Rebuilding Iraq: How Much Risk is Too Much?

Military acronyms have filled the airwaves over the past few months as the United States won the war in Iraq and committed to rebuild that country's deteriorated infrastructure and industrial complex. Although LSTK EPC may sound like just more military-speak, it's actually a construction acronym for the standard design-build method for "turnkey" delivery of large scale construction projects like power plants and chemical manufacturing facilities. In lump sum or fixed price engineering, procurement and construction projects, the contractor generally provides design, procurement, construction and plant "start-up" services, allowing the project owner simply to "turn the key" and operate the completed facility. When successful, this type of construction contract offers significant rewards. It can also carry significant risks.

Military acronyms have filled the airwaves over the past few months as the United States won the war in Iraq and committed to rebuild that country’s deteriorated infrastructure and industrial complex. Although LSTK EPC may sound like just more military-speak, it’s actually a construction acronym for the standard design-build method for “turnkey” delivery of large scale construction projects like power plants and chemical manufacturing facilities.1 In lump sum or fixed price engineering, procurement and construction projects, the contractor generally provides design, procurement, construction and plant “start-up” services, allowing the project owner simply to “turn the key” and operate the completed facility.2 When successful, this type of construction contract offers significant rewards. It can also carry significant risks.

In what can only be described as a global feeding frenzy, companies from around the world are jockeying for position and the chance to land a contract for a piece of the reconstruction pie in Iraq. Firms that participate in the massive reconstruction effort and the “mega” power, infrastructure and process projects that will be built would do well to ask the following question: Does the significant profit potential of this project justify providing engineering, procurement and construction (EPC) services on a lump sum turnkey (LSTK) basis? For an increasing number of contractors, the answer may be no.

For the short term, work is underway to restore and stabilize Iraq’s war-torn infrastructure. Two American firms, Bechtel National and Kellogg Brown and Root, have received multi-million dollar contracts to spearhead the effort to get Iraq back on its feet.3 Once the basic infrastructure is restored, longterm needs will require the construction and rehabilitation of everything from power plants and electrical grids to communications systems, water/sewer facilities and major transportation infrastructure projects. The estimates for reconstruction costs are staggering. Independent estimates predict such costs will approach $20 billion, with some foreign experts pegging the final total at closer to $100 billion.4

Whatever the final number, all agree that the post-stabilization opportunities for profitable work are enormous. Contractors will make or lose money depending on how they structure their contracts and assess and allocate risk. Any contractor that offers to perform design-build work for a lump sum price should be aware, however, that the nature of LSTK EPC contracting has changed over the last few years and it may no longer be an attractive delivery model for significant industry sectors, including power, oil-and-gas, chemical, water, wastewater and transportation.5

This article briefly analyzes some of the original advantages of LSTK EPC contracting, what went wrong, and a few of the promising alternatives that leaders in the field are considering in their search for ways to provide design-build “plus” services with an acceptable level of risk. Understanding the benefits EPC was intended to achieve and the reasons it has fallen out of favor may help firms seeking work in Iraq to structure acceptable project risk profiles, leading to more profitable projects.

THE INTENDED BENEFITS OF LSTK EPC: A SOUND THEORY

EPC became the standard method of project delivery for the fledgling private power sector in the early 1980s.6 An enhanced form of design-build, EPC was especially attractive to owners because it provided a single source for all the services necessary to deliver a fully operational facility that met the owner’s performance requirements.7 Advantages for owners of EPC projects included:
(1) the ability to bring large-scale, complex projects on line on a fast-track basis so the owner’s investment could begin to generate revenue earlier;
(2) reduced owner costs in the initial project development and design phases through specification of desired performance criteria;8 and
(3) effective realization of project design and compressed project duration brought about by improved communication between design and construction personnel.9
The added services that contractors provided in addition to design-build included plant commissioning, start-up, performance testing, personnel training for facility operation, and others. Finally, most early EPC projects were bid for a “lump sum” price and delivered on a turnkey basis, effectively shifting to the contractor the bulk of the risks inherent in the construction and operability of the facility.

