In the past few years, engineering, procurement and construction (EPC) contracting has emerged as the most preferred option for renewable energy developers as it passes the majority of the design, development and construction risks to the EPC contractor, along with the responsibility of designing, procurement of materials and construction.
Under a typical EPC contract, the principal contractor is engaged to carry out the detailed engineering design of a project, procure all the necessary equipment and materials, and then construct and commission the plant for the client. The contractor commits to deliver the completed plant for a guaranteed price within a stipulated date and with a guaranteed performance level. Failure to comply with any of these usually results in the contractor having to pay financial compensation to the owner in the form of liquidated damages.
Apart from the transfer of risk, outsourcing EPC works to specialised entities offers several other benefits to renewable energy project developers. Financiers prefer investing only in projects that have financially strong contractors. EPC contracts are also immensely beneficial for diversified players who consider renewable energy projects as more of an investment. Many EPC players also provide end-to-end solutions, from conceptualisation and site identification to operations and maintenance (O&M), which is more useful for the relatively inexperienced players. Lenders are also more comfortable with EPC agreements in the case of newer and untested technologies as the EPC contractor takes care of the three most important aspects of project development – performance, cost overruns and time overruns.
Current trends
- EPC models in the Indian renewable energy space: Traditionally, wind project development has been dominated by the concept-to-commissioning model, under which projects are fully developed by manufacturers and offered as end-to-end solutions to asset owners. Wind project development practices have, however, been changing rapidly with the increasing number of independent power producers (IPPs), following the introduction of the generation-based incentive scheme and hiking of feed-in tariffs in the key wind states. IPPs seek to generate the maximum output at the lowest possible costs to optimise returns and hence, are now shifting from the concept-to-commissioning model to the self-development model, and are engaging in site selection, land acquisition, securing permissions, etc. With the emergence of this model, wind turbine manufacturers have increased their focus on delivering efficient and cost-effective technologies and undertaking only installation, commissioning and O&M, without participating in the early-stage project development activities. A shift to the IPP-led model has paved the way for the entry of pure-play EPC companies that provide a broad range of services across different product categories.
Meanwhile, in the solar sector, since many developers are also engaged in solar equipment manufacturing (mostly modules) or are integrated players, many of them prefer to split their project contracts and execute certain tasks themselves. For instance, the developer can procure key equipment (generally modules and inverters) and outsource the remaining works to an EPC contractor. In some cases, the developer may also opt for a separate contractor to establish an electrical balance of the plant system. Full-wrap EPC, however, is the preferred option for diversified players and captive consumers.
- Falling solar EPC prices: A significant drop in global commodity prices and fierce competition among project contractors have led to a steep fall in the prices of solar EPC contracts, benefitting power asset owners and consumers. EPC contractors are learnt to have quoted the lowest ever prices of around Rs 56 million per MW for solar power projects of NTPC in Rajasthan (260 MW) and Madhya Pradesh (250 MW) in the first-ever reverse auctions conducted under the domestic content category. The development comes at a time when global and domestic solar power developers are aggressively participating in the auctions and pushing down solar power tariffs to as low as Rs 4.34 per unit.
Tendering agencies have also played a key role in reducing EPC costs by offering larger projects, more secure contracts and pre-developed facilities. This has particularly benefited integrated players, who have taken the economies of scale advantage to quote low tariffs and EPC bids.
- IT in EPC: The EPC space is increasingly adopting a more strategic information technology (IT) approach and is strengthening its IT infrastructure by improving its wireless data connectivity, and adopting mobility and cloud solutions. EPC contractors are leveraging big data and modelling tools to save time and reduce costs by testing designs before they enter the construction process. Firms are also experimenting with prefabricated structures that are constructed off-site in some standard portions, and later shipped to the required location and assembled to form the desired structure.
Possible impact of GST on EPC
With the roll-out of the goods and services tax (GST), all work contracts including EPC contracts are proposed to be taxed as services. The GST rates and provisions, such as the place of supply rules (or place of provision of service), will apply to work contracts as applicable on services. A probable benefit of this could be that the tax will now be charged on actual contractual base. In some cases, the new regime will mean avoidance of double taxation because of the single tax structure and tax credit being available at each stage of production. However, the restriction on availing credits on goods and work contract services used for setting up infrastructure projects will continue. According to the model GST law, no credit can be taken on goods and services in the “execution of work contract”, which results in the construction of immovable property. So there is still an ambiguity with respect to availing of such tax credits.
Further, under the new regime, both inter-state and intra-state sales would be subject to a creditable system. This was not the case earlier, when interstate sales were not creditable, so contactors sought to structure “in-transit” sales, which was questioned by the tax authorities. GST could thus also reduce tax disputes and litigation. Moreover, EPC contracts will also be affected by the impact of GST on material, equipment as well as technology suppliers.
Key challenges faced by EPC players
Despite the significant number of opportunities and renewed euphoria backed by increased support from the government, the EPC segment in the Indian renewable energy sector continues to be plagued by various challenges. There is a lack of an integrated framework and holistic approach for the selection and execution of projects. Further, many developers do not undertake the necessary feasibility studies, including preparation of detailed project reports, despite the fact that this exercise accounts for just 1-2 per cent of the overall cost of a project. This leads to delays due to multiple changes in the scope and design of the project concerned. Moreover, several projects have been delayed in recent years due to the lack of regulatory clearances and land acquisition issues.
Dispute resolution is another key issue. The presence of multiple stakeholders simultaneously in one project at the implementation stage increases the potential for conflicts arising at every stage of the process chain. Hence, businesses need to be prepared to manage and mitigate such disputes effectively. Another major challenge is cost overruns resulting from aggressive bidding. EPC players, while bidding for projects, fail to account for all the costs that will be incurred at the execution phase.
Meanwhile, the key concern that has emerged with regard to EPC contracts is the lack of standardisation. While this may not be a major problem for big players, it is a serious issue for sub-50 MW players. EPC contracts often fail to address the problems occurring during the construction phase. In return for receiving a guaranteed price and a guaranteed completion date, the developer cedes most of the day-to-day control over the construction.
Therefore, developers have limited ability to intervene when problems occur during construction. The more a project developer interferes, the greater the likelihood of the contractor claiming additional time and costs. In addition, interference by the project company makes it substantially easier for contractors to defeat claims for liquidated damages and defective works. As a result, it is of vital importance that care is taken to ensure that the contractor has sufficient knowledge and expertise to execute the works. Given the significant monetary value of EPC contracts and the potential adverse consequences of any problems that may occur during construction, the lowest price should not be the only deciding factor when selecting a contractor.
Going forward, it is imperative that the construction contract contains provisions specifying the scope of work, acceptance and testing, price and payments, delays and defaults, suspension and termination, force majeure and performance security. A detailed contract with specific project milestones at all levels of contracting is important for ensuring that the risks associated with a project are appropriately distributed.
