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Part 2 Detailed engineering and construction

An essential guide to feasibility planning and construction procurement for junior mining

Part 2 Detailed engineering and construction

An essential guide to feasibility planning and construction procurement for junior mining

A NORTON ROSE LLP GUIDE august 2011

Part 2 Detailed engineering and construction

Norton Rose Group

Norton Rose Group is a leading international legal practice. With more than 2600 lawyers, we offer a full business law service to many of the worlds pre-eminent financial institutions and corporations from offices in Europe, Asia Pacific, Canada, Africa and the Middle East. We are strong in financial institutions; energy; infrastructure, mining and commodities; transport; technology and innovation; and pharmaceuticals and life sciences. Norton Rose Group comprises Norton Rose LLP, Norton Rose Australia, Norton Rose OR LLP, Norton Rose South Africa (incorporated as Deneys Reitz Inc.), and their respective affiliates. nortonrose.com

The purpose of this publication is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Norton Rose LLP on the points of law discussed. No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any constituent part of Norton Rose Group (whether or not such individual is described as a partner) accepts or assumes responsibility, or has any liability, to any person in respect of this publication. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of, as the case may be, Norton Rose LLP or Norton Rose Australia or Norton Rose OR LLP or Norton Rose South Africa (incorporated as Deneys Reitz Inc) or of one of their respective affiliates. Norton Rose LLP NR11049 08/11 (UK) Extracts may be copied provided their source is acknowledged.

Contents

Contents
04 Summary 05 Introduction 07 EPC contracts 20 EPCM contracts 30 Appendix 1 32 Contacts

Part 2 Detailed engineering and construction

Summary
The importance of a robust strategy for the procurement of a mining project, from project inception through to construction implementation, can not be underestimated. Full consideration of the key procurement issues identified in this guide can often mean the difference between achieving a bankable project with optimal returns for the mining company, and an expensive project failure.

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Introduction
General
This is the second part of a two part guide exploring the key steps and considerations to be made by junior mining companies (the Sponsors) to achieve a project structure that is both bankable and able to deliver optimal returns for the Sponsors. On the assumption that the Sponsors have determined through a full and proper feasibility process that the project is economically viable, they must then consider how the project is to be delivered. We have produced several briefing papers on issues to be considered when looking to secure finance for projects in the mining sector, but a key aspect of securing such finance will be convincing lenders (or any debt repayment guarantor in the context of a Chinese debt solution) that the structure for project delivery is robust. In this part two we will look at the key considerations to be made by Sponsors in terms of achieving a construction structure that is both bankable and economically viable. Whilst this guide is primarily written from a western perspective, the increasing significance of Chinese debt solutions in this sector should also be taken into account. This guide will therefore, as appropriate, also offer some insight into the contrasting issues to be considered in the procurement of mining projects in the context of a Chinese debt solution.

Bankability

We have explained the meaning of bankable or bankability in part one to this guide. To recap, the terms are usually used to describe a lenders view on the robustness of the project structure in terms of its ability to secure full repayment of outstanding debt, either through project delivery in accordance with Sponsor requirements or, in a default scenario, through appropriate recourse against the contractor (or other stakeholders (as appropriate)) responsible for project delivery.

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In the context of detailed engineering and construction delivery, lenders will typically look for one financially robust party to accept full responsibility for the delivery of the works on time, on budget and to meet the required technical and performance specification. The key candidates in this regard are typically large internationally recognised engineering and construction contractors. The identity of the contractor can certainly have an impact on the lenders view on bankability. The importance of achieving this single point of responsibility relates to a desire by the lenders to see the party with the deepest pockets bearing the entire risk of project delivery. To the extent that more than one party is responsible for delivery of the works (in terms of direct liability to the Sponsors), lenders will be concerned that either: there may be gaps in liability cover; or that there may be interface issues when it comes to identifying the party responsible for a failure; or, perhaps worst of all that the party identified as being responsible for a failure can not be held to account either because its liability is limited in some way under the terms of its contract with either the Sponsors or the EPC contractor (as the case may be) or more generally because it does not have the balance sheet to meet the liabilities in question.

Contract structures

The preferred option for delivery of the single point responsibility solution described above will typically come in the form of a turn key engineering, procurement and construction (EPC) contract. Whilst it is recognised that there are several internationally recognised forms of EPC contract, each offering a balanced approach to contracting risk, the hardening of the lending market in recent years (and especially post global financial crisis (GFC)) has seen a move away from use of these forms, in the context of a limited recourse project finance transaction, without significant amendment. When procuring an EPC

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contractor, it is essential that there is transparency regarding likely lender requirements from the outset. Raising these points post selection of the preferred EPC contractor will place the Sponsors in a weak bargaining position if (and more likely, when), as a consequence, the EPC contractor proposes additional contingent risk pricing. We have discussed above how the development of detailed design at feasibility stage may undermine the Sponsors ability to achieve a single point of responsibility solution without being exposed to inflated construction pricing, either because there is a lack of appetite in the market to take on 3rd party design risk or because those parties willing to take on such design risk will only do so with a significant amount of contingent risk pricing. In circumstances where the single point responsibility position described above can not be achieved, the Sponsors may look for alternative structures. In this respect, we will consider below, in the context of bankability considerations, the fundamental differences between the EPC and the alternative engineering, procurement and construction management (EPCM) contracting structures. In particular, we will identify the likely challenges when opting to use the EPCM structure in a hardening lending market.

