May 8, 2018

PM0018 [Contracts Management in Projects] Set1 Q2

Question 2. Describe the characteristics and legal issues of Lump-Sum Turn Key type (LSTK) contract.

Ans:

Lump-sum contracts (also called Lump-sum fixed price or Fixed price contracts)

In a lump-sum or fixed price contract, the prime contractor agrees to complete the project, as described in the contract documents, for a fixed price. For firm fixed-price contracts, once a contract is in place the contractor is responsible for any cost-overruns. In this case, the buyer is responsible for providing a complete definition of what is required and schedule for delivery. The price provided by the seller is going to include an estimate of its costs and its profit. If the seller’s costs are less than the costs included in its fixed price, the seller earns additional profit. If the seller’s costs are more than the costs included in its fixed price, the seller earns less profit.

Fixed-price contracts are adopted and are effective when the scope of work is well-defined. Fixed-price contracts shift at least some of the uncertainty associated with a project to the contractor. The evident advantage of a Fixed-price contract is that it encourages efficiency in the contractor’s work since the level of profit realized depends on a contractor’s ability to control costs. Fixed-price contracts are among the easiest to administer if change orders are not required. However, they can result in relatively inflexible project activities, with significant institutional disincentives to modifying activities once work has commenced as per the contract.

Variations of Fixed price contracts:
Other forms of fixed-price contracts allow variances or change orders if conditions are significantly different from what the original statement of work described. The example of the latter variety is a fixed price contract having some items of work having a fixed price per unit of these items. For these items, the price per unit is fixed, but their sub-total cost will depend of the number of units of work that get built. A portion of the fixed price applied for items of work that cannot be quantified in the beginning can adopt this mode of Unit prices. This is discussed later in this section under the heading ‘Unit Price Contracts’.

Another variation is that if a project has a long duration, the fixed price contract might include an allowance for future labor and material escalation costs. Escalation provisions for labor and materials costs are frequently tied to relevant indices that are published by the federal government. Some public sector undertakings in India (e.g. Nuclear Power Corporation of India Ltd.) allow escalations for projects having a completion period of longer than twelve (12) months, and do not allow escalation if the period is less than twelve months. It must be noted here that theoretically, the escalation can result in either an increase in the fixed price or a decrease in the fixed price depending on how the indices vary.

EPC contracts:
EPC refers to Engineer, Procure and Construct, which implies that the three scope elements which we discussed earlier in this section viz. design, procurement and construction are in the EPC contractor’s scope. D-B contracts have the nature of EPC contracts except that financing is invariably involved for the contractor in the case of EPC contract. Also EPC contracts are usually of the Lump-Sum Turn Key type (LSTK).

Lump-sum turnkey (LSTK) EPC contracting is now popular world-wide as a project delivery system for large process and power facilities. Examples are steel mills, LNG facilities, petroleum and petrochemical facilities, power plants. It is also being adopted for large infrastructure developments such as airports, water treatment facilities and telecommunication systems. While the term LSTK implies a fixed price for the whole contract, one must understand that several variations of the EPC mode of contracting are in vogue. The contract price issue can however vary from ‘fixed price’ to a ‘hybrid price’.

LSTK EPC contracts offer the following benefits:
  • It meets the primary expectation of the owner which is that the owner looks to the EPC contractor as a single point of responsibility (SPR) for all facets of the project from basic design through commissioning and start-up. The project owner has therefore preferred to transfer more risk to the EPC contractor, understanding that this risk allocation carries a higher price tag. Examples of some risks which are handled by owner even in a D-B contract, but are transferred to the contractor in a EPC contract are:
          - Contractor should account for existing site conditions (including sub-surface conditions).
          - Even risk for some force-majeure conditions can be transferred to contractor.
  • If the scope of the contract is well defined, the potential for significant changes is very low. Without the risk of significant changes, the schedule for performing the work is unlikely to change. In this case, a fixed-price contract is usually the best approach. Most standard materials are procured using a fixed-price contract approach since the scope of work and the schedule objectives are easy to define.
If the design of engineered materials can be finalized prior to the need of acquiring them, they can also be procured using a fixed-price approach. Engineering equipment could also be acquired using a fixed- price contract if it is possible to articulate sufficient performance objectives for the project.

