This is one of an occasional series of blogs from the team at Freshfields that explore the challenge associated with transition to renewable energies.
One of the few positives which came out of 2020 is the commitment from governments, corporates and financiers to energy transition, with several energy majors making a bold move to put green construction, renewable energy and net zero carbon ambitions at the core of their future strategies. Renewables have and will continue to be an ever-increasing part of the energy landscape; they make up between 40% and 50% of the energy generated in the UK in any given quarter and there are some 8GW of renewable energy projects under construction in the UK. This is likely to increase significantly in the near future.
As technology has matured, and the scale and ambition of renewables projects has boomed (in particular offshore wind), the balance of project risk has started to shift from the owner to the contractor and supply chain. And perhaps for good reason. The market for both specialist manufacturers/suppliers and construction contractors has widened, the risks are better understood and project costs have become more predictable. This means that projects can be delivered more reliably on time and to budget, lowering overall cost.
However, this trend is coupled with a shift in how such projects are typically financed, which we will cover in more detail in the next blog in this series. Initially, the majority of renewables projects were small enough that they could be financed off-balance sheet, often made viable by government subsidy and support. Now, most projects are carried out on developers’ balance sheets (largely funded by sustainable corporate financing) with a growing reliance on project financing for the more recent waves of mega and giga projects in established renewables technologies. Both the lenders and corporates are seeking a return, and so the projects need to be commercially viable. This puts pressure on owners to deliver projects at a lower capital cost than ever before, which in turn can squeeze both contractor and supplier margins. History tells us that this can lead to an increase in disputes and adversity in relationships at all levels of the contract structure, but is there an alternative?
In this second blog in our series, we consider the trends in renewable project procurement strategies, whether there is a risk of a ‘race to the bottom’ and what the alternatives might look like.
Renewables projects were historically procured on a multi-contract model, where the owner retained the interface risk among the various packages, for example installation of foundation piles, turbine manufacture, grid connection and cable laying. This approach requires significant in-house technical expertise (or the engagement of an EPCM contractor or construction manager), but in turn gives the opportunity for the greatest control over the development of the project and, so the theory goes, at the lowest cost.
More recently, the trend has been for large scale renewables projects to be procured on an EPC or turnkey basis, split among a number of significant works packages, with the owner retaining the interface risk among the packages. For example, the £3bn 1075mw Seagreen wind farm development (a joint venture between SSE and Total) in the North Sea appointed four tier 1 EPC contractors: (i) MHI Vestas (turbines), (ii) Petrofac (onshore transmission module), (iii) Linxon (onshore/ offshore substation), and (iv) Nexans (onshore/ offshore cables).
A key driver of this trend is the requirement of lenders investing in renewables project to have the security an EPC wrap provides to make the project ‘bankable’. As an EPC contractor takes the risk of project/package delivery, this model gives both owners and lenders a simpler route to recovery for performance failures and makes step-in more straightforward in the event of insolvency. This trend is likely to increase given the greater levels of investment in renewables projects, both from typical infrastructure and energy institutional investors and from energy majors as they seek to grow their portfolios of renewable assets. To meet this demand, there has been a corresponding number of Tier 1 contractors willing to take on a greater level of project risk, including in respect of specialist suppliers (such as turbine or solar panel manufacture or cable laying), and with it a trend towards EPC procurement structures.
For many, this is a welcome development, driving down capital cost in line with technological development and contractor experience, helping the new wave of mega projects progress from planning to generation. However, does this shift bring with it a greater risk of disputes?
Potential for increase in disputes
In a competitive market, there is always a risk of a ‘race to the bottom’ on pricing, particularly where the contract is offered on a lump sum or fixed price basis. This means that the contractor’s margins are often razor thin, which necessarily leads to stringent contract management in order for the contractor to turn a profit. This is especially true in a stressed market, such as the one we are currently experiencing, particularly where contractors are under pressure to keep winning work to ensure they continue to meet cashflow needs.
Such an approach can still deliver projects successfully, with careful planning and clear, robust contractual obligations, however, it can be difficult to adequately set out all contract risks at the outset. History has taught us that this increases the risk of disagreements, disputes and ultimately lengthy and costly claims, especially where there is any ambiguity about the scope of the work or standards to be met.