EPC contracts
General
Figure 1 below demonstrates a typical EPC contracting structure under which lenders and Sponsors will look for the EPC contractor to accept single point responsibility for all aspects of design and construction. Notwithstanding the fact that the Sponsors may be able to achieve this contractual structure, the bankability of the contracting structure will depend also on satisfaction of certain key lender requirements under the terms of the EPC contract. These key requirements will establish the obligations on the EPC contractor in terms of project delivery and importantly, the recourse available against the EPC contractor in a default scenario.

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Mining company EPC contract EPC contractor

Sub-contractor A

Sub-contractor B

Sub-contractor C

Figure 1 typical EPC contracting structure

In order to gain a better understanding of the approach being seen more recently by lenders in the mining sector, it would be helpful for us to set out what we see as being those key commercial terms that lenders will typically be looking for under the terms of an EPC contract.

Key lender requirements

Design risk As we have indicated earlier in part 2 of this guide, the lenders ideal position will be for the party delivering the works to be responsible for all aspects of the works, including design (whether or not produced by the party assuming responsibility for the works). This transfer of responsibility should even extend to mistakes in the Sponsors own stated initial design requirements. If this design risk transfer is not achieved, the risk to the Sponsors of cost overrun could be significant since there is likely to be increased exposure to claims for additional time and money resulting from the requirement to remediate errors identified in 3rd party design. Since the liability for cost overruns in the circumstances described above may be significant, it is unlikely that this risk may be backed off fully with the party ultimately responsible for producing the design in question. It is more likely therefore that the residual cost overrun risk will rest with the Sponsors. Whilst in the first instance, this is clearly a concern for the Sponsors, lenders will also be concerned to see that the Sponsors are able to manage the potential financial consequences.
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Whilst the intention of the parties may be for the EPC contractor to accept entire responsibility for the adequacy, accuracy and completeness of design, the lenders will nonetheless want to assess fully the extent to which design risk may filter back to the Sponsors under the terms of the EPC contract. An example of where this may happen is in circumstances where the Sponsors accept the risk in certain sub-surface site conditions. For instance, the Sponsors may warrant the correctness of survey information relating to the site and accordingly the EPC Contractor will develop its detailed design and submit its tender price in accordance with the warranted information. However, if this information is incorrect, the risk in the design, and in particular the impact of the changes to the design required to reflect actual sub surface conditions, will pass back to the Sponsors. In practice, the lenders technical adviser will review the risk profile proposed under the terms of the EPC Contract generally and will advise the lenders as to the Sponsors potential exposure to cost overrun risk arising from circumstances of the type described above. It will ultimately be for the Sponsors to either convince the lenders that any such risk identified may be managed by the Sponsors. Sponsors should be aware that lenders may seek additional mitigation through equity contributions, additional security or appropriate contractual mitigants. In the alternative, Sponsors and/or their lenders will seek to push the risk in question back to the EPC contractor, which may of course have pricing consequences. Time and cost Whilst we have discussed time and cost risk specifically in relation to design above, as a general point of principle, lenders will want to limit to the fullest extent possible the EPC contractors ability to claim for additional time and/or money under the terms of the EPC contract. Again, lenders will be concerned about the ability of the Sponsors to manage the financial consequences that will accompany these time and cost claims and more generally the extent to which exposure to such claims may impact on the delivery of the works in accordance with the requirements of the EPC contract. Many of the international forms of EPC contract contain scope for time and money claims being made by the contractor. For instance, FIDIC

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Silver Book places time and cost risk for the occurrence of changes in law, compliance with certain employer instructions and the discovery of objects of antiquity at the works site with the employer. Whilst on balance this may not appear unreasonable, the employers potential cost and loss of revenue exposure arising as a result of accepting these risks may be significant. We have seen more recently lenders pushing back on the acceptance by Sponsors of these types of risk, allowing for contractor time and money claims only in very limited circumstances. The key point to recognise is that the acceptance by the Sponsors of any aspect of time and/or cost risk will undermine the fixed price assumption sought under the EPC structure. On the assumption that lenders can get comfortable with this type of risk being retained by the Sponsors, the Sponsors should themselves think very carefully before accepting such risks. The potential exposure to additional costs will need to be appraised fully by the Sponsors as will any potential impact on the financial model for the project. The Sponsors should ideally seek board buy-in to any such proposals, and in particular to the commitment of additional equity as may be required at an early stage in the project. Parent company buy-in may also be necessary particularly where finance guarantees will be required. We would additionally expect the sponsors to formulate a strategy for managing any such risks. A lets wait and see approach is unlikely to be satisfactory, since it is likely that prompt and calculated action will be necessary on the occurrence of the risk in question if the Sponsors financial exposure is to be mitigated to fullest extent possible. Delay damages To the extent that the works are completed on a date later than that fixed under the terms of the EPC contract, the contract will typically include provision for payment of liquidated and ascertained damages (LADs). These LADs will typically be paid at a daily rate to cover anticipated lost revenue and costs (including debt service costs (as applicable)) during the period of delay. It would be unusual for the EPC contractor to accept unlimited exposure in this regard and any liability sub-cap agreed will typically be sized to the level of LADs payable up to the construction long stop date. Whether or not any such sub-cap will fall within the contractors overall liability cap is likely to be an area of debate between

