EPC contracts and NEC

NEC has recently published a practice note explaining how the NEC4 Engineering and Construction Contract (ECC) can be adapted for use as an engineering, procurement and construction contract (EPC) contract.

The practice note, EPC contracts and NEC, is available as a free download from NEC's website.

EPC contracts are used in major infrastructure projects all over the world. Key factors in choice of form for this type of project typically include party preference, project type and funder/sponsor views. Common standard forms used for EPC contracts tend to include traditional forms of construction contracts such as FIDIC, ICC, IChemE for processing plants, LOGIC or CRINE for oil and gas and often bespoke arrangements for complex projects such as on-shore and off-shore wind. For more information on EPC projects, see PLC practice note, "Engineer, procure and construct (EPC) contracts: key issues".

It has been clear for some time that NEC, as a globally recognised standard form, endorsed across Asia-Pacific, and regularly used in major infrastructure projects is an obvious contender for use in such projects particularly with its focus on collaboration and proactive management of programme. For further discussion, see "Wind of change - is NEC the future for wind projects in APeC?".

However, for these significant undertakings, parties tend to stick to what they know and so the uptake of NEC, the relative newcomer, has been slow although steady. It is therefore good to see NEC proactively making the case for the use of the NEC suite on these types of projects.

This article takes a closer look at the reasons advanced by NEC for why it is well suited to EPC projects.

Key features

Turnkey

EPC contracts are turnkey in nature: the contractor is responsible for designing, constructing, completing, testing and then handing over the project in a completed state. NEC explains that the ECC can be structured as a turnkey contract through selection of appropriate pricing options, secondary options and use of Z clauses.

For more information on using NEC4 ECC, see PLC practice note, "NEC4: Using and amending the Engineering and Construction Contract".

Risk allocation and collaborative risk management

A key characteristic of EPC contracts is that risk sits (largely) with the contractor.

NEC explains that the ECC can be structured to place risk on the contractor through use of pricing and secondary options and appropriately selected compensation events. For example, parties can select either Option A (Priced contract with Activity Schedule, in simple terms a fixed price lump sum option) or Option C (Target contract with Activity Schedule). Secondary Options can be utilised to further help the client allocate risk to the contractor under an EPC arrangement, including for example for inflation (Option X1) or changes in law (Option X2). If greater risk transfer is required, the ECC can be amended through the use of Option Z clauses.

A key advantage of the ECC is that it is a project management tool with its focus on programme obligations and pro-active risk management, with early warning systems and swift resolution of client risk events with time and/or cost impacts. The benefits of this approach are obvious for EPC projects, as they tend to involve complex engineering and such procedures will help delivery of the asset on time and better costs control.

It should be noted that most funds and sponsors will not be familiar with the NEC forms, especially with Option C which does not provide the certainty of a lump sum price commonly used for EPC contracts. They may therefore still prefer the currently used standard forms with their focus on clear delineation of risk, liabilities and responsibilities offering a high degree of price certainty. The added certainty on price however often results in contractors including a substantial risk premium or even an unwillingness to accept such a high level of risk, which has resulted in clients looking for alternatives to the traditional way of procuring EPC contracts.

Design allocation

Under an EPC contract the contractor typically assumes full responsibility for design. NEC confirms that this approach is possible under the ECC, by using the Scope to identify the level of the contractor's design responsibility. Unless Option X22 is utilised, design-related proposals accepted by the client are binding on the contractor and cannot be amended without a Project Manager instruction.

The detail of design submission defines the level of involvement a client wishes to have in the design process and relevant timescales need to be provided in the Scope. The contractor can change submissions made during the contract, but they must continue to meet the client's requirements. Any submitted design remains the responsibility of the contractor and it is also liable for any failure, despite acceptance by the project manager.

Testing and commissioning

Another core feature of an EPC contract is the requirement for the contractor to prove the reliability and performance of the plant and equipment, particularly where the project is funded through project financing. This is because the lender's security is largely dependent on the ability of the complete facility to operate and generate revenue.

When selecting a standard form contract to use in EPC procurement, provisions relating to testing, commissioning and handing over the works and how this is to be undertaken are very important. It is also critical not only for the project to be delivered within time and cost restraints but also to be capable of meeting the specified performance parameters, which may include production and output levels. This will often involve factory testing by a supplier, as well as a series of pre and post completion tests designed to ensure the project is capable of achieving the desired outcomes.

The ECC provides for testing and inspection requirements to be set out in the Scope. This allows the client to incorporate performance tests and any specific requirements under an EPC arrangement. Performance can also be linked to secondary Option X17 Low Performance Damages, which provides for a reduction in payment if the work does not achieve the required performance standards.

Payment

Payment under EPC contracts is typically lump sum and will be subject to adjustments in very limited circumstances for example, client breach or client driven variations.

The wide variety of payment options that the NEC suite offers means that the ECC can accommodate the EPC payment model, for example, lump sum payments can be made using ECC, Option A. Here, the client can specify the schedule of activities as the basis for payment and payment is made for each completed activity.

Alternatively, Option C can be used in order to share the construction cost risk, which may be a suitable solution for highly complex projects carrying unusual risks where a lump sum approach may not represent value for money. Under Option C, the contractor is paid the cost of the work carried out, together with a fee, with any saving or overspend against the target being shared with the client following completion.

Selection of contractor

Selecting an EPC contractor will depend on the particular requirements of the project and unlike the core features of EPC contracting mentioned above there is no singular way of doing this.