There were also benefits for the contractor. Liability, for instance, was typically limited to a percentage of the overall contract price. Since the work was performed for a fixed price or lump sum, the contractor could increase its profit margins through cost-effective design, streamlined engineering and construction operations, and on-time schedule performance. Finally, contractors that beat their completion deadlines and exceeded performance requirements were often entitled to substantial bonus payments.10

EPC contracting was successful, but only on certain types of projects, particularly those that were moderate in scale. Generally, owners and contractors both fared well on projects that were:
– well defined from the outset (minimal owner-sponsored changes);
– carried out in a predictable environment;
– valued up to $250-$300 million; and
– of an execution duration greater than or equal to 30 months.11

For projects with contract values over $500 million, the results were dramatically different. According to an industry study of these large-scale chemical, process and power projects, both domestic and international, unless major unexpected political and/or national labor difficulties resulted in price adjustments for contractors, “contractors only met or exceeded their expectations about 20% of the time.”12 Contractor losses and extended completion delays were attributed to various causes, including unrealistic goals set by the owner; inadequate owner oversight; inadequate risk assessment by the contractor; lack of adequate project controls and change management; and “excessive exuberant bidding,” among others.13 The post-war Iraq market is prime for many of these same pitfalls.

WHY EPC DELIVERY FELL OUT OF FAVOR

Contractors initially welcomed the lion’s share of risk on EPC projects in return for the significant profit potential that could be derived from having simultaneous control over design, procurement, and construction and any resulting cost and schedule efficiencies. Over time, however, owners began to demand an increased role in the design process, heightened fast-track completion requirements, and enhanced performance guaranties with no corresponding assumption of risk. Risks associated with third-party technology and equipment supplied by owner equipment manufacturers (OEMs) were also increasingly shifted to the contractor.14 Contractors bid on EPC projects where they were unable to adequately utilize value engineering and innovation to balance the increase in accepted risk.15 Profit margins declined, owner penalties increased, and EPC contractors were caught in the squeeze. Not surprisingly, contractors met the increase in risk with higher pricing, thereby depriving owners of the cost savings EPC projects were intended to provide. Even worse, the incidence of disputes soared, often followed by protracted and costly litigation.

By the time the ’90s drew to a close, the effectiveness of the EPC delivery mechanism had clearly diminished, with escalating project costs and fast-track schedules inexorably pushing many contractors towards insolvency. For those left standing, the EPC contractor’s dilemma — getting cold feet about using a high risk/high return method of project delivery in the face of growing demand — left many companies scrambling for modified forms of project delivery for power and process facilities with a more balanced allocation of risk.16 As one industry consultant pointedly remarked, “How can the power sector deliver one new power plant per week for the next 20 years, when its major contractors are falling like flies?”17

Except for the occasional project, many now believe that the risks of LSTK EPC outweigh the rewards. The evolving situation in Iraq, coupled with the trend toward owners combining into large consortiums, even for a single project, in order to minimize their own risk, recently prompted one of the top international construction firms to draw a line in the sand. “In the offshore market, we continue to win some business, but we announced that we will no longer pursue EPC [engineer-procure-construct] on a lump-sum, turnkey basis,” says Ken Allen, senior vice president of sales and marketing for Kellogg, Brown & Root (KBR), a unit of Halliburton Company. As far as lump sum turnkey construction goes, Allen admits, “The risk-reward profile on those projects is totally out of balance. Other companies have taken a similar position, but have not been so outspoken.” Changing established commercial practices with customers can be problematic, however. As KBR’s Allen put it, once “[owners] have agreed on a contracting approach, it gets difficult to change.”18

Nevertheless, even some owners have reluctantly concluded that the LSTK EPC model is flawed because it fosters an adversarial “who’s to blame” contracting culture. In their experience, dealings with contractors and suppliers have too often resulted in increased project costs, out-of-control schedules and protracted litigation to settle claims.19 Simply stated, LSTK EPC has in large part failed to achieve its primary goals: owners are not receiving lower cost plants and on-time completion, and contractors are facing project losses due to disproportionate risk assumption.