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lenders and the EPC contractor. This issue will tend to be considered by lenders in the context of the EPC security package as a whole and we will discuss this point in further detail below. Performance liability Following completion of construction and the handover of the works, the Sponsors and the lenders will be keen to ensure that the plant is able to achieve certain performance guarantees. These are required in order to provide both parties with a degree of comfort that projected project revenues can be achieved by the completed plant over a sustained period. It is usual therefore for the EPC contract to also document the requirement for a post completion testing regime. To the extent that the required performance guarantees can not be achieved for a sustained period of operations, the EPC contractor will typically be liable for payment of performance liquidated damages up to an agreed liability cap. The damages will usually be sized according to the loss of revenue and/or profit occasioned by the performance shortfall for a finite period of time. It would be extremely unusual for the Sponsors to achieve a life of mine performance guarantee and, as such, it would be usual for the liability cap in relation to performance damages to be capped at the Sponsors loss of revenue and/or profit for a specifically negotiated period. Whilst residual liability will be a Sponsor risk, it would be usual for Sponsors to manage this risk by building headroom into the financial model for the project. The pre and post handover testing regime will be subject to scrutiny by the lenders technical adviser. If, for instance, it is apparent prior to handover of the works that the plant is not going to achieve the lenders base case performance/output requirements, the lenders would typically expect to see a right to reject the plant in its entirety with full recourse against the EPC contractor for debt outstanding. For obvious reasons, EPC contractors will tend to resist any such position. They may, for example, look for an extended period of additional testing in order to refine the plant and to achieve the required performance levels. If this is permitted, time and cost impact of this additional testing will tend to be at the EPC

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contractors risk and the lenders will typically seek to retain the right to reject at the conclusion of any such repeated testing, if a required level of performance is not demonstrated. Again, where detailed process design is not provided by the EPC contractor, it may be more difficult to require this party to accept performance risk in full, particularly in circumstances where the technology is more complex in nature. Carving out these types of risks from the EPC contractors liability under the terms of the EPC Contract is however likely to make potential lenders nervous for the reasons discussed above. Whilst lenders may accept the interface risk in this liability gap being filled by the designer itself (whether under the terms of a design contract with the Sponsors or under the terms of a collateral warranty), it is often the case that the party providing the detailed process design is either unwilling or unable to accept the type and extent of liability for design failure that would usually rest with an EPC contractor under the terms of the EPC contract. If this is the case, lenders may require additional security from the Sponsors to bridge the liability gap. Limitations on liability As indicated above, a key consideration for lenders when considering lending into a mining project will be the extent to which they will have recourse against the EPC contractor for debt outstanding in an EPC contractor default scenario. There is, as may be expected, a tension between the lenders requirement for full coverage of debt outstanding from the EPC contractors security package and the legitimate requirement of a contractor to limit its liability exposure. It is not unusual however for lenders in the current market to look for an aggregate liability cap of up to 100 per cent of the contract price, especially where the works include an unproven technical solution. The lenders may however accept a lower liability cap of say 60-80 per cent of the contract sum in these circumstances on the basis that liability for certain key risks is excluded from the aggregate liability cap. It is not uncommon for instance for lenders to seek to exclude liabilities that are the subject of a sub-cap, such as delay or performance liquidated damages, from the aggregate liability cap.

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The appropriate exclusions from the aggregate liability cap will be negotiated on a project specific basis by the lenders following adviser input. The list of exclusions will typically include those liabilities that are not able to be limited at law (and this will require local law advice), those liabilities that are uninsurable and those liabilities that are not quantifiable at the date of contracting. Security package As we have discussed above, to the extent that the EPC contractor fails to deliver the works, the lenders and, in the first instance, the Sponsors, must have direct recourse against the EPC contractor to recover their losses. The lenders will ultimately control this process through restrictions placed on the Sponsors in the finance documentation. For instance, the lenders will not allow the Sponsors to use (and ultimately deplete) the EPC security package to replace a defaulting EPC contractor in circumstances where such replacement is unlikely, in itself, to secure delivery of the project. It is more likely in these circumstances that the lenders will look to call a default under the terms of the finance documentation, trigger its security over the project documentation and access the EPC security package to recover debt outstanding. The security provided by the EPC contractor in respect of its potential liabilities will typically be formed, in part, by a form or forms of liquid security. Liquid security and bonding When we talk of liquid security, we are talking about forms of security that should be as good as money in the bank for the Sponsors. The Sponsors should be able to claim any such monies by simply serving a demand on the party providing the security on behalf of the EPC contractor. Typical forms of liquid security are performance bonds, retention bonds and letters of credit, all usually provided by international banks with lender approved credit ratings. Leaving retention bonds to one side for the time being, the lenders in the current lending market will typically require the EPC contractor to procure performance security (ie, performance bonds and/or letters of