This is true of any EPC or turnkey contract but is especially relevant for renewables projects utilising relatively new technology in a sector where there are, as yet, no specific industry-wide standard forms and limited interpretation of the application of standard terms to the specifics of renewables projects. Moreover, even where the technology used is tried and tested, renewables projects are susceptible to a broad range of uncertainties from sub-sea ground conditions (which are notoriously difficult and expensive to survey) and extreme weather (affecting both construction and operation) to the macro-economic issues, such as those brought about by the Covid-19 pandemic and Brexit (e.g. delivery of components, price escalation for transportation and import of materials). The clear apportionment of risk for any such uncertainties is paramount to minimising the risk of claims during project execution.
However, even with this firmly in the parties’ minds at the outset, it is not always straightforward. The often referenced cases of Fluor Limited v. Shanghai Zhenhua Heavy Industries Limited  EWHC 2062 (TCC) and MT Højgaard A/S (“MTH”) v. E.ON Climate & Renewables UK Robin Rigg East Limited  UKSC 59 shine a spotlight on this potential issue. Each case concerned the meaning of ‘fitness for purpose’ obligations under the relevant contract terms, the former where there was an absence of express detail in the contract as to what ‘fitness for purpose’ meant, and the latter where attempts had been made to define the standards to be met by reference to international standards, which themselves turned out to be deficient.
At this turning point in the growth of renewables projects, does the trend towards EPC contracting offer best value? For some projects the answer will undoubtedly be ‘yes’, but for others, particularly where newer technology (such as floating offshore foundations or integrated large-scale battery/energy storage), a more collaborative approach between the owner, contractors and suppliers may ultimately offer the best approach of successful delivery.
What are the alternatives?
There has been much discussion within the industry of a resurgence in partnering and alliancing approaches for the delivery of major infrastructure projects, which have at their heart a fair balance of risk, reward and incentivisation. See for example the ICE’s ‘Project 13’. A delivery partner model, where the contractor(s) have an interest in the overall successful delivery of the project, not just their own scope, can have a huge overall impact on project success. For example, the two key contractors in the German Merkur wind project both held stakes in Merkur Offshore GmbH, the company responsible for planning and constructing the wind farm. GE, the turbine supplier, held a 6.25% stake through GE Energy Financial Services while DEME, the Balance of Plant contractor, held a 12.5% stake through its subsidiary DEME Concessions. Contractor buy-in was successful in this example as the project phase completed in June 2019, just three months behind the March 2019 date set several years earlier.
A procurement structure which has at its core appropriate incentivisation can have the following benefits:
- Reduction in overall cost due to contingency/risk pricing;
- Encouragement of value engineering throughout the project;
- Reduction in interface risk; and
- Building a longer-term relationship with the contractors for future portfolio projects.
Moreover, where novel and emerging technology is involved, such as tidal power, molten salt solar or large-scale battery storage, a partnering approach can help overcome the risks of the ‘unknown unknowns’ which can often beset even the best planned projects. This contract model can also have real benefits where the owner and contractor will (likely) be working together on a number of developments, where valuable lessons learned and value engineering can be integrated into future plans and developments.
A partnering approach to contract structuring will not be appropriate for all projects, and for smaller or more straightforward developments utilising well-established technology they may neither be necessary nor offer best value for money. Such approach also requires a greater level of management, involvement and oversight from the owner. However, for the largest and most complicated projects, or for first of a kind projects, which necessitate a multi-contract approach, it is worth considering at the outset whether a partnering structure may aid successful delivery, incentivise collaboration among contractors and offer best overall value to the owner.
Tom Hutchison: Tom specialises in mitigating risk and resolving disputes arising from major projects around the globe, with a key focus on construction and engineering, infrastructure, energy, and oil and gas.
He has advised clients in many high-profile disputes, including in international arbitrations under as well as litigation before the English, Irish and Scottish Courts and has significant experience of structuring projects and negotiating both project agreements and construction contracts.
Vanessa Medina: Vanessa specialises in providing strategic, practical and ethical advice to protect stakeholder interests, minimise risks and maximise returns in connection with the delivery of global, complex major projects.
She advises clients on the whole-of-life project cycle and has experience advising on high-profile government projects, project administration and governance, disputes and arbitration in the construction and engineering, infrastructure, energy, and oil and gas sectors.
Freshfields Bruckhaus Deringer is a law firm that combines the knowledge, experience and energy of the whole firm to solve the biggest global organisations’ most complex challenges, wherever and whenever they arise. Their global teams span specialisms, regions and industries to deliver against three fundamental client needs: transactional, regulatory, risk.