NEC addresses this topic in its practice note explaining that the ECC form offers the client various routes for contractor selection including:

• Single stage tender - where the contractor is selected to carry out the work based on responses to a tender advertised by the client.
• Multi-stage tender - where the contractor is selected in stages for the carrying out of works. Using the example of two-stage procurement, at the first stage, tenderers bid in competition in respect of preliminaries, overheads and profit on the basis of initial design information. The second stage involves the submission of a lump sum price for the works based on full information. This process tends to be used in a buoyant market where the contractor is in a strong bargaining position. It requires strong management by the client to ensure that costs are controlled during the pre-construction stage and that the negotiated lump sum price remains competitive.
• Early contractor involvement (ECI) (Option X22) – here the parties contract on a two-stage basis (Stage One (pre-construction phase): scope and design development and agreement of price and Stage Two (Construction phase): design finalisation and development delivery).

By appointing the contractor at an early stage of the project, they can contribute to the design development and planning process and add value in areas such as buildability, logistics, programming and sequencing of works, procurement of key trades and so on.

It is seen as a powerful tool to facilitate collaboration and partnering among the key team members responsible for delivery of the project. It is similar in many respects to the two-stage tender process described above although some details of the arrangements (covering, for example, matters such as payment) are treated differently. For more information on Option X22, see "NEC4: 2020 amendments".

For more information generally on two-stage tendering, see PLC practice note, "What is two-stage tendering?".

Time

A key concept of EPC projects is that the project is delivered on time so that the asset can start operating and generating revenue, which will often be part of the funding arrangements.

A core reason parties opt for NEC on major infrastructure projects is because the ECC includes project management tools with its emphasis on proactive managing of the programme and proactive tracking of progress allowing the Employer to monitor delivery; and troubleshooting potential issues before they arise by using early warning notices.

NEC explains that the ECC can be adapted to accommodate the more "hands off" approach of EPC contracting. While the programme is under the control of the contractor, the client will have, through regular updates to the programme, a clear view of the contractor's progress and any issues affecting the project, allowing the client to take action where necessary. The frequency of updates is determined by the client based on its required level of involvement in the project.

Flexibility for different scenarios

NEC recognises that for some projects variations on the EPC contract will be appropriate and its practice note considers how the NEC suite could be adapted for such use in the following two scenarios.

Contractor to design, build and operate asset

EPC contracts do not normally extend to the operational stage. However, if the contractor is required to operate the asset, then rather than adapt the ECC and use a term service contract for the operational phase, NEC recommends the use of the NEC4 Design, Build and Operate form of contract (DBO).

The DBO provides for the appointment of a single contractor to design, build and operate or maintain a client's asset over a defined service period. It can also be used where a client wants to have an existing asset operated by the contractor while it is being upgraded or extended.

As with the ECC, the DBO allows the client to create any price-based or cost-based payment strategy according to the selection of options. A performance table is used to incentivise the contractor to achieve or better the targets set for the operational requirements.

For more information on NEC4 DBO, see PLC practice note, "NEC4 Design Build and Operate Contract".

Engineering, procurement and construction management (EPCM)

In recent years, various factors including the intricacy of infrastructure projects and commodity prices have led to the rise of EPCM contracting.

EPCM contracting is different from the turnkey EPC contracting approach. Here, the EPCM contractor does not build but rather manages the project and the client lets work packages directly. Broadly speaking the client retains the cost and programme risk. This type of procurement route requires significant project management as the client enters into multiple construction contracts (instead of one EPC contract), although it may be a way to reduce costs (by avoiding an EPC contractor's risk premium and tendering each element of the works) and enable more agile programming of works.

It is common in the mining industry and is also used from time to time in other sectors for example, petrochemicals, power and desalination where an EPC procurement route is not an option for one reason or another.

When adopting an EPCM route, NEC explains that the EPCM contractor would normally be appointed under a NEC4 Professional Service Contract (PSC) on a priced, target or reimbursable cost basis, with key performance indicators (KPIs) to motivate and reward meeting the client's objectives.

As regards appointing the various suppliers, the supplier providing the design element would typically be appointed under a PSC while the suppliers constructing the project would be appointed under either the ECC or the NEC4 Engineering and Construction Short Contract (ECSC). Pricing and secondary options can be tailored to each contract.

The success of EPCM depends on the co-ordination of the parties and NEC's emphasis on collaboration makes the NEC suite well suited to this form of contracting. NEC highlights that the use of Option X12 multiparty collaboration in complex contracts further encourages all engaged on the project to collaborate for a shared benefit.

For more information on EPCM contracting, see PLC practice note, "Engineer, procure and construct (EPC) contracts: key issues: EPCM contracting model".

Final thoughts

It is clear that the NEC suite can be tailored to the demands of an EPC or even an EPCO or EPCM project with appropriate use of pricing options and secondary options. NEC's focus on proactive project management and collaboration is a benefit for the handling and procurement of a complex infrastructure project. However, the uptake of NEC in this area will be influenced by the willingness of those carrying out the projects, and their funders and sponsors in particular, to use a form that they are less familiar with or stick with tried and tested contracts. It is hoped that the benefits of the NEC4 forms of contract will be evident when looking at procuring complex infrastructure projects where the traditional complete risk transfer to a contractor based on a firm lump sum price is less suitable.

---

A version of this article was published in PLC Construction on 8 November 2023.

This article was co-authored by trainee solicitor, Kristiya Navushtanova.