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credit) with a value no less than 15-20 per cent of the contract sum, but this may vary on a project specific basis. The lenders are however likely to permit a step down in performance security coverage as the works progress to reflect reduced risk in the project for the lenders. Typically, the level of performance security coverage may reduce by 50 per cent, for instance, following the completion of operational testing and will usually be discharged completely upon expiry of the defects liability period (ie, 12-24 months post handover of the works). In the UK domestic market, there has been a shift in recent years in the surety market away from providing performance bonds of the type described above. This is not to say that such bonds are not available, however procuring them can be prohibitively expensive. Instead the UK has increasingly seen use of conditional bonds under which the beneficiary must first establish the right to make a claim and the quantum of any claim before a call is made on the bond. Whilst a fraudulent claim under an unconditional bond of the type described above can be challenged, a conditional bond is more akin to a form of guarantee and for the reasons set below will be less attractive to both Sponsors and lenders. It is usual for lenders to also require that a fixed amount of any payment being made to the EPC contractor is retained and held by the Sponsors as security for the remedying of defects subsequently discovered in the works. Unlike the performance security which secures more general performance by the EPC contractor under the terms of the EPC contract, retentions are held for a specific and defined purpose. However, in reality this is somewhat of a falsity as lenders generally view retentions as part of the wider security package available to the Sponsors, and ultimately the lenders, as security for non-performance by the EPC contractor. The level of retention required by lenders will vary but typically will be between 3-5 per cent of the contract sum. Instead of a cash retention being made on any payment to the EPC contractor, and to assist the EPC contractors cash flow, lenders will usually instead accept a form of retention bond as an alternative which will provide security for monies that would have otherwise been retained. Any such instrument should be in the same form as the performance bond discussed above, ie, provided

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by an international bank with an approved credit rating and permitting claims for payment upon the presentation by the Sponsors of a demand for payment. Again, any such bond should be as good as money in the bank for the Sponsors. To the extent that any advance payment is made to cover the cost of the ordering of plant and materials or mobilisation, lenders will expect the Sponsors to secure such payments by requiring the contractor to procure an advance payment bond. Again, any such bond should have the characteristics of the performance bond and the retention bond described above. Illiquid security and guarantees Outside of liquid forms of security, lenders will typically require a guarantee from the ultimate parent of the EPC contractor. The ultimate parent is usually a requirement as a shell holding company, for instance, with limited or no assets will not be acceptable to the lenders. In practice, lenders will carry out their own due diligence on the parent company proposed to ensure that it is sufficiently robust to meet its potential liabilities under the guarantee. Unlike the forms of liquid security described above, a guarantee of this kind will usually first require the establishment by the Sponsors of liability against the EPC contractor, which the EPC contractor has failed to discharge. Furthermore, the Sponsors will run the risk that any claim made under the guarantee will be subject to challenge by the guarantor. Far from being akin to cash in the banks, the pursuit of a claim under a parent company guarantee can be a lengthily process which is why claims under the liquid forms of security will usually be the Sponsors first port of call. Termination Lenders will tend to have certain minimum requirements in terms of the circumstances where they will expect the Sponsors to have the right to terminate the EPC contractor and access the EPC security package to either replace the defaulting EPC contractor and secure project continuance or bring the project to an end. As we have indicated earlier,

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the lenders will control the actions of the Sponsors in this regard through the restrictions imposed on the Sponsors under the terms of the finance documentation. It would be usual for lenders to look for the EPC contract to contain a right to terminate the EPC contractor in circumstances where recourse against the EPC contractor may be limited in some way or where key requirements relating to performance are not achieved. Lenders will typically look for advance warning of any problems relating to the works so that affirmative action may be taken before the circumstances become critical. Lenders will be especially concerned to see that the losses recoverable on termination will (to the fullest extent possible) cover amounts outstanding under the terms of the finance documentation (ie, principal, interest and fees). The ability of lenders to recover these losses tends to be very difficult for the uninitiated to understand and accept this, but this is part and parcel of limited recourse project financing where the lenders security is limited to the project and those responsible for delivering it.

EPC contracts in a Chinese debt context

As we discussed in part one of this guide, the focus of project scrutiny in the context of a Chinese debt solution will typically differ from that under a western project finance solution. The nature and extent of security typically required by Chinese lenders from the State of the Sponsor or its parent company (as the case may be) will tend to mean that the lenders themselves will be looking less closely at the project structure. Whilst the bankability requirements discussed above will not tend to be pressed by Chinese lenders, the Sponsors should themselves be looking to secure these positions and indeed this is likely to be a requirement of the relevant guarantor. In the context of a Chinese debt solution, Sponsors and guarantors must together take on an almost lender due diligence type approach towards the project structure and ensure that appropriate mechanisms are in place to secure completion of the works on time, on budget and to meet

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a required performance and technical standards. Consideration of these issues in isolation and without lender support is often a new dynamic for sponsors. In the context of an Export Credit Agency (ECA) backed Chinese debt solution, we considered in part one to this guide the typical Chinese content requirement under the Sinosure policy. To recap, Sinosure is the official ECA for China and will provide lenders with political and commercial risk cover to support exports of Chinese goods and services. It will however be a condition of providing such cover that the export contract (for instance, an EPC contract with a Chinese contractor) has a Chinese content of at least 60-70 per cent. It should be noted that whilst a breach of this requirement may have consequences for the Sponsors under the terms of the finance documentation, it would actually be unusual for Sponsors to ever have sight of the policy and hence be aware of the specific details of the Chinese content requirement. If the EPC contractor is a Chinese entity and has itself or through its agents procured the debt solution (as is often the case in this context), it is likely that the EPC contractor will have visibility on the specifics of the Chinese content requirement and can therefore develop its design, procurement strategy and price accordingly. In these circumstances, any failure to meet the Chinese content requirement should be an EPC contractor risk under the terms of the EPC contract. There is a strong argument that the EPC contractor will be best placed to manage this risk in any event. We have set out above the key requirements that lenders are likely to seek under terms of the EPC contract in the context of a western debt solution, but it is recognised that these requirements may not always be achievable. Each project will see different positions that the EPC contractor will look to push back on, usually because it has not adequately priced for the risk in question. Whilst the obvious answer would be for the EPC contractor to price every risk, the real concern will be the extent to which

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unknown risks can be priced sensibly without an unacceptable amount of contingent. Whilst the EPC contractor may be willing to offer a single point of responsibility, the price on offer may not be acceptable to the Sponsors. In these circumstances, the Sponsors must consider how they will provide lenders with reassurance that the risk or risks in question can be managed by the Sponsors themselves. In the alternative, the Sponsors may wish to consider use of a different contracting structure, and we will consider this option in further detail below.

