Coping With Volatility- The New Reality Of EPC Contracts

Engineering, procurement and construction (EPC) firms are operating in an environment of uncertain, complex and ambiguous conditions. They are hit hard by rising commodity prices and cost escalation, exacerbating pressure on margins. The need of the hour is to work transparently and find collaborative solutions to arrive at win-win solutions to manage volatility.

Total installed power generation capacity in India is 403.82 GW, of which 114 GW is renewable energy. India is targeting to achieve an ambitious goal of 500 GW of renewable energy, which culminates to adding 45 GW per annum till 2030. What India needs is a 360-degree integrated approach towards a robust programme implementation framework to address the entire value chain – and a seamless coordination of synchronous actions towards macro-economic, policy and regulatory, and project delivery aspects.

Challenges for EPC Contractors

Project developers face key risks across the value chain, which can jeopardies project completion and leads to deferment of capex. The most vulnerable link in the project implementation value chain is that of the EPC contractors. Most EPC contractors are facing unequal sharing of risks by project developers.

The EPC industry is becoming highly dynamic with external market factors and fragmented, complex industry dynamics affecting the ecosystem. In today’s business and economic environment, volatility in markets, emergence of new technologies and introduction of new regulations are leading to more frequent changes, posing a real challenge in terms of costs, profitability, and performance requirements for EPC contractors.

Headwinds to Project Execution

In the current market scenario in India, the pace of project execution has slowed down due to increase in project cost, a volatile macro-economy and an uncertain regulatory environment. Most EPC contracts haven’t factored in the volatility in commodity prices, rising inflation and crude prices, currency devaluation, rise in logistics cost, supply chain disruptions, and increase in interest rates.

As a result, cash flows of project execution agencies are getting impacted, their execution capabilities are severely affected, and project completion is inordinately affected. Availability of skilled manpower, unpredictable site conditions, unequal sharing of risks in contracts, frequent work stoppages and scope changes, and a lengthy dispute resolution process are the key factors affecting EPC contracts today. Such delays can be catastrophic as they shoot up the project cost, expire the validity of permits and increase the chances of facing environmental and political setbacks.

Risk Assessment

Risk assessment in the present global environment is a pre-requisite for projects dealing with EPC contracting. It is imperative to understand the key risks involved in project execution to ensure the end-goal of the project is not jeopardized.

The use of engineering, procurement and construction management (EPCM) contracts for large infrastructure projects has challenged the risk appetite of stakeholders, forcing them to share more in the risk. With rising material costs, EPC contractors should consider including cost escalation clauses in the projects as well.

Understanding Key Risks

1. Business environment risk

Today, it is important to take into consideration the current business environment across the globe, with rising cost of commodity prices, crude oil, inflation, interest rates, and devaluation of currencies of various countries and supply chain disruption. This is leading to rising logistics cost, poor inter-global business confidence and geo-political crisis, further accentuating business and security risks.

As per the study, ‘IEA’s Roadmap to Net Zero Emissions by 2050’, the demand for silver for solar PV manufacturing could exceed by 30% of total silver production by 2030, up from 10% today. This rapid growth and long lead times for mining projects increases the risk of supply-demand mismatch, leading to cost increases and supply shortages. China plays a dominant role in production of key minerals used in photovoltaics and the industry’s demand for these minerals is set to expand significantly. The Indian government has approved the expansion of financial outlay under the PLI scheme – up from US$ 604.25 million to Rs 3,222.67 million (Rs 24,000 crore).

2. Execution risk

For the successful implementation of renewable energy capacity of 500 GW by 2030, it is indeed significant to understand the ground realities around EPC execution. If not mitigated properly, potential risks associated with EPC execution could create an adverse impact on expected outcomes. Besides normal execution-related challenges, a volatile macro-economic environment and policy-level aspects play a key role in seriously impacting the capability of EPC contractors to deliver the project within set parameters and create an impact on its successful completion.

3. Availability of manpower

As of FY21, the renewable energy sector employs a workforce of 111,400 across various project phases including business development, design, construction and commissioning, and operation and maintenance. To meet our target of 500 GW by 2030, the sector will create about 3.4 million jobs and potentially employ around 1 million people, 10 times more than the existing number. For this, workers will need the competencies and knowledge to respond effectively to shift to greener business practices and to learn the skills required for these projects.

4. Unpredictable site conditions

EPC players face a challenge of unexpected geological strata/ soil conditions, which substantially increases cost and time for civil works for Balance of System (BoS). Also, often proper access roads and accommodation facilities are not available in the vicinity. As EPC contractors lack detailed geo-technical investigations and complete logistics arrangement details at the time of tendering, the cost cannot be factored in at this stage. Hence, the EPC contracts need to provide for this clause to avoid contractors from incurring losses and for overall project delay.

5. Unequal sharing of risks

Equal risk sharing is the key to viability in project execution from the viewpoint of developers and contractors. FIDIC contracts are signed up for asset creation of 25-30 years tenure, and an increase of 5% to 10% in project cost should be absorbed by project developers. Given the lack of this clause, EPC contractors often incur losses. Developing modal EPC contracts is the key for equal risk sharing by stakeholders, facilitating smooth delivery of projects, and protecting the stakeholders’ interests.

6. Work stoppages

Frequent work stoppages at project sites result in additional cost for demobilization and remobilization of workforce and raw material. An extended period of project completion also results in additional overheads. In several cases, the extension of time (EOT) request is considered by developers, but cost escalation claims are often rejected.

7. Changes in scope of work

With rapidly altering technologies and significant changes in the business environment, EPC contractors often face changes in the scope of work. As resources get stuck in a single project for an extended and uncertain period of time, planning and execution of multiple projects creates artificial resource deficiency and results in a cascading impact on projects under execution. Increase in overheads and unwanted delays also lead to cost escalation.

8. External risks

External risks are troubles affecting construction of project from the outside. Delay in payments made to EPC construction partner affects project work to a great extent and results in significant delays. In addition, strikes by unions that supply local raw material locally, lack of access to land, delays in statutory and regulatory approvals, and resource-led issues such as non-availability of drinking water and food facilities at remote locations, non-availability of safe accommodation for labour, and lack of proper road access also impacts completion of EPC projects. Further, lack of digital infrastructure for seamless flow of information and non-completion of power evacuation infrastructure are other key deterrents.

Accelerating Participation in Capacity Increase

There is a need to accelerate the process of creating interest for stakeholders to actively participate in capacity addition. Below are some areas where more work is required:

• Improving financial health of DISCOMs to ensure timely payment to energy suppliers
• Introducing multiple distribution franchise to create competition for service improvement
• Increased penetration of Energy Exchanges to increase free trading of electricity
• Enhanced Grid Stability by promoting reasonable price for creating ancillary sources to deal with power situation
• Strengthening regulators for transparent actions, creating adequate T&D infrastructure to avoid tripping of solar power projects
• Robust planning, monitoring and control to quickly identify the root-cause of non-performance and initiate swift policy action
• T&D infrastructure planning for EV integration
• Ring-fencing of sovereign contracts and PPAs against breach is in progress

The Changing EPC Landscape

The EPC landscape is gradually transforming. As changes in capital projects leads to introduction of risks, causes delays and increases costs, there is a need for strong change management work processes and best practices. The EPC industry is rooting to recognize, plan, evaluate, and implement project changes effectively and efficiently. There is also a definite move towards an efficient EPC project delivery system – one that integrates work processes and collaborates with a single cohesive team from front-end planning through construction.