB may help to set out incentives for a proper contract administration. The Employer´s Representative should not believe that his role is less challengeing than the role of the Engineer or that the FIDIC Book does allow much more discretion than the Engineer may exercise under the FIDIC Yellow Book. The extreme opposite is correct.

5. Practice

It is true that the FIDIC Silver Book is a tested and good product. However, it requires great skill and care form both parties in order to achieve a succesful result. It is not an universal remedy or magic bullet against cost and time overrun. It is an instrument which may -if properly used- achieve very good results. Inproper use and inappropriate modifications will result in disputes.

The aformentioned authority ALSTOM LTD v. YOKOGAWA AUSTRALIA PTY LTD & ANOR (No 7) [2012] SASC 49 from Australia involved a Major contract for the refurbishment of a coal fired power plant at Port Augusta. It clearly demonstrates the extreme risk which is inherent in the turnkey approach. In this case the Court found considerable evidence in relation to problems associated with coal mills, the absence of separator plates, the fineness of the grind and the claim by Alstom (the turnkey contractor) that the problems it encountered with running the plant, particularly at high loads, was a consequence of the mills which had been excluded from its scope of Works. In respect of Alstom´s argument that its failure to perform was attributable to these Problems the Court took the view that the … contract did not limit the liability of Alstom either expressly or by necessary implication in the event that works which were excluded from the Technical Specification inhibited Alstom’s performance. Rather it found that Alstom’s “Works” or its “Scope of Works” were functionally defined, performance based, and required Alstom to produce a particular result within a specified time. Therefore the Court concluded that the head contract was undoubtedly a  turnkey  contract.

In Sedgman South Africa (Pty) Ltd & Others v. Discovery Copper Botswana (Pty) Ltd the Supreme Court of Queensland His Honour Justice Philip McMurdo dismissed Sedgman Limited’s (Sedgman) (the Contractor) application for an interim payment in the sum of USD20,027,470.07 and awarded costs in favour of DML.  His Honour Justice Philip McMurdo was required to interpret certain provisions of the Engineering Procurement & Construction form of contract of the International Federation of Consulting Engineers (Fédération Internationale des Ingenieurs-Conseils), abbreviated FIDIC, also referred to as the FIDIC Silver Book Contract, entered into between the parties in May 2010.

Sedgman entered into a EPC/Turnkey Projects contract incorporating modified FIDIC Conditions of Contract for EPCT, referred to as the FIDIC Silver Book, with Discovery for the design and construction of the Boseto Copper Project in Botswana. Sedgman claimed that it was entitled to an interim payment of USD$20,027,470.07. Sedgman made its application for the payment in accordance with the bespoke Sub-Clause 14.6. This clause required the employer to give the contractor notice of any items in the Statement with which the Employer disagrees, together with supporting particulars, within seven days after receiving the Statement. Discovery failed to do this within seven days from 22 August 2012, but it did give notice of its disagreement with the Statement by a letter to the applicants dated 5 September 2012. It then disputed most of the components of Sedgman’s claim and maintained that it was entitled a contractual set-off against the balance.

Another EPC Engineering Procurement and Construction contract incorporating the FIDIC Silver Book 1999 Edition was for the development of the King Shaka International Airport in South Africa (see Avenge (Africa) Ltd and Others v. Dube Tradeport and Others (1482/2007) [2008] ZAKZHC 80 (26 September 2008). However in this case the Court was not required to construe particular FIDIC clauses. Rather it involved a request in respect of the production of documents.

A further contract for the design, construction and commissioning of a Plant (“Turnkey  Contract”) is reported from New Zealand which comprised two sections, a boiler and a turbine Generator (see Rolls-Royce New Zealand Ltd v. Carter Holt Harvey Ltd [2004] NZCA 97; [2005] 1 NZLR 324 (23 June 2004)). The  Turnkey  Contract had as its general conditions (GCC) the FIDIC (Federation Internationale des Ingenieurs-Conseils) Conditions of Contract for Electrical and Mechanical Works (including Erection on Site) (3rd Edition) (1987). The Dispute involved issues with regard to the duty of care owed by the turnkey contractor and a related disclaimer clause. Under the contract Rolls-Royce acknowledged the turnkey nature of contract and agreed to provide a fully operational plant that met the specification and would be suitable for its intended purpose.

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Dr. Hök has been involved in EPC turnkey Projects worldwide, in particular in the power section and in respect of process plants. He has been a friendly reviewer of the FIDIC Gold Book and he is the legal advisor of TG 11 (Operate Design and Build) also referred to as the FIDIC Bronce Book. He has operated as a member of DABs for design and build contracts in the offshore windmill industry, harbor projects, wastewater and irrigation projects.

WARNING: the material contained in these notes is a simplified guide to some of the major topics in international and German construction law. It is not intended as a substitute for legal advice on individual transactions, and does not necessarily stand on its own. Whilst the contents are believed to be correct, the authors cannot accept any responsibility for errors or omissions.