Bribery Act new legislation for companies with UK links

Whilst not an issue that will directly affect the financing of a mining project or more generally its economic viability, Sponsors incorporated in the UK or carrying out business or any part of their business in the UK should be considering very carefully the requirements of the Bribery Act 2010 (the Act). The Act will make it a criminal offence, for persons to whom the Act relates, to bribe another person or to be bribed, but perhaps most significantly it also introduces a new criminal offence for corporates of failing to prevent bribery. Corporate entities can be guilty of this offence if an associated person, which given the scope of this definition is likely to include any EPC contractor or operator, carries out an act of bribery when acting on their behalf. It is important to recognise that the associated person does not need to be incorporated in the UK or indeed have any business connection with the UK. The only defence for an entity being prosecuted for failing to prevent bribery is to show that it had adequate procedures in place designed to prevent bribery being carried out on its behalf. Whilst the precise meaning of adequate measures is not clear, the UK Government has made available guidance as to the key principles to be followed.

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Given the significant scope and extraterritorial reach of the Bribery Act, it will be extremely important for Sponsors to firstly ensure that they have robust internal policies in place to guard against bribery and secondly to ensure that its supply chain members have robust anti-corruption compliance programmes and are subject to appropriate due diligence and monitoring. Specific advice should be sought by Sponsors having any particular concerns about the scope and implications of the Act.

EPC contracts key point summary

In terms of delivery of the detailed engineering and construction phase of a project, Sponsors should, and lenders will, look for one financially robust party to accept full responsibility for the delivery of all aspects of the works on time, on budget and to meet the required technical and performance specification. In achieving this single point of responsibility position there will be reduced risk that: there may be gaps in liability cover; there may be interface issues when it comes to identifying the party responsible for a failure; or the party identified as being responsible for a failure can not be held to account either because its liability is limited contractually or more generally because it does not have the balance sheet to meet the liabilities in question. If the single point of responsibility position can not be achieved, and on the assumption that lenders accept this, the Sponsors must consider how they will themselves manage the risk(s) in question and in particular the concerns identified above. The Sponsors should at an early stage plan for the management of the relevant risk(s) and obtain board approval to the provision of additional security (as may be necessary) and the financial support that may be required upon materialisation of the risk(s) in question.

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The lenders will have key requirements in terms of: the obligations on the EPC contract to deliver the works on time, on budget and to meet a required technical and performance specification; and the recourse available against the EPC contractor to the extent that it fails to discharge its obligations under the terms of the EPC contract. The preferred EPC contractor should be procured on the basis that these key requirements will be included in the form of EPC contract eventually signed. This will allow for certainty of EPC price at the conclusion of EPC procurement process and will mitigate the likelihood of price escalation following EPC contractor selection.

EPCM contracts
General
The acronym EPCM is commonly mentioned in the same breath as the EPC structure described above. However, from both a structuring and risk allocation perspective, the two contracting solutions are fundamentally different. The confusion would appear to come from the shared use of the work construction in their titles. It is important however to recognise that an EPCM contract is (amongst other things) essentially a design and construction management contract and that no physical construction will actually be carried out by the EPCM contractor. The EPCM structure has been used extensively in the mining sector, especially in the years leading up to the global financial crisis (GFC) where the lending market became more contractor friendly in terms of both risk allocation and pricing. However, post GFC the lending market has hardened and the liquidity gap has meant that lenders are now increasingly risk averse and far more selective about the projects they are willing to back. For the reasons set out below, the EPCM structure has tended to be less attractive to lenders in the form typically employed in the mining sector

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and so more challenging to achieve a project financing. We will however consider below what the writers see as the likely requirements needed to bring an EPCM solution to market and importantly to attract project finance.

The EPCM structure

In contrast with an EPC contract (and as mentioned above), the EPCM contractor does not undertake primary responsibility for delivery of the construction works. The EPCM contract is essentially a professional services contract under which the EPCM contractor will typically carry out the following services: Engineering services the EPCM contractor will typically be the party producing the basic design at feasibility stage or will be appointed post feasibility under the terms of the EPCM contract to complete the basic design developed by or on behalf of the Sponsors. The EPCM contractor will typically be responsible for overall co-ordination of design for the project to ensure that the completed works meet the required technical and performance specification (but note Appendix 1 descibing the limited liability typically accepted by EPCM contractors in this regard). Procurement services the EPCM contractor will be responsible for the overall procurement strategy and will source contractors, consultants and the necessary plant and equipment in accordance with the Sponsors requirements and the assumptions established at feasibility stage. The EPCM will advise on the timing of the letting of the relevant packages and will advise the Sponsors on the terms available and will negotiate the contract packages on the Sponsors behalf. Construction Management services the EPCM contractor will typically be responsible for overall management of the carrying out and completion of the works. This will include the co-ordination of the works and services being procured on the Sponsors behalf to achieve completion of the works in accordance with the project schedule, the project budget and to meet the required technical and

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performance specification (but again, note Appendix 1 and the limited liability typically accepted by EPCM contractors in this regard). The construction management services will also typically include the management of health and safety at the site, the establishment of quality assurance systems and the management of the remedying of defective works and or services provided by other parties. Many mining clients are adopting a slight variant to the EPCM arrangement which is essentially a split EP & CM structure. Under this variant the Sponsors will appoint a firm generally with greater expertise in engineering design and, possibly procurement, as the EP Contractor. Sponsors then appoint a specialist construction management firm to appoint and manage the trade contractors and the rest of supply chain (including the engineering designer). This assists getting lenders comfortable that an appropriate party will be in place having expertise in procurement to ensure the best chance of success and avoiding cost overruns. Whilst the EPCM contractor will negotiate the terms of the contract packages, whether for delivery of works, services or the provision of plant and equipment, it is the Sponsors that will enter into direct contractual relations with the relevant third parties and assume the rights and obligations under the relevant contracts. For reference, we have set out below the typical EPCM structure.
EPCM contract

Mining company

EPCM contractor

Ccontractor A

Contractor B

Contractor C

Figure 2 typical EPCM contracting structure

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It should be noted that we have structured arrangements for clients where the EPCM contractor actually enters into all of the trade contractor on behalf of the sponsors. The reasons being for particular project specific ECA coverage reasons. However, the EPCM contractor will, if well advised, insist on back to back protection for all liabilities under the trade contracts. As we have indicated above, the EPCM structure may be considered by Sponsors where the single point of responsibility EPC structure can not be achieved or is not attractive for one reason or another. This may be because: The securing of the single point of responsibility EPC solution may expose the Sponsors to inflated pricing which may have an impact on project affordability and which may not be considered by the Sponsors to offer value for money; There may be a general lack of appetite in the market to take on the project in question on a turn key EPC basis; The Sponsors have a good track record in project delivery and have a large internal management resource and as a result prefer to adopt the EPCM structure to significantly reduce overall outturn cost and increase equity returns. In the context of a mining project, the EPCM contractor will typically be the party developing the basic design at feasibility stage. This party will then be retained to develop the final design and to provide the other relevant EPCM services for the construction phase of the project. This structure will obviously generate continuity in design responsibility throughout works planning and implementation and will typically allow for greater employer influence in design evolution than would otherwise be available under the EPC structure. In considering the use of an alternative structure (and on the assumption that an EPC structure is otherwise achievable) the Sponsors will typically

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balance, amongst other things, the increased cost and reduced equity return that is likely to accompany use of the single point of responsibility EPC solution against the corresponding key benefits, namely, price certainty for project delivery and the increased likelihood of securing project finance. If the negatives of the EPC solution outweigh the positives, Sponsors may be inclined to consider use of an alternative contracting structure. EPCM and bankability The fundamental point for the Sponsors to consider will however be the extent to which the EPCM solution may be considered bankable by potential lenders. A key difference between the EPC and the EPCM solutions is that the EPCM solution does not offer a single point of responsibility for delivery of the works. There will be multiple interfaces which must be carefully managed by the EPCM contractor and the Sponsors and there will remain a risk that there may be gaps in liability or that a party identified as be liable for a failure will not, on its own or collectively with other culpable parties, be willing to accept the measure of liability typically recoverable by Sponsors when using the EPC structure. The provisions of the EPCM contract, in terms of both scope (as identified above) and liability for the services provided, will differ fundamentally from the terms seen in a typical EPC contract. To illustrate these differences, we have provided at Appendix 1 to this guide a comparison between the key lender requirements under the EPC structure and the corresponding terms and risk allocation typically achieved in the context of an EPCM structure. The reader should note that the summary at Appendix 1 provides only a high level overview for the purposes of comparing the risk allocation typically seen under the EPC and EPCM structures. There will of course be exceptions to these positions on a case by case basis. To provide a more detailed picture, we provide our clients with EPC and EPCM risk matrices that essentially show the positions taken on the key risk issues on recent projects closed in the mining sector. These invaluable tools

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allow us to quickly identify the market position on any given risk and more particularly show how a particular risk allocation has been banked (if at all). From the high level summary at Appendix 1, it is apparent that the usual risk profile under the EPCM solution is far less favourable from the Sponsors (and ultimately the lenders) perspective when compared with the position typically secured by Sponsors under the EPC structure. It is easy to see why lenders prefer the certainty and security that comes with the EPC solution and also why many of the key principles under that solution should gain support from the Sponsors. However, whilst risk allocation considerations are very important, Sponsors will also be looking at the commercial imperative of (a) bringing a project to market where, for instance, the EPC structure is not achievable and, (b) maximising equity returns from the project by securing a significantly lower construction cost. EPCM key requirements We will consider below the more robust Sponsor approach to risk transfer typically adopted in other sectors, such as the petrochemicals sector, where the EPCM solution remains a popular contracting structure for project delivery (although not always on a project finance basis). On the face of it, there would seem no reason why a similar more Sponsor friendly approach to risk transfer should not be pursued in the mining sector. If the EPCM solution is to be considered, it will be important for the Sponsors to first satisfy themselves and ultimately the lenders that the proposed solution can offer a robust structure for project delivery. The following requirements will, in the writers view, be key to demonstrating a robust EPCM structure best equipped to secure project delivery: The selected EPCM contractor should be a robust experienced organisation with a strong track record of securing project delivery on an EPCM basis in the mining sector. The terms of the EPCM contract should reflect an appropriate risk transfer to the EPCM contractor.