**LOOKING FOR NEW ROADS*

To solve the current problems with EPC, some contractors and owners are experimenting with more collaborative delivery models which apportion the risk more evenly. Risk-sharing alliances, engineering-and-contractor consortiums, owner-contractor cooperation and target pricing have all been “test-run” with some success.

Project-alliance contracting, which claims to offer an integrated management approach, open-book accounting and financial incentives to share risks, has been fairly successful in the oil-and-gas, water, wastewater and transportation sectors. Participants share risks, define common business goals, and set target costs and schedules together as a team. Successfully accomplishing these tasks can reduce oversight management, completion risk contingencies and legal costs. Problems are solved jointly, and innovations are rewarded.20

However, even a well-intentioned owner seeking to balance the risk makeup of a project can be seriously restricted by project financing requirements and lender and/or underwriter demands for a complete shifting of risk to the contractor.21 Despite the many advantages and benefits touted by the alliance method, many lenders and owners in the power plant market remain resistant to adopting this collaborative model chiefly because it involves such a dramatic change in the traditional project relationship between owner and EPC contractor.22

EPC contractors are also returning to cost-plus contracts. Faced with industry-wide losses and even insolvency, some contractors are forgoing the possibility of earning a windfall from a fixed price contract and opting for the potentially lower profit but increased likelihood of obtaining that profit which the cost-plus model affords. Other contracting firms are encouraging owners to share risks in return for receiving a steep discount in project pricing.

“Target pricing” represents yet another stop on the road to balanced risk. With the target price method, the contractor and the owner set a target price, and share the overruns or underruns as defined by the contract’s terms.23 Contractors benefit from the more manageable cost risks, and owners benefit from the lower prices that flow from reduced risk contingencies and lower insurance costs. Although the target pricing alternative may not be for every project owner since it requires a different level of owner involvement than that required by an LSTK EPC contract, some who have employed the target pricing method have found that negotiating cost overruns can promote good contractual relationships, particularly when viewed as a “lesser evil” alternative to litigating such problems.24

As a way to spread the risk inherent in the truly huge projects, large EPC contractors are also joining the consortium bandwagon. For example, Foster Wheeler Ltd. recently announced that BSF, a consortium of Bechtel Petroleum & Chemical of the United States, Sinopec Engineering, Inc. of China, and Foster Wheeler Energy Limited of the UK, had been appointed as the project management contractor by Chinese oil producer CNOOC and Shell Petrochemicals Company Ltd. for the implementation phase of a world-scale, $4.3 billion petrochemicals complex in China’s Guangdong province.25 The CSPC Nanhai Petrochemicals Project represents the largest-ever joint foreign-Chinese investment in China. The plant will be built on Daya Bay in the Huizhou Municipality of Guangdong province.

THE CHALLENGE FOR THE FUTURE: AVOIDING THE EPC TRAP

Post-war Iraq will present plenty of opportunities for contractors to provide design-build services, but Iraq’s risk-laden environment also presents tremendous challenges, including inadequate qualified labor, security, insurance issues and terrorism, to name just a few.26 Contractors should seriously consider whether LSTK EPC delivery would be appropriate under any circumstances, much less those currently in Iraq. Of course, careful contract drafting can help minimize contractor risks, particularly through inclusion of realistic time and performance guaranties, force majeure clauses, and limitations on owner control over scope.

The core design-build components of EPC are likely to remain. It is equally likely, however, that a more balanced approach to risk allocation will occur. Those pursuing large scale construction projects using alternative delivery methods or modified versions of EPC should take a close look at the history of EPC to see what works and what is likely to end up just another casualty of the rebuilding war.