The drawbacks of the LSTK EPC contract are as under:
  • It provides less incentive for a contractor to minimize schedule duration than is the case for reimbursable contracts. In addition, fixed-price suppliers and contractors often minimize quality management activities in order to reduce costs, which can result in quality problems. Therefore, the project manager needs to maintain close oversight during the project.
  • Renegotiations of the price might come into play since fixed-price contractors are reluctant to proceed with any work associated with a change request before resolving the cost of the change. These negotiations might have a negative impact on the schedule of the project.

Characteristics and legal issues of LSTK EPC contracts:
We now review a few of the noteworthy characteristics and legal issues concerned with LSTK EPC contracts, the understanding of which is necessary in order to reap the benefits that this project delivery system can provide:
  • Design
In a LSTK EPC contract, the responsibility for basic and detailed design rests with the contractor. Owner gives the design criteria and contractor gives his price based on his basic and detailed design, which in turn are based on owner’s design criteria. In practice, the design criteria can vary from generic through broad to very detailed. If owner gives very clear design criteria, he becomes responsible for design deficiencies. If owner’s design criteria are ambiguous, then the contractor should clarify this ambiguity prior to submitting his price.
If the design criteria are critical to the project, he should ensure that it is made part of the contract. Otherwise, different interpretations of the design criteria by owner and contractor can lead to disputes affecting both the schedule and cost of the project. This can only be prevented by pre-contract negotiations, scope review and clarification sessions, agreement on preliminary P & I d s (Process and Instrumentation diagrams) and design drafts. Such pre-contract discussions should not be restricted to project personnel only, but should include end users of the project like operation personnel.
  • Changes or Variations
Even when design criteria are clear, EPC contracts allow for variations (see note on FIDIC in this section). The impact that a change will have on the project will depend on the timing of the change e.g. a change in the P & I d at the design stage will have less adverse impact than at the construction stage. This means that changes should be addressed early.
  • Schedule delay
Owner regards schedule as contractor’s responsibility in a LSTK EPC contract. However, for the owner to claim compensation for schedule delay from the contractor, he must prove that the contractor delayed a work on the critical path of the schedule. Similarly, the contractor will have to keep producing a time-impact analysis of each delay throughout the course of the project in order to claim the right to be given an extension in the project completion schedule as well as any financial compensation he may desire from the owner.
  • Force majeure
These are occurrences beyond the control of either owner or contractor e.g. war, terrorism, labor strikes, radiation, changes in the law, natural catastrophes. However, precise terms regarding force majeure conditions also need to be included in the contract. These terms should also address whether only time extension will be given for occurrence of such events or whether financial compensation will also be allowed.
  • Owner controlled activities
Notwithstanding the single point responsibility to be owned by the LSTK EPC contractor, the owner is also responsible for his actions, some of which are:
  • Adequate site access
  • Assurance that basic design issues are addressed. This is usually handled by the protocol of owner formally affixing his signature on the basic design document prepared by the contractor conveying owner’s formal approval of the same
  • Facilities for commissioning like raw material feed, water, power and other utilities as applicable which are usually in owner’s scope.
  • Payment and performance assurances
EPC contractor is invariably bound for performance by a Bank guarantee for satisfactory performance of the project for a period (usually one to one and a half years) termed as the Defect Liability Period. For the owner, this is a mechanism to cover defective work or even late project delivery.
In some contracts, contractor can get his payment assurance for work done by owner agreeing to open a letter of credit in favor of the contractor. However, this is usually for delivery of costly equipment or imported equipment.
  • Insurance
Insurance companies offer several options to both owner and contractor. Examples are LD insurance, cost over-run insurance, insurance for even some force majeure items etc. Insurance is an important risk mitigation mechanism adopted by owners and contractors in EPC contracts. However, the fine print of insurance policies must be scrutinized to understand complex policy terms, deductibles, exclusions which limit the coverage etc.

Conclusion about LSTK EPC contract:
EPC projects offer a mutually beneficial and exciting form of project delivery for both the owner and the contractor. However, project owners should not mistake the LSTK EPC approach as a license to do anything they want without the threat of increase in project cost or delay in project schedule. They must discharge their responsibilities without hindering the work of the contractor. Both owner and contractor must realize that the goal of LSTK EPC contract is to allow the work to proceed without disruption due to changes throughout the implementation of the project. Otherwise many of the benefits of this mode of project delivery will not be realized.

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