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In view of the more limited liability typically accepted by an EPCM contractor under the EPCM structure, the Sponsors should appoint a full time experienced and well resourced internal team to monitor and manage the execution of the project in order to ensure that the Sponsors key requirements are being achieved and to permit early identification of issues that may impact on project delivery. There should be developed a clear internal strategy for the management and resolution of all risks retained in part or whole by the Sponsors. The contractors, service providers and equipment and plant suppliers should also be robust entities with experience and a track record of project delivery in the mining sector. Where possible, these contracts should be finalised on a fixed price basis with any limits on liability and security requirements being appropriately determined in accordance with the role assumed by the relevant party. The Sponsors should identify possible interface issues and put in place an appropriate mechanism to co-ordinate the completion of the works and to address the allocation of risks that may impact on delivery of the work. This mechanism should provide for prompt resolution of the relevant circumstances in a manner which does not detract in any material respect from project delivery. Whilst the points identified above will be important in developing robustness in the structure for project delivery, there is little doubt that potential lenders will seek from the Sponsors security for the residual risks that may be retained at Sponsor level under the EPCM solution. The nature and extent of this security will really depend on the lenders view on the robustness of the project structure. Provided Sponsors are comfortable with the robustness an EPCM structure and the key requirements listed above can be achieved, the contracting freedom under a Chinese debt solution may make this financing option more attractive, especially where security requirements for delivery of an EPCM and an EPC solution may not be substantially different.

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A more robust view on EPCM risk transfer

As Sponsors and contractors operating in the mining sector are usually large sophisticated entities, it is perhaps surprising that the approach taken to risk transfer in the context of EPCM solutions has remained relatively simplistic in nature when compared to the approach taken in other sectors. Given that the role of an EPCM (or EP&CM) contractor will be fundamentally different to that adopted by an EPC contractor and given, as a consequence, the significantly lower price paid for EPCM services when compared with that payable under a typical EPC contract, the wholesale transfer of risk from the Sponsors to the EPCM contractor will not be appropriate. However, use of more innovative ways to transfer risk to the contractor, without necessarily seeing a dollar for dollar pricing consequence, deserve more serious consideration in the mining context. Whilst use of these solutions will not, in themselves, secure a bankable position for the Sponsors, they will however create a more robust EPCM structure by ensuring that the EPCM contractor has skin in the game and is further motivated to secure project delivery in accordance with Sponsor requirements. Incentivisation The key aspect of the EPCM risk allocation in other sectors is the concept of incentivisation. Although sometimes seen in the mining sector, the nature and extent of its use is not of the order of that seen in other sectors. It is not really apparent why this is the case and the writers would simply put this down to Sponsors and contractors following approaches used previously. With no international standard form EPCM contract, there has previously been no real impetus to shift away from market practice. However, given the liquidity gap and the bankability issues discussed in this guide, it is perhaps clear that this approach requires a re-think.

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Incentivisation provisions will typically provide for EPCM contractors accepting financial risk and reward in the achievement of key project requirements, including, completion of the works within the agreed project budget, completion of the works in accordance with the project programme and the final works achieving key performance and other quality requirements. Again, we produce for clients risk allocation matrices demonstrating in more detail how key risks are allocated through incentivisation provisions under the EPCM structure in other sectors. Whilst these risks are not passed to the EPCM contractor in full, the EPCM contractor will be accepting a degree of liability in the relevant risk, so will be more motivated to manage it. The key point to understand is that the EPCM contractor will be responsible for the financial downside of the incentivisation provisions irrespective of whether it has used reasonable skill and care in managing the risk in question. There is therefore a clear imperative for the EPCM contractor taking ownership of the management of the risk in question from that date of contract to secure project delivery in accordance with the Sponsors requirements. There would ordinarily be concerns that the EPCM contractor will simply price the risk in question on a contingent basis, and this will of course not offer value for money for the Sponsors, particularly if the risk never materialises. These concerns however tend to be mitigated by the fact that the EPCM contractor s risk in the project will be limited to its agreed profit margin on which there should, in theory, be absolute transparency beyond the actual agreed cost for providing the EPCM services. Conversely, there will also typically be a bonus structure under which the EPCM contractor will receive additional payments for meeting and surpassing key project delivery requirements.

EPCM key points summary

An EPCM contract is essentially a professional services contract under which the contractor will accept no primary responsibility for the carrying out of the works.

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The EPCM contractor will be responsible for: completion of detailed engineering; the procurement of contractors, service providers and plant and equipment suppliers on behalf of the Sponsors; and management of the carrying out and completion of the works on behalf of the Sponsors. The contracting structure under an EPCM solution is fundamentally different to that adopted under a typical EPC solution. Unlike the EPC solution, it will be the Sponsors, not the contractor (but see our comments above where this can be an option), that will enter into contractual relations with the contractors, service providers and plant and equipment suppliers responsible for delivery of the works. The risk profile under an EPCM solution is substantially more onerous from a Sponsor perspective when compared with the EPC structure. In order to attract project finance Sponsors will need to: demonstrate an allocation of risk between the Sponsors and the EPCM contractor appropriate in the post GFC lending market; and demonstrate to potential lenders how the risks retained by the Sponsors will be managed. It is likely, in any event, that Sponsors will be required by any potential lenders to provide additional security in respect of these risks. Given the level of risk retained by the Sponsors under the EPCM structure, it is likely that the level of security required by lenders from the Sponsors will be significant. The level and nature of the security required from the Sponsors will be determined on a project specific basis and will depend on lenders view as to the robustness of the EPCM structure procured by the Sponsors.

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Appendix 1
Note: the reader should note that this summary provides only a high level overview for the purposes of comparing the risk allocation typically seen under the EPC and EPCM structures. There will of course be exceptions to these positions on a case by case basis. To provide a more detailed picture, we provide our clients with EPC and EPCM risk matrices that essentially show the positions taken on the key risk issues on recent projects closed in the mining sector. These invaluable tools allow us to quickly identify the market position on any given risk and more particularly show how a particular risk allocation has been banked (if at all).
EPC risk allocation Typical EPCM position EPCM risk allocation Risk typically transferred to the contractor EPC Contractor to be responsible for completing the works on time. The EPCM contractor will not usually guarantee delivering the works on time and will therefore not usually have responsibility for the payment of delay liquidated damages in this regard. As the delay damages recoverable from the EPCM contractor, and any other Any damages recoverable from other contractors contractors, who are identified as identified being responsible for delayed as being completion of the works, will not responsible typically be of the order recoverable for delayed under the EPC structure (either completion because of quantum or capping of the works, arrangements agreed). will not be Nominal delay liquidated damages may sufficient to cover the be payable by the EPCM contractor to the extent that the design, or other Sponsors potential loss deliverables for which the EPCM contractor is responsible, are delivered in revenue and debt otherwise than in accordance with service costs the project programme. occasioned The EPCM contractor will be responsible by such delay, for managing the overall works the financial programme and any failure to use risk of delayed reasonable skill and care in doing so completion will give rise to liability. Any such of the works liability will usually be restricted to a will ultimately contractual damages claim and will rest with the be subject to the limitations on Sponsors. liability identified below. EPCM

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EPC risk allocation

Typical EPCM position

EPCM risk allocation

Risk typically transferred to the contractor EPC EPCM

Completion of works for a lump sum fixed price.

The EPCM contractor will not usually guarantee the overall outturn cost of the works. The EPCM contract will provide for the EPCM contractor setting the budget and managing adherence to the budget. Any failure by the EPCM contractor to use reasonable skill and care in doing so will give rise to liability. Given the limits on the EPCM contractors liability typically agreed under the terms of an EPCM contract (see below), it is unlikely that liability for any significant cost overrun will be recoverable from the EPCM contractor. In procuring the works, services and plant and equipment supply packages on behalf of the Sponsors, the EPCM should attempt to procure such packages on a fixed price basis. However, this is not always possible. Notwithstanding the fact that fixed price solutions may be achieved, the multiple interfaces will however widen the scope for time and money claims by the third party contractors which will be a Sponsor risk to the extent that the liability giving rise to any such claim can not backed off fully with other contractors. Payments to the EPCM contractor for services performed are typically made on a monthly basis based on actually costs incurred at agreed rates. The parties will usually agree a target final contract price with a capped sharing mechanism for savings and any cost overrun.

The Sponsors will ultimately accept the risk of any material cost overrun.

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EPC risk allocation

Typical EPCM position

EPCM risk allocation

Risk typically transferred to the contractor EPC EPCM

EPC contractor to provide performance guarantees in respect of the completed plant.

The EPCM contractor typically accepts full responsibility for the final design and for it meeting the required technical and performance requirements and will typically be responsible for coordinating the design produced by other parties. Establishing that a performance failure has resulted from the design produced by the EPCM contractor and not from the implementation of such design by other contractors may not always be straight forward. The liability of the EPCM contractor for design failure will however be limited as set out below.

Due to interface issues relating to identifying the party responsible for performance failure and the more limited liabilities accepted by parties under the EPCM structure, it is more likely that the majority of the liability for any substantive performance failure will retained by the Sponsors. The Sponsors (and ultimately the lenders) recourse for recovery of debt outstanding and other losses in a project default scenario will be limited. The residual liability in this regard will ultimately be a Sponsor risk.

Any limit on liability to provide sufficient coverage for recovery of amounts outstanding under the terms of the finance documentation. Appropriate carve outs to be agreed in respect of which the EPC contractors liability will be unlimited.

The EPCM contractors liability will typically be limited to anything from 50-100% the EPCM contract price (which will typically be US$510m) or, as is more common in the mining sector, re-performance of the services. Carve outs from the liability cap are usually limited to those liabilities than can not be limited at law. Sums recoverable from the other contractors in the aggregate (on the assumption that the parties responsible can be held to account) are unlikely to be of the order of sums recoverable from an EPC contractor under the EPC structure.

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EPC risk allocation

Typical EPCM position

EPCM risk allocation

Risk typically transferred to the contractor EPC EPCM /

Security package to include liquid performance security, retentions and parent company guarantees.

Whilst parent company guarantees tend to be procured, it would be less usual for EPCM contractors in the mining sector to provide other liquid forms of security. The EPCM position in this regard is symptomatic of the nature and extent of liability being accepted by the EPCM contractor. The nature and extent of the security package obtainable from contractors, services providers and plant and equipment suppliers will be determined on a project specific basis.

Sponsors accept cash flow risk during the period in which a claim is established against the EPCM contractor and sums for which the EPCM contractor is liable are recovered.

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Contacts
For further information, please contact:
Mark Berry Partner Norton Rose LLP Tel +44 20 7444 3531 mark.berry@nortonrose.com Matthew Hardwick Associate Norton Rose LLP Tel +44 20 7444 5550 matthew.hardwick@nortonrose.com

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