ENDNOTES:


  1. This article is adapted from a presentation by Mark de St. Aubin, EPC Contracting: Can the Lessons of its Shortcomings Lead to its Successful Application on Future Power and Process Projects?, in “The Future: Alternative Contracting Arrangements for EPC Deliveries”, The Contractor’s Construction Superconference, San Francisco, California, December 12-13, 2002. 
  2. Mark W. Cohen, EPC Delivery Mechanism Fundamentals, in “The Future: Alternative Contracting Arrangements for EPC Deliveries,” The Contractor’s Construction Superconference, San Francisco, California, December 12-13, 2002. 
  3. Bechtel National, Inc., headquartered in San Francisco, USA, was awarded in April 2003 a $680 million “cost plus fixed fee” prime contract for reconstruction activities in Iraq by the United States Agency for International Development. KBR is working pursuant to two contracts. See www.bechtel.com and www.halliburton.com
  4. Elizabeth Becker, Aftereffects: The Contractors; Feeding Frenzy Under Way, as Companies From All Over Seek a Piece of the Action, N.Y. TIMES, May 21, 2003, at 18; Dalal Saoud, Experts Discuss Iraq Reconstruction, ENGINEERING NEWS-RECORD, May 23, 2003. 
  5. Joseph Grynbaum, Risk-shifting Contracts Hurt, ENGINEERING NEWS-RECORD, Sept. 17, 2001, at 63. 
  6. Id
  7. Peter F. Fitzgerald, Chadbourne & Parke LLP: Project Financing Technique, in PROJECT FINANCING 2000 BUILDING INFRASTRUCTURE PROJECTS IN DEVELOPING MARKETS 69 (PLI Corporate Practice Course, Handbook Series No. B0-0000, 2000). 
  8. Charles P. Woodward & Kartar Singh, Managing Risk on Global Projects, in 1996 TRANSACTIONS OF AACE INTERNATIONAL (1996). 
  9. Mark C. Friedlander, A Primer on Industrial Design/Build Construction Contracts (last visited June 28, 2002) <www.schiffhardin.com/practice/p_construction_article12.html>. 
  10. Richard W. Pearse, Uncovering Hidden Costs, INDEPENDENT ENERGY, June 1997. 
  11. Louis J. Cabano, Lump Sum Contracting: Too Hot to Handle? (last visited June 2002) <www.pathfinderinc.com>
  12. Id
  13. Id
  14. Cohen, supra note 2. 
  15. Id
  16. Richard Korman, Risk-Sharing Returns to Contracts and Rearranges Market Priorities, ENGINEERING NEWS-RECORD, Dec. 3, 2001, at 21. 
  17. Grynbaum, supra note 5 (“Consider the recent fates of former, once-reputable firms such as Stone & Webster, Morrison Knudsen and Raytheon Engineers & Constructors”). 
  18. Gary J. Tulacz & Mary B. Powers, Global Political and Business Turmoil Takes a Toll on International Revenue, ENGINEERING NEWS-RECORD, May 19, 2003, at 79. 
  19. Grynbaum, supra note 5. 
  20. Id
  21. Korman, supra note 16. 
  22. Grynbaum, supra note 5. 
  23. Korman, supra note 16. 
  24. Id
  25. Press Release, Bechtel/Sinopec Engineering/Foster Wheeler Consortium Implements $4.3 Billion Petrochemicals Project in Southern China, Business Wire, May 28, 2003 <http://biz.yahoo.com/bw/030528/285378_1.html>
  26. Potential bidders have been told they must arrange for and supply their own security and telecommunications, as well as provide living accommodations and food for their crews. Employees will be required to wear Kevlar helmets and flak jackets for personal safety reasons. Workers already there often need military escorts to protect them, which can take several days to arrange and are often subject to last-minute cancellation. Not to mention snipers, unexploded ordnance, mines, looters and other assorted obstacles. Sherie Winston & Peter Reina, Thousands Jockey to Rebuild Iraq, ENGINEERING NEWS-RECORD, June 2, 2003